European policy-makers have been moving towards a dangerous state: optimism.
At the annual meetings of the International Monetary Fund and the World Bank in Washington earlier this month, the halls and corridors were full of talk of 17 continuous quarters of euro area growth, falling unemployment and improved debt profiles.
The better picture is welcome and overdue. It stands in contrast to a gloomier assessment of the UK’s prospects in the light of the sluggish pace of negotiations to leave the European Union.
However, partly reflecting potentially adverse monetary circumstances in the US and Europe, the next two years are likely to bring increased euro area attrition. Unless the European Central Bank can find a way to raise interest rates in the next 12 months, Europe may run out of conventional monetary instruments to counter the next economic downturn in perhaps two years.
Such an unfavourable juxtaposition would raise intense pressure for further quantitative easing in Europe, just at the time when it becomes virtually impossible because of opposition in Germany.
This would be highly uncomfortable for Jens Weidmann, president of the Bundesbank, as he gears up for the candidature as a possible successor for ECB President Mario Draghi in November 2019.
There are plenty of indications that Weidmann wants the top ECB job, in spite of warnings that it could be a mistake. The Bundesbank chief has long opposed the ECB’s €2tn QE programme practised since March 2015. However, in view of continuing worries about the strength of the upturn, weak inflation and fragility in indebted southern states, the 26 October gathering of the ECB governing council is widely expected to prolong monetary easing into 2018 and delay any tightening of the bank’s negative deposit rates.
One of the main factors spurring Weidman’s possible nomination is that, as a monetary hawk, he would be an ideal figurehead to preside over a reduction of the ECB’s swollen balance sheet, now 40% of euro area GDP. However, if the US enters a recession in the next few years with damaging effects on Europe, Weidmann could arrive in the top European job at a time when the ECB’s long-foreseen balance sheet normalisation proves infeasible.
The US, after a long upturn, may enter recession in 2019, according to well-canvassed opinion in New York and Washington, with short-term US rates around 2%, leading the Federal Reserve to cut rates immediately to zero and restart QE after three years of ‘normalisation’.
An indication of the Fed’s preparations came in comments by Janet Yellen, the Fed chairman, in Washington on Friday: ‘We must recognise that our unconventional tools might have to be used again… A significantly less severe economic downturn than the great recession might be sufficient to drive short-term interest rates back to their effective lower bound.’
If that happened, the ECB would be in an intractable position. QE would have ended in 2019, but ECB balance sheet normalisation would not have begun, and interest rates would still be negative, with continued detrimental effects on European banks’ profitability. Against this background, in view of the difficulty of cutting interest rates further, the ECB would have little alternative but to consider restarting QE – but would encounter ever greater political resistance. The German parliament, reconvening today after the 24 September general election with the anti-euro Alternative for Germany (AfD) and the eurosceptic Free Democratic Party making up nearly 25% of seats, will scrutinise the ECB’s monetary manoeuvring far more intensively than hitherto.
The FDP is negotiating with Chancellor Angela Merkel’s conservative Christian Democrat-Christian Social Union grouping and the Green ecology party over forming a three-party coalition that will take at least until the end of the year to assemble. Both the FDP and AfD will highlight the German constitutional court’s announcement in mid-August that it finds ‘important reasons’ for believing that the ECB’s QE contravenes the European ban on monetary financing of budget deficits.
The constitutional court has asked the European Court of Justice to answer key questions before a verdict next year. In a widely overlooked part of the announcement, the court has pointed out that Germany could be liable for large financial risks stemming from possible losses by other national central banks’ purchasing their countries’ government bonds. The German government and the Bundesbank believed they had ruled this out when the ECB decided QE in January 2015. A clash between the ECJ and the constitutional court could lead to legal action between the German government and the ECB.
All this poses considerable headaches for Weidmann. But, driven by the sense that it is time for a well-qualified German to take the top role, he may find he has no choice but to remain a significant candidate for the ECB post.
David Marsh is Managing Director of OMFIF.