(Source: investorvillage, editing by the Author)

Expectations of the ECB’s Monetary Policy Framework Review are being anticipated in advance of final delivery. Expectations are framed by the results of the Fed’s recent review and mission, closer to home, to keep the Eurozone from fragmenting.

Expectations of the ECB’s Monetary Policy Framework Review are being anticipated in advance of final delivery. Expectations are framed by the results of the Fed’s recent review and mission closer to home to keep the Eurozone from fragmenting.

As it transpired, the COVID-19 pandemic cast a greater shadow than that from the Fed.

(Source: ECB, caption by the Author)

Specifically, in relation to the new framework, a working paper from the ECB entitled “How to measure VAR after March 2020” auspiciously raised expectations that the COVID-19 pandemic has structurally changed the ECB’s monetary policy framework. Such expectation infers an element of a permanent structural change to how monetary policy is made and executed. This structural change also implies an innate bias, towards easier monetary policy, until at least the 2% inflation target has been comfortably overshot for a considerable period of time.

A permanent structural change to monetary policy as envisioned above is a natural precursor to the adoption of Modern Monetary Theory (MMT). The second precursor required is a permanent structural change to fiscal policy that is also innately expansionary. As will be seen in the following account, Eurozone policymakers at the national and central EU level are nudging their way towards such a permanent fiscal policy change.

The June article in this series looked forward to, a time in the near future when the Eurozone nations jump into the abyss by collectively abandoning all pretenses of fiscal discipline. Ironically, now that they claim to be emerging from the COVID-19 pandemic they are actually jumping into the fiscal abyss. This suggests that the Eurozone was already decelerating going into the pandemic and that the deficit-funded emergency spending has only taken it back to a position below the declining trendline.

The last report also discussed how the diverging trends in fiscal response, from national Eurozone governments, reflected the underlying heterogeneous political and economic environment within the bloc. This heterogeneity and fiscal divergence represent a challenge to the model of economic convergence and free movement that the Eurozone is based upon. Consequently, the Eurozone remains at an elevated risk of fragmentation despite the best efforts of the new EU joint-fiscal compact to hold it together.

The latest heterogeneous response, from Italy, highlights the risk of fragmentation. Italian Prime Minister Giuseppe Conte recently held a Lake Como colloquium of the great and good in Italian politics, state bureaucracy, media, finance, and industry. This gathering similarly resonated with Mussolini’s embrace statist capitalism. Ostensibly, the gathering was held to find a new state-sponsored and governed solution to Italy’s economic travails.

Cynical onlookers viewed the gathering as nothing more than a stronger embrace of crony-capitalism, that will sustain defunct yet well connected industrial Zombies, whilst pretending to embrace productivity-driven growth. All this will come at the Italian taxpayers’ expense. Unfortunately, the Italian taxpayer is already stretched so the EU’s joint-fiscal transfers to Italy will get diverted instead. In addition, the ECB will be cajoled, with threats of “Italexit”, to enable and sustain the crony-capitalists with pandemic emergency and further QE bond-buying.

The Italian cajoling will not, however, be a smooth process and the EU is likely to wish to see and then approve the details in Conte’s plan. At this point, there will be tension and EU pushback which will lead to market volatility especially in yield spreads. The Euro may also suffer.

Bank of Italy Governor Ignazio Visco tried his best to frame the negative perceptions of Prime Minister Conte’s strategy. Visco evoked the need for structural reform, along with investment in and leverage from the knowledge economy. By broadly talking about these potential productivity multipliers of growth he sought to make them credible and deliverable in Conte’s plan.

Although Germany’s fiscal position is much better than Italy’s, political survival has prompted Angela Merkel’s alliance grouping to examine how far they can go down the parallel roads of state aid and protectionism for the beleaguered German auto sector. Other sectors will demand the same treatment, thus, dragging Germany into a similar strategy as that under construction in Italy. The Germans are, therefore, in no position to lecture the Italians on economic and fiscal policy.

