After looking mostly over the past few days about the likely economic future for the UK post Brexit it is time to widen the perspective and look at the implications more widely in Europe. As it and the UK go through a phase of what Chris Martin and Gwyneth Paltrow described as “consciously uncoupling” there are many implications across Europe. This was on the mind of ECB ( European Central Bank) President Mario Draghi yesterday as he spoke at its summer conference at Sintra Portugal. We do not know if he toasted absent friends as US Federal Reserve Chair Janet Yellen and Bank of England Governor Mark Carney were late withdrawals from summer camp. So no chianti and chat with Mario this summer for them!
Mario wants alignment
The speech was revealing in the fact that whilst it explicitly avoided the word Brexit there was an implicit theme which addressed it. Let me explain.
So we have to think not just about whether our domestic monetary policies are appropriate, but whether they are properly aligned across jurisdictions.
This is quite a shift if you think about it. There was talk of aligning policy around currencies earlier this year but of course we have large economies both explicitly ( Japan) and implicitly ( China and the Euro area) trying to push their currencies lower. If we stay with the Euro area some would argue that the 80 billion Euros a month of QE and an official interest-rate of -0.4% have contributed to its fall. It’s trade-weighted exchange-rate has fallen from 104.5 in April 2014 to 94.43 now with the Brexit impact being around 0.5 of that. Just to explain whilst the Euro has risen against the UK Pound £ it fell against the US Dollar.
Still we do have a fall of the size Mario discussed in 2014.
Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points.
So he thinks it has raised inflation by circa 0.5% but you note that he does not mention economic growth here. That is because currency depreciations are very awkward for an economic entity which consistently posts current account surpluses.
The current account of the euro area showed a surplus of €329.5 billion (3.2% of euro area GDP) in 2015
After noting such factors it is hard to avoid the view that the phrase “exporting deflation” applies to the Euro area overall. Other nations and trading blocs may well be not entirely keen on “alignment” after the Euro area has already moved some chess pieces in its favour.
There was a clear attempt by Mario to shift the debate to world issues.
What I am saying here is that the same applies at the global level. We may not need formal coordination of policies. But we can benefit from alignment of policies. What I mean by alignment is a shared diagnosis of the root causes of the challenges that affect us all; and a shared commitment to found our domestic policies on that diagnosis.
There are various problems here as I have just pointed out. How can the Euro fall against the Yen or Yuan whilst they are falling against it for example? In fact Mario Draghi sounds rather like he has borrowed the TARDIS of Dr.Who and jumped back to 2008 to talk to Martin Wolf of the Financial Time and Bank of England Governor Mervyn King ( he wasn’t a Baron back then).
Indeed, to the extent that the environment in which we operate is more affected by the global output gap, and the global savings-investment balance, the speed with which monetary policy can achieve domestic goals inevitably becomes more dependent on others – on the success of authorities in other jurisdictions to also close their domestic output gaps; and on our collective ability to tackle the secular drivers of global saving and investment imbalances.
Is Mario singing along with Lilly Allen “It’s not me it’s you” and “It’s not fair”? Also you may note that he is agreeing with one of my themes which is that the credit crunch provided the coup de grace to “output gap” theories. He would not put it like that but you see it has now failed in countries ( UK for example) and now apparently we are told by default in the Euro area so now we have a world one! Please just think through the implications of that and let me offer just one. How would you possibly ever measure it?
As ever the more private thoughts meet a leaky vessel and let us hope that unlike in the past hedge funds were not given an “early wire” to this. But Bloomberg have picked up on some details.
#Brexit cutting Euro GDP by as much as 0.5%, document shows
That is a little vague as there were mentions of three years and others used the word growth as we wait to see if that is total or annual. But there was more to come.
Draghi Warns Brexit Will Lead To “Competitive Devaluations”
I wonder if he managed to say that with a straight face! Also I note that the Brexit purdah did not last long. However there is more.
ECB’s Draghi: Concerned Brexit will lead to competitive devaluations, says its time to address bank vulnerabilities ( @DailyFXTeam )
The latter bit caught my eye as we have been told for the last 8 years or so that the ECB has been on the case of reforming the banks and time and time again we have been told that they are “resilient”, yet vulnerable is apparently the new resilient. Every ECB press conference Mario Draghi speaks about economic reform and each month it is the same groundhog day style statement. This if course comes back to the issue of how you can ever reform banks that know they will be bailed out?
The Italian banks
There is an obvious problem here as resilience morphs into vulnerabilities like the 360 billion Euros of sour loans at the Italian banks. This is a fast-moving situation where it appears that Italy has been informed that an outright bailout breaks the new Euro area banking rules. I am grateful to @liukzilla for pointing out that the vehicle below might be used.
CDP MAY HAVE ROLE IN BANKS CAPITAL RAISING: REPUBBLICA……yep, Cassa Depositi e Presiti http://www.cdp.it/en/index.html
This is 80% owned by the state and seems at first sight to be an effort similar to Portugal where you help the banks but try to keep it off the national debt numbers. For now we seem to be left with the bad bank Atlante which cannot have much more of its 4.25 billion Euros left. The problem with other banks putting money into it is that they are weakened too and this is similar if not the same to the way that some of the cajas in Spain hit trouble.
Any large-scale move here seems set to blast a hole in the Euro area banking union rules and post questions for the whole concept of it.
So we see one of the reasons for the equity market rally or what is called “risk-on”. There is no explicit “whatever it takes” phrase but Mario Draghi is hinting at yet more asset purchases. So we have a type of Mario “Put Option” for the equity markets. The danger is that he ends up turning fully Japanese and we end up with a Frankfurt Whale competing with the Tokyo Whale. The play King Lear has the image of a little old lady turning the wheel of fortune well each turn of this particular wheel is one more nail in the coffin of the concept of price discovery as instead markets front-run central banks.
Meanwhile we have gone beyond a drum beat and a bass line to a full orchestra playing one of the longest running themes of my work.
Since Thursday, global stock of negative-yielding debt has jumped $1 trillion to just under $11trn, says BAML ( Chris_Whittall )
There is more.
Global 10y sovereign bond yields tumble to record low 0.5826% after Brexit, according to Citi. ( @ReutersJamie )
I still remember going to a UK “think-tank” around 5 years ago and warning about this and noting it hit home. But everybody apart from me then forgot about it.