Next week Mario Draghi hands over the reins at the European Central Bank to Christine Lagarde. She takes over with a war still being fought, a divided army around her and the ammunition already fired. Draghi's time in power has demonstrated the extraordinary economic firepower held by central banks, but also that this has its limits.
To give the euro-zone economy a better chance of avoiding recession and regaining momentum, political action is needed too, but there is no sign of it happening. Lagarde faces a tricky first few months in office.
While we have all been watching Brexit dramas in the last few months, the euro-zone economic indicators have worsened. The annual rate of inflation fell to 0.8 per cent in September. The euro-zone economy will probably grow by little more than 1 per cent this year, and there are few reasons to expect a pick-up in 2020.
Central bankers rarely have Dirty Harry moments
Draghi won the battle to save the euro, but the war to avoid the euro-zone economy slipping hack into a slump goes on. The heady days of 2017 when economic growth was picking up and there was talk of interest rates starting to rise again seem a long way off. Now Trump's trade war with China – and tensions with Europe – and Brexit uncertainties have slowed growth and investment internationally, leading to a fall-off in exports from the euro zone and fostering new uncertainty. Draghi may have saved the euro, but the euro zone is still in trouble.
Not that we should understate what Draghi achieved. Taking the helm in November 2011, the Italian soon reversed the two interest rate increases early that year under previous president Jean-Claude Trichet. But it was his "whatever it takes" statement in July 2012 – as the bailout crisis, a shaky banking sector and soaring bond yields in countries like Ireland cast a shadow on the future of the single currency – that will be remembered. It is worth quoting in full. "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."
Financial firepower
Central bankers rarely have Dirty Harry moments, but Draghi was pointing out to the financial markets that bets against the euro and its members would be risky. It was a no-so-gentle reminder that betting against the house has its risks. And that the central bank would not be slow to use its financial firepower to clean out the institutions making these bets. It was a message that the ECB would not let any member be pushed out of the euro zone, exposing investors in that country’s bonds to risks.
It did the trick. It would be 2015 before the ECB actually started its programme of major buying of government bonds . But by the end of 2013, euro zone interest rates were already down at 0.25 per cent and evidence of recovery was emerging. Ireland then Portugal and Greece were able to exit their bailouts. And the era of super-low interest rates was a huge plus in the subsequent progress of indebted economies, saving Ireland hundreds of millions a year in debt-servicing costs and lowering the average interest rate on all our outstanding national debt. The annual cost of servicing our debt will be about €4.5 billion next year, some €3 billion lower than its 2014 peak.
Lagarde will know the outlook is fragile. And that there is only so much more the ECB can do
Low interest rates have been part of the Irish recovery story. But on our high-growth island we don’t have a feel for the slowdown afflicting much of continental Europe. Whether Europe technically enters a recession or not may rest on Donald Trump’s mood as he considers his next move with China, or even on what finally happens with Brexit.
But the point is that it is now close to stagnation and the German economy may have gone through a mini-recession earlier this year. The risk facing the euro zone, or at least its core economies, is a prolonged period of very low growth and inflation, often called “Japanifaction” as this is what happened there after an asset bubble burst in 1991. For about half the time since, headline inflation figures have been negative. In turn, this has led consumers to hold off making purchases as they expect better deals in the future.
Interest rates
History rarely repeats itself exactly. And not all the big euro zone economies are as poorly placed as Germany’s, hit particularly hard due to its export reliance and troubles in the car sector. But Lagarde will know that the outlook is fragile. And that there is only so much more that the ECB can do, with interest rates already on the floor and, in the case of the rate paid to banks for depositing cash overnight, in negative territory. This is causing huge problems for the banking sector.
She faces two big challenges. The first is to ensure the ECB presses ahead with its policy of reviving bond buying – so-called quantitative easing – agreed in the dying days of the Draghi regime. The second – more difficult – task is to get the big creditor countries, notably Germany, to loosen the purse-strings on government spending.
Despite clear infrastructure needs and slumping growth, the political balance in Germany is still clinging to the dogma of the balanced budget. But to lift Europe from its slump, budget policy as well as ECB monetary policy will be needed.
There are risks here, of course. There is already a bubble in international bond markets. And Lagarde is facing strong kick-back from a German-led group on the ECB council and beyond. On the surface, it will all look genteel, but international economic relations are now a bear-pit, with trade wars, threats of competitive currency devaluations, Brexit and slowing growth internationally. Draghi did, indeed, do what is needed, but his successor still faces a huge challenge.