Global markets stuck on horns of nasty German dilemma

The German government is stuck on the horns of an extremely nasty dilemma. Berlin’s decision will go a long way towards determining whether or not we endure serious instability on global financial markets over the coming months. The future path not just of the eurozone but also the UK and, in fact, the entire world economy will be impacted significantly by Angela Merkel’s next move. The German Chancellor, moreover, has just days to make up her mind.

Is Berlin to permit full-scale quantitative easing? Will Germany’s coalition government allow money created ex nihilo by the European Central Bank to be used to buy the sovereign bonds of otherwise insolvent eurozone nations? While this is an arcane,technical question, the real-world implications are huge.

Stock markets surged across the Western world last Wednesday, on new data showing eurozone prices were 0.2pc lower in December than the same month in 2013. This “slip into deflation” puts the ECB under pressure to address falling prices, and their potentially debilitating effect on investment and growth, by implementing fully-blown euro-QE – which is why the news saw equities rocket and sovereign bond yields drop.

Indeed, the only reason eurozone bond-markets have been relatively stable of late, with the danger of a tumultuous break-up seemingly over, is that ever since his “whatever it takes” speech of mid-2012, ECB President Mario Draghi has been hinting at QE salvation just around the corner. That’s allowed cash-strapped eurozone governments to borrow at ultra-low interest rates even while presiding over moribund economies and national balance sheets riddled with debt.

For a couple of years, then, eurozone stock and bond markets, and their global counterparts, have been pricing-in, ever more enthusiastically, the idea the ECB will ride to the rescue. Almost everyone is betting on the Frankfurt-based institution joining its US and UK equivalents in using money-from-nothing to buy up vast swathes of government debt, so “solving” Europe’s chronic state indebtedness and ensuring the eurozone remains intact. Draghi was at it again last week, commenting in an obscure letter, which just happened to come to the media’s attention, that ECB measures “may entail the purchase of a variety of assets, one of which could be sovereign bonds”.

While the ECB’s six-member committee formally decides whether or not to wield the QE bazooka, the reality is that Germany, the eurozone’s paymaster-in-chief, calls the shots. And the trouble is that, for all Draghi’s promises, while Merkel has never ruled out ECB sovereign bond purchases, she has never formally approved them either.

Thanks to Draghi, and the siren calls of an army of economists working for financial institutions set to benefit from a dose of eurozone funny-money, there’s a near-universal market expectation that the ECB will announce a no-holds-barred QE programme at its next meeting on 22 January. Such is the hype that a weak announcement will result in a serious lurch, as equities tumble and bond yields spike.

This expectation has been created, of course, precisely to pressure Merkel. A German “nein”, after all, will result not only in a damaging market downturn. The impact on the bonds of weaker “peripheral” eurozone members like Portugal and Greece, and potentially large economies such as Spain and even Italy, will put “eurozone breakup” very firmly back on the table.

Yet, Draghi’s plan is probably illegal under EU Treaties. Next Wednesday, the European Court of Justice will rule on a challenge brought by a group of German activists and politicians. The ECJ will no doubt fudge the ruling, leaving the too-hot-to-handle decision in Merkel’s court. The action reflects, though, a very deep-seated German aversion to government debt “monetisation”. That’s hardly surprising given the country’s inter-war experience of such measures unleashing spiralling inflation, economic collapse and a well-documented era of political extremes.

So, is German to accept euro-QE? Doing so would abandon the economic principles of monetary caution and budgetary restraint upon which it built post-war success, transforming itself from a bombed-out shell of a country, disgraced and defeated, into an exporting powerhouse and Europe’s biggest economy by far.

Were Berlin to refuse euro-QE point-blank, though as many Germans instinctively feel it should, the resulting systemic lurch, as markets unwind, could easily result in one or more countries enduring such economic duress that they crash out of the eurozone. Germany would then stand accused of “abandoning Europe” – a prospect perhaps equally as horrifying as money-printing to many citizens, not least those born in the 1940s and 50s who are currently calling the shots.

For several years now, egged on by his fellow Italian politicos, and their French cousins, to say nothing of his numerous friends working in finance, Draghi has been pushing Germany, gradually prising open this ghastly “Europe or us” dilemma, picking at the sore. Merkel has been mostly silent. She hasn’t dared to support euro-QE given the domestic opprobrium that would generate. Desperate for a short-term economic boost, though, to hold together a fragile coalition, she hasn’t ruled it out either.

Now, with the eurozone officially “in deflation”, stock and bond markets on a knife-edge and the region flirting with triple-dip recession, Merkel is under immense pressure to show her cards. Even Germany itself, the region’s economic engine-room, has stalled.

No matter that “deflation” is an almost entirely bogus argument. Strip out an oil-driven 6.3pc drop in energy prices and inflation was positive in December. Yes, we’re below the ECB’s 2pc target, but that’s because the economy has stalled, with survey data pointing to fourth quarter growth of barely 0.1pc. But that’s not down to a lack of printed money. Firing up the ECB’s virtual presses will do nothing to address the genuine obstacles to eurozone growth – the silted-up labour markets, the ghastly demography, the still massively debt-soaked banking sector that is too fragile to lend, so starving credit-worthy firms and households of finance, in turn strangling aspiration and commerce.

Addressing such entrenched problems requires leadership, courage and immense political will. This isn’t just a eurozone problem, of course – although here in the UK, with less regulatory fug and a stronger entrepreneurial culture, we’ve lately managed to eek out more growth. But to think that QE will fix the eurozone, and solve “deflation” is just nonsense. Once begun, fully-blown eurozone QE will go on for years. By cossetting busted banks and draining resources, a euro-QE drip-feed will send Europe into a decade or more of near-zero growth.

Three days after the “ECB ruling” on 22 January there will be an election in Greece. The prospect of a government ruled by Syriza has made calls for QE even louder. The radical left-wing party, of course, is threatening to abandon the fiscal reforms imposed by the EU and IMF that were conditions of the double Greek bail-out.

If Germany then punishes Athens, the Greeks could walk, putting us in extremely dangerous eurozone break-up territory. Even if Syriza agrees to negotiate, other bailed-out countries will then demand less onerous terms, which could send bond markets haywire.

So the markets desperately want euro-QE. The prospect of a Syriza government has provoked calls for the ECB simply to hose down the entire incoherent mess that is the eurozone with printed money. Most governments, too, across practically the entire Western world, desperate for the feel-good upside, are willing Draghi on.

In 2012, the ECB said the eurozone can do overt QE. Before the month is out, Merkel will almost certainly say it will. Despite that, German instincts, while unpopular, are correct. History shows, time and again, that this policy is madness and, ultimately, deeply counter-productive. But since when did we learn from history?

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