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Analysis
ECB on brink of egregious policy error

ECB on brink of egregious policy error

Clear warning signs of impending European slump

by Desmond Lachman in Washington

Thu 15 Nov 2018

October's sanguine press conference by European Central Bank President Mario Draghi is reminiscent of the apocryphal story about the captain of the Titanic. When asked why he did not swerve the ship to avoid the iceberg, the captain replied, 'What iceberg?'

Like the Titanic's captain, Draghi sees no need for the ECB to change course from its decision to withdraw monetary policy stimulus by concluding its bond-buying programme later this year. He does so despite growing signs of vulnerability in the European and global economies.

In Draghi's view, Europe is recovering at a satisfactory pace, inflation is rising and the risks remain balanced. But since the ECB's last meeting, clouds have gathered over Italy, the euro area's third largest economy and the world's third largest sovereign bond market. There are clear signs that Italy is on a collision course with its European partners, which could have major implications for the European banking system.

Rome has no intention of acceding to Europe's demands for revisions to its expansive budget. That budget is in flagrant violation of the euro area's rules and threatens Italy's public finances. As underlined by an unprecedented letter of complaint that the European Commission sent to Rome last month, Brussels shows no signs of giving Italy a pass on the euro area's rules for budget discipline.

While Draghi might be choosing to ignore Italy's budget crisis, markets are not. Italian bond spreads have risen to more than 300 basis points and capital is flowing out of Italy at a rapid rate. This risks throwing the Italian economy into yet another recession that would only exacerbate its public debt and banking sector problems.

While Italy would seem to be the most serious risk to the European economic outlook, it is not the only threat. UK Prime Minister Theresa May's government is preparing for the possibility that the UK might crash out of the European Union without an exit deal by end-March 2019, when the two-year Article 50 negotiating deadline expires. Meanwhile, risks of a German economic slowdown have risen because of continuing trade tensions with the US and growing political difficulties in Berlin following Chancellor Angela Merkel's announcement that she will step down from the leadership of the ruling Christian Democratic Union in December.

If it turns out that Draghi is ignoring clear warning signs and the European economy does succumb to a slump, he will not be the first central bank president to make an egregious policy error. In 2008 Ben Bernanke, then chair of the Federal Reserve, dismissed the subprime crisis as a non-event. Jean-Claude Trichet, Draghi's predecessor, went one step further by ill-advisedly raising interest rates in the months immediately preceding the September 2008 Lehman Brothers bankruptcy. Europe in 2018 may yet face similarly debilitating conditions.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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