US medicine won't cure Europe's ills

Markets now believe the EU is stuck in a Japan-style deflation trap. Worse, the American QE solution can't get it out.

The sudden disappearance of the European Central Bank’s credibility is potentially the most shattering global financial event since September 2008.

In New York last Thursday, ECB President Mario Draghi said: “Let me be clear: we are accountable to the European people for delivering price stability, which today means lifting inflation from its excessively low level. And we will do exactly that.”

He wasn’t believed; in fact he was all but ridiculed.

The German 10-year bond rate promptly crashed to the stunning level of 0.812 -- the lowest long-term European interest rate since the deflation of 15th century Genoa. Five-year inflation expectations as measured by the five-year forward swap rate crashed to below 1.8 per cent. Equity markets had their worst week of the year, with wild swings on all major markets.

Markets now believe Europe is headed for a Japan-style deflation trap and fear that the ECB is incapable of doing anything about it.

In June 2012, when Mario Draghi declared the ECB would do “whatever it takes”, he was referring to the crisis in the periphery, with Italian and Spanish bond yields spiralling upwards out of control.

“Super Mario” as some called him then, engineered the start of a powerful two-year global bull market with that speech, especially when he said: “And believe me, it will be enough.” Investors pinned their ears back.

At the time, markets had feared that Italy or Spain would default, breaking up the Eurozone and causing a dominoes collapse of the European banking system.

It turned out to be a liquidity crisis that could be ended fairly simply by the ECB promising to supply cash, and with the threat of a European collapse off the table, the markets were able to focus on the recovery in the United States, which then allowed rising US earnings to be fully valued on Wall Street.

The new European crisis is entirely different: it’s not just the periphery but the core that’s in trouble as well. Germany’s economy has stalled and the euro area as a whole is on the brink of a triple-dip recession.

Over the weekend, the IMF told European countries to spend more on infrastructure and to reform their economies, which only served to highlight the policy confusion that now grips Europe, and the world for that matter.

Fiscal balance is still pursued in many countries, especially Germany, and including Australia, even though most of the developed world is in a liquidity trap with central banks at zero lower bound interest rates.

America’s quantitative easing programs, three of them since 2009, are held up as the saviour policy that the ECB must now pursue, but in fact it seems likely that the main factors behind the United States’ (relatively weak) recovery have been low wages and cheap energy.

More than 80 per cent of the money that the Federal Reserve created has ended up as excess bank reserves. Even though the monetary base has grown by 367 per cent over the past six years, the velocity of the money base (GDP divided by money supply) has collapsed from 17 in 2007 to 4.4.

That’s even lower than during the Great Depression of the 1930s, and it’s what Keynes referred to as a “liquidity trap”, when extra money from the central bank is held onto rather than spent, so that monetary policy doesn’t work.

And it’s clear from the fact that US inflation has fallen to 1.7 per cent even as money supply has expanded at such a quick pace, that money itself does not create inflation.

This has come as a massive shock to markets, which had been raising inflation expectations up to the start of this year, with the bears predicting hyperinflation. The US 10-year bond yield got to 3 per cent from a low of 1.5 per cent in 2012 and has now fallen back to 2.28 per cent. European yields have fallen even more than that.

Inflation, it turns out, is actually caused by a capacity constraint -- usually labour, but often energy (the 1970s oil shock) or infrastructure, land or food. Growth in money supply can lead to supply constraints, but only if the money is spent.

So QE is not a panacea for European deflation. Markets understand this now and do not believe Mario Draghi can achieve 2 per cent inflation in Europe by printing money, even if Germany allowed him to do it -- which is not certain either, in the Byzantine world of European politics.

The problems in Europe run deep, as they did in Japan in the 1990s and 2000s.

In many ways those problems are similar, a political inability to deal with insolvent banks and the demographic deficit caused by population ageing.

Japan eventually produced Shinzo Abe, who managed to cut through with his “three arrows” -- monetary expansion, fiscal spending and structural reform.

So far Europe has nothing but the promise of the first of those, let alone the actual implementation.

Don’t forget it took Japan 23 years of deflation to get Abenomics.