ECB reliant on ‘confidence’

We should be reluctant to ascribe either recessions or even recoveries to changes in the level of the nebulous concept of “confidence” because consumer confidence indices only have a weak and often lagging correlation to actual economic outturns while business confidence indices, though often more accurate, tend to be coincident rather than leading economic indicators. But the new ECB President apparently believes that, while Europe may fall prey to an austerity-policy-driven recession in the near term (a forecast that we suspect is already true), the downturn will be mitigated or perhaps solved by a return of confidence. It’s not clear as to what form of confidence he refers and perhaps he is referring to investor confidence which conceivably could generate a drop in peripheral borrowing costs, but if we assume an unchanged supply side situation, an economy will only expand if the level of injections exceed the level of withdrawals. If Euroland governments attempt a prolonged period of austerity, which implies a reduction in public sector ‘injections’, then their economies can only be expected to expand if, and only if, their current account positions improve (i.e. exports rise and/or imports fall significantly); and/or their private sector savings rates fall and/or private investment rises.

In Italy this year, the budget deficit declined slightly, the current account deficit widened, CAPEX was weak and we may suspect that the savings rate rose. In each case these variables moved in the ‘wrong’ direction to create growth. Spain seems to have been a little less affected, if one believes the data, but the retail sales and tax collection data seem to suggest that the official nominal GDP numbers may be a little generous. However, Mr Draghi is apparently hoping that by cutting the government deficits of Italy and others, people will magically decide to save less. As a nerdy aside, this could happen under the particular circumstances of Ricardian Equivalence theory but few real world economists would expect this. The theory that government saving will allow others to dis-save was in vogue in the mid 1980s US fiscal experiment but subsequent practical experiences rather undermined the theory. An alternative get-out-of-jail outcome would be companies spontaneously deciding to invest more despite the weakening final demand outlook. So we have Mr Draghi seemingly relying on ‘confidence’ to conjure up a recovery.  This has some similarities to the UK government’s hopes that 1992 would see a confidence driven recovery – and what actually happened was a continued recession and an ignominious exit from the constraints of the ERM once it became clear that the electorate no longer had the stomach to pay the deflationary costs of ERM membership. Unless there is more decisive action by governments and central banks, history may well repeat itself, with the current form of the Euro following the ERM into the history books.

We also have to be surprised that the media and commentators have not cottoned on to the reality that, despite all the calls for the ECB to “print money”, the ECB cannot actually do this itself since it does not have its own balance sheet. Instead, if the ECB were to attempt to ease in this fashion, the ECB would have to ask its member banks to print more money and, in the current fragile situation in which the PIIGS and France for that matter are running balance of payments deficits within the system, the only central banks which could sensibly ‘print money’ are the surplus countries, which in practice means Germany and the Bundesbank.

Somewhat ironically, markets have recently harangued Hungary’s authorities for attempting to monetise their debts while facing a weak balance of payments position but the very same commentators are asking Italy et al to do the same when then blithely say the ECB should start expansive policies with printing. In reality, a quantitative easing within Euroland would have to come from a massive proactive expansion of the Bundesbank’s balance sheet which the Germans have rejected for a long time. Perhaps Mr Draghi’s seeming reliance on recovering confidence reflects his recognition that his room for action is limited Germany’s apparent view of appropriate central banking policies.  Put simply, for the Euro not to fail, the Bundesbank must utilise its balance sheet in a committed manner and yet when we look back to the 1987 equity market crash and the breakup of the ERM, we can note the Bundesbank’s commitment to price stability: on both occasions markets bet wrongly that the Bank would yield, but on both occasions the central bank did not, and markets were forced to adjust.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla