The One Chart To Explain Why Draghi's Blunt Tool Can't Fix Europe

The monetary policy transmission mechanism is broken in Europe; we all know it and even ECB head Draghi has admitted it (and is trying to solve it). As Bloomberg economist David Powell noted though, Draghi may have to address the economic fragmentation of the euro area before undoing the financial fragmentation of the region. The latter may just be a symptom of the former. The Taylor Rule, a policy guideline that models a monetary authority’s interest rate response to the paths of inflation and economic activity, highlights the drastically different monetary policies required across the various EU nations as a result of their variegated domestic economic conditions. This variation creates concerns over sustainability and the rational (not irrational as Draghi would have us believe) act of transferring deposits to 'safer' nations for fear of redenomination; and Draghi's bond-buying plan is unlikely to allay that fear anytime soon - as economies remain hugely divergent.


David Powell, Bloomberg: Draghi's Financial Fragmentation Fight Ignores Root Problem

Unemployment rates demonstrate the divergence of the region’s economies.




A Taylor Rule demonstrates the drastically different monetary policies required in those countries as a result of their domestic economic conditions. The model, based on coefficients estimated by the Federal Reserve Bank of San Francisco, signals the main policy rate should be minus 7.75 percent for Spain. It should be minus 3.75 percent for Portugal, minus 3.5 percent for Ireland and minus 10 percent for Greece. Germany is at the other end of the spectrum. It requires a main policy rate of 4.25 percent.



It appears broadly the Euro-zone rate is set 'fair' which means any rate cuts will be notably euro-zone inflationary - something Draghi wants to avoid.


Those economic divergences appear to have led depositors to question the sustainability of the monetary union in the absence of large-scale fiscal transfers to cushion the weakness in certain countries.


Savers may be transferring their funds to the banks of the creditor nations within the monetary union. Deposit growth in Finland jumped to 10.1 percent year over year in July. The figure for the Netherlands stood at 4.8 percent and that for Germany at 4.2 percent. Those transfers allow depositors to hedge – at no cost – the risk of redenomination of their savings into weaker domestic currencies. That behavior appears completely rational, as opposed to the “irrational fears” cited by the ECB president.


One of the basic principles of finance is an investor will always choose an investment with less risk than another if the levels of return are the same.

Draghi will probably have to convince market participants of the economic sustainability of the monetary union before the financial fragmentation of the region is ended. The OMT is a way to achieve a more focused 'easing' implcitly as QE does in the US at ZIRP - but the conditionality removes the mechanism for that benefit to flow. The large-scale extension of central bank credit to potentially insolvent countries is unlikely to accomplish that.




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