Delayed tightening, poisoned chalice
European Central Bank: pivotal but vulnerable
by David Marsh in Berlin
Mon 16 Apr 2018
An unpleasant cocktail of monetary circumstances is starting to bubble up in the heartlands of Europe. Financial markets may be about to suffer from a repeat of previous policy upsets.
The concerns focus on the European Central Bank, the centrepiece of efforts to shore up European stability. An edifice of solidity displays symptoms of astonishing vulnerability.
Exact historical reprises are rare but there are unsettling parallels with the past. The warning signals include indications of Franco-German strains, signs that central banks on both sides of the Atlantic may be dangerously delaying necessary interest rate rises, and an incipient row over who takes over as ECB president when Mario Draghi leaves at the end of October 2019.
The main worry reflects the likelihood that President Donald Trump, enacting procyclical tax cuts when the US shows accelerating growth and full employment, will force the Federal Reserve to brake credit more sharply than expected. The result could be a US recession in two to three years when, particularly in Europe, governments and central banks will be running perilously low in downturn-beating fiscal and monetary ammunition.
The ECB, 20 years old on 1 June, forms the pivot in the fragile construct of European integration. Partly responsible for the disastrous monetary imbalances of the euro's first 10 years, the ECB stepped in to rescue the benighted southern debtor countries. It then promoted euro-bloc recovery through generous cuts in interest rates and a huge outpouring of liquidity, opposed by the Bundesbank. The measures have fuelled German growth and boosted employment but are deeply unpopular with many Germans who believe (probably rightly) they will end up paying for it all.
Moreover, the view that the ECB will somehow stand behind Italy is the single biggest factor protecting Italian bonds from sell-off following the country's Eurosceptic March election swing.
The story is unlikely to proceed benignly. French and German policy-makers are engaged in mutual cajoling bordering on blackmail.
Two not-so-subtle Parisian threats face Chancellor Angela Merkel's fractious, freshly constituted coalition. First, the Germans must reinforce the institutional structure of monetary union – by providing guarantees and funds to alleviate budgets and support banks – or otherwise face further unpalatable pressure for the ECB to bail out debtors again in the next downturn.
Second, unless Berlin helps Emmanuel Macron underpin pro-European ideals, the reformist French president will be swept away by an anti-euro rightist in the next presidential poll in 2022.
Balancing this is still direr menace from Berlin. If France pushes Merkel too far, anti-European forces in Germany seen with the rise of the far-right Alternative for Germany, now the formal Bundestag opposition, will grow further.
The Bundesbank is in a tangle. In the last 18 months it has held back from habitual vociferousness about loose money. This is partly because Jens Weidmann, the president, is in a structural minority on the 25-strong ECB governing council. And it is no secret that he is campaigning (though with only half-hearted Berlin backing) to replace Draghi.
Weidmann is acceding to the ECB's hazardous hesitation in tightening money, even though he regards the foot-dragging as morally distasteful and economically unsafe. Yet for all Weidmann's intellectual standing and diplomatic demeanour, the Bundesbank's record may stop him winning the European backing to run and potentially quell the institution that many Germans (with some legitimacy) believe needs reining in.
Disruption will ensure when the ECB – reacting to Fed tightening – is finally forced to squeeze credit. The process may start in a small way in Draghi's final months, but his successor will bear the main burden. There are parallels with when the Bundesbank slammed on the brakes far too late in August 1991 after delaying interest rate rises during German unification. The outcome: Italy and the UK left the exchange rate mechanism in 1992. Nearly all the other countries devalued against the D-Mark, pushing Germany into recession.
Tactical power-play over the ECB raises eerie memories of January 2011. Merkel privately told Axel Weber, the Bundesbank president, that she would back him for the ECB presidency to succeed Jean-Claude Trichet, but he would complicate her European tasks. Weber withdrew his candidature, Draghi got the job and Weber became chairman of Swiss bank UBS.
Whoever becomes ECB chief in 18 months will inherit a poisoned chalice. Whatever his superficial ambitions, Weidmann must, in his heart, be hoping it won't be him.
David Marsh is Chairman of OMFIF.
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