So who is more important, the 380 million-strong European electorate, or the six members of the executive board of the European Central Bank, plus the other central bank governors on the ECB governing council? To judge by what has happened in financial markets over the past three days it is no contest: the ECB wins hands down. We may have had an earthquake in European politics but in European economics what will matter is the decision next week by the ECB.
European shares have barely moved, still trading near their highest levels since the beginning of 2008 and the German Dax poised just below the 10,000 mark. The euro has barely moved. Bond yields have, if anything, fallen – which suggests greater confidence in the region’s economic policies, whatever the voters might think of them. Why this apparently insouciant attitude to the democratic revolt? The answer: everyone expects the ECB to ease monetary policy at its meeting next week.
We have been given broad hints of something big to come from the ECB president, Mario Draghi, on Monday when he repeated his assertion that the bank would not allow inflation to remain too low for too long and was looking at action to ease the squeeze on credit that was holding banks back from lending more to their customers.
You can see just how dire the lending situation has become in the top graph. This shows that aside from a brief recovery in 2011, bank loans to companies in the eurozone have plunged ever downwards, falling last year at an annual rate of 5 per cent. European companies are more reliant on bank loans that UK ones, and corporate lending accounts for nearly half the total outstanding loan book, as the pie chart shows.
Yesterday we had another clutch of news that will push the ECB into action. Bank lending in the eurozone in April fell yet further, French consumer spending declined, German unemployment rose, and the first eurozone country to report May inflation, Belgium, disclosed this was down to 0.4 per cent, down from 0.6 per cent in April. We will get the full eurozone inflation numbers next Tuesday, two days ahead of the ECB meeting, but on the basis of what we know now, it would be very hard for it to do nothing.
What will it do? The financial community is agog with speculation, but this is one of those moments where, while the detail will be very important to professionals, the broad thrust will be what matters to the wider economy.
As far as detail is concerned, the French bank Société Générale has done a very thorough paper on the options. It argues that there will be two broad strategies. One will be to use conventional measures such as a cut in interest rates and pumping more liquidity into the banking system. Since rates are at or close to zero I don’t think we should rule out negative interest rates for deposits with the ECB. (For people interested in the detail, Barclays thinks that the ECB will make a small cut in the refinancing rate to 0.1 per cent and a cut in the deposit rate to minus 0.1 per cent.)
The second line of attack will be to have some targeted scheme to boost lending to companies, maybe by a Funding for Lending scheme, whereby it will supply funds to banks that pool together packages of company loans.
Société Générale does not think the ECB will go further to the third strategy and start a full-scale quantitative easing programme at this stage. This would involve it buying government bonds, as have other central banks including the Bank of England, which the ECB cannot do under its present mandate. This would be the tool of last resort.
Let’s assume this is broadly right. What then?
Well, there can be little doubt that this will be good for European companies and hence good for their share prices. It will also help European banks, for anything that nudges that red line in the top graph above the watermark will benefit both. It may weaken the euro a bit but it is always hard to get currency movements right. Remember how a year ago just about everyone was bearish about sterling, yet it has been the best performer among the major currencies this year.
I suppose what really matters most is whether the ECB is simply aiming to fix the twin problems of incipient deflation and European banking weakness or whether it is trying to do something more – such as lifting the eurozone economy more generally.
If you think that averting deflation and helping the banks get lending again are the main problems holding back the eurozone economy, then fixing these two specific issues would go a long way towards lifting the economy more generally.
If, on the other hand, you think that Europe’s poor growth prospects are embedded in its economic structure, its rigid labour markets and its high tax burden, then the results may disappoint. You would be asking the ECB to do too much. It is the most effective European institution but it is only a central bank, and one whose purpose is to protect the euro, itself a rigidity that is widely accepted to have exacerbated the downturn.
Anyway, expect something big next week from the ECB. It has saved the euro, albeit at hideous cost for the citizens of the periphery nations that had to impose austerity in return for bailouts. Many would argue that it was a Pyrrhic victory – though with hindsight its timing was excellent and it did the job. Now it has to secure some growth, building on the fact that business sentiment has recovered well. My guess is that once again its timing will be excellent and there will be at least a couple of years of eurozone growth.