Governments against the euro zone

Christine Lagarde, in her first official speech as President of the ECB, called for the implementation of a new policy mix to allow the Eurozone to develop all its growth and employment potential. The complementarity between fiscal and monetary policy should, according to the new President of the ECB, allow such a scenario. The Eurozone could then have more growth autonomy and a greater capacity to decide for itself.

Christine Lagarde will have to be convincing because governments do not take the demands of the central bank seriously.
Mario Draghi, before her, had already, and from the beginning of his mandate, called for a rebalancing of economic policies. The request of Christine Lagarde shows that the former President of the ECB has never been listened to or taken into account.
Draghi committed to a strategy of low interest rates to improve the public finances solvency. By pushing interest rates down, he facilitated more aggressive fiscal policies and structural reforms to improve the growth profile of the Eurozone economy.. Governments have never engaged on this point.

The ECB has, since the arrival of Mario Draghi, carried out an accommodative monetary policy. In the summer of 2012 the ECB became the lender of last resort of the Euro Area, thus guaranteeing the safeguarding of the banking and financial system. It then lowered policy rates to around 0% and then launched its QE in March 2015. All these unorthodox policies have been criticized from all sides as being excessive and in no way boosting growth or inflation.

How could it have done when the fiscal policy of the Euro zone is restrictive since 2011? The structural primary surplus (i.e. corrected for cyclical effects) since 2012 reflects a fiscal drag. In no case has there been fiscal stimulus at the euro area level since 2010 (the data are calculated by the IMF and a larger deficit reflects a fiscal stimulus).
At the time, 2008/2009, the collapse of the economy had caused this large public deficit. But as soon as growth resumed, with the revival of the G20 decided in London in April 2009, Europeans have become systematically restrictive again. The ECB then played the same role as the Commission, helping to accentuate the six-quarter recession in the Eurozone.

The Eurozone fiscal policy has never been conducive to supporting activity and enhancing growth.
The primary fiscal surplus has been around 1% of potential GDP since 2013 and has not moved since. The rigor implemented in 2011/2012, which resulted in the very long recession, was never questioned. The budget texts put in place in 2013 to signal the seriousness of the budget options and to reassure the financial markets have not, in fact, helped to strengthen growth in the Eurozone.

One may wonder whether accommodative monetary policy has not been the pretext for not adopting a proactive fiscal policy. Another interpretation, monetary policy became frankly accommodating only because Draghi had the perception that governments and the Commission would never let go on fiscal policy. Since the ECB adopted a strategy to support growth, it was no longer necessary to do so at the Eurozone level.
Draghi has allowed governments not to reform, not to promote growth, to criticize the inefficiency of monetary policy with impunity while being able to complain about populist excesses.

Will Christine Lagarde fall into the same trap as Draghi?

Eurozone growth painfully above 1%

GDP growth in the Euro zone is 1.2% (annualized rate) since the last quarter of 2017.
The figure of 0.2% (0.75% annualized rate) for the third quarter of 2019 does not change this trend. The carry over for 2019 at the end of the third quarter is 1.1% and growth over the year will be around 1.2% at best.
 After the catch-up in 2017, the economy of the Euro zone no longer has the capacity to accelerate. What does one do with the German budget surplus?Can we use it and put in place a more proactive fiscal policy in order to lock in a higher growth trajectory? See here in French

