Paul Donovan of UBS to Bloomberg: The toxic problem in the EZ is low Nominal GDP growth

The video of Bloomberg’s Guy Johnson interview with Paul Donovan, managing director of global economics at UBS AG can be found here.

For me the interview is a mixed bag. It sounds like this guy is a market monetarist, though maybe still in the closet. He mentions that the real problem in the EZ is not real, but nominal. But then talks about the barriers to the ECB and likely 5th or 6th best policies that would help.

…When we’re talking about debt dynamics and deficit dynamics for governments, it’s not real GDP that matters. It‘s nominal GDP, price change plus GDP, and that’s where the euro zone has been particularly weak. The policy options are not great because the policy solution to this is the politicians get their act together. And I have very little faith in structural reforms. It means reform in the labor markets. It means getting a proper banking union. Not this halfhearted nonsense they keep going on about. A proper integrated banking system. One of the big problems that Draghi has got, and he’s valiantly trying to do the best he can to solve it, is that the transition mechanism, taking money from the central bank, putting it into the euro zone economy… That’s just broken in large swathes of the euro zone. You need to get around that problem; get that money flowing freely.

The banking situation is likely a problem. But there are other options to doing QE, like secondary markets, for example.

So what does he think about QE as a potential for increasing nominal GDP growth in the EZ? Not good he says – too many political issues:

It won’t work. I don’t think. The problem is, if you’re going to do a quantitative policy, a proper quantitative policy, everyone has got to believe that you’re going to carry on printing money until you’re objectives are met. No one is going to believe that. If the ECB did announce a formal quantitative policy, no one believes it’s going to carry on. Everyone believes it will carry on until 20 university professors in Germany get on a trend to call through and object to it. So you don’t have that conviction of unlimited printing of money. Which is what you did have in the UK and in the United States, and eventually you got in Japan. So you don’t, I think, have the ability, in reality to implement a proper quantitative policy.

It’s true that there may be a political problem presented by QE. But there are political problems that come with the status quo also. Do we really think the people in the EZ are going to put up with an ever increasing size of the “sacrifice ratio” without there being ramifications to the politics in the EU? What about the rise of the euro-skeptics and far right anti-immigration/protectionism parties in a number of EZ countries that we’ve already seen? That isn’t going away until things start getting better in the EZ. It can only get worse – especially if some shock were to rock the EZ once again. The current nominal problem in the EZ is quite a corner to have been painted into, quite a gaping vulnerability to try to muddle through.

But why isn’t Draghi being more forceful about the price stability mandate? He should be, and he needs to do what he needs to do. Price stability isn’t lower-that-target inflation that is sinking. It isn’t deflation. It isn’t waiting until deflation is a problem to do something about it. And it’s in the treaty. If Draghi doesn’t do QE or some alternative approach to get that under control, he’s causing the ECB to violate the treaty (and probably some EU law). How about beating the German professors up with that? He needs to start talking (not just talking, but squawking) about the treaty, and getting the other EZ governments on board to enforce it. Stir the stew.

But alas, there’s a really big difference between the EZ and Japan which should be the saving grace.

There’s one big, big difference between the euro zone and Japan. Which is in the 1990’s the Japanese middle-sized businesses were bust and that was a really big problem. You don’t have that problem in the euro zone. [..]The middle size businesses in Germany, even the middle size businesses in France, they’ve got problems, absolutely. But they’re not bankrupt the way that they were in Japan. And that means there is more natural dynamism in the economy. Which I think will prevent deflation coming through in the Eurozone as a whole.

And how does this happen? Does the confidence fairy keep prices from falling further? I don’t understand this at all. It’s not debt that causes a deflationary spiral – it’s a nominal problem.

Mr. Donovan’s forecast for the EZ?

The euro zone, I think, is going to be this mediocre growth story for some time. Now there are risks around this. There are clear political risks. We saw European election this year. The rise of nationalism in most countries except Germany. What worries me is if the Germans do start to experience their inflation rate rising, and that’s possible. The German inflation rate goes up while the ECB is easing policy, you then start to get more anti-euro zone sentiment coming from the German middle class, in the way that we saw in France. For different reasons. But potentially problematic.

Oh yeah. We wouldn’t want to upset the Germans, no matter how many other EU citizens have to be made part of the sacrifice ratio for the benefit of the Germans (isn’t that some kind of beggar-thy-neighbor policy in terms of deflation?). But somehow, I’ve got a feeling that they’re going to end up upset anyway. Because there are limits to the amount of deflationary pressure that can go on in the EZ before the benefit of receiving the capital flight starts to diminish. There will also be an end of the road for Germany in this nominal problem, and I really would not want to be there when that happens – especially as a politician.

Follow

Get every new post delivered to your Inbox.