The further German stealth mission-creep, away from “Black Zero” fiscal policy, was announced and then nudged by Deputy Finance Minister Werner Gatzer. According to Herr Gatzer: “a balanced budget isn’t obligatory” and “we (Germany) should return to normality. But normality isn’t necessarily a Black Zero.”

Preceding this latest nudge and drift, Gatzer’s boss Finance Minister Otto Scholz had opined that Germany should get its finances back to “normal” by 2022. It is rumored that Scholz currently still expects a 36 billion Euro fiscal shortfall as far out as 2024. The German deficit projections just keep getting nudged further and further out into the future. This nudging has a growing feeling of permanence about it. Clearly, German fiscal policymakers are in the process of re-defining what “normal” is. What it is not is “Black Zero”.

The broad aim of German fiscal policy is to allow for a net 96 Billion Euros of new borrowing in 2021 but to return to mandated “Black Zero” in 2022. This aim to return to fiscal prudence is, no doubt, influenced by the desire to set an example for the Eurozone in general to follow.

The Dutch are blowing the dust off a pre-COVID counter-cyclical stimulus involving their national investment fund. This will be spent on technology and infrastructure. It should be noted that this new spending is in addition to the emergency pandemic spending being applied currently. Adding things up, it is clear that Dutch policymakers are not expecting a V-shaped economic rebound back to pre-COVID levels. In addition, since they are considering a pre-COVID scheduled stimulus it is, also, clear that the Dutch economy was on a downwards trajectory even before the pandemic. The Dutch fiscal deficit will thus blow-out. As with Germany, it will be harder for the Dutch to lecture the profligate Southern Europeans, going forward, when they are doing the same thing.

The situation in Holland is similar to that in France. The French national statistics agency INSEE recently claimed that the economy has returned to 95% of its pre-COVID outbreak levels. This has been sustained by massive deficit-sapping fiscal support. This support, however, has only been able to return the economy to 95% of a declining economy trajectory going into the pandemic. There has been no Keynesian multiplier effect thus far. Despite this missing catalyst, President Macron is keen to press ahead with his new “Relaunch” fiscal program. Evidently, this relaunch is more about the launch of his re-election campaign than sound aggregate demand management per see.

In addition to the heterogeneous internal fiscal and political forces, that may risk fragmentation, the Eurozone also faces external ones. Concurrent with the trade challenges, from China and America, Brexit has started to fester again.

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Since Johnson’s halo is slipping, with his poor handling of the COVID-19 pandemic, he has copied President Trump’s tangential disrupting tactics, to evade criticism, by framing a new narrative. This has had the awkward knock-on effect of undermining EU sovereignty. If this starts to unravel further, then it could end in a weakening of the legal and political forces that hold the Eurozone itself together as other nations challenge the EU’s sovereign dealmaking power.

The EU is already positioning for a schism with the Anglo-Saxon Axis in addition to China. Chairman of the EU leaders Charles Michel recently opined that the EU’s strategy is now aimed at greater autonomy and independence from its global trade partners. The EU is, thus, positioning for a Hard Brexit in the context of its global autonomy and independence strategy. ECB Governing Council member Gabriel Makhflouf believes that a resultant Hard Brexit is the most likely outcome and that preparations for it are already at an advanced stage.

The architects of the European Project may, likely, deem that a Hard Brexit is preferable to a deal that accommodates Johnson. A Hard Brexit has been anticipated in the Eurozone, but this will still come as an economic headwind if and when it occurs. Looking on the bright-side for Christine Lagarde, it gives her one more piece of evidence in favor of further fiscal and monetary support which then ostensibly becomes Modern Monetary Theory (MMT).

(Source and caption by the Author)

The last report suggested that the ECB may have to do something more radical, such as an outright securities purchase if it is to deliver the scope and scale of monetary policy to enable MMT. Thus far, the ECB continues to push the envelope of its existing programs to its practical limits. In doing so, it makes them irreversible by making the recipients dependent upon them permanently. It is this dependency that will make them a permanent feature of monetary policy and hence MMT.

