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Analysis
Europe’s distant ‘grand bargain'

Europe’s distant ‘grand bargain'

Trapped in intersecting vicious circles

by David Marsh

Mon 26 Sep 2016

The need for a ‘grand bargain’ in Europe to relax fiscal policy and tighten the European Central Bank’s monetary stance is becoming greater than ever in the face of lacklustre growth, high unemployment and anti-governmental ‘populism’. But the chances that this will happen are diminishing, as a result of increasingly hazardous political constraints on necessary Europe-wide action.

Europe is trapped in intersecting vicious circles where ending the ECB’s easy money policies would unleash financial market turmoil, yet continuation risks widening the political and economic fragmentation the ECB is trying to overcome.

At the end of a relatively calm summer for the member states of monetary union, the threat of a mishap plunging the euro bloc into new turbulence seems as high as at any time since the unrest over Greek debt in July-August 2015.

In February, I outlined the need for Mario Draghi, the ECB president, and Wolfgang Schäuble, Germany’s finance minister, ‘to seal a monetary and fiscal compact to guide Europe out of crisis’. The suggestion was that they ‘should engineer tighter euro-wide monetary policy and simultaneously loosen fiscally’.

Seven months later, finding ways of reining back controversial plans for more ECB government bond asset purchases (quantitative easing) is more necessary than ever. This reflects a widespread perception that a combination of QE and negative interest rates is promoting financial instability, impeding banks’ lending ability, destroying pension funds’ long-term viability, and undermining central bank independence.

However political difficulties in key countries heavily circumscribe Europe’s cohesion. Amid an upsurge of support for anti-establishment parties exploiting disillusionment with European policies, all five leading euro economies – Germany, France, Italy, Spain and the Netherlands – confront electoral jousts of various kinds in the next 12 months. Tensions across the European Union following June’s British referendum vote to withdraw further exacerbate these vulnerabilities.

Chancellor Angela Merkel’s growing weakness – symbolised by the entry of the anti-immigrant, anti-euro Alternative for Germany (AfD) party into 10 of Germany’s 16 regional parliaments – has increased Germany’s desire for rigid application of monetary union rules. Mistrust over the effects of diluting state aid limits for troubled banks is having a big impact on the quest for a systemic solution for Italy’s chronic banking problems, exacerbated by 20 years of sub-standard growth and the latest downwards revision of the country’s prospects.

Some observers question whether Europe’s vaunted move to banking union has left the euro area in a limbo, by taking away national means to recapitalise or clean up problem banks without substituting an adequate European mechanism for these actions.

With Schäuble openly blaming Draghi’s policies for fomenting the AfD surge, the disturbed environment crucially restricts the ECB’s room for manoeuvre.

The dilemma for the ECB is that, in the absence of complementary support measures from governments, raising interest rates or ending its €80bn a month bond purchase programme would provoke a financial market sell-off and a further fall in economic confidence.

Yet continuing easy money measures risks intensifying support for AfD, reducing the ECB’s already worryingly low standing in German public opinion and constraining Merkel’s ability to offer Draghi assistance vital for his and the ECB’s credibility.

ECB committees are examining various models for possibly extending QE beyond March 2017. The ECB is likely to decide in December what to do next, based partly on the inflation outlook. QE extension – even in modified or 'tapered' form – would require the ECB to overcome self-imposed hurdles on bond-buying designed to prevent the mechanism from becoming overt monetary financing.

But, given the political and technical complexity of the issues being considered, all of these measures will be contested and controversial.

David Marsh is Managing Director of OMFIF.

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