By Erik Norland
The contrast between the state of Europe’s economy and the state of its politics could hardly be starker. Despite some evidence of a slight moderation in the pace of growth, Europe’s economy continues to improve even as political situations in Germany, Italy and Spain become increasingly delicate. Brexit remains the source of significant uncertainty; the refugee issue continues to roil politics and NATO’s foundations have developed cracks. As we head to the European Central Bank (ECB) meeting on July 26, markets appear to be more focused on what’s going wrong in Europe rather than what’s going well. From an economic perspective, there are three positive trends that are easily overlooked:
- Unemployment, while still too high, is falling in Europe at a steady pace (Figure 1).
- Budget deficits are getting smaller across the Eurozone, even outside of Germany (Figure 2).
- Amid extremely low interest rates, most European countries are successfully deleveraging (Figures 3, 4, 5 and 6).
Figure 1: ECB 2010 Rate Hikes Delayed Europe’s Recovery for Four Years but it’s Now Underway.
Figure 4: Debt Levels are also Falling in the Netherlands, Italy and, Soon, in Post-Restructuring Greece.
Figure 5: German and Austrian Debt Levels Continue to Fall as Well.
Figure 6: Debt Levels Have Started Falling in Belgium and Finland; France Leverage Ratios are Stable.
The fact of an improving economic situation doesn’t mean that the ECB will be in any hurry to raise rates. Eurozone inflation remains extremely low, with core inflation nearly a point and a half below that of the U.S. (Figure 7).
Figure 7: Eurozone Inflation Remains Subdued.
This implies that the ECB can probably wait at least 12-18 months before raising rates. The major issue facing the ECB over the next year isn’t raising rates or ending quantitative easing (QE), the latter being a foregone conclusion; it’s choosing a successor to outgoing ECB president Mario Draghi. The theoretical favorite is Germany’s Jens Weidmann. Weidmann, however, has opposed nearly every measure that Draghi has taken, sometimes vocally. With Europe’s recovery still four years behind that of the U.S. – owing in no small part to policy mistakes in 2010 and 2011 under the more hawkish Jean-Claude Trichet and Axel Weber – many Europeans are in no mood to have a policy hawk at the helm of the ECB.
As such, while Germany may feel that it is owed the chairmanship after having been held previously by the Dutch, French and the Italians, a variety of alternative candidates are being put forth to challenge Weidmann. Moreover, it’s not clear how hard Angela Merkel, who is beset by political problems at home, will fight on his behalf and what she might have to sacrifice in return for securing him the chairmanship. All in all, Draghi’s upcoming departure doesn’t necessarily signal a turn towards a more hawkish monetary policy in late 2019 and in 2020 – although such a development can’t be ruled out.
In the U.S., when Federal Open Market Committee (FOMC) chairs leave, they often try to normalize policy on their way out. Alan Greenspan’s FOMC hiked rates 16 times between June 2004 and May 2006 so that the incoming Ben Bernanke would have what the Fed thought (mistakenly) to be a neutral monetary policy. The FOMC hiked rates one last time in June 2006, the month…