Europe Compass: Jury is still out

EUROPE COMPASS WEEKLY UPDATE JANUARY 14, 2013

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Jury is still out   ECB President Mario Draghi was guardedly optimistic on January 10 in his monthly press conference. Although he noted much improvement in terms of financial market conditions, he cautioned that "the risks surrounding the economic outlook for the euro-area remain on the downside", that "the present situation is characterised by high uncertainty", that any recovery is "going to take some time" and that the turnaround in the real economy would start in late 2013. He also made it clear that even though the ECB governing council decided unanimously not to loosen monetary policy, they were not looking to tighten monetary conditions and were "not thinking about an exit" from reliance on non-standard monetary policy instruments. When asked whether his own efforts to calm the markets had been successful, Draghi responded, "The jury is still out". But who is on the jury?

Market participants   No one doubts that market participants play an important role in passing the verdict on ECB effectiveness. In many ways, influencing market sentiment is what monetary policy is all about. As Draghi explained, there are three blockages that could be holding up the flow of credit from banks to industry: access to funding; adequate capital; and a combination of risk appetite and market confidence. Draghi argued that the ECB had tackled the funding problem with the long-term refinancing operations (LTROs) and that the problem of capital was being addressed as well. Any remaining blockage must therefore be due to market sentiment, which he suggested should improve alongside the acceleration of the economic recovery later this year.

Voters   The weakness of the euro-area economy will form the backdrop for elections in Italy. The release of Eurostat's latest revisions of key euro-area statistics on January 17 will add more fuel to the debate. The Italian economy is directly affected and former centre-right Prime Minister Silvio Berlusconi is using this to discredit his centrist and centre-left opponents. Berlusconi argues that outgoing Prime Minister Mario Monti has been too quick to follow German calls for austerity and that centre-left candidate Pier Luigi Bersani would be too weak in the face of trade union opposition (and too 'communist') to undertake meaningful structural reforms. These arguments are hardly new, particularly as a critique of the centre-left. However, the poor state of Italy's economy gives them resonance: A public opinion poll published on January 11 by RAI 3 shows a high level of popular disaffection with Monti as a politician and with austerity as a policy. Polls also show that Berlusconi's coalition has closed the gap with Bersani's, to 10-15 percentage points at the national level; Berlusconi is also 10-15 percentage points ahead of Monti's centrist coalition. At the regional level, new polls have come out for Campagna, Lazio, Lombardy, Piedmont and Sicily, which account for more than half of the Senate. Berlusconi's centre-right coalition currently leads Bersani's centre-left coalition in Sicily and ties with them in Lombardy. If Berlusconi wins the contest in Lombardy, then together with the seats allocated to Monti's centrists and Beppe Grillo's Cinque Stelle movement, he could prevent a clear Bersani majority. This means that Berlusconi has the potential to block Bersani from controlling the Senate, even if he has little chance of leading in the Chamber of Deputies. Ironically, this would make it more likely for Monti to return as head of a government of national unity. However, it could also lead to a prolonged process of government formation and an unstable governing coalition. If anything, the elections in Germany are even more important, both at the state (Land) and federal levels. The German economy is performing much better than the European average, but it cannot help suffering from declines in its major export markets. Moreover, the contrast between German strength and weakness elsewhere is having a powerful influence on the shape of the debate: German voters are not ready to fund a bank bailout in Cyprus. They expect more efforts at fiscal consolidation and market structural reform from their neighbours. They are unlikely to support any further action by the ECB to attempt to buy time with a relaxation of policy. Although there were plenty of rumours that the ECB may take advantage of last Thursday's governing council meeting as an opportunity to lower interest rates, Draghi made it clear that the appropriate venue for additional action is at the national level, that the ECB is united in this perspective and that resolving unemployment is not part of the ECB's mandate. It is hard not to see this message as being addressed to German voters as well as to the representatives of the financial press.

Central bank watchers   Last week, two debates re-emerged about the ECB and its mandate: whether central banks can avoid being political; and whether it makes sense to run a central bank with a single 'price stability' target. Central banks are political insofar as central banking assigns winners and losers, depending upon how the policy instruments are set and when they are changed. This is true particularly when the long-term consequences are shrouded in uncertainty, while the short-term costs and benefits are more easily foreseen. That is the situation we are in today, not just in the euro-area but across advanced industrial societies. The only defence for central bankers is the clarity of their mandate: so long as they can claim to be doing as instructed, they cannot be accused of engaging in politics. The problem is that a clear and transparent mandate, such as that possessed by the ECB, may not be the best way to use central banks. This creates a political dilemma of a different sort, where the ECB throws its weight behind a dysfunctional mandate in order to protect its own independence -- even at the expense of better policy outcomes. These debates about central banking are not clear cut and are unlikely to be resolved quickly. The world's major economies will probably have to emerge from the on-going crisis first. Nevertheless, such arguments are likely to feature prominently in political debates about the state of the economy and will feature in how market participants interpret and anticipate central bank policy. In that sense, the three different parts of the jury are all inter-connected. And, as Draghi was careful to mention, the jury is still out.

I trust you have found this weekly Europe Compass note helpful. The Europe Compass is one element of Oxford Analytica's Europe Practice, which provides analytical insight and advice on the changing political economy of Europe and the implications for corporations, investors and public institutions in all markets and regions. I invite you to contact me or anyone at our Europe Practice with your queries or concerns.