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Italian Prime Minister Mario Monti speaks on the phone during a session at the Parliament on Nov. 18 at the Parliament in Rome. Monti, who succeeded Silvio Berlusconi, has the unenviable task of balancing Italy's fiscal budget to calm the European financial markets. (Andreas Solaro/AFP/Getty Images)
News of Prime Minister Mario Monti successfully forming a government in Italy and some encouraging German GDP data was not enough to lift stock markets in Europe.
The Euro Stoxx 50 benchmark equity index lost 3.79 percent to close at 2,236 last week, drifting lower every day with only a few brief relief rallies. The euro currency lost 1.70 percent to close at 1.35 on Friday.
GDP Data on Track but Inflation High
Q3 real GDP for the 17 countries that share the euro grew 1.4 percent in the 12 months ending September, which was exactly as 28 economists surveyed by Bloomberg expected.
Germany’s GDP surprised slightly on the upside (up 2.5 percent year-on-year versus 2.4 percent expected) and French GDP came in line at 1.6 percent year-on-year growth for the third quarter 2011.
While this is encouraging, the consumer price index for the eurozone increased 3 percent year-on-year, which is far above the European Central Banks (ECB) target rate of 2 percent. Also, in Germany producer prices increased 5.3 percent in October 2011 compared to October 2010.
The ECB—unlike the Federal Reserve—is obliged by its mandate to keep the harmonized consumer price index for the eurozone below 2 percent over the medium term.
Calls for Debt Monetization
Given this rather inflexible mandate, the ECB is increasingly finding itself in an uncomfortable position. On the one hand, price inflation is already too high and orthodox monetary policy would suggest that the ECB raise rates and withdraw liquidity from the system.
On the other hand, the eurozone is faced by an unprecedented credit and sovereign debt crisis that many analysts believe can only be solved by monetizing bad debt or “printing money.”
In its commentary on the Germany economy, Goldman Sachs argues, “In particular the worries about the inflationary impact of debt monetization are exaggerated. Sovereign debt purchases of a central bank do not necessarily lead to inflation” and cites the Japanese example, where large scale purchases of government debt did not lead to meaningful increases in the consumer price index. Goldman analysts also cite in the same paper that monetization of government debt only leads to inflation if it is accompanied by an increase in fiscal spending. Given that many governments are implementing so-called austerity measures and are cutting spending, Goldman does not see that as a risk.
Deutsche Bank (DB) also calls more action on the side of the ECB in a recent report. It cites a lack of confidence of markets in the European Union’s institutional framework and that the situation in Italy brought markets to the tipping point. According to the report, Italy needs to issue 300 billion euros ($405.42 billion) of bonds in 2012 but that its “sovereign bond market is broken.” Given that the European Financial Stability Facility (EFSF) has not gained the support of bond investors, DB calls for the ECB to “announce [a] large, targeted buying plan [of sovereign bonds] (i.e. 200 billion euros over 12 months).”
Fitch and Unicredit Results Fuel Italian Problems
Underscoring this dire assessment of the situation in Italy was the announcement by Fitch ratings agency that Italy might be cut to “low investment grade” under that condition that it “loses market access.” Given the fact that the ECB already had to buy another 4.48 billion euros ($6.05 billion) worth of mostly Italian and Spanish debt in the week ending Nov. 11 to support prices, this might already be the case.
Italian Banking Giant Unicredit added to the worries by announcing a huge disappointment for its Q3 reporting period. Net earnings came in at a loss of 10.6 billion euros ($14.32 billion) caused by 9.77 billion euros ($13.20 billion) write down on its debt portfolio. The company will pay no dividend in 2011 and has to raise as much as 7.5 billion euros ($10.13 billion) in equity to make up for the capital shortfall.
Germany Reluctant to let ECB ‘Print’
Voices out of Germany, however, make a monetization scenario that would help mainly peripheral countries unlikely. Germany had to suffer through a hyperinflation in the early 1920s and held its post-World War II central bank (The Bundesbank) by a strict inflation mandate. The ECB was designed around to the rules of the Bundesbank and also has to follow a strict inflation mandate.
German officials and politicians have cited various reasons that speak against a more pro-active role of the ECB. They say that outright monetization would be against eurozone treaties and that it would lead to so-called moral hazard, a process where bad fiscal behavior by governments is encouraged rather than penalized.
Yves Mersch, the ECB governing council member from Luxembourg, supported the German view in a speech in Frankfurt last week. Mersch said that monetization “is tantamount to inflation” and “not feasible.” Using this technique “would reduce incentives for governments” to become fiscally responsible and “would raise the risks of even higher future inflation and greater output volatility. Uncontrollable wage-price spirals would be likely.” He denied the role of the ECB as a “lender of last resort for governments” and emphasized that governments must take responsibility for past spending.
20 billion euros Maximum for Weekly Bond Purchases
In what seems to be a compromise of the two extremes, last Friday, the German Daily FAZ reported that the ECB agreed not to buy more than 20 billion euros ($27.03 billion) of peripheral debt per week.
The newspaper did not say where it got the information from but did report that other countries opposed to outright money printing include the Netherlands and Austria. Nonetheless, adding up 20 billion per week would still amount to more than 1 trillion euros ($1.3514 trillion) per year, but this buying would have to be offset by selling other securities such as German government bonds which enjoy ample demand in the marketplace.
The Week Ahead
Spanish general elections took place last Sunday where the center-right People’s Party was leading the exit polls and is expected to win an absolute majority in Parliament according to broadcaster RTVE. This marks a defeat for the incumbent socialist party around Prime Minister Zapatero.
Consumer confidence for the eurozone is expected to come in at minus 21 versus minus 19.9 the prior month and retail sales in Italy will give a hint if the state troubles remain isolated or have spilt over to the private sector. Economists expect a 0.5 percent increase from the previous year.