Euro-zone Growth Tepid - Euro Will Suffer!

The confession by Mario Draghi that growth in the Euro-zone may be on the wane comes as little surprise to us who have watched the area struggle for over a decade. Recently Draghi warned, "we can't declare victory over inflation yet." This is where Euro-zone watchers point to problems in countries such as Italy, Spain, and Greece. The fact is that for all the stimulus thrown at it overall euro-zone growth remains not so good. Many of the issues never addressed continue to haunt these economies while Germany's growth has been pushed front and center in an effort to mask the desperation growing across a broad swath of the region. This has become more complicated with the threat of a global trade war now hanging over Europe’s export-oriented economy.

The Idea Of Euro-zone Growth Remains Questionable

Dishing out many of the usual lines he has used in the past the President of the European Central Bank Mario Draghi played down concerns over softness in the Euro-zone economy. During a press conference, Draghi argued the economy of the 19-country currency block remained strong but acknowledged evidence of a “pull-back” from the exceptional growth readings it had previously experienced around the turn of the year. As the ECB moved to bolster expectations for a gradual withdrawal of the ECB’s monetary stimulus. It seemed clear the ECB did not want to upset investor expectations that its 2.55 trillion-euro ($3.09 trillion) stimulus program would end this year and its policy rate would rise for the first time since 2011 towards the middle of next year. 

While the US and the UK were mired in political chaos during 2017 the EU was busy claiming it was experiencing improved economic conditions. This did not move them in the direction of implementing long-needed EU and eurozone reforms but merely fueled the complacency that has haunted the region for so long and set the stage for another crisis down the road. How can anyone claim the situation is under control when a story in Reuters in the middle of last year claimed officials in Europe actually thought telling the public that they will not have access to their funds, even funds covered by official deposit insurance was somehow helpful to addressing Europe’s troubled banking system.  

This is a reminder to anyone thinking that Europe is anywhere close to adopting an effective approach to dealing with failing banks may want to think again. The policy that has been in the works for some time was floated out for a reaction less than two months after a run on deposits at Banco Popular contributed to the collapse of the Spanish lender. Judging by the continued reaction by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector. That could be why even today the European Central Bank, as expected, left interest rates unchanged saying it would continue its program of asset purchases through September, "or beyond, if necessary."

The banking issue circles back around and infecting and poisoning how money flows within the Euro-zone. It is only logical that wealth would flee the weaker countries and seek refuge where banks are thought to be at least stronger if not solvent. This has become an increasingly dangerous game as EU officials talk publicly about getting tough on insolvent banks and even suspending access to funds for retail depositors while countries are more or less forced to continue bailing out troubled banks and large creditors in a display of cronyism and business as usual. The ugly choice is to let the bank fail which would unleash a wave of bank runs that would spread into total chaos.

Contrast the EU proposal with standard practice in the US, where the Federal Deposit Insurance Corporation (“FDIC”) begins to market troubled banks before they fail. Bank closures and sales usually occur on a Friday with the branches of the failed bank opening on the following business day as part of a solvent institution without any interruption in customer access to funds. All this feeds into and creates a strong argument that nothing is really better or has been fixed in the Euro-zone and that the area continues on life support. The fact is the ECB is trapped in a box of its own making or why else would it leave its refinancing rate at 0%, the rate paid on deposits parked overnight at the bank at negative 0.4% and the rate on the deposit facility at 0.25%.  

While some Wall Street analysts started encouraging investors to jump into EU bank stocks last year, the fact is that there remains nearly €1 trillion in bad loans within the European banking system. This represents around 6.5% of the EU economy. That compares with non-performing loans (NPL) ratios in the US of 1.7 percent and 1.6 percent of gross domestic product in Japan. Circling back to the issue of the banking sector and public faith in these institutions, the idea that the banking public would ever be denied access to cash virtually ensures that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble. The US learned the hard way in the 1930s and again with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation.

Unfortunately, much of the problem is rooted in the fact the euro itself was constructed on a weak and flawed foundation. Any currency joining and binding states or countries together must allow for an adjustment to send back funds to its weakest part or eventually it will become so unbalanced it will fail. The United States does this by collecting taxes on a federal level and sending back money and aid to areas that are economically weak and need help. In the same way, the EU has still refused to deal with Greece’s mounting debt it cannot seem to accept that protecting the small depositors of European banks is the price to be paid for preserving social order and even the euro itself. The bottom-line was revealed in Draghi's comment: "An ample degree of monetary stimulus remains necessary." This most likely means the euro will suffer more pain going forward.