Mario Draghi as (Successful) Football Manager

It is sometime said that the chief skill of a football manager is to pick to which team he should lend his magic at any one time. Much the same  might be said of central bankers and their policy initiatives. For example, when Mark Carney accepted the post of Governor of the Bank of England in late 2012,  it could be inferred that he was fairly confident the boat was not going down.

Something similar may be true of the European Central Bank’s latest clutch of easing measures. The combination of further interest rate cuts (including more deeply negative interest rates on banks’ deposits with the central bank; an enlargement and extension of its asset-buying program, and a new round of even-more generous long-term refinancing offers) probably can’t secure the ECB’s inflation target of near-but-not-quite 2% in the medium term. Nor can they guarantee the rehabilitation of the Eurozone’s banking system: the Japanese experience of the last 25 years shows how hard it is for even the most extreme monetary policy to resuscitate broken banking systems.

However, ECB governor Mario Draghi has pushed the new measures at a time when it is reasonable to expect the Eurozone’s current grinding and acyclical expansion to continue and  accelerate modestly. If so, future commentators will congratulate M Draghi on the part he played in securing it.

In more detail:

i) the ECB’s refinancing rate is cut 5bps to zero; its marginal lending facility rate is cut by 5bps to 0.25%, and the deposit facility rate charged on banks’ excess deposits with ECB is raised 10bps to 0.5%. 

ii) the ECB raised its target for monthly purchases of assets by Eu20bn to Eu80bn a month, with investment euro-denominated corporate bonds included.

iii) a new series of four refinancing operations will be launched in June, each with a four year maturity, under which banks will be able to borrow up to 30% of a specific eligible portion of their loan-book as of end-Jan 2016, with the rate set at the main refinancing rate (ie, zero). 

The Eurozone is still in the early stages of a weak recovery, with 4Q’s 0.3% qoq GDP growth being the 11th successive quarter of sustained fractional growth. This sustained expansion owes nothing to credit growth, but everything to rising employment, which in turn reflects in labour productivity gains wrung out of a labour force in the teeth of a shrinking and aging capital stock.  It is not exciting, but it is durable, and it looks very similar to the post-crisis expansions seen already in the UK and US. 

At the heart of this grinding recovery are improvements in the return on capital, and rising labour productivity. Looking first at return on capital: by 4Q, real GDP was growing at 1.6% yoy, and nominal GDP was growing at 2.6% yoy, whilst gross fixed capital formation was growing at 3.4% yoy in real terms, and 4.1% yoy in nominal terms. Eurozone’s nominal capital stock finally stopped shrinking during the middle of 2015, and by the end of the year was growing at about 0.3% yoy. With capital stock growing only 0.3% whilst nominal GDP is growing around 2.6%, the return on capital must be rising. Moreover, unless nominal GDP growth slumps below 0.3% yoy,  that rise in return on capital will continue for the foreseeable future.  

How is it being achieved?  The answer is: in the same way as we have previously seen in the US and the UK. This recovery is driven by a rise in labour productivity attributable to something other than rises in capital per worker (longer hours? more efficient working? upgraded skills?). As the chart below shows, real output per worker, deflated by changes in capital per worker, has been rising modestly but continuously since 2013, and by the end of last year, output per worker was rising 1.4% yoy. This laid the foundations for a similarly modest but sustained rise in employment. By 4Q15, employment was rising 1.2% yoy, with 4.5mn jobs added since the nadir of 1Q13. 

That slow and steady rise in employment is also responsible for a slow but steady recovery in demand, achieved in the absence of any noticeable credit cycle, and despite the private sector’s unchanged financial caution.  In fact, the private sector is running a savings surplus of just over 5% of GDP, as it has been since 2013. By definition, this savings surplus means the private sector is making more new deposits into the Eurozone banking system than it is taking out in new loans. Nothing the ECB does to interest rates or refinancing opportunities can result rises in net new lending until the private sector waives this financial caution. Even when you flood the banking system with liquidity, as M Draghi is doing, banks’ loan/deposit ratio will fall as the private sector generates net savings flows. 

This continued deleveraging also means that although ECB action may be able, finally, to encourage growth in money M2, the impact of that monetary growth on GDP will be muted by an answering fall in monetary velocity (GDP/M2). What’s happening here is that whilst M2 is a count of the stock of money (essentially cash and deposits), what matters for economic activity in the short term are the activity-creating flows between those accounts.  And the problem is that banks are either unwilling or unable to act effectively to re-circulate those funds around the private economy. 

Nevertheless, even with savings surpluses undiminished, and even with banks’ ability to lend therefore circumscribed, the productivity-based rise in employment is sufficient to allow a steady expansion of demand, even in the absence of the sort of credit-based accelerators usually experienced in a classic business cycle.  This is precisely the sort of steady, acyclical grinding recovery we have been watching for the past few years in the UK and US.