The German saving rate doesn’t depend on the ECB interest rates

There is a lot of talks about the German savings rate, which is supposed to have increased recently in response to the drop in interest rates, notably the ECB rates. The anxiety caused by the fall in interest rates would encourage Germans to save more to counteract this uncertain environment.
It does not work. Germans do not vote against the ECB by increasing their savings as savings rates are stable.
This story about the Germans’ behavior is supposed to show the frustration of our neighbors and the inability of the ECB to manage monetary policy. Very Smart People are still alive and in action.
I have looked at the series of the household savings rate (savings on disposable income) and the global saving rate (Total income minus private consumption minus public consumption as a% of total income). These are the two relevant series for measuring the savings rate, in Germany or elsewhere.These two series, in recent years are flat like the back of the hand.
The household savings rate has fluctuated between 9% and 11.2% since the first quarter of 2009 and stands at 10.8% in the second quarter of 2019. It can even be said that since the start of the euro area, the German household savings rate is stable on these same levels.
Yet since 2009 the refi rate has declined by 250 basis points, same for the deposit facility rate.
There is no impact of the ECB rate on the behavior of the savings rate.
We can also look at the overall saving rate, that of the German economy as a whole. As the households’ saving rate, this one is stable. Since 1991, it has been slightly above 25% of GDP. It is not an additional saving behavior that explains the increase in the German external balance but the decline in the investment rate (the difference between the savings rate and the investment rate is the current account balance as a% of GDP). For the overall saving rate also, the impact of the Bundesbank rate and then the ECB rate does not seem to exist.

The ZEW remains weak in September

The ZEW measured as the average of its two components remains in very negative territory in September. Its reversal mentioned here and there is very relative. The expectation component is less degraded but remain at a low level. The current conditions component has trending downward for at least a year and September is not immune to this negative dynamic.
The pace of the ZEW still suggests that the GDP figure will still be in the red in the third quarter. The upturn in activity and the reversal of the trend in the fourth quarter are not yet clearly perceptible.

ECB accentuates financial repression for an extended period

The ECB has lowered its deposit rate by 10bp to -0.5% and will keep all of its rates at the current level or lower until inflation converges to 2%. In the ECB’s forecasts, inflation will be 1.5% in 2021. Therefore, the short-term rates will remain at the current level until at least 2022.
The ECB has also decided to resume it Quantitative Easing program (QE) by 20 billions euro from November the 1st.. This has already resulted in a spectacular decline of the 10y Italian rate.
This QE measure will accentuate financial repression. The aim is to push the entire rate structure for all countries in negative territory, Italy included. It can last beyond what we imagine. The purpose of financial repression is to reduce the incentive to save and to increase the incentive to spend to curb activity on the upside.
The wish of the ECB is that fiscal policy will change and be more active so that the measures taken are more effective and faster. However, he has been repeating this since the beginning of his term.
The ECB will reduce its deposit rate to -0.5% with the adoption of a system that will adjust this rate according to the type of reserve (tiering). Excess reserves will be paid at 0% and the rest at -0.5%.
The TLTRO is extended to 3 years and the rate on each transaction will be the main refinancing rate over the remaining time of this TLTRO tranche.
Given the length of the TLTRO and the expectations mentioned above on inflation, the applicable rate could be on average the deposit rate over the duration of the transaction for banks whose loans exceed the loan reference defined by the ECB. This means that for banks with excess liquidity, they may have an interest in lending and placing their loans in excess reserves. This will strengthen the banking sector.

The financial repression put in place by the ECB implies that interest rates for all maturities and for all countries are low and negative for a very very long time.
Economic players have changed their behavior when interest rates dropped to 0 or negative. But this change is now over. Behavior’s change will be marginal. The upward macroeconomic impact will therefore be very limited.
Moreover, the ECB’s signal could also be interpreted as reflecting a particularly degraded situation, thus raising concern for households and companies. Th risk is that signal may, at the end, have a negative effect on the economy. Will the stronger banking sector be enough to counteract this effect? It’s an unknown today.
Growth forecasts are revised downwards to 1.1% in 2019, 1.2% in 2020 and 1.4% in 2021. An external shock could tip the Eurozone into recession. For now, the ECB considers this probability to be very low.
This nonetheless reinforces the need for an effective and proactive fiscal policy to get out of the current liquidity trap whether or not there is a recession.
Given the lack of willingness of governments to have a coordinated fiscal policy, the position of Draghi is associated with a strong bet on the future at the risk of becoming wishful thinking.
Good luck Christine Lagarde