Italy

Relentlessly falling inflation is bad news for Eurozone banks.  It increases the real (inflation-adjusted) value of borrower debt and the real cost of servicing that debt.  It causes loan defaults, and therefore bank loan losses, to rise. So with Eurozone inflation, currently at a near-record low of 0.4%, clearly at risk of heading into deflationary territory, what did the ECB say was the “adverse scenario” for this year?  Inflation of 1% – more than twice its current level.  This is indefensible; the ECB’s dire scenario for this year is actually much cheerier than the IMF’s baseline forecast, which pegs inflation at 0.5%.  The country-by-country comparison is shown in the graphic above. Disturbingly, at no point through the end of 2016 is the ECB even willing to contemplate the possibility of inflation being less than it already was in September: 0.3%.  This is a serious failure on the part of the central bank, which this month assumes supervisory responsibility for Eurozone banks.  It suggests that the ECB is more concerned with the reputational costs of acknowledging the possibility of deflation than with testing accurately the ability of banks to withstand it.  As the private sector is not privy to the proprietary bank data that would allow such a proper test, the ECB’s failure to address deflation risks raises the critical unanswerable question of how many of the seven banks that barely passed should actually have failed. Buiter: Four Rescue Measures for Stagnant Eurozone Evans-Pritchard: ECB Stress Tests Vastly Understate Risk of Deflation and Leverage Legrain: Yet Another Eurozone Bank Whitewash Financial Times: Bank Stress Tests Fail to Tackle Deflation Spectre Steil and Walker: Restoring Financial Stability in the Eurozone   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

Should the European Central Bank finally join the Fed, the Bank of England, and the Bank of Japan and deliver a good, stiff dose of Quantitative Easing? Maybe, came the surprise response from the hawkish Bundesbank president on March 25.  But “any private or public assets that we might buy,” Jens Weidmann warned, “would have to meet certain quality standards.” That’s a big but, as the quality of Eurozone assets has deteriorated markedly since 2009.  In fact, as today’s Geo-Graphic shows, if the ECB were to limit its asset purchases to the universe of AAA-rated Eurozone sovereign debt and securitized assets a whopping 80% of the total available would be German Bunds. But would a Eurozone QE program focused on gobbling up Bunds be such a bad idea?  We don’t think so. First, it might actually play a useful role in helping to eliminate structural imbalances within the Eurozone by pushing up German prices and wages disproportionately.  “While buying Greek or Portuguese paper could help tame deflation there,” an unnamed Eurosystem official recently told Reuters, “the falling consumer prices in these countries were part of a natural adjustment of their economies to become more competitive, and were actually welcome.” Second, through the so-called portfolio-balance effect the prices of other Eurozone assets will also be pushed up (and their yields down) as Eurozone banks replace the Bunds they sell to the ECB with other securities.  The Fed’s purchases of Treasurys and MBS most surely boosted asset prices across the spectrum in the United States (and abroad – just ask the ever-voluble Brazilian finance minister); the effect should be similarly broad in Europe. Finally, if a AAA focus for Eurozone QE were the price of getting Germany on board politically, it would be a small price to pay. Mario Draghi’s 2012 pledge to do “whatever it takes” remains in the background should he ultimately feel the need to operationalize OMT (Outright Monetary Transactions) and push down sovereign yields in Spain, Portugal, Italy, or elsewhere. Financial Times: ECB Policymakers Plot QE Road Map Bernanke: Monetary Policy Since the Onset of the Crisis The Economist: Turning Over a New Leaf? Bloomberg: Weidmann, Citing QE Legitimacy, Paves Way for ECB Consensus   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

Back in April, we showed that the eurozone countries most in need of lower corporate borrowing rates benefited only marginally from ECB rate cuts. Today’s Geo-Graphic shows that little has changed in this regard; the financial crisis has clearly done serious and lasting damage to the monetary transmission mechanism in Europe – particularly as it affects Greece, Portugal, Spain, and Italy. In April we also showed that the GDP-weighted inflation rate of the countries where the monetary transmission mechanism was working normally – Austria, Finland, France, Germany, and the Netherlands – was 1.8%, right near the ECB’s target of just-below 2%. Thus, the countries that most needed lower borrowing rates needed much more than an ECB rate cut to boost business lending, whereas those where business lending was responsive to ECB rate cuts were not clearly in need of one – at least according to the ECB’s inflation criterion. Inflation in the strong countries, however, has declined significantly since then – it now stands at a GDP-weighted 1.5%. This means that a rate cut at the ECB’s November 7 governing council meeting should be a no-brainer. Sadly, our Geo-Graphic suggests it will also be a no-gainer; the ECB will have to take far more aggressive action to prod business lending in the worst-hit crisis states. Financial Times: ECB Weighs Up Options Amid Concerns Over Falling Prices Bloomberg News: Draghi Weighs Whether Rate Cuts Too Valuable as ECB Meets Wall Street Journal: A Call to Arms for the ECB The Economist: Waiting for the Cut   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

Eurozone leaders meeting for tomorrow’s summit are unnecessarily worried about contagion to Italy, but a growing sovereign debt crisis highlights the role of politics in the markets and the need to find common, EU-wide solutions, says expert Franco Pavoncello.