The giant black cloud hanging over Europe’s economic recovery

A remarkable ECB ‘dialogue paper’ last month on QT in the eurozone said the institution “should think more carefully” about the risks of draining reserves too fast and setting off bank runs. “The ECB should be extremely careful about the interaction of QT with the unwinding of its TLTROs,” it said.

The paper leaves no doubt that “political and legal” motives are driving the process, not economics. The ECB wants to clean up its balance sheet and fight (valid) perceptions that it has degenerated into a fiscal agent for Club Med governments. It is being done to placate the German constitutional court and to avoid a eurosceptic tantrum in Northern Europe.

Any number of things could set off another eurozone crisis. A crash in commercial real estate is one. A bigger and less understood danger is spelled out in the International Monetary Fund’s Stability Report: what happens when the Bank of Japan scraps its policy of holding down bond yields, as the new governor is itching to do? The move could trigger a vast and sudden repatriation of Japanese funds, reversing the world’s biggest carry trade overnight.

The Japanese have accumulated $5 trillion of foreign portfolio assets, mostly debt, and much of it in Europe. Their share of each bond market is: Ireland (15pc), Netherlands (11pc), France (7pc), Belgium and UK (5pc), Spain and Italy (4pc), and Germany (3pc).

The eurozone never sorted out its fundamental problems. It never completed the banking union, needed to break the doom-loop of banks and sovereigns, each dragging the other down in a self-feeding crisis. Germany and Italy could not agree on terms even when Mario Draghi was Italy’s premier. Compromise is near hopeless with a hard-Right coalition in Rome. 

The northern creditor states never signed up fiscal union, the sine qua non of a viable monetary union over time. There was a one-off burst of joint bond issuance during the pandemic but Emmanuel Macron’s hopes of turning this into a proto-EU treasury have been dashed by Berlin. Germany refuses to share its credit card with France and Italy.

“Fiscal integration is a super-tough nut to crack in Europe because it is intrinsically linked to national sovereignty and democracy,” said Jeromin Zettelmeyer, director of the Bruegel think tank in Brussels.

“We thought for a moment that it was some kind of ‘Hamilton moment’ but clearly it was not a permanent game-changer. As a consequence we will probably never get to the minimum economic constitution required for the euro to deliver stability and prosperity,” he told a forum on the euro.

“Is it better than monetary independence, essentially the path that the UK took? It’s not fully clear,” said Prof Zettelmeyer, asking what would happen in the eurozone if one country went feral with anything like Trussonomics. 

The episode was embarrassing for Britain but was corrected quickly with little lasting damage. “The UK’s political and economic institutions absorbed the shock. Now think of something like this in the eurozone with, say, a populist right-wing in France trying to pull a Liz Truss. The consequences would be disastrous,” he said.

The ECB has limited margin for error. It has already overtightened twice in its short history. It raised rates into the teeth of recession in 2008 and again in 2011, both times turning a bad situation into something much worse.

One Lost Decade is bad enough. Two would be tempting fate.