(Source: ECB, caption by the Author)

The latest Governing Council decision was, therefore, a disappointment by nature of not delivering anything new. The meeting did, however, signal the ECB’s intentions and capabilities to move towards MMT by guile if not by stealth. The guile to be employed is a simple mission-creep, that involves the continuation of existing programs as far as possible, to test the envelope of acceptance of MMT whilst, thereby making them irreversible in practice without triggering a recession. In effect, the ECB is acting like a drug-pusher, to feed the Eurozone economy’s debt-habit so that a long-term dependency is established.

Thus, whilst benchmark interest rates were left unchanged, the ECB signaled that it will continue with its Pandemic Emergency Purchase Programme (PEPP), at least until 2021, and its Asset Purchase Programme (APP) for as long as is necessary. The commitment to end PEPP early, if growth strong growth persists, was completely walked back.

(Source: ECB, caption by the Author)

Christine Lagarde’s introductory remarks, for her post-meeting press conference, were similarly expansive in the direction of MMT. She began by noting that the expected economic bounce is petering out, especially in the service sector. The future outlook is also clouded with virus uncertainty. Inflation is expected to remain negative until 2021 at the earliest. Against this backdrop, it is clear to her that monetary policy must remain supportive.

Expanding into the supposedly taboo fiscal realm, Lagarde called upon national governments rather than the EU to invoke greater fiscal stimulus. Evidently, the new and unprecedented joint-fiscal stimulus is not enough. Lagarde would thus like national governments to bend and break Stability Pact guidelines even further and push themselves deeper into fiscal deficit positions. She is thus encouraging the other permanent fiscal stimulus dependency required for MMT.

Lagarde then issued a disclaimer that, whilst breaking Stability Pact rules, each nation should enact structural reforms to deliver the productivity growth that mitigates their parlous deficit conditions. This was a simple box-ticking exercise, to avoid her being labeled as a moral hazard instigator. In practice, Lagarde needs each nation to get into fiscal difficulty to make her monetary policy solution appear indispensable.

(Source: ECB, caption by the Author)

The ECB staff economic projections them, pictorially, explained the situation that Lagarde described. Readers should note carefully that inflation does not reach target in 2022, although the chart is given a gently upward sloping trajectory. The gentle trajectory, however, implies that monetary policy will be loose for a substantially longer period beyond 2022.

(Source: ECB, caption by Dr. Leonard McCoy)

The staff GDP forecast was even more depressing, if you live in the Eurozone, or more helpful if you are an MMT agency. After a brisk recovery, the Eurozone settles down into a state of near-death stasis. The flat trajectory of real GDP growth perfectly describes a permanent situation that requires a permanent monetary and fiscal policy solution.

(Source: ECB, caption by the Author)

Chief Economist Philip Lane’s blog then added greater detail and context to the narrative that frames perceptions and expectations for MMT. The detail and the context are that a stronger Euro is a headwind, undermining the ECB’s best efforts to hit its inflation target. Since the economic recovery has not been uniform across the Eurozone nations, this currency headwind will be unevenly distributed also.

Whilst Lane is awaiting greater clarity on Brexit and how the strong Euro has affected the data, so far, he is not holding his breath for any great positive news. His baseline working-assumption assumes that interest rates can go further negative and, also, that further lockdowns in response to the pandemic will occur going forward.

After Lane set the gloomy stage and context, his colleague Vitas Vasiliauskas swiftly ran a disinformation campaign, to prevent critics from accusing the ECB of managing and targeting the exchange rate for the Euro. According to Vasiliauskas, the Euro’s current strength is not historically significant. What he fails to say is that the previous history did not have the COVID-19 datum. Since COVID-19, history will never be the same. Going forward, COVID-19 will be the beginning of a new trend for many policymakers, central bankers, traders, and investors.

