BlogSpot - September 8th, 2014
Economic weakness in Europe remains pervasive, from Germany, France, and Italy. GDP (0 percent), PMI (50.7 percent), and inflation (0.4 percent, see Eurostat) slowed in Q2, bolstering calls for central bank action (see for example EuroIntelligence). Dragghi, in his recent speech, indicated that expectations of future economic weakening and that high unemployment (a point also made by the OECD, as reported by the FT) and slack are now the main factors behind the weakness in prices—i.e., a shortness of aggregate demand.
An extensive policy agenda: from monetary policy to structural reforms
In a series of policy briefs, Bruegel sent its policy recommendations to the new European leadership. They highlight three overarching challenges: growth, institutional reform, and treaty change. Economic recommendations go beyond explicit structural reforms and aggregate demand support with specific recommendations: (i) strict implementation of the EU’s new fiscal rules; (ii) a European investment program of 1 percent of EU GDP; (iii) a reform of the organizational structure of the Troika; (iv) deep financial sector reforms.
Strong actions on the monetary front… The ECB (transcript) cut all benchmark rates by 0.10bp (refinancing rate at 0.05 percent and the bank deposit rate negative 0.2 percent), and announced a purchasing programme of asset-backed securities and covered bonds, triggering a sharp fall in the euro against the dollar (see EuroIntelligence, FreeExchange, and Roubini). The Bundesbank’s Jens Weidmann (Wall Street Journal) opposed the decision, among others.
In Bruegel, Silvia Merler notes a major change in the ECB’s language over both inflation and the economic outlook, emphasizing risks that inflation expectations could dis-anchor and that the drivers of (dis)-inflation are “not exogenous to the Eurozone economy.” In Project Syndicate, Jean Pisany Ferry noted that Draghi broke three taboos in his speech at Jackson Hole–the acceptance of a fiscal-monetary mix, the existence of an aggregate eurozone policy stance as opposed to a country-by-country approach, and the argument that preventing the ECB from acting as a lender of last resort imposes a high price.
Nouriel Roubini describes Draghi’s stance as a kind of Abenomics for the eurozone, with three arrows: an acceleration of the structural reforms needed to boost the eurozone’s potential output growth, a reduction of the drag on growth from fiscal consolidation, and quantitative and credit easing with purchases of public bonds and measures to boost private-sector credit growth.
In terms of details, the purchasing program is expected to be around €500bn. Though there is no indication on the size of the program, the volume of new issues in the ABS market is small, just under €20bn in Q2 (FT). With mezzanine tranches, the ECB only buys the senior tranches—differentiating the program from pure QE. The ABS purchases will include residential mortgage backed securities, and ABS-backed by corporate loans.
Ernesto Ekáizer argued that the expansion of the ECB’s balance sheet did not increase broad money because of banks building up capital in response to regulatory pressure. The ABS program would be a useful remedy. German commentators were particularly critical of the program—Holger Steltzner (Frankfurter Allgemeine) sees a conflict between banking supervision and purchase of the banking system’s assets. Hans Werner Sinn regrets that the measure paves the way for QE to the detriment of savers. Axel Weber (in Handelsblatt) criticizes the decision as ‘implicit state financing’ and low interest rates likely leading to new crises.
The move leaves commentators divided on the usefulness of QE.
In support of QE: Barry Eichengreen (Finanz und Wirtschaft) describes a virtuous spiral of increasing prices, higher spending and positive demand side effects and criticizes the Bundesbank’s desperate attempt to achieve inflation by explicitly welcoming higher wage agreements. Gene Frieda (FT) says QE would work through three channels: the portfolio-balance channel (altering the risk/return trade-off for investors); the expectations channel, and by providing for a single eurozone wide risk free interest rate.
Against QE: Lorenzo Bini-Smagi gives nine arguments against QE: 1. the prevalence of the banking channel in the eurozone; 2. stability in the 5y-5y inflation forward rates; 3. threat of future inflation through QE; 4. potential for asset price bubbles; 5. legal obstacles against monetary financing of government debt; 6. distortion in the relative prices of financial securities; 7. discrimination against net savers; 8. ineffectiveness without structural reforms; 9. lower incentives to reform. EuroIntelligence further writes that proponents have yet to explain how QE can be made to work in a heterogeneous monetary union. Others (Santiago Carbó in El País and Juan Laborda in Vozpópuli, hat-tip EuroIntelligence) argue that QE will come too late to be effective.
A crucial structural reform agenda ahead… In its annual Employment Outlook, the OECD argued that structural reforms, alongside demand stimulus measures, are needed to reduce the number of unemployed, echoing Drahgi’s Jackson Hole speech. Recent recommendations include Mateusz Szczurek’s proposal (VoxEU commented by RealTime Brussels) for an EU-wide investment program of 5.5 percent of GDP to close the output gap in the short term while increasing long-term productivity growth. Funded by EU members and private leverage, it could operate as a special-purpose vehicle under the EIB.
But reforms take time to pay off: Goldman Sachs finds that it can take five years to realize the benefits of structural reforms. According to GS, a one standard deviation change in the direction of lighter employment protection lifts GDP growth by 1.6 percent in the first two years, overall, while product market liberalisation causes an increase of 1 percent boost in output over 5 years. Measuring the degree of liberalization, they find that Germany, the Netherlands and the UK are at the top of the ranking, while Greece, Belgium and Hungary score poorly.
Who’s in charge? The EC’s new organigram
Poland’s Prime Minister Tusk was appointed as European Council President (reuters), and Italian Minister of Foreign Affairs Mogherini as EU Foreign Affairs chief.
The rumor mill is active on the future composition of the Juncker Commission. Euractiv presented a draft organigram, with Katainen at economics and financial services; Moscovici for competition, Oettinger for trade, and no more single market portfolio—adding to the buzz described earlier by Peter Spiegel (FT), New portfolios (including for “better regulation”) are created and Finland’s Jyrki Katainen will also be in charge of financial regulation oversight. Die Welt (hat-tip EuroIntelligence) reports that current Dutch Foreign Minister Frans Timmermans is reportedly to be responsible for basic rights, rule of law and reducing bureaucracy, and to become First Vice President, with veto right on legislative proposals. Other vice presidents include former Finnish PM Jyrki Katainen, to have the portfolio for ‘Growth and Jobs’, and Pierre Moscovici as Commissioner for ‘Economic and monetary affairs’.
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