Mario Draghi believes that the Eurozone will slowly return to health over 2013 as a result of the bond market’s ongoing stabilization. He calls the effects that we are observing a “positive contagion.” The ECB’s intervention has merely hidden the symptoms of the economic malaise rather than curing it, and the Eurozone will continue to stagnate under current monetary policy.
The bond buying pledge via the ECB’s OMT program combined with monetary easing is the cause of the decrease in yields of PIIGS debt. While Draghi also points to significant political progress on a closer economic union among the Eurozone states, this is a fiction. There has been much talk of banking unions and fiscal compacts but no measures have been implemented. The FANG countries will still be required to pay for a banking union, and they have shown no desire to do so.
Draghi boasts of several improvements in the Eurozone financial picture:
- Lower bond yields and CDS spreads
- Higher stock markets
- Low volatility
- Low inflation
What is important to remember about these cosmetic improvements is that economic fundamentals underpinning the crisis have barely changed. The PIIGS still have large budget deficits and uncompetitive economies. Unemployment is high, and large internal balances remain within the Eurozone.
The ECB has created trillions of Euros out of thin air, and this money must be deposited somewhere. European banks are purchasing high-yielding PIIGS bonds with cheap ECB loans. Note the steep rise in the ECB’s balance sheet starting in 2011 when it began purchasing PIIGS debt to stabilize the market.
In response to the easing of credit, stock markets have risen. Bears have been driven from the market because no one can fight the printing press. The liquidity provided by the bears has been removed from the system, but the consequences of this event will not be known until there is a panic.
The official rate of inflation remains low because of the recession, not the excellent monetary management techniques of the ECB.
The most significant problem that the Eurozone must solve is its zombie banking sector. The chart at the top of the post illustrates that shoveling money into dying banks may keep them from failing but it does not spur lending. Loans are what the economy needs to begin growing again.
All of this extra money is either being hoarded at the ECB, or it is being used to purchase higher-yielding PIIGS debt. With the ECB’s OMT guarantee sitting around waiting to be activated, a virtual guarantee on PIIGS debt allows the banks to purchase sovereign bonds yielding 2% or more while paying just 1% to finance the transaction. Since banks are earning riskless profits from this trade, there is very little incentive to originate much riskier loans to the private sector. Large government financing needs are crowding out the private sector.
As long as this monetary policy persists, the periphery should be able to finance itself, particularly since the Swiss National Bank is enabling the ECB’s actions, but this is the topic of another post. Money printing will maintain the stable disequilibrium currently in place in Europe.
The downside to a world where banks and sovereigns are not permitted to fail is economic stagnation. The banks will continue refusing to lend to the private sector, and increased economic activity will not take place.