ECB may be running out of stimulus options but France, Spain, Italy are not

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Is the ECB running out of bazookas? The latest data showing weak private sector credit flows in the euro area suggest that might well be the case.

The growth of the broad monetary aggregate, M3, slowed to an annual rate of 4.7 percent in December from a recent peak of 5.3 percent in October. That deceleration was mainly a result of a sharp drop in bank credit to the private sector, which contributed only 0.9 percent to the M3 growth, compared with 1.5 percentage points in November.

A closer look at the euro area's private sector loan demand indicates that lending to non-financial corporations in December virtually ground to a halt, after hovering around an average 0.4 percent annual increase since last summer.

That is a bad sign for business investments because the European firms chiefly rely on bank loans for their plant and equipment outlays. More generally, it also shows that businesses don't see the need to expand their production capacities because their sales outlook is not good.

The leveling out of the consumer loan demand is fully in tune with that subdued mood in the corporate sector. The banks' consumer lending was stagnant in December, and it only grew at an average annual growth rate of 1 percent in the second half of last year.

Is the ECB 'pushing on a string?'

Clearly, the ECB is now looking at a situation where an exceptionally easy monetary policy is not doing much to rev up bank lending, and to lift the euro area economy to a growth rate that would accelerate job creation for 16.7 million people (10.4 percent of the labor force) that are currently out of work.

That is prompting a legitimate concern that the ECB's strategy may be losing effectiveness. Here is what that strategy was supposed to achieve.

The ECB's intermediate policy objective was to provide cheap and abundant funds to the euro area banks to help them strengthen their capital structure by purchasing member countries' government bonds. Once that was done, the ECB expected that banks would step up their lending to businesses and households. And to make sure that they did that, a negative interest rate was introduced on excess reserves (i.e., loanable funds) that banks would hold at the ECB.

Now what?

The ECB says that it will keep pumping money into the system until the euro area economy begins to generate an inflation rate of 2 percent.

TheBank of Japan can tell its Frankfurt colleagues how easy it is to go to 2 percent from a 0.2 percent consumer price inflation in the year to December.

Just think of how long it will take (a) to reduce the euro area's huge labor market slack and (b) to raise a virtually stagnant industrial output to create rising inflationary pressures. The Japanese problem might look like a walk in the park by comparison.

And things may even get worse because the euro area banks' declining equity valuations will make them more reluctant to increase their exposure to businesses and households.

Under these circumstances, the only reasonable assumption is that banks will continue to use the cheap funds supplied by the ECB to finance governments. So far, that has been regular practice. Last December, for example, the euro area bank lending to governments increased at an annual rate of 7.8 percent for the second consecutive month.

Einstein's curse

The question now is: Will "doing the same thing over and over again (i.e., providing more free money to the banking system) and expecting a different result" be a proof of reason, or, as the famous German physicist said, a proof of insanity?

The only way to rescue the ECB's strategy is to see a gradual pickup in the private sector's demand for money. But that can only happen under conditions of rising (personal and corporate) incomes and a much faster employment creation than is currently the case.

In view of that, it is puzzling to note the ECB's strong advocacy of tight fiscal policies and short-run job-destroying structural reforms, when exactly the opposite is needed for its policy to work. Luckily, I believe the ECB will get the opposite of what it wants the euro area governments to do.

Take a case of France. With President Francois Hollande's dismal approval rating of 15 percent, the Socialist government knows that there are no votes in spending cuts or in job losses by giving a free hand to businesses to hire and fire at their discretion. And neither will be allowed.

International factors are very important: BOE
International factors are very important: BOE   

The spending will increase because the government is maintaining a state of emergency and is stepping up security measures. The beleaguered president also wants to raise his profile by expanding military operations in the Middle East and in Central and North Africa. That will not please Berlin's fiscal taskmasters, but Paris won't care. The French will continue to argue that Europe cannot be absent from these crucial battlefields against international terror.

Spain won't go to war, but will be saying a long adios to fiscal austerity and "flexible" labor market policies introduced by the outgoing "ultra-liberales" (i.e., the center-right government) who lost the parliamentary majority in the last elections. An attempt is now under way to form a government on a center-left and extreme-left ("yes, we can") political platforms to step up economic growth, create jobs and reduce poverty and destitution.

Italy has deftly placated German opposition to its tax cuts. Feisty Prime Minister Matteo Renzi has fudged around the edges of politically flammable labor market legislation, while promoting a vote-grabbing tax relief in spite of Italy's huge public debt of 160 percent of GDP.

The official Berlin is keeping quiet, but the German media are furious that Renzi dared to challenge Germany's self-appointed supreme leadership of an unraveling European Union. Some of the hostile German media headlines – "Italien gegen Deutschland" ("Italy vs. Germany") – looked to me like the announcement of a high-profile soccer match.

So, yes, Italians are going to get a tax cut because Renzi wants to shore up his parliamentary majority and to raise Italy's economic and political footprint.

Hailing from Machiavelli's hometown of Florence, Renzi also chose a perfect timing for a full-scale assault on Germany's constant hectoring and, what he calls, "double standard" policies. His killer instinct was spot on, with a France in disarray and Germany humbled by its disastrous migrant/refugee policies. No wonder Germans are fizzing with fury.

And, oh irony, the ECB may also get a respite from Berlin's public lectures if – as some financial analysts pretend - German banks have indeed become vulnerable because of their sharply declining equity valuations.

Investment thoughts

The latest euro area bank lending statistics suggest that the ECB may be running out of its "whatever-it-takes" shots to prop up the economy and to raise capacity pressures in labor and product markets.

The best bet to rescue the ECB's current policy is for the euro area governments to relax their fiscal stance and to take a break from their job-destroying structural reforms. That would be exactly the opposite of what the ECB is advocating.

France, Italy and Spain are easing their fiscal policies under growing political pressures and election agendas. German government spending is also rising as the country struggles to provide shelter and basic public services to seemingly unstoppable migrant/refugee inflows.

Investors should watch carefully how, and whether, these looser fiscal policies are being deployed, keeping in mind that the ECB's "whatever-it-takes" measures can begin to work within a reasonably short time lag only in an environment where a (temporarily) weak private demand is offset by a (temporarily) stronger public spending.

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