Unorthodox measures from the ECB cannot make up for the underlying design defects of the euroby Paul Wallace / March 13, 2019 / Leave a comment
The euro area has made a dispiriting start to 2019. Gone is the backslapping that accompanied its 20th anniversary on 1st January. As so often in its chequered history, the monetary union appears better at surviving than thriving. But just how bad have things become and what is the root cause of the problem?
For a brief moment, in 2017, the euro area was on a roll as GDP expanded by 2.4 per cent, the highest for a decade. But the sun wasn’t out for long before clouds started to mass. Growth slowed from a sprightly quarterly average of 0.7 per cent in 2017 to a still acceptable 0.4 per cent in the first half of 2018. But then the sky darkened further, as GDP rose by a mere 0.1 per cent in the third quarter and 0.2 per cent in the fourth.
That wrenching deceleration has affected both the weakling and the strongman among the big economies in the euro area. Italy, the third largest but long fragile economy, went into recession as output declined over two consecutive quarters. More unusually, the biggest has powered down, too. Accounting for around 30 per cent of eurozone GDP, Germany has been the mainstay of the eurozone economy since the financial crisis. But the bloc’s powerhouse only narrowly managed to dodge a recession at the end of last year as German output stalled in the fourth quarter after falling in the third.
The introduction of new vehicle emission tests for the car industry contributed to Germany’s economic reverse especially in the autumn. But worryingly, business surveys show that the setback is continuing this year. Although the services sector has picked up, manufacturing, the engine of the German economy, deteriorated further in early 2019. Chiming with the message from surveys, official figures published on 8th March show that new manufacturing orders fell in January by 2.6 per cent, leaving them 3.9 per cent down on a year earlier. And figures out on Monday showed that a broad measure of industrial production fell by 0.8 per cent in January, leaving output 3.3 per cent lower than a year earlier.
The main brake on Germany and the wider euro area has come from sagging trade. For a large economic area, the eurozone is particularly open not just to commerce between its 19 members but to the rest of the world. That openness is double-edged. When global trade is surging, as in 2017, the euro area does particularly well but when exports slow, it takes a knock. Germany’s very success in selling to China has left it vulnerable to the weakening Chinese economy. That downdraft shows no sign of abating as Chinese premier Li Keqiang announced a lower growth target for this year in a policy statement on 5th March.
The trade slowdown and the uncertainties caused by Trump’s trade hostilities and Brexit in turn hurt the eurozone economy by curbing corporate investment. When there is so much uncertainty business leaders tend to put capital projects on hold. In an economic forecast published on 6th March, the OECD said that “policy uncertainty, weaker external demand and lower confidence are likely to weigh on investment” in the euro area.
The picture is not uniformly bleak. For one thing, some parts of the currency union such as Spain, whose industrial production rose sharply in January, are faring better. For another, consumer spending, the main component of domestic demand, should be sturdy enough to avoid outright recession in the euro area. That reflects a greatly improved labour market. Unemployment in January stayed at 7.8 per cent, the lowest since October 2008. Consumers also have more income to spend now that wage growth has picked up. A tilt towards a modest fiscal easing across the euro area as a whole should also help.
Even so, the outlook has worsened sufficiently to prompt a U-turn at the European Central Bank based in Frankfurt. When it ended its big quantitative easing programme in December, the ECB appeared to be starting a journey back towards more normal monetary policy. Instead on 7th March it unveiled yet more measures to shore up the eurozone economy. A first baby step to higher (initially, less negative) interest rates has been put back from this autumn to the start of 2020 at the earliest. And there will be a new round of bargain basement longer-term loans to the banking sector, which will be available with maturities of two years every quarter from this September through to March 2021.
Even though the ECB did more than expected, its latest package of goodies went down badly in the markets. In particular bank stocks took a battering despite the new offer of cheap funding to the banking sector. What rattled investors was the central bank’s decision to push back the date of a first rate rise. Banks hate the current regime of negative interest rates—the ECB’s crucial deposit rate has stood at -0.4 per cent for three years—because it squeezes their profits by compressing the interest rate margin between their lending and deposit rates.
Another reason for investor nerves was that the ECB slashed its growth forecast for 2019 from the 1.7 per cent it had expected in December to just 1.1 per cent (down from 1.8 per cent in 2018). Making matters worse, the ECB said that risks remained on the downside despite the steps it had taken. Mario Draghi, the bank’s president, explained that this was because those risks emanated predominantly from outside the euro area.
The trouble is that the euro area is especially vulnerable to external shocks. Germany, its indispensable hub, which is forecast by the OECD to grow by just 0.7 per cent this year, has long been an export-driven economy. Its reliance on trade has intensified since the euro was introduced, not least since German firms selling around the world can exploit the competitive advantage of what has become an endemically weak currency. Meanwhile other economies such as Portugal and Spain have buoyed their performance since the financial crisis by trading more heavily with countries outside the union.
Most important, the eurozone remains inherently fragile. Despite reforms made during the crisis in the early 2010s to underpin the euro area, it lacks the solid foundations of a fiscal and political union. Under Draghi, the ECB has reinvented itself as a proactive central bank, behaving in a way unimaginable for the architects of the currency union. But monetary policy, however unorthodox, cannot make up for the underlying design defects of the euro.