Mario Draghi, the Latin Bloc’s monetarist avenger
The eurozone money supply is contracting at an accelerating pace on all fronts. The broad M3 gauge has fallen for the last three months in a row. A slump is already baked in the pie.
By Ambrose Evans-Pritchard
6:28PM GMT 29 Jan 2012
Credit to households and firms shrank by €90bn in December alone. It is the biggest drop in a single month since the launch of the euro, worse than after the Lehman collapse in October 2008 or at any time during the Great Recession.
One dreads to think what would have happened to Europe’s banking system and to the solvency of Italy and Spain if Mario Draghi had not come to the rescue before Christmas with unlimited three-year funding at 1pc, against almost any collateral: that is to say, if the mad Hayekians had still been in charge of the European Central Bank.
“We know for sure that we have avoided a major credit crunch, a major funding crisis,” said Mr Draghi in Davos.
Let us hope so. In the meantime, great damage has been done. The International Monetary Fund expects economic contraction of 2.2pc this year in Italy and 1.7pc in Spain, with further declines in 2013 – if all goes well.
This will play havoc with debt trajectories. Italy’s debt will rise to 127pc of GDP by next year. Spain’s will rise to 84pc, more than 11pc worse than forecast in September. There will be scant improvement to the budget deficit in either country. So much austerity for so little gain.
For Spain, it means yet more cuts. Citigroup has pencilled in 26pc unemployment this year. This would push the youth jobless rate to around 54pc nationwide, rising towards 60pc in Andalucia.
The bitterness is starting to show. Rodrigo Rato, head of Bankia and a former IMF chief, said the structure of monetary union is rigged in favour of Germany. “When the Germans are in trouble, the other EU members help it, and when the others have problems, Germany takes advantage to lower its own borrowing costs,” he said.
There is a core of truth to this. The ECB set rates too low over much of the last decade to help Germany out of slump, setting off credit booms that destabilized half of Europe. The favour was not returned in mid-2011 when the Trichet-Stark team raised rates even though real M1 deposits were collapsing across Club Med, with consequences that are now painfully apparent.
The IMF has not yet announced its new forecasts for Portugal. If the changes are anything like the Spanish revisions, Portugal’s public debt will peak at nearly 130pc of GDP next year instead of 118pc. This does not include an array of quasi state bodies that push the figure a great deal higher.
Olivier Blanchard, the IMF’s chief economist, blames Europe’s double-dip recession on the twin effects of fiscal cuts and tight credit as banks slash their books in a scramble to meet core Tier 1 capital ratios by June to avoid being nationalized.
“Decreasing debt is a marathon, not a sprint. Going too fast will kill growth. What is happening in Europe is making things worse,” he said. The rush to slash is “leading to a dangerous downward spiral“ for the system as a whole.
“If not contained, this downward spiral can lead to even worse outcomes, be it disorderly default or Euro exit, with major spillovers, first to the rest of the Euro area, and then to the rest of the world,” he said. It took 20 years to slowly purge the excess debt left by the Second World War. The IMF fears it may take even longer this time.
Mr Blanchard is a Keynesian. Those of a monetarist bent are less alarmed by fiscal contraction. I have no doubt that monetary stimulus a l’outrance – the classic remedy of Britain’s Ralph Hawtrey, Sweden’s Gustav Cassel and America’s Irving Fisher in the 1930s – can counter the effects of fiscal tightening if conducted in the right way. The debt-to-GDP burden falls faster that way and deflation is averted, a lesson that Japan forgot.
The great question is whether Mario Draghi is embarking on just such a policy, covertly, through his Long-Term Repo Operations (LTRO), starting with €489bn in three-year loans to 523 banks December and to be followed by another blast in February.
The LTRO is not entirely a free lunch. It is replacing funding that has dried up, but to the extent that banks in Italy, Spain, France and Portugal use the cheap money to buy government bonds at rich yields – the Sarkozy “carry trade” – they are not lending to business, as newly bankrupt Spanair can attest.
“It is a Pyrrhic victory,” says Guy Mandy from Nomura. It has prevented a liquidity shock and brought confidence back from the dead but “is increasingly punitive” because the haircuts on collateral are crowding out the banks’ balance sheets.
The more they use the facility, the more collateral they hand over to the ECB. Since the ECB has senior status, everybody else faces “subbordination”. At some point this dynamic may turn nasty, causing private credit to tighten. Mr Mandy frets about what will happen if Fitch and Moody’s join S&P in downgrading Italy to BBB+, triggering a 5pc margin call.
Fitch did downgrade Italy by two notches to A- with a negative outlook, citing “lack of clarity on the ultimate structure of a fundamentally reformed EMU; the risk of self-fulfilling liquidity and even solvency crises in the absence of a fully-credible financial ‘firewall’ against contagion”.
Yet, monetarists think Draghi is quietly pulling off a remarkable coup. “This is stealth QE: the impact is dulled because they are not making it clear what they are trying to do, but in the end it may ultimately be as powerful as QE in America and Britain,” said Lars Christensen from Danske Bank.
Tim Congdon from International Monetary Research said Mr Draghi had already boosted total credit to banks from €580bn to €832bn since early November, entirely reversing the Trichet tightening of late 2010.
This may rise to nearer €1.5 trillion this year. While it does not lead to a rise in broad money at first (just the monetary base), it is likely to feed through over coming months in complex secondary effects. “My conclusion is that the Draghi bazooka is such an aggressive example of monetary easing that Eurozone M3 growth will run at 5pc or more [annualized] in mid and late 2012.”
“I remain sceptical about the viability of the European single currency in the long run, but the day of the execution has been postponed once again,” he said.
If Mr Draghi really is the Latin bloc’s monetarist avenger, the Germans will find out soon enough. It is Germany that will overheat, inflate, and suffer a “Latin” credit bubble as EMU’s wheel of fortune turns. Europe’s crisis will take on a whole new political turn. But that is a chapter for tomorrow.