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ECB horses without Caligula: Berlin holds the reins, but investors should fear crash

According to historical revisionists, Roman Emperor Caligula appointed his favourite horse as Consul not out of madness but with the intention of signalling to the masses that the work of top state officials had become so meaningless that any underling could do it. We see now that same logic in the filling of top appointments at the European Central Bank. Berlin is the real centre of power (without German backing, EMU would collapse sooner or later) and ECB officials whatever their credentials or protestations of independence have by their deliberations and decisions acknowledged that. Yet no-one, not even the biggest detractors, would say that the German Chancellor resembles the Roman Emperor in seeking to demonstrate flamboyantly power; in fact, for domestic political reasons she would rather not draw attention to the reality of Berlin’s power and its cost.

Last weekend brought news that the Eurogroup Finance Ministers had unanimously resolved that Irish central bank head Philip Lane should become the chief Economist of the ECB and board member; likewise for the nomination as ECB vice-chair of ex-Spanish Finance Minister Luis de Guindos (originally CEO of Lehman’s in Spain and Portugal until its demise in 2008, then making his way up the political ladder in Madrid to be banking system fixer in the post-crisis conservative government and head of the Euro-group).

Pantomime of ECB appointments

All of this is a far cry from the Bundesbank’s heyday in the 1970s when Otmar Emminger, as chief economist and vice-Chair (finally Chari), played such a crucial role in launching the Deutsche mark as a hard currency under the German version of monetarism. And we can say that despite Dublin Professor Lane’s two listed academic publications – one on the “voracity effect” (a bout of economic prosperity can be self-ending under stipulated conditions through its effect on the fiscal balance); and the other a compilation of statistics on the holding of foreign assets.

This appointment almost certainly does not mark the start of Europe’s journey towards sound money. In no way does the Merkel regime want that change in direction. No one, in their right mind, would imagine that sound money would be born within the ECB or more generally the central bankers’ club.

The ECB and EMU would not last long without the backing of the German hegemon. And no-one is more aware of that axiomatic fact than Signor Mario Draghi – never mind his notorious (some euro-advocates would say “brave”) boast about doing all necessary to save the euro.

That statement was empty of content except in so far as Chief Draghi had some diplomatic power of persuasion over Berlin (to impose the necessary burdens for survival on the German population) – a highly dubious proposition. And don’t wait in suspense, despite the excitement of some journalists and other ECB watchers about the succession spectacle, to find out who the Council of Ministers will nominate in June to succeed ECB Chief Draghi. Chancellor Merkel (if not a complete lame duck by then, as could be the case if the SPD pull out of her coalition in response to a disastrous result in the European Parliament elections), has no great reason to favour her ex-economic adviser and now Bundesbank Chief Jens Weidmann.

The latter’s playing along with Chief Draghi, in accordance with Berlin’s wishes despite occasional nominal protest sometimes under the pretence of “safeguarding central bank independence”, has made him a risible figure on the German right who hate the Merkel-Draghi axis. His nickname for them is “Weichmann” (softy). Frau Merkel would not win back votes from the AfD (the party to the right of Merkel’s CDU/CSU which is anti-EMU and anti-immigration and is the third largest group in the Bundestag) by insisting in discussions with President Macron that Dr. Weidmann be the next ECB Chair. Better to concentrate on getting her man (Manfred Weber) appointed to the head of the European Commission.

In principle Chancellor Merkel could have used the upcoming occasion of the ECB Chief nomination to insist on a hardening of the monetary regime (perhaps in exchange for a French citizen at the head). A key demand could have been the setting aside of the 2 per cent inflation target in favour of meaningful long-run price stability and market determination of interest rates. Frau Merkel. However, is under no inclination to move in that direction which almost certainly would force Italy out of the monetary union.

