Is the Eurozone leadership up to the task?

During the period when this quarterly economic outlook was being compiled, Euro-area bond and stock markets were intensively focused on the impending changes of leadership in the European Commission and at the ECB. 

Subject to approval by the European parliament in Strasbourg it seems likely that the nominated candidates, Ursula von der Leyen and Christine Lagarde (previously Managing Director of the International Monetary Fund) will assume those positions at the end of September. 

Up to the task?

The real question for financial markets is whether in combination or alone, either candidate has the knowledge and the support to drive through policies that can shift the sluggish growth and sub-target inflation of the euro-area.

The role of the EU Commission in macroeconomic policy is limited largely to enforcing the fiscal rules imposed on member countries by previous treaties of the EU. 

While fiscal policy is the junior partner to monetary policy in steering the economy, inadequate monetary stimulus exacerbates the difficulties of meeting fiscal targets for those countries suffering weak growth. 

Italy

In this arena Italy has been the main problem-child in the euro-area since the two populist parties of the centre right (Matteo Salvini’s League) and the anti-establishment left (Luigi di Maio’s Five Star Movement) formed a coalition following the election of 4 March 2018. 

However, in recent weeks the government in Rome has promised to make nearly €8 billion of cuts in its 2019 budget, and to take further steps to reduce debt in 2020. 

For the present this is probably enough to enable Brussels to back down.

Impact on markets

On the more important monetary side, the prospective appointment of Christine Lagarde has already had some dramatic effects in the financial markets. 

The euro weakened on the announcement, German 10-year bund yields fell to the same level as the ECB’s refinance rate (-0.4%), and the spreads for Italian BTPs over bunds decline sharply. 

All of this reflected the consensus relief that the EU leaders had not appointed the German Bundesbank president, Jens Weidmann, to the ECB presidency, together with the view that Mme Lagarde would continue the dovish or expansionary policies of Mario Draghi.

Key question

The key question, then, is whether this change of leadership at the ECB will really make any difference to policy in the years ahead. 

Mme Lagarde is not an economist but having had extensive experience of involvement with IMF interventions in crisis economies and proposing solutions to restore growth and reduce inflation, she should have plenty of ideas about how to restore the fortunes of the euro-area.

However, the ECB and the euro-area more generally are rule-bound, legally constrained organisations which could inhibit her, even if she comes with new ideas.

Outlook

It remains the case the euro-area aggregate demand (spending) is weak and faster money and credit growth is still required. I forecast growth of 1.1% in 2019 with consumer price inflation slowing to 0.9%, well below target.

Draghi’s legacy

In the world at large Mario Draghi’s legacy is mostly good, starting with the LTROs launched in late 2011, his famous statement that the ECB was “ready to do whatever it takes” to preserve the single currency at a speech in London in July 2012, and carrying through to the implementation of QE from March 2015 through to December 2018.

However, in my judgment, the LTROs did not work as banks simply substituted lending from the ECB for other sources of funds, and bank lending fell from +4% to -4% year-on-year over the period the loans were being granted.¹

Moreover, his QE policy was diluted by buying securities mostly from banks instead of from non-banks. The result was that the purchases did not create enough deposits to boost money growth sufficiently.