In a research note, economist Mike Darda of MKM Partners absolutely hammers Mario Draghi and the ECB today after Draghi said, to quote Reuters, “any intervention would come at the earliest in September once governments had activated their rescue funds to buy bonds, and the countries at risk had requested assistance and accepted tough conditions. The absence of immediate action, the conditional nature of Thursday’s decision and the reservations of Jens Weidmann, head of Germany’s influential Bundesbank, the ECB’s biggest shareholder, spooked investors.”
Draghi offered nothing but a lot of conversation that will result in another tumultuous month in Europe. Here is Darda:
Today marks the third major blunder by the ECB since 2008. In July of that year, two months before Lehman Brothers failed, the Trichet-led ECB tightened because it thought inflation was the dominant threat in the eurozone.
It did not learn from this blunder. Three years later, the ECB raised rates twice in 2011—despite the fact that Europe was in the throes of the most significant debt crisis in modern times and the pace of monetary expansion was subdued. Now, after throwing markets into a lather last week over the prospects of open-ended monetary easing, the ECB followed this unveiled threat with—drumroll, please—no immediate action. Markets understandably were sent reeling on the news.
In fact, this could credibly be called the fourth ECB blunder, as ECB President Mario Draghi made a mistake when the second LTRO was launched earlier this year by bending over backwards to warn markets that it would likely be the last and was “necessarily temporary and limited” in scope.
Thus, it is clear to us at this point that the ECB is neither willing nor disposed to follow words with adequate deeds (i.e., to do enough to create an adequate monetary expansion in the eurozone). And that means progress on structural reform will difficult, if not impossible.
Austerity will prove fruitless, if not self-defeating, if bond yields continue to tower over actual and expected nominal GDP growth. Peripheral countries will likely remain in near-depressionary states for years to come. The core of Europe, led by Germany, will eventually recover, but likely not robustly enough to pull the periphery out of the current slump. Europe seems destined for its second Lost Decade. Portfolios should be structured accordingly.
As long as nominal GDP growth rates remain below nominal bond yields in Europe, debt ratios are likely to rise inexorably. This is one reason that we have used the Market Monetarist mantra that the eurozone crisis is one of nominal GDP; exploding debt ratios are simply a function of weak current and expected NGDP growth.
Since nominal variables fall under the province of the central bank (central banks control NGDP and inflation in the long run, but RGDP and NGDP are highly correlated in the short run), we can place the blame squarely at the feet of the ECB in this regard.
We also reject the “single mandate” excuse for the ECB’s tight policies; it has a monetary growth reference rate (that is supposed to mimic trend NGDP growth around 4% per annum) and has undershot it for 37 consecutive months. Every measure of the money stock, save the base, is below its pre-crisis trend level, as is NGDP. The GDP price deflator for the euro is running at less than a 1% annualized rate and is nearly 3% below its pre-crisis path. No wonder there’s a debt crisis across the Atlantic.
Let me end with a comment by Scott Sumner on this very issue:
Lots of news articles on the eurocrisis focus on the sky-high interest rates now being paid by the Spanish and Italian governments, roughly 6%. But I rarely see people pointing out that until a few years ago 6% interest rates on gvernment bonds were completely normal. As was the 70% ratio of public debt to GDP that you see in Spain. So why is this interest rate now such a crushing burden? Simple, in the old days 6% interest rates were accompanied by much more robust NGDP growth rates. The problem today in the periphery is that NGDP growth has collapsed.
If structural problems prevent a return to normal real growth rates, then the living standards in those countries must take a hit. If you continued the normal pre-2008 NGDP growth rates, then the burden would be shared by both debtors and creditors. If you have near zero-NGDP growth and keep paying 6% interest to creditors, then the entire burden falls on debtors. Indeed creditors would be receiving a much greater share of GDP than they anticipated—a windfall.