After Draghi departs, eurozone deluge looms

The ECB chairman quits next year after an impressive eight-year term. But as money growth slows to a halt, troubled times lie ahead 

Tim Congdon

Among Milton Friedman’s many controversial statements, one stands out for its intellectual provocation. In a 1982 volume co-authored with Anna Schwartz, Monetary Trends in the United States and the United Kingdom, he examined money supply statistics going back over a century. On their basis, he said that the assumption of a constant velocity of circulation of money was “an impressive first approximation”. In other words, changes in money are accompanied by the same proportionate change in national income. If the quantity of money rises by 10 per cent in a year, then so will national income; if the quantity of money triples, then so will national income; and so on.

Dozens of scholars have responded by checking the data, with the resulting consensus being that Friedman was overstating the case. As numerous examples can be cited of significant changes in velocity, movements in money do not always portend exactly similar movements in nominal national income or inflation. However, the critics went too far. The evidence is overwhelming that — in the US, the UK and all countries — large changes in the rate of growth of the quantity of money matter to macroeconomic outcomes.

Let us — for the purposes of this article — suspend the disbelief and set aside scepticism about Friedman’s work; let us take the notion of a constant velocity of circulation as a reasonable working hypothesis; and let us apply that hypothesis to the European single currency from the start in 1999. As will emerge, our analysis will have a deeply worrying message for those who believe — as Europe’s single currency approaches its 20th birthday — that its future is secure.

As far as money growth is concerned, the almost two decades of the euro’s existence split readily into three periods. The first, from the beginning of 1999 to the third quarter of 2008, had an annual rate of money growth of 7.5 per cent; the second, from the onset of the Great Recession at the end of 2008 to the end of 2014, saw the annual rate of money growth dip to a tiny 2 per cent; and in the last and most recent, from the end of 2014 to early 2018, it recovered to 5 per cent.

Anyone persuaded by the monetary approach to economics would expect the first and third periods to have the highest increases in nominal national income, and the middle six-year period the lowest. Further, the middle period might have experienced negligible increases in the price level or even occasional falls. After all, if velocity is constant, a 2 per cent increase in money implies a 2 per cent increase in nominal national income; and, if an increase in output of about 2 per cent is achieved (which might be seen as normal in mature industrial societies), a 2 per cent increase in nominal national income means no change in the price level. That was indeed more or less what happened for the eurozone as a whole on average between 2008 and 2014, much as Friedman might have envisaged.
However, the experiences of particular nations and the details of monetary policy-making were harrowing for the eurozone’s decision-takers. In some countries and in some years prices fell by several per cent, raising concern that deflation might become entrenched. Worse was the unevenness of the deflationary risk. Germany did quite well. In 2009 it succumbed to the Great Recession, like almost every country, but it did not undergo any further declines in national output. By contrast, the rest of the eurozone entered a second recession in 2012 and 2013, with some member states suffering traumatic declines in demand, output and employment. Worst hit were Cyprus, Greece and Italy.

People who had left money with Cyprus’s banks lost a high proportion of their deposits in March 2013, a disaster at the level of an entire nation which is unique in modern times. (Note the differences from the Northern Rock case in the UK. Depositors had all their money returned, while the British state  made a profit from its disreputable seizure of the bank from its shareholders.) The Greek government had lied to the European Commission and the International Monetary Fund, as well as to its own people, about the size of the public debt. In 2011 it reneged on its obligations to private creditors, in the world’s largest-ever sovereign debt default. Notoriously, some of its politicians — including the headline-seeking Yanis Varoufakis, its minister of finance in early 2015 — threatened to take Greece out of the eurozone in a brazen attempt to undermine the legitimacy of the single currency project. Less noticed in the British media, Italy’s gross domestic product went down by 2.3 per cent in 2012, 1.9 per cent in 2013 and 0.6 per cent in 2014. 

Although the Greek challenge to the euro was rebuffed, quarrels between the different member states were openly reported. Even worse, the overarching European Union organisations (notably the Commission and the European Central Bank) clashed in public with politicians representing their own nations’ interests. One lesson of the six years to end-2014 — and particularly of 2012 and 2013, when the eurozone’s macroeconomic plight was far worse than that of the rest of the advanced world — was that too low growth of the quantity of money can cause deflationary headaches, just as too fast growth of the quantity of money can result in disagreeably high inflation.

The obvious question is, “why did money growth fall from an annual growth rate of 7.5 per cent a year in the decade or so before the Great Recession to a mere 2 per cent during and after it?”. Much of the answer is that the banking system was weakened by the events of the Great Recession and the regulatory response to crisis. The downturn of 2009 was accompanied by a big fall in asset prices, including the prices of houses and commercial property. Many eurozone banks found that the collateral for their loans had slumped in value, so that a significant proportion of their loans could not be repaid in full. As they had therefore lost part of their capital, they would have had to restrict their assets even if regulatory capital/asset ratios had stayed the same.
But in late 2008 these ratios were abruptly and drastically increased. Just as banks were tripping up over  bad debts, the International Monetary Fund and the Bank for International Settlements — backed by the G20 group of nations — decided to kneecap them. They were told that in future they must operate with capital/asset ratios more than 50 per cent higher than before. This double shock stopped banks from increasing their loans to the private sector. In the decades leading up to the Great Recession such lending had been the key force in bank-balance-sheet expansion, the main driver of the benign increase of 7.5 per cent a year in the quantity of money. (When a bank extends a new loan, it adds identical sums to both sides of its balance sheet. The new loan is an asset which should in due course be repaid; the new liability is a deposit, which is part of the quantity of money since it can be used to make transactions.) 

