Christine Lagarde ECB - AP Photo/Michael Probst, File
European equities have risen by 30pc since October. Bourses have shrugged off the collapse of Credit Suisse. They have all but forgotten the spasm of bank contagion last month. The euro is on the march.
Investors are anticipating the softest of soft landings now that Putin’s energy war has fizzled out. Gas futures contracts in Europe are back to pre-invasion levels, though British consumers have yet to see condign relief thanks to the UK’s dysfunctional pricing mechanism.
The European car industry is roaring back. New registrations rose by 29pc in March. You might be forgiven for concluding that Europe’s economy is limbering up for the Roaring Twenties.
The giant spoiler is that the eurozone money supply is in free-fall. The process has been going on long enough to raise the risk of an economic sudden-stop over coming months. European Central Bank data shows that 'narrow' M1 money has been contracting since last September in absolute terms.
Nothing like this has been seen since the creation of the euro. The annual growth rate never fell below zero even during the Lehman crisis and the eurozone debt crisis. Furthermore, the pace of contraction has been quickening, not that the ECB is paying any attention. It abandoned its monetary 'pillar' long ago and embraced the New Keynesian gospel.
“The impact has yet to kick in but it will over the next two quarters. The normal lag is 6-12 months for the economy, and two years for inflation,” he said.
Note the long lag on inflation. The latest CPI horror in Britain is the mechanical legacy of a mistake made by the Bank of England a long time ago. It would be jejune for the Bank to raise rates at this late juncture to chase this effect. It is already in danger of making the opposite mistake.
Is money data in Europe giving a false signal? Perhaps. The pandemic has jammed the indicators. The ECB flooded the system by persisting with quantitative easing for too long, leading to an overhang of excess money. Savers have switched from bank accounts to money market funds in search of higher yields, though not on the scale seen in the US. So yes, there are distortions, but such an unprecedented rate of M1 contraction cannot be ignored.
Monetarists are even more alarmed by the plummeting growth of ‘broad’ M3 money, which matters most for lending under standard monetary theory. This has also turned negative over recent months, foretelling a shrinkage of lending as the banking multiplier goes into reverse.
“Even before the banking turmoil that erupted in March, eurozone credit flows had evaporated, raising the risk of a full-blown credit crunch,” said GianLuigi Mandruzzato from EFG Asset Management.
The ECB’s quarterly bank lending survey in January said the “net tightening in credit standards was the largest reported since the euro area sovereign debt crisis in 2011”. This is particularly damaging in the eurozone where capital markets are stunted and banks still account for the lion’s share of lending.
Yet still the ECB keeps raising rates. German-led hawks are pushing for a further 50 point rise in May. The bank has stopped buying bonds and switched to quantitative tightening (QT). It is retrenching on every front, shutting down €1 trillion of cheap loan facilities (TLTROs) to struggling banks.
A remarkable ECB ‘dialogue paper’ last month on QT in the eurozone said the institution “should think more carefully” about the risks of draining reserves too fast and setting off bank runs. “The ECB should be extremely careful about the interaction of QT with the unwinding of its TLTROs,” it said.
The paper leaves no doubt that “political and legal” motives are driving the process, not economics. The ECB wants to clean up its balance sheet and fight (valid) perceptions that it has degenerated into a fiscal agent for Club Med governments. It is being done to placate the German constitutional court and to avoid a eurosceptic tantrum in Northern Europe.
Any number of things could set off another eurozone crisis. A crash in commercial real estate is one. A bigger and less understood danger is spelled out in the International Monetary Fund’s Stability Report: what happens when the Bank of Japan scraps its policy of holding down bond yields, as the new governor is itching to do? The move could trigger a vast and sudden repatriation of Japanese funds, reversing the world’s biggest carry trade overnight.
The Japanese have accumulated $5 trillion of foreign portfolio assets, mostly debt, and much of it in Europe. Their share of each bond market is: Ireland (15pc), Netherlands (11pc), France (7pc), Belgium and UK (5pc), Spain and Italy (4pc), and Germany (3pc).
The eurozone never sorted out its fundamental problems. It never completed the banking union, needed to break the doom-loop of banks and sovereigns, each dragging the other down in a self-feeding crisis. Germany and Italy could not agree on terms even when Mario Draghi was Italy’s premier. Compromise is near hopeless with a hard-Right coalition in Rome.
The northern creditor states never signed up fiscal union, the sine qua non of a viable monetary union over time. There was a one-off burst of joint bond issuance during the pandemic but Emmanuel Macron’s hopes of turning this into a proto-EU treasury have been dashed by Berlin. Germany refuses to share its credit card with France and Italy.
“Fiscal integration is a super-tough nut to crack in Europe because it is intrinsically linked to national sovereignty and democracy,” said Jeromin Zettelmeyer, director of the Bruegel think tank in Brussels.
“We thought for a moment that it was some kind of ‘Hamilton moment’ but clearly it was not a permanent game-changer. As a consequence we will probably never get to the minimum economic constitution required for the euro to deliver stability and prosperity,” he told a forum on the euro.
“Is it better than monetary independence, essentially the path that the UK took? It’s not fully clear,” said Prof Zettelmeyer, asking what would happen in the eurozone if one country went feral with anything like Trussonomics.
The episode was embarrassing for Britain but was corrected quickly with little lasting damage. “The UK’s political and economic institutions absorbed the shock. Now think of something like this in the eurozone with, say, a populist right-wing in France trying to pull a Liz Truss. The consequences would be disastrous,” he said.
The ECB has limited margin for error. It has already overtightened twice in its short history. It raised rates into the teeth of recession in 2008 and again in 2011, both times turning a bad situation into something much worse.
One Lost Decade is bad enough. Two would be tempting fate.
