Why Mario Draghi Is Too Optimistic

If you look to the eurozone’s stock markets as guides to the region’s economic prospects, you might think the future is looking bright. The EURO STOXX 50 index of blue-chip stocks is already up 17 percent this year. The German DAX index has soared by 21 percent, while shares in recession-hit Italy have leapt by 20 percent. Amid this financial exuberance, European Central Bank (ECB) President Mario Draghi even suggested on March 16 that “a sustained recovery is taking hold.”

Really?

It’s a triumph of diminished expectations that eurozone officials celebrated GDP growth of 0.3 percent in the final quarter of 2014 as a success. That left the economy only 0.9 percent bigger than a year earlier and still 2 percent smaller than in the first quarter of 2008, the pre-crisis peak. With stagnant wages and a jobless rate of 11.2 percent, ordinary Europeans are hardly popping champagne corks. Indeed, on March 18 anti-austerity protesters disrupted the inauguration of the ECB’s lavish new headquarters, which cost 1.3 billion euros ($1.4 billion), well above its initial 850 million euro budget.

But growth this year is likely to be somewhat higher, thanks to lower oil prices, a weaker euro, the launch of quantitative easing (QE), and less restrictive fiscal policy. In euro terms, oil prices are a third lower than six months ago. That gives households more money to spend and cuts companies’ costs. Meanwhile, the euro has plunged by 24 percent against the dollar over the past 12 months — and by 12 per cent since the start of the year alone. With a euro now worth only $1.06 and American consumers spending again, that should boost exports.

The weaker euro is partly due to QE. On March 9, the ECB finally started buying government bonds in force, which markets have long been anticipating. Deflation fears and expectations of ECB buying have driven down the interest rates on government bonds to new lows. Indeed, many yields are now negative. (So long as yields keep falling and therefore prices rising, investors can still make positive returns even with negative rates: the Bloomberg Eurozone Sovereign Bond Index is up 4.3 per cent this year.)

Lower interest costs will help governments meet the budget-deficit targets set for them by eurozone authorities. Companies large enough to tap bond markets are also benefiting: their borrowing costs have plunged, while share prices are rocketing. The hope is that easier financial conditions will encourage banks to lend, households to spend, and companies to invest.

Last but not least, eurozone governments won’t be tightening their belts in 2015 in the way that they did in previous years. The austerity policies imposed by eurozone authorities in 2011–13 were extremely aggressive. This year, though, fiscal policy is set to be broadly neutral overall, according to the European Commission.

All of that should boost growth. But that doesn’t mean it’s time to celebrate quite yet.

These positive factors aren’t as substantial as they seem, and with the huge negatives still weighing down the eurozone, they are hardly enough to generate a sustained recovery, let alone a strong one.

Because of the euro’s fall, the one-off boost to Europeans’ spending power from lower oil prices is already unwinding. While oil prices are down this year in dollars, they have actually risen by 10.4 percent in euros. The weaker euro is likely to push up import prices more generally, too. The ECB may welcome that if it increases inflation, but it will crimp household budgets and raise many companies’ costs — including exporters’.

Since eurozone exports increasingly rely on inputs sourced from global supply chains, the competitive boost from a weaker euro may be smaller than expected. Indeed, exporters may simply pocket any gains as fatter margins rather than seek to expand market share. In trade-weighted terms, the euro’s depreciation over the past 12 months is only 13.9 percent. Yet even the pound’s 25 percent fall in 2007–9 conspicuously failed to boost British exports.

For sure, the global economy is in better shape now that it was then. But the stronger dollar seems to be tempering U.S. growth, China’s economy is slowing, and the prospect of the U.S. Federal Reserve starting to raise interest rates later this year threatens to drain capital from fragile emerging economies.

In any case, there is a limit to how much exports can drive growth in an economy as large, and as largely closed, as the eurozone. At just shy of 2 trillion euros ($2.6 trillion) in 2014, eurozone exports are bigger than China’s, so there is only so many more the rest of the world can absorb. And with its (largely German) current-account surplus already the world’s biggest, a further increase could trigger a protectionist response elsewhere. Moreover, since exports account for only a fifth of eurozone GDP, there is only so much they can do to offset depressed domestic demand, which is the currency area’s biggest problem.

That leaves Draghi’s hopes for a sustained recovery resting precariously on the shoulders of QE. Yet if growth and inflation enjoy a temporary bounce this year, the clamor to curtail it will grow. In any case, Britain’s and the United States’ own experiments with QE have only generated small boosts to growth, not the kind of economic lift-off that the eurozone needs.

Even in those more capital-market-driven economies, artificially inflating asset prices scarcely spurred consumers to spend and businesses to invest. In fact, QE may just encourage financial speculation at the expense of business investment: why should companies take the risk of investing in the real economy, where demand is weak, when their share price is soaring in any case? QE would be more effective if combined with a fiscal expansion. But EU rules prevent that. Indeed, Ireland, France, and Italy are all due for a further squeeze.

In the eurozone, where companies rely primarily on bank financing, credit conditions are improving a little. But lending to businesses is still falling in southern Europe and flat overall. And as financial blogger Frances Coppola has pointed out, negative interest rates on bank reserves at the ECB, combined with the difficulty of imposing negative rates on depositors and the flattening of the yield curve through QE — the long-term rates on which banks base their lending rates are now scarcely higher than the short-term ones at which they borrow — is “deadly for banks.” Especially when they are zombies weighed down by bad loans which they have not fully recognized.

The eurozone economy is set for a better 2015. Real-time “nowcasting” models suggest it may be growing at an annual rate of 1.5 percent. Berlin will doubtless claim that this modest improvement is evidence that its crisis response is working, when in fact the uptick is due to other factors — including the easing of the austerity policies implemented at Berlin’s behest. In any case, the eurozone will only escape from its balance-sheet recession once it tackles its zombie banks, the crushing overhang of mostly private debt, the huge shortfall of investment, the barriers that restrict enterprise, and the deflationary drag of German mercantilism.

In March 2012, during a lull in the crisis, Draghi prematurely declared, “The worst is over.” He may again have to eat his words. This looks more like a temporary bounce than a sustained recovery.

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