Quite apart from the Grexit pantomime, the plunge in the growth of credit and money was so severe that by mid-2011 the eurozone faced an existential crisis. Mario Draghi, the current president of the European Central Bank, assumed the job on  November 1, 2011. As an Italian himself, Draghi was more alert than his north European colleagues to the impact of the crisis on output and employment. He realised that radical steps had to be taken to ease the pressures on the most vulnerable banks in the weakest countries. Within a few weeks of his appointment he announced what became known as “the Draghi bazooka”, a huge programme of long-term, low-cost loans from the ECB to any bank in the eurozone that might want the money.

Here was the first of two vital crutches for the eurozone cripple. Banks were given more time to meet official demands for higher capital ratios, and by 2014 the mood of emergency and fears of financial disintegration had gone. But the Draghi bazooka enabled banks only to fund their existing levels of business. It did prevent too sharp declines in loans and deposits, but it did not spark renewed growth in banks’ asset portfolios or the quantity of money. In April 2014 Draghi began to argue the case for large-scale ECB asset purchases, citing the success of comparable schemes already implemented under the “quantitative easing” label in the US and the UK. An increase in money growth might not fully restore the happy conditions in the first period of the eurozone’s existence, from 1999 to 2008, but it would improve demand and output, and counter the vicious deflationary processes in Greece, Cyprus and elsewhere.

The ECB started buying assets on an immense scale in early 2015. For a time these purchases ran at a rate of €80 billion a month, equivalent at an annual rate to almost €1 trillion. When a central bank buys assets from non-bank companies and financial institutions, the effect is to boost the bank deposits held by the companies and financial institutions selling the assets. In other words, the effect is to increase the rate of growth of the quantity of money. The ECB asset purchases — the second crutch for the crippled eurozone’s banking system and economy — explain why money growth revived to a 5 per cent annual rate in the third and latest period of the single currency’s existence. Consistent with Friedman’s claims about the importance of money to economic activity, the higher rate of money growth has been accompanied by above-trend growth of demand and output, and rising employment. The asset purchases (eurozone QE, in effect) seem to have revitalised the patient. Instead of hobbling around on its last legs, the single currency area has started to walk. It recorded good economic growth, with output up by 1.8 per cent in 2016 and 2.3 per cent in 2017, fully matching the performance of the United States.
So what is the problem? Why was a warning given earlier that recent financial developments are “deeply worrying” for the eurozone? The trouble is that in the last few months money growth has been sliding. In the first four months of 2018 the quantity of money went up by only 0.8 per cent. If that continued for a year, the figure would be a mere 2.5 per cent, much as it was in the stressful six years from 2008. Moreover, the figure is likely to go down further in the rest of 2018.

For the time being the ECB is still buying assets and so taking steps to increase the quantity of money. But an announcement has been made that the asset purchases will end in September. It is even conceivable that money growth will come to a complete halt. No doubt many economists dislike Milton Friedman and a monetary interpretation of macroeconomic developments. All the same, given the eurozone evidence since the start of the new currency, only an extreme optimist could dismiss the risk of a renewed recession if money growth does indeed tumble to zero.

Draghi has been an astute operator. He deserves all the praise he has received for keeping the inherently dysfunctional eurozone in being. Defenders of the single currency might say that he can ensure that appropriate measures remain in place later this year and in 2019 to prevent too extreme a deceleration in money growth. Unfortunately, that is not the position. Draghi’s term ends in November 2019, but already other personalities with different views are coming to dominate the ECB power hierarchy. A key drawback of Draghi’s two main policy innovations — the long-term, low-cost loans to weak banks, and the large-scale asset purchases — is that they discriminate between countries.

The loans have been particularly to banks that have high levels of bad debts on their books, and far too many of them are in Italy; the asset purchases have included large quantities of Italian government bonds, when it is Italy that has a particularly heavy burden of public debt. In short, Italy has benefited disproportionately from Draghi’s cleverness and guile. His successor will probably come from northern Europe (or perhaps France, as a compromise), and may try to reverse some of the decisions taken since November 2011. The Protestant work ethic, with its disapproval of easy money and short-term expedients, is about to confront the Club Med mentality. If the ECB does take away the two crutches that have kept money growth positive at about 5 per cent in the last three and a half years, and if money growth does in fact return to where it was in the 2008-14 period, the eurozone will again be the cripple of the international monetary scene.

Or will it? Many economists dispute that money is of any relevance to demand, output, employment and the price level, and will continue to be rude about Milton Friedman and his intellectual legacy. Interesting events and a fascinating debate lie ahead.

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