As Europe’s leaders are pulled about in a three-way tug of war over fiscal, monetary and reform policies, the EU’s economic situation is so desperate that it should be prepared to break rules and taboos, said senior economists and debt bankers.
Stark disagreements divide the continent – and international experts – on whether Europe needs fiscal austerity or expansion, and whether the European Central Bank should stamp its foot to the floor on quantitative easing.
UK Chancellor of the Exchequer George Osborne weighed in on the side of austerity and structural reform this week. Asked about France and Italy’s moves to delay hitting their EU budget deficit targets, the Chancellor said: “If you have created a whole set of rules for the eurozone to demonstrate your budget responsibility and fiscal discipline, you can’t start breaking the rules at the first test.”
His words may ring hollow: the UK budget deficit, at 5.8% in 2013, is much larger than France’s or Italy’s.
Many wish eurozone countries had the same latitude. Erik Nielsen, global chief economist at UniCredit, said “stupid rules” in the Stability and Growth Pact were constraining countries’ ability to stimulate the economy fiscally.
“It would be very helpful if the Germans would agree to some sort of fiscal stimulus,” said Andrew Milligan, global head of strategy at Standard Life in Edinburgh. “The previous rise of the euro earlier this year has caused problems to the manufacturing sector, and is leading to political responses.”
But German finance minister Wolfgang Schäuble has set his face against deviating from a balanced budget.
“My worry is you have a situation where France and Italy need to do reforms and Germany is reluctant to spend, though German growth is weakening too,” said Alberto Gallo, credit strategist at Royal Bank of Scotland in London.
In the worst case scenario, if the politicians cannot agree on fiscal leeway, the European Central Bank could be forced to do more, angering Germany even more.
But while many financial market participants are baying for quantitative easing, knowing it will push up asset prices, some doubt its efficacy.
“We’re barking up the wrong tree when pushing the ECB to do more balance sheet expansion and quasi-fiscal stuff,” said Nielsen. “There is another instrument, which is straight-up fiscal.”
Germany’s stock of public investment has declined over the last 10 years and with low interest rates, the time was ripe to “build the bridges” and restore this stock, he said.
“If inflation drops further, the ECB will do more, but this is not a debt crisis,” said Gallo. “Yields are under control – the problem is a crisis in the fundamentals of the economy.”
Reza Moghadam, vice-chairman in global capital markets at Morgan Stanley and former director of the European department at the IMF, said: “At the bottom of the problem is a macro supply and demand issue.”
Efforts to restore the health of the banking sector via the Asset Quality Review and stress tests, for which the results are due on October 26, were “a necessary but not sufficient step to generate credit growth,” said Moghadam. “The perception is that [the AQR] will get to the bottom of the problem, transmit balance sheet details to all observers and recognise the extent of the problems. But it’s not the silver bullet.”
Even if banks suddenly became eager to lend, there was “virtually no demand” for credit in the eurozone because companies didn’t see any demand for their products, said Nielsen.
Creativity called for
A severe situation calls for radical action, many believe. Moghadam said there was a precedent for breaking financial rules in time of need.
“One taboo after another has fallen in order to address global financial issues,” he said. “Be it no-bailout, debt destructing or scepticism about banking union. These taboos have all been broken and macro-economic problems require macro and fiscal policies. I think those will come, because there are no clear alternatives.”
One radical idea is to take QE more directly to those who will spend the money fastest – the poor.
Referring to the US’s still “moderate” growth, Federal Reserve governor Dan Tarullo said: “Aggregate demand is probably not unrelated to income distribution, because of the propensity to spend.”
The comment implied that, even after extensive QE, demand remained weak in the US because poorer people had little spending power, while those with plenty of money were more inclined to save it.
“The danger with QE is that it’s not very targeted,” said a French bank official, based in New York. “We have neglected to our own detriment the poorest 40%. Who has benefited from monetary policy? Asset holders, people who own real estate, the equity market. The bottom 30% or 40% have no assets. They are mainly suffering from QE, because of higher property prices. Pensioners’ annuities are going down the drain.”
Even with QE and programmes to buy ABS, central banks were still being too conservative, he said. “Financial institutions are so heavily regulated they can’t assume their traditional role, yet for monetary policy we are still relying on them,” he said.
Since the conventional monetary policy transmission mechanism, through banks and securities markets, was broken, he argued, central banks should circumvent it, by giving money to citizens directly. The banker recalled how this had been done in southern Manhattan to restart the economy after the September 11 attacks.
Milligan said minimum wage expansion might help.
Russian gloom
But underlying all these currents is a nagging doubt. Is there any chance of Europe’s economy picking up while the stand-off with Russia remains unresolved?
Europe should by rights be recovering more quickly this year than last, but instead forecasts have been revised downward. A big part of what has changed is the Russia-Ukraine conflict.
“I’m not sure you can point the finger at Russia,” said Andrew Milligan, global head of strategy at Standard Life in Edinburgh. “It’s only 2% of total trade and much less of the whole economy, so it’s difficult to say that would be sufficient. But it’s true that it has a depressing effect on confidence.”
The deceleration of the Chinese, UK and Japanese economies was also weighing on spirits, he said.
Werner Hoyer, president of the European Investment Bank, though confident overall that Europe can recover, told Emerging Markets this week that tension with Russia was a severe threat.
“For me this is a horrifying development,” he said. “There is so much that has been built up in the last 25 years – we are losing so much wealth and positive effects of peace and cooperation that I’m really worried. I hope reason will prevail.”
The gloomy news from outside the EU’s borders made it all the more clear, Hoyer said, that “consumer and investor confidence is the number one issue in Europe”.