Executive Board member Fabio Panetta hinted that something has structurally changed, due to COVID-19, as he tried to jawbone the Euro lower. In his view, the Eurozone’s progress on dealing with the virus is mixed and has a long way to go. Similarly, the ECB’s progress on hitting its inflation target is also challenged. Consequently, the Eurozone and the ECB are “not out of the woods yet”; so that vigilance and readiness to act must be maintained. According to Panetta, the ECB is on standby, ready to act again, if and when its medium-term inflation targeting is challenged by the stronger Euro.

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Governing Council member Ollie Rehn has chosen the prism of the Fed’s new Monetary Policy Framework to frame perceptions of the ECB. He strongly advocates that the ECB take on board the expected influence, of the Fed’s lower for longer implied bias, in its own monetary policy framework review. The nuance, from Rehn, is that the ECB should incorporate something similar into its own framework.

In view of the reluctance of the ECB, to forge ahead with further monetary policy easing, the Euro has been resilient on the foreign exchanges, thereby, creating an economic headwind and ceiling on inflation. Euro strength is a worry for the ECB, but not something that compels the central bank to upset the delicate global trade balance with stronger verbal intervention just yet.

Instead, the ECB prefers a concerted whilst passive-aggressive approach to verbal currency intervention. Lagarde has passively-opined that Euro strength automatically means inflation undershooting. Philip Lane is more aggressive in his description of the currency headwind.

Vice President Luis de Guindos is somewhere between Lagarde and Lane. He states that the level of the Euro is “one of the most important variables” in monetary policymaking. In his view: “A relatively brisk and intense fluctuation in the exchange rate affects inflation expectations and the conditions that determine inflation” and “the ECB could not be happy with its own forecast for a 1.3% inflation rate in 2022.”

Governing Council member Olli Rehn has opined on the Euro indirectly, by saying that inflation has stabilized at lower levels. In his view, there is a clear risk to the downside for inflation from the Euro’s strength. Executive Board member Isabel Schnabel is also vigilant and ready to act if the Euro gets much stronger.

Further pressure on the ECB has been applied from its Bank of Spain members. The Spanish central bank estimates that unemployment will be above 20% until well into 2022.

The latest Governing Council meeting was overshadowed and upstaged, somewhat, by the panegyrics, for the Franco-German alliance, from Governing Council member Francois Villeroy de Galhau which ran contemporaneously. The fact that the ECB said and did nothing about the ECB’s monetary policy framework was, thus, quickly obscured by the projection of a new fiscal-political framework for the Eurozone by Villeroy. In effect, he projected something political into the monetary policy void left by Lagarde.

(Source: Bank of France, caption by the Author)

Speaking in Berlin, whilst Lagarde was speaking in Frankfurt, Villeroy reinforced the strong perception that the French Montagne was coming to the German Mohammed. From his speech, it was evident that he feels the forces working against Eurozone integrity. Consequently, he defended the role of the Franco-German bulwark, that holds the bloc together, whilst suggesting that it will need to become more inclusive going forward if it is to hold together in perpetuity.

The last report observed the mission-creep towards MMT via a Green Capital Markets Union. Villeroy’s speech touched on all the conditions precedent to achieve this with brio and bullet points. These are as follows, with the author’s explanations in italics:

  • An unprecedented recovery plan – the joint-fiscal compact.
  • A Financing Union for Investment and Innovation – Capital Markets Union.
  • Reviving the single market, our essential asset – no free movement prime directive means no Eurozone.
  • Climate change and carbon tax – the Green New Deal becomes the enabler of Green Capital Markets Union.

To achieve all of this grand strategy, it will be essential for the Franco-German alliance to promote like-minded public servants, from other Eurozone nations, into executive policymaking positions from which to first sell and then execute.

(Source: ECB, caption by the Author)

ECB Executive Board member Isabel Schnabel member then responded with alacrity on behalf of the German side of the alliance. Her soliloquy was the clearest signal that MMT is the endgame. It was also a dry-run of how the ECB will respond to the German legal challenges to its actions in the future. From this author’s view, it was dangerous, in that it combined all the aberrant traits of overconfident self-affirming bias that are employed when someone picks their evidence and data to suit their pre-agreed agenda.

