Bill Jamieson Clash of the titans

COMMENT

BILLJAMIESON | Executive Editor of The Scotsman

Clash of the titans

As a modest recovery struggles to gain traction across the eurozone, a War of the Titans has broken out for the hearts and minds of policymakers.

How can the spectre of deflation be avoided and recovery strengthened? In one corner is Christine Lagarde, formidable head of the International Monetary Fund. In the other is Mario Draghi, head of the European Central Bank. Frustrated at the timid rates of economic upturn, Lagarde has been urging the ECB to abandon what many see is prolonged dithering over monetary policy and boost bank lending by adopting monetary expansion through Quantitative Easing.

But Mario Draghi continues to hesitate. In what resembles a slow motion Dance of the Seven Veils, he continues to hint that a resort to unconventional policy is not ruled out. But action there comes none.

Meanwhile, deflation fears are rising. Few prospects are surely worse than a prolonged period of Japan-style stagnation, the economy barely ticking over as banks are crippled by huge levels of bad debt and households and businesses are averse to stepping up spending.

The good news, for the moment, is that the eurozone recovery is gaining ground. Member economies began to recover in the second quarter of last year following a double dip recession from the end of 2011 to the opening months of last year. Eurozone GDP as a whole still fell by 0.4 per cent over the year but Germany registered growth of 0.4 per cent while French GDP rose by 0.3 per cent. The Italian, Spanish and, especially, the Dutch economies look to have emerged from recession by the end of last year.

Encouragingly, growth is spreading from core eurozone to the beleaguered peripheral economies. And Markit and other surveys suggest that the pace may pick up this year. Germany is expected to remain the bestperforming major country, while France, the Netherlands, Spain and Portugal may grow by around one per cent.

However, the upturn is muted overall, and given high unemployment rates in many of the eurozone’s member states (above 25 per cent in Greece and Spain), worries about deflation, the continued problems in the banking sector and the continued need for austerity, it would be premature to assume that the eurozone’s difficulties are behind it.

And the spectre of deflation looms closer. The fall in March’s inflation rate to 0.5 per cent has sparked calls for ECB action to loosen monetary policy to get inflation nearer to the two per cent target. In response, Mario Draghi has said: “We do not exclude further monetary policy easing. The Governing Council is unanimous in its commitment to using also unconventional instruments.” However, there was no indication of the possible timing of any QE. And Draghi also refused to give details as to how it might work.

“The channels of financial intermediation in the zone are fractured. Until that is fixed, nothing the ECB tries to do will make much difference.”

Doubts persist

The Governing Council could wait some months before any further loosening of policy, if any, to see whether the recovering economy and the effects of low interest rates push the inflation rate towards the target.

The argument for waiting (and waiting) is that, except in the eurozone periphery, incomes are rising faster than prices and the risks of deflation may prove over-stated. In Germany, for example, there has recently been a far from deflationary, and above-inflation, pay settlement between German public sector workers and their Government employers. The deal, which covers 2.1m workers, granted a 3.0 per cent wage increase backdated to 1 March, with a further 2.4 per cent next year.

And according to a leaked ECB internal assessment of QE, the central bank would need to buy assets worth €1 trillion of purchases of euro-denominated securities (or €80 billion a month) to lift inflation by as little as a fifth of a percentage point. This adds to the suspicion that the ECB remains doubtful about the efficacy of QE and suspicious of taking radical QE action.

Asked about the IMF’s calls for monetary easing, Mr Draghi’s reply was regarded as a sharp rebuff. He may have felt it necessary to guard the sovereignty of the central bank. Or it may be that he does not share the urge to activism demonstrated across the Atlantic.

There is a respectable case for scepticism over the efficacy of cheap money schemes. For five years, the response of central banks in the developed world to sub-normal growth rates has been to devise programmes aimed at delivering more monetary stimulus. When these schemes have yielded disappointing results, central bankers have argued that things would have been a lot worse without them and, egged on by market traders keen to enjoy a ride on rising asset values, have sought fresh ways of delivering cheap money. For the eurozone as a whole, the scope for such stimulus looks even more constrained. Says Monument Securities economist Stephen Lewis, “In such circumstances, monetary policy would probably have scant effect in boosting consumer prices. As Mr Draghi laboured to explain, the channels of financial intermediation in the zone are fractured. Until that is fixed, nothing the ECB tries to do will make much difference.” The Titans look set to slug it out for some time yet. n