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The ECB's put – explained by Draghi

European Central Bank President Mario Draghi
Francois Lenoir | Reuters
European Central Bank President Mario Draghi

Investors in euro-denominated assets can get very useful insights from important points that European Central Bank (ECB) President Mario Draghi made last week while addressing several committees of the Italian Parliament.

At the outset, Draghi pointed out that the main purpose of the ECB's asset purchase program ("quantitative easing") was to create a more favorable environment for structural reforms.

These reforms are an absolutely essential part of freeing up market mechanisms in Europe's rigid economies and bloated welfare systems. They are supposed to create conditions necessary for steady and balanced economic growth.

The rub is that the short-term impact of these reforms also creates flammable socio-political problems of rising unemployment and falling revenues.

No euro area government has a mandate for such policy outcomes. Those who tried sank to oblivion. Witness the social turmoil and political changes in Greece, France, Italy, Spain and Portugal. All of these countries are currently experiencing a powerful pushback to reforms and austerity policies.

The new leftwing government in Greece got an overwhelming popular vote to roll back most of the socially painful structural reforms and accompanying austerity policies. Last week's regional elections in France showed a similar result. Spain's Podemos party, an upstart anti-austerity movement, is breaking up the country's traditional two-party system, leading to a huge defeat of the center-right government in regional parliamentary elections a week ago. And tens of thousands of people were marching in Rome last Saturday to protest against new regulations introducing a bit of much-needed flexibility to an excessively rigid Italian labor market.

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These are the people Mario Draghi was addressing while speaking two days earlier to Budget, Finance and European Affairs Committees of the Italian Parliament.

"Bread today, hunger tomorrow"

What he said there is that the ECB can help with expansionary monetary policies to ease the (short-term) pain of structural reforms, but that without these reforms the euro area recovery will peter out, bringing the economies back to stagnation, falling output and rising unemployment. [That reminded me of a good old Spanish proverb: "Pan de hoy, hambre de mañana," literally translated as "bread today, hunger tomorrow".]

Elaborating on this argument, Draghi told Italian legislators that the encouraging signs of improving economic activity in the euro area are mainly the result of falling energy costs, cheap credit (and the sinking euro)and favorable effects of structural reforms in some member countries. But he warned that what he sees is a "cyclical recovery" rather than a more sustainable "structural recovery," which rests on flexible markets, rising productivity and an increasing non-inflationary growth potential.

And the sad truth is there. The trade theory's growth-enhancing "dynamic effects" of genuinely free-trade areas don't seem to have done much for the euro zone. Its potential growth rate of 0.9 percent – the sum of a dismal labor force growth of 0.2 percent and a productivity growth of about 0.7 percent -- makes the monetary union, an estimated 14 percent of the world economy, look like a hopeless backwater of global commerce and finance, where the structural unemployment remains stuck at close to 10 percent.

Rome "confidential"

Now, here is where Draghi delivers the punchline: Fiscal policies, banks' balance sheets and the lending to the private sector are inextricably related. He neatly puts together the imperative of credible and sustainable fiscal policies and the ECB's objective of promoting output, demand and employment in an environment of price stability.

The argument runs like this: Bond markets promptly sanction any perception of unsound fiscal policies likely to aggravate budget deficits and public debt, or to violate euro area commitments on deficit and debt targets. Rising bond yields then shrink the value of banks' assets consisting of huge holdings of government bonds. That, in turn, makes banks more risk averse and less inclined to finance consumer spending and business capital outlays.

The upshot is that the entire financial intermediation process – the transmission mechanism of the monetary policy – becomes less efficient or utterly dysfunctional, especially if banks are strictly supervised and expected to pass stringent asset quality and capital adequacy tests.

That is the problem the ECB is facing now. In spite of its virtually free supplies of loanable funds to the banking system, bank lending to the private sector fell slightly last February from the year earlier, but lending to governments continued to grow at a rate of more than 2 percent in the first two months of this year.

Hence the objective of the ECB's asset purchases: Keep euro area bond yields down so that banks' improving balance sheets can stimulate lending to businesses and households to support structural reforms and economic recovery.

It is unfortunate that Draghi's interesting and detailed discussion with Italian parliamentarians got virtually no attention outside the Italian media. His testimony was not even available on the ECB's press service. It almost looked like it was a "confidential" chat with friends Draghi saw the last time in 2009 when he was reporting as the governor of the Bank of Italy.

Investment thoughts

The ECB's expansionary policy is calibrated to serve as (a) a strong offset to restrictive fiscal policies and (b) an effective support to the banking sector's return to its core business of lending to industries and households.

On current evidence of euro area growth (1.3 percent) and inflation (-0.3 percent) developments, the ECB's objective of maintaining its asset purchase programs through September 2016 looks plausible.

Euro area bond market gains have largely run their course. Equities are a better bet in an economy showing signs of a broadening recovery.

Investors, however, should remain vigilant. The continuing excess supply of euro liquidity will keep the exchange rate under downward pressure. That will help exports, but it is also likely to spur costs and prices.

The core inflation rate in February accelerated to 0.7 percent, which means that a 0.3 percent price deflation was caused by collapsing energy prices. Any reversal of energy costs, and a strengthening recovery in an economy which is already growing above its non-inflationary potential, could lead to a rapid revival of inflation pressures and a review of the ECB's policy stance.

Michael Ivanovitch writes about world economy, geopolitics and investment strategy: @msiglobal9