Why European Monetary Policy Is Now Impotent

For the last year or so, Mario Draghi (the omnipotent head of the ECB) has discussed 'market fragmentation' as a major concern. The reason is clear - his easy money policies are entirely ineffectual in a monetary union when his actions do not 'leak' out to the real economy. Nowhere is this fragmentation more obvious than in the inexorable rise in peripheral lending rates (to small business) compared to the drop (over the last 18 months) in the core. Simply put, whether it is demand (balance sheet recessionary debt minimization) or supply (banks hoarding for safety), whatever the punch ladeled from the ECB's bowl, it is not helping the most needy economies. Of course, that was never really the point anyway - as we have pointed out many times; the actions of the ECB are (just as with the Fed) to enable the banking system to live long enough to somehow emerge from the black hole of loan losses and portfolio destruction that they heaped upon themselves. This chart is yet another example of proof that monetary policy is entirely ineffectual in the new normal - and yet the central planners push for moar...




The real divide within the euro area is the still broken monetary policy transmission mechanism. An Italian (or Spanish) and a German (or French) company having similar credit ratings are actually not in the same currency zone because the former would get medium term loans at 5.8% vs. 3.5% for the latter (prime rates for 1-5Y loans of less than € 1 mn, Italy and Germany). Note that this 230bp spread is roughly the same as the Italy vs. Germany spread for 2Y government bonds; a perfect illustration of the lethal link between sovereigns and banks within the euro area.


Politics aside, this divide is the main threat for the very existence of the euro because it is fuelling a vicious circle, making weaker countries suffocated by a credit crunch while stronger ones are drowned with liquidity. Since one-off effects-adjusted inflation is now significantly lower in Italy and Spain than in Germany, by around 30bps for Italy and a whopping 170bps for Spain, the real interest rate divide is even larger. The ECB has long ago identified the financial fragmentation of the euro area as its main monetary policy challenge. The medicine has been identified: it is the banking union, which should restore a level playing field for euro area companies.


The main fallout of the Cyprus deal is that it has revealed how much political leaders have become allergic to commit taxpayer’s money to bail out bankrupt banks. Welcome to the bail-in world. Yet, the Cyprus tree or even the bail-in grove should not hide the much larger and darker euro crisis forest. A 400 basis points differential in terms of the real cost of credit for companies within the euro area is not sustainable.

And with the bail-in becoming the new normal in Europe, we suspect the chance of a full banking union without significant pain from normalization of all banking systems (before Germany will submit to implicitly backing all European depositors) is the same as Florida Gulf Coast going all the way (well less actually).


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