Schnabel began by saying that the ECB’s independence will guarantee that it is not captured by politicians and forced to monetize their fiscal deficits. Allegedly, the fact that inflation expectations remain subdued, and yield spreads widen when countries have fiscal problems, are evidence that the ECB is independent and not monetizing deficits. Rather disturbingly, she sees the massive private debt piles as evidence that public deficits are not crowding out the private sector. Since there is no crowding out, she erroneously concludes that there has been no deficit monetization. What she failed to mention was that the ECB must monetize public deficits, to keep interest rates low, so that the private sector is not crowded out of the capital markets. No additional mention was made by her of the sustainability of these private debt piles or how the commercial banks use creative accounting and emergency ECB lending to maintain them.

(Source and caption by the Author)

Neither did Schnabel mention the doom-loop of commercial banks holding more sovereign debts that are, in fact, crowding out their ability to lend to the private sector, based on the assumption that the sovereign has the highest capital adequacy rating. The high levels of debt-to-GDP and the current weak economic activity directly challenge this representation of AAA sovereign credit ratings. Were it not for the ECB, forcefully compressing yields, this credit assumption would be openly challenged.

Schnabel then flipped the story, in order to venture that fiscal policy is now more important than monetary policy because the Eurozone is at the lower bound. Apparently, at this point governments are virtuously paid with negative interest rates to borrow and their spending is more impactful than monetary policy easing. An indebted and over-leveraged sovereign can allegedly move the economic needle farther than the central bank that is enabling this over-leveraged borrowing.

Effectively, Schnabel was saying that the ECB is independent and this independence guarantees that it will not monetize fiscal deficits permanently. This is an intention and not a guarantee of central bank fidelity. In practice, the ECB does not have the capability to remain independent once it becomes a permanent enabler of MMT.

(Source: the Author)

Isabel Schnabel’s glowing support for MMT is by no means representative of the whole German position. In the last report, this author suggested that German diffidence and open resistance to MMT will be part of a process by which it seeks to try and set some governance and enforceable rules of the game. The ease with which the Stability Pact and ECB Capital Key have been bent out of shape has informed the Germans that the new principles-based fiscal and monetary policy governance regimes in the Eurozone are chaotic. The Germans would like there to be some rules from which to govern.

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All the previously done good work done by Isabel Schnabel, in pretending that the ECB is not performing monetary repression by monetizing deficits, was then undone by some indelicate guidance from Governing Council member Ignazio Visco. Visco unashamedly stated that the ECB must be careful not to allow falling inflation to increase the debt burden in real terms on borrowers. Obviously, Visco thinks that it is the ECB’s job to monetize fiscal deficits and inflate sovereign nations out of debt.

Just to make the situation worse, it is rumored that banking regulators will soon allow banks to start paying dividends again; as the Eurozone pretends that it is returning to post-COVID normality. Zombie banks that pay handsome dividends to shareholders, as a conduit from the ECB’s balance sheet will, thus, be supported in an egregious example of moral hazard. The monetary policy transmission mechanism, therefore, runs from the ECB’s balance sheet to investors and not to the real credit creation process. The more the ECB eases, to ostensibly stimulate the Eurozone economy, the more this moral hazard status quo remains. Plus ca change plus c’est la meme chose.

The ECB can thus be seen to be encouraging fiscal indiscipline by sovereign nations and lending indiscipline by private lenders. In addition, the ECB is encouraging political leaders to endorse this general decline is fiscal probity and financial discipline.

(Source: the Author)

A previous report noted that further German legal challenges to the ECB were in the planning phase. It has recently been announced that the Bundestag will set up a committee to regularly monitor the ECB’s behavior.

(Source: the Author)

This new German monitoring committee is not so much a challenge as a form of governance best-practice that is sadly lacking within the ECB itself. The German Constitutional Court, then moved into gear, for a potential pincer-movement, by calling in Bundesbank President Jens Weidmann for a closed-door session.

