Euro area needs more bank lending

Euro logo sign European Central Bank ECB Frankfurt Gerrmany
Ralph Orlowski | Reuters

Here is the euro area's real problem: bank lending to the private sector has been falling at an annual rate of 1.4 percent during the third quarter of this year, despite the fact that banks can get all the money they need from the European Central Bank (ECB), and more, at an interest rate of 0.05 percent.

This should give pause for thought to people calling on the ECB to (over)flood the euro area financial market with massive new liquidity. Indeed, what purpose would that serve at the time when the ECB is trying to get more bank lending from the existing huge volume of loanable funds?

Apart from issues related to the ECB's recent asset quality review (AQR) in the banking system, the cause of weak bank lending is entirely on the demand side: high unemployment and stagnant (real personal disposable) incomes are depressing the demand for money from businesses and households.

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The latest numbers show that things are getting worse. The rate of decline of euro area's consumer and mortgage lending accelerated in September (from dismal levels of a year ago), while business loans were falling at a roughly unchanged pace seen in previous months.

Absurd opposition to ECB's easy policies

Looking at this evidence, it becomes obvious how misguided Germany was for ferociously attacking the ECB's call a few months ago for less restrictive fiscal policies, within the agreed budget deficit guidelines, to support a modicum of euro area's growth, employment and bank lending.

Sadly, pressures for the region's fiscal consolidation are growing more intense. They are also assorted with demands aimed at a systematic deconstruction of the European welfare state that will aggravate poverty and unemployment in the short run – and beyond.

These are the political and economic problems the ECB is dealing with.

France, for example, just got a three-page letter from the EU Commission with a detailed description of demand- and employment-stifling structural reforms it has to implement – as a condition of getting access to the €300 billion investment package the highly-paid Brussels commissioners have yet to figure out how to finance.

The key part of these reforms are more flexible labor markets, a euphemism for easier hiring and firing and all sorts of part-time and fixed-term employment contracts. At the moment, 84.2 percent of all French labor hires are based on loathed CDD fixed-term contracts (contrats à durée determinée).

The rub is that without a permanent job contract you can't even rent an apartment in Paris, or, apparently, anywhere else in France.

Read MoreJob losses and weak demand dent euro zone economy

This example makes it easy to understand the social outrage at radical labor market reforms. The present French government, with record-low approval ratings (somewhere between 15 and 20 percent), and squeezed from left and right, is likely to ignore the demand for further labor market reforms while insisting on its share of any future EU manna.

Italy is another example of a country that is getting nowhere with its reform agenda. Mired in a continuing recession, with a jobless rate of 12.6 percent, 43 percent of unemployed youth, and government's approval ratings falling 13 points so far this month, Italy is experiencing daily protests against the proposed changes in labor protection laws. The three main labor unions – more than 8 million strong -- have scheduled a nationwide strike for December 12.

¡Si se puede! ("Yes, we can!")

With a growth rate of 1.2 percent in the first nine months of this year, Spain looks like a booming euro area country, despite its 24 percent unemployment rate, more than 50 percent of its jobless youth and 30 percent of its working poor earning less than €1,216.00 per month.

With a budget deficit of about 6 percent of the gross domestic product (GDP) expected to be overshot by the end of this year (after a deficit of 7.1 percent of GDP in 2013), Spain is very far from the euro area budget deficit limit of 3 percent of GDP. In spite of that, a number of fiscal stimulus measures have been put forward as the governing center-right party gets ready for elections in late 2015. It is currently running neck-and-neck with a recently launched radical left Podemos ("We Can") party polling at about 28 percent. Podemos is led by a pony-tailed political science professor whose members are chanting President Obama's slogan "yes, we can!"

Germany's weak economy will probably end up with a balanced budget next year, but its center-right and center-left governing coalition will also face growing political challenges. In a historic deal, the three left parties – the far-left party Die Linke, Social Democrats (who are now part of the governing coalition) and the Greens – have agreed last week to form a "red-red-green" government in the federal state of Thuringia.

This may not have an immediate impact on German economic policies, but it could complicate an apparently already strained relationship between Chancellor Merkel's coalition partners.

At the moment, the three left parties (Social Democrats, Greens and Die Linke) have a majority (320 seats, against 311 seats for the center-right CDU/CSU) in the lower house of the German Parliament (Bundestag). Thuringia, therefore, presents a serious political first in a reunited Germany. If Thuringia's new government turns out to be successful, the "red-red-green" movement could spread to other states, setting the stage for a nationwide contest.

That brings up an interesting investment question: could Germany's possible shift toward a center-left government (a) relieve austerity pressures on the euro area, (b) weaken Berlin's opposition to ECB's supportive monetary policies and (c) generate more growth from domestic demand to stop living off its trade partners?

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The rest of the euro area, along with the U.S., would applaud such economic policy changes.

Investment thoughts

Facing a restrictive fiscal stance and unsettling socio-political conditions, the ECB will maintain an easy policy posture for the foreseeable future.

The ECB's recent statements that it stands ready to implement "nonconventional" measures (whatever that means) to prop up the economic activity – and to boost inflation – sound more like a dialog with financial markets than an expression of policy intent.

Markets are already flooded with cheap euro area liquidity. But that is not finding its way down to businesses and households because the ECB's intermediation mechanism (i.e., the banking system) is not functioning properly. That structural hurdle would not be removed even if an additional wave of euro liquidity could get past the ever vigilant German kibitzers.

If the ECB is really keen on "nonconventional" policy measures, it should focus on getting the banks back to their core business.

Meanwhile, the ECB's easy monetary policy is good for euro area equities. A huge investment bonus would also come if Europeans could stop hate, exclusion, killing fields and misery on a continent presumably sworn to peace, solidarity and brotherhood.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.