Why Europe’s success could prove to be its undoing
For once, the European Central Bank has been doing the right thing. Regularly blamed for not doing enough, or being too late with policy solutions, the ECB’s monetary super-stimulus is finally paying dividends. Euro-zone growth is outpacing its Group of Seven (G7) partners and the bloc’s unemployment rate has fallen dramatically. Understandably it is building hopes for sustainable recovery ahead.
Things are clearly looking up after years of economic poor health and crisis in Europe. Thanks to the first quarter’s 0.6 per cent GDP gain, the euro-zone economy grew at its fastest pace in five years, driven by unlikely stars such as France and Spain. Critically, the euro-zone economy has risen above its pre-crisis peak, with growth surging past the US and the UK.
Sadly, the euro zone’s success could easily prove to be its undoing. The more euro-zone growth gets onto a stronger footing, the more it strengthens the case for Germany’s hawkish central bank to put a future block on open-ended ECB easing. Unfortunately, the recovery still needs more careful nurturing to deal with major economic headwinds coming the euro zone’s way.
External risks and internal frictions still pose serious pitfalls for the economy. Slowing global growth, entrenched deflation pressures and deepening financial market uncertainty have enough potential to derail the euro zone’s nascent recovery. The euro zone also needs to chart its way through dangerous political waters. Threatened exits by Britain and Greece out of the European Union could trigger deeply troubling shocks to the euro zone economy up ahead.
While the recovery in growth is clearly welcomed, it is raising concerns in Germany that the ECB is going over the top with too much stimulus. Negative interest rates and vast infusions of quantitative easing (QE) money might have put the euro zone back on track to recovery, but German policymakers are worried that too lax policy will open up the floodgates to overheating and inflation risks down the line. The economy may be getting too much of a good thing.
Upcoming ECB policy meetings could see some brutal confrontation between the monetary hawks and doves. The Bundesbank is likely to press for more monetary stability with no new easing, possibly even calling for a policy taper at some stage soon. In its view, ECB policies have already made enough positive inroads. The banks are lending more and consumer demand is picking up thanks to easier access to cheap credit and stronger labour markets.
The Bundesbank’s key concern is that the euro zone has become overdependent on the flow of easy money and the dilemma is what happens when the taps are finally shut off. Consumers, businesses and financial markets must be weaned off the steroids of super-stimulus before it is too late and the euro zone follows Japan into a similar zombie land of economic stagnation, perpetual deflation and ineffectual policymaking.
ECB doves remain adamant the central bank’s monetary accelerator must stay firmly rammed to the floor. The pro-easing camp believes the euro zone is bogged down by fiscal austerity, high debt, weak bank profits, high unemployment and too much excess capacity in the economy. While ECB President Mario Draghi might have met his pledge to do ‘whatever it takes’ to secure recovery, the argument now is about ‘how much more will it take’ to secure sustainable prosperity longer term.
Right now the omens are not encouraging. Last month the euro zone slipped back into deflation again, the euro zone’s all-important economic sentiment indicator has started to flatline, while German business sentiment indicators are looking more lacklustre. If Germany, the euro zone’s biggest growth driver, loses much more momentum, the chances of the ECB hitting its modest 1.5 per cent growth target this year will be compromised.
As a result, ECB policy is heading towards potential deadlock. The monetary policy meeting in June could prove to be a critical High Noon for rate policy intentions with neither side looking likely to back down. It could end up in a dangerous stalemate.
Any sign of a policy stall is unlikely to go down well with the markets. The US Federal Reserve and the Bank of England are both in ‘wait and see’ mode, while the Bank of Japan is keeping its powder dry in case of emergency. If the ECB looks in any doubt on future easing, it could catapult global risk appetite and world equity markets into a very nasty tailspin.
David Brown is the chief executive of New View Economics