(Source: the Author)

Allegedly, whilst defending the ECB’s actions so far, Weidmann agreed that closer monitoring must be maintained, going forward, to ensure that the central bank is not monetizing deficits. The last report suggested that Germany is trying to set some rules and regulations around MMT. The behavior of German lawmakers and Weidmann, so far, is not inconsistent with this hypothesis.

Austerian ECB Governing Council member Robert Holzmann has also changed his style of resistance, to ECB monetary policy action, in the wake of the Fed’s change of monetary policy framework and the German failed legal challenge to the ECB. Holzmann has abandoned short-term resistance in the hope of influencing medium-to-long-term monetary policy. His adjusted view is that negative interest rates are dangerous if they maintained over a longer-term horizon. Clearly, this will be the thrust of his input into any new monetary policy framework from the ECB.

Holzmann’s identification of the long-term threats, from negative interest rates, clearly shows that he is worried that they will become permanent. Logically, by extension, this means that he is also worried about permanently loose fiscal and monetary policy aka MMT.

Perhaps the biggest threat of Eurozone fragmentation, from the bloc’s heterogeneity, comes from the impact of and response to the COVID-19 pandemic. There is not one single unified approach to fighting the pandemic throughout the Eurozone and also the EU. Neither is there an equal distribution of fiscal and healthcare resources to fight the pandemic. Consequently, the Eurozone and EU are fundamentally weak.

Going forward, a unified policy on funding and fighting the pandemic is, perhaps, the only way to be successful and, hence, to lower the probability of Eurozone fragmentation. Perhaps this is the real route to economic and political union. Linking it to the Green New Deal would then make it the quickest route to MMT via Green Capital Markets Union also. Clearly, this author is not the first person to imagine this. Clearly, also, there are some Eurozone policymakers and central bankers who have seen this one coming a long time ago. The ECB is already positioning itself in anticipation of Green Capital Markets Union. Most recently, the central bank has positioned itself as a rule maker by joining the steering committee of the Network for Greening the Financial System.

(Source: Wikipedia, caption by the Author)

This author believes that it is highly likely that monetary policy will become digital in the near future. The ECB recently signaled that thanks to Lithuanian digital pioneering, it is keeping pace with its global central banking peers in relation to e-monetary policy. The ECB has recently become the world’s first to have an e-collectible coin. This collectible coin is legal tender, so the ECB is effectively the world’s first central bank to have a legitimate e-currency.

It is clear, that Germany is raising its challenges, not only to the idea of MMT but also, to the anticipated outcome of the ECB’s own monetary policy framework review. It is also clear that this review will be heavily influenced by the Fed’s recent monetary policy framework change. Evidently, the Germans see this tapering-off into an era of permanently combined fiscal and monetary policy stimulus. Whilst this frightens some Germans, it is clear that it is being eagerly anticipated and embraced by others. Isabel Schnabel is one of the said eager anticipators. It is also fair to say that she is not a naïve embracer who will let things get out of control.

(Source: ECB, caption by the Author)

Schnabel has clearly framed the outcome of the ECB’s monetary policy framework review process in practical terms. For her, the threat is that the pandemic has increased the risk of Eurozone fragmentation by nature of the facts that (A) the bloc is heterogeneous, (B) the impacts have been uneven, and (C) the various national government responses have been disparate and uncoordinated.

(Source: ECB)

In view of the heterogeneity, on the ground, Schnabel advocates that the Eurozone policymakers enact greater coordinated fiscal and structural initiatives aimed at improving standardized economic convergence. She sees the digital economy and the Green New Deal as central themes in this unification mission.

Looking through Schnabel’s prism, the new ECB monetary policy framework should be viewed as an enabler of this unification mission with its balance sheet. As yet, she has not delivered any rules of the game so it appears to be principles-based and, thus, chaotic by default. An expected German challenge may present some rules to be either accepted or flouted.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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