Thursday 18 April 2019

Light at the end of the tunnel, but it is an oncoming train of crisis

Two years ago, we were promised a 'seismic shift' and a 'game-changer'. So what happened, asks Colm McCarthy

ECB chief Mario Draghi
ECB chief Mario Draghi
Financial markets.

COUNTRIES with heavy debts and deficits have an urgent interest in economic recovery: it would enhance tax revenues, reduce the pressure on social spending and thus help painlessly to close the budget deficit and stop adding new debt. They also have an interest in avoiding very low rates of inflation.

Debts are fixed in money terms. Even a modest rate of inflation erodes the real burden of debt. If Ireland and other troubled economies in the eurozone could experience economic growth at 2 or 3 per cent per annum, and inflation around the official target of 2 per cent, the sustainability of their debts would be greatly improved and the solvency of their banks would benefit too.

Unfortunately, the prospects for the eurozone do not correspond to this happy picture. Overall economic growth will be no more than about 1 per cent this year on the latest forecasts, lower and possibly zero in some troubled countries and the inflation rate is way below target, again close to zero in several countries including Ireland.

Thursday's announcements from the European Central Bank should be seen against the background of the condition of the eurozone economy.

Recovery is weak to non-existent, especially in the distressed periphery, and the threat of a static or falling price level continues. Mario Draghi, the ECB president, admitted that the inflation rate, which is supposed to be 2 per cent or close to it, will continue to undershoot for the next three years on the ECB's current projections. Inflation has been running below target for more than a year and the ECB expects this to continue through 2016.

At his press conference on Thursday, Mr Draghi looked surprisingly unconcerned about this expected failure to meet inflation targets for four years in a row, involving, in real terms, a substantial transfer from debtors to creditors.

The low growth and inflation problems reflect amongst other things the strength of the euro, the inability of the distressed countries to pursue a looser budget policy and the unwillingness of the stronger countries to do so.

The eurozone does not have a centralised macroeconomic policy, one of the critical design weaknesses in the single currency. If what you actually do is deemed to be your policy, then the combination of tightening budgets and a strong exchange rate is a deflationary policy in the middle of a continuing deep recession. The standard offset is monetary policy: faced with these conditions, the ECB as the only macro-policy actor was under pressure on Thursday to come up with some stimulatory measures. Given the scale of the problems, it has stuck resolutely to the established course: do too little, and do it too late.

Thursday's measures will have only a marginal effect. The interest rate reduction is tiny, for the good reason that official interest rates are already very low. The ECB has declined thus far to follow the route chosen by other central banks faced with the same problem. Central banks in the USA, Britain and Japan have been purchasing financial assets directly, including government bonds and other securities, so-called quantitative easing, or QE. This operates directly on bank balance sheets with the intention of encouraging greater lending to the private sector. Several eurozone countries, including Ireland, would welcome a policy of this type, particularly if targeted at the countries in greatest difficulty.

There is opposition to QE in Europe, in particular from Germany, as well as practical difficulties. Some countries are doing fine, and do not need it. The German economy had a good first quarter, the budget deficit is not a worry and the country is running a large trade surplus. The ECB does not interpret its mandate as permitting policy actions which differentiate between member countries, and so must make policy aimed at what it sees as the average position in the eurozone. Thus it announced some additional provision of liquidity to banks conditional on extra credit advances to the private sector, but available in all countries.

There was no mention of the dreaded f-word – fragmentation – on Thursday. In a proper monetary union, financial conditions are supposed to be the same everywhere, including the availability and cost of credit for business. When interest rates and credit availability begin to diverge,

this is fragmentation, and the fact that it has been happening in the eurozone is due to another design flaw, namely the continuing absence of a full banking union. While government bond yields have converged over the last two years, the fragmentation problem persists at the level where it hurts, namely the provision of credit to enterprises. The net impact of the ECB measures in Ireland is likely to be a further bonus to those (the silent majority) mortgage borrowers on trackers, with adverse effects on the ability of banks to restore profitability.

Meanwhile, the principal threat to economic recovery in Ireland remains the Government's mismanagement of expectations. It is now almost two years since the announcement, at 4am on June 29 2012 after a meeting of eurozone leaders in Brussels that they would "examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme".

This was promptly described by the Irish government as a 'seismic shift' and a 'game-changer'. The implication was that some portion of the excess costs of the bail-in of Irish taxpayers to rescue unsecured bondholders in bust banks, imposed at the behest of the ECB would be refunded. Nothing has happened, and the EU's weasel words were over-interpreted.

The excess spin continued through 2013. The exit from the Troika programme at the end of last year, which saw Ireland draw down the final tranches of €67.5bn in rescue lending from the EU, IMF and bilateral government lenders, was spun by the Government as a restoration of national economic sovereignty.

It was nothing of the kind. It meant only that the providers of emergency lending would lend no more, and that all future borrowing would be from the markets. When the Troika headed for Dublin Airport it left behind a little matter of €67.5bn of debt, which remains due for ultimate repayment. Meanwhile the planned additions to the state debt for this current year alone will be €8bn, with further additions planned in future years.

National economic sovereignty, if that means unfettered access to the sovereign credit market, cannot be restored until such time as the State debt, already 150pc of national income, is seen to be contained and ultimately reducing. That means the elimination of the Budget deficit, still almost 5 per cent of GDP this current year.

The credibility of 'anti-austerity' opposition candidates at the recent elections was greatly enhanced by the premature lap of honour that Fine Gael and Labour embarked on as the Troika departed. After all, if 'sovereignty' has been re-attained, why stick with painful deficit-reduction policies? The official reaction to the election outcome, with broad hints that October's Budget will contain tax reductions, is more of the same.

The Government's news management strategy has also given credence to the notion that the deficit-reduction policies of the last few years have been somehow imposed by the Troika, which of course implies that the Troika's departure should permit a change of course. In reality the path was set before the Troika arrived, when Ireland could still borrow in the markets. Expenditure reductions began as far back as July of 2008 and the programme agreed with the Troika was modelled closely on a medium-term strategy already in place.

The Troika's departure, for slow learners, means that some official agencies, who lent massive sums to Ireland when nobody else would, are no longer available to lend more. It is true that market funding is now available at affordable interest rates, a reflection of the Europe-wide convergence in sovereign bond yields and the elimination of market fears, widespread in 2012 that the eurozone might break up. The reduction in the interest rates charged to Ireland, in other words, is only weakly connected to economic policy and performance in Ireland.

What the markets giveth, the markets taketh away. Permanently benign conditions in European bond markets cannot be taken for granted, and another panic is a continuing possibility. If the restoration of sovereignty is the objective, there can be no relaxation in the battle to close the deficit.

Sunday Independent

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