The President of the European Central Bank Mario Draghi is on his way out. Photographer: Stringer/AFP/Getty Images
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Max Headroom to do whatever it takes.
When European Central Bank President Mario Draghi speaks, markets
usually take notice. Back in 2012, he effectively ended the euro zone’s
sovereign debt crisis by promising to do “whatever it takes” to protect
the euro. His words were so effective that the market never tested his
resolve. The crisis abated, even as the economy went into a long and
slow malaise.
On the face of it, his comments after the ECB monetary policy
meeting Thursday, held this month in Lithuania, were almost as
aggressive as those he spoke in 2012. He was obviously determined to
convince all that he was prepared to be far more dovish if necessary. He
even suggested that he had “headroom” to resort to more quantitative
easing, or bond purchases, if necessary. And yet the market did not take him all that seriously.
The euro somehow strengthened against the dollar, exactly the opposite
of what should happen when a central banker hints at interest rate cuts.
This is partly because Draghi is half way out the door,
as Bloomberg Opinion columnist Ferdinando Giugliano put it. It is also
because the ECB is running out of ammunition. Rates are already low, and
its balance sheet is loaded. It does not have anything like as much
freedom of movement as the Federal Reserve. The need to do something is
clear enough. The euro zone’s economy has not lagged behind the U.S. as
badly as many believe since the single currency came into being in 1999,
but the latest dip, while the U.S. is gaining strength, is concerning.
Another
problem is that inflationary expectations appear to have become
untethered. The German bund market is signaling inflation of less than
0.8% per year over the next 10 years. This is lower than at any point
when the sovereign debt crisis was at its height, from 2010 to 2012, and
approaching its lowest since the euro’s inception. The ECB has another
deflation scare on its hands:
The
Achilles heel responsible for Europe’s relative weakness is its banking
system. The price-to-book multiple that shareholders pay for
bank shares is as good an indicator of this as any. Ever since the first
Greece bailout crisis broke out in early 2010, European banks have
traded at a discount to their book value, and a big discount to banks in
the U.S. This explains why the ECB needs to keep propping up the
banking system with targeted help. But as it wants to avoid moral
hazard, that help cannot be too generous, which is why I found the plans
for the latest “TLTRO” loan program to shore up banks rather
unconvincing.
There
is a decent argument that pessimism towards the euro zone has become
excessive. But with the real possibility that we will have to wait
months to learn the identity of Draghi’s successor – he is due to leave
at the end of October, just when the U.K. is due to leave the EU – there
is a nasty tail risk from the euro zone to look forward to over the
summer.
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