The Five Star movement of anti-euro comedian Beppe Grillo is leading Italy's polls just weeks before an election. With the end of QE looming, there could be trouble in the bond markets
Brexiteers must hold their nerve. By a twist of timing, the eurozone is briefly basking in economic glory while Britain languishes in relative stagnation.
It is an illusion of the economic cycle, magnified by Europe’s elastic snap-back from a needlessly severe recession. The EMU sorpasso over recent months looks more meaningful than it really is, yet it is inevitably creating confusion and will colour Brexit talks at a crucial juncture.
We can all agree that the UK economy has long been mismanaged. It needs a radical shift from consumption to investment if it is to avoid falling further behind the US and the rising powers of Asia. But one problem that it does not face is being left behind by the eurozone in any lasting sense.
OECD analysts think the region’s economic speed limit is around 1pc. The eurozone has been able to grow at well over twice that rate in recent quarters without running into trouble only because it has had a legacy output gap to cover. The UK is far ahead in the cycle.
The European Central Bank has turbo-charged recovery by running an extreme liquidity experiment, with interest rates at minus 0.4pc, or minus 2pc in real terms.
It has been buying €60bn (£53bn) of bonds – down to €30bn this month – pushing its balance sheet to 41pc of GDP, much further than the US Federal Reserve ever dared to go. It has bought €130bn of corporate debt in a direct intervention in the credit markets.
Fiscal austerity has given way to net stimulus. Spain, Italy and France have all been flouting EU spending rules. If this heady cocktail cannot produce a catch-up boom, nothing can.
Yet this burst of growth is ephemeral unless the eurozone uses the opportunity to grapple with its own dysfunctional pathologies – rigid labour and product markets, non-performing loans, zombie companies, warped welfare incentives – and to reestablish the currency union on workable foundations before the next crisis hits. Little of this has happened.
The IMF’s Article IV report on the eurozone for 2017 is one long indictment of structural paralysis. “Unresolved legacy problems are holding back a stronger medium-term outlook. Risks are large and policy buffers remain thin,” it said.
Poul Thomsen, the IMF’s Europe chief, says the fundamental picture is getting worse. Intra-EMU divergences are becoming more extreme. Those countries that had the poorest productivity growth at the launch of the euro are falling even further behind. “The gaps in real per capita income levels have widened rather than narrowed,” he said.
Germany’s real GDP is 14pc higher than its pre-Lehman peak, while Italy’s GDP is still 6pc below and will not recover its previous output until the “mid-2020s” – amounting to two Lost Decades. What is extraordinary is that these two countries are still trying to share a currency union, given their starkly contrasting fates, and the lack of any sign that this is will ever self-correct.
Brussels admits that the eurozone’s slump from 2008-2015 was so deep that it crossed into hysteresis, the point where "cyclical unemployment becomes structural" and causes lasting damage to job skills and economic dynamism. Hysteresis is why austerity policies become inherently self-defeating if pushed beyond the therapeutic dose. They lower trend growth rates decades ahead, making it even harder to bring debt ratios back under control.
Youth jobless rates peaked at 56pc in Spain, and are still 38pc today. The shock was so profound – and went on so long – that a whole cohort of Spanish youth went through their twenties without ever holding a durable job, with subtle macro-economic effects. Variants of this occurred in Italy, Greece, Portugal, and to some extent in France.
There have been episodic bursts of reform in southern Europe and France – usually less than advertised – but the OECD still thinks the currency bloc is so sclerotic that it will hit capacity constraints long before it has reached what would be considered full employment in Anglo-Saxon states. In economic parlance, the "Nairu" floor for unemployment is 8.8pc, exactly where the jobless rate is today. The output gap has essentially closed, and in Germany it is long past closing.
The eurozone boom therefore contains the seeds of its own demise. The stronger the recovery now, the sooner it hits the buffers, and the sooner QE will have to end. ECB board member Yves Mersch warned this week that Frankfurt must be “very careful not to act too timidly and too late, and to fall behind the curve”.
This brings Italy into uncomfortable focus. ECB has bought €319bn of Italian debt and is essentially covering the Italian budget deficit. This has compressed bond yields sufficiently to head off a debt compound spiral. It has been a life-saver but it has not restored self-sustaining viability. The public debt ratio remains stuck above 130pc of GDP, at the outer limits for a country with no sovereign currency.
Italy must refinance debt worth 17pc of GDP next year without obvious buyers. Italian banks and foreign funds have been systematic sellers, rotating the proceeds into accounts in Germany or Luxembourg in what amounts to slow capital flight.
“The end of QE does not frighten us,” says the defiant Italian finance minister Pier Carlo Padoa. Yet it will certainly frighten bondholders if it coincides with the election of a radical anti-euro government in March. The Five Star movement of Beppe Grillo leads the polls at 29pc, while the ruling Democrats are in slow collapse. Five Star is no longer calling for the restoration of the lira but its manifesto flouts the basic rules of monetary union.
Spain is in better economic shape, to the extent that it has clawed back competitiveness by slashing relative wages in an "internal devaluation". But this should not be mistaken for good health. Productivity has not recovered. “Much of the post-crisis growth has been in lower-skill, lower-productivity sectors,” said the IMF.
My guess is that bond yields in both countries will spike high enough by mid-2018 to cause heartburn, and this time Germany will be in a less accomodating mood with the anti-euro Alternative fur Deutschland commanding 94 seats in the Bundestag, and snapping at chancellor Angela Merkel’s heels.
The ECB’s policies are becoming more intolerable for Germany by the month. Negative rates are destroying the business models of the local savings banks that fund the Mittelstand backbone of the industrial economy. QE has pushed the Bundesbank’s net credits through the ECB’s internal Target2 payments system to €880bn. It is becoming a backdoor "transfer union" without democratic consent.
The economy is overheating. The IFO confidence index has reached the highest level since 1969. The Bundesbank expects 2.5pc growth next year, twice the German speed limit, describing it as “clearly above the production potential”.
“It is very clear that monetary policy is too expansionary for Germany by any rule you care to use. The lesson of the past is that the longer this momentum goes on, the more dangerous it becomes, and I see a lot of dangers,” said Professor Clemens Fuest, head of the IFO Institute.
The ECB’s Mario Draghi can push Germany only so far. If he tries to stretch QE even longer to buy time for Italy and Spain, he risks further eroding – and ultimately losing – German political consent for monetary union. Yet what Germany needs is incompatible with what the Latin bloc needs.
"IMF officials fear that sooner or later one country will be hit by an asymmetric shock, revealing the EMU system is as unworkable as ever"
IMF officials fear that sooner or later one country (Italy) or region will be hit by an asymmetric shock, revealing that the EMU system is as unworkable as ever. There is still no fiscal union, and Germany is unlikely to offer Mr Macron much beyond the symbolism of a eurozone finance minister with no budget. The banking union lacks the genuine backstop needed to avert a repeat of sovereign/bank "doom-loop" that almost engulfed EMU in 2012.
Such a brutal denouement is a story for the next global downturn, not a looming threat for this year. What is likely to become clear in 2018, however, is that boom conditions are much harder to handle than the sluggish Goldilocks growth of early recovery. Deep rifts within monetary union are becoming visible again. The removal of the ECB shield may prove very painful for high debtors.
So if you think Britain looks like the crisis child of Europe right now, just wait a few months. Rivals abound.