The Bundesbank has certainly not been campaigning for such a sound money regime – all very different from the Emminger era, when crucially the social democrat/liberal coalition government of the time was also backing the monetarist agenda as a means of winning middle-class support. It would not be the first time that Berlin would favour a Dutch one-time hawk turned softy as ECB head. And the Dutch central bank chief Kurt Knot seems to know how to play his cards here – signalling in recent days that he would favour the ECB postponing “monetary normalization” plans (for example implicitly postponing rate rises from present negative levels until far into 2020) in view of the current European economic slowdown.

Italy risk transcends ECB musical chairs

This change in stance may not be enough for Dr. Knot to get the populist government in Rome’s support. The Italian government, however, would be unlikely to veto the Dutch man’s nomination, even though it is now playing hard ball with the insiders at the Banca d’Italia in opposing their formal proposal for top official succession.

Yes, a regional election last Sunday (in Abruzzo) has strengthened the position of Northern League chief (and euro-sceptic) Matteo Salvini. Yet the recipient of a perpetual motion gravy train from Berlin cannot be a strong decision-maker regarding who sits in the driver seat.

In the bigger picture, the existential question of when Rome might pull out or be forced out of the euro is the key uncommented upon question that transcends all this nomination speculation.

The spread of 10-year Italy government bond yields above German yields is now around 270bp (2.80% and 0.12% respectively). There are several competing and non-exclusive explanations for this startling divergence within a monetary union.


The lead scenarios, in the minds of investors, include the re-emergence of an independent Italian currency or German currency (or both) at some point in the next 10 years.

Then the exchange rate between the euro/lira, mark/lira, or mark/euro, would be at a substantial discount to present parity.

An alternative implicit scenario is that EMU might persist in its present form but ultimately Rome would “reschedule/re-arrange” its public debt, imposing a forced scale-down on some present holders (say non-Italian) of bonds, with examples drawn from Greece’s write-downs.

The view here is that the likelihood of this latter scenario (EMU remains intact and Italian debt is written down) is very low; the process would be so convulsive as to bring about an explosion of the euro and in any case Italy has much stronger cards to play than Greece ever had in rejecting debt solutions (including some repudiation of government bonds held by domestic residents) drawn up in Berlin.

Plausibly, the crude bond yield spread (between 10-year BTP and Bund) is an under-estimate of currency risk events, given the desperation for yield generated by the ECB’s (and the BoJ’s and the SNB’s) negative rate policies and the role of relatively high-yielding Italian government bonds in that process.

Moreover, the attraction of Italian bonds to the “hunters” may gain in strange ways from Italy’s huge holdings of gold (2452 tons, the third highest after the US and Germany): a consideration that could well cause the Italian populists to back down from their present talk of taking over the Banca d’Italia’s gold for the people.

“Incredible shrinking Europe”

Incidentally that hunt for yield and related currency carry trade (investors moving from negative yielding euro bills and bonds into higher yielding foreign assets) has meant the generation of massive capital exports from Europe – a key factor in explaining European economic failure. Capital flight to escape negative rates results in weaker domestic investment, at the cost of economic prosperity. Hudson Institute distinguished fellow Russell Mead writes in an op-ed this week (Wall Street Journal, 11/2) about “incredible shrinking Europe” and how its grand unity project is failing.

The difference between no cumulative growth in the euro-zone since 2010 as against 34% in India, 145% in China, and 37% in the US, is startling (albeit given serious doubts about China data).

Mead does not have the space within an op-ed to comment on monetary matters in depth. Yet the role of Europe’s non-ending monetary union “experiment” in bringing about such disappointment is so serious as to at least raise the question how US policy makers in the 1990s (first under the administration of G.H Bush and then Bill Clinton) were so flawed in their analysis as to encourage the euro-birth process rather than standing firm in thoughtful and friendly opposition.

This error (supporting the EMU project) has been much less commented upon than the blatant error of Washington in permitting the entry of China into WTO. Some critics link the latter blunder to a conflict of interest – Clinton Foundation financing by Chinese business interests. Hence there were not remotely adequate safeguards against the undermining of free trade principles (highly likely given the extent of state ownership and direction of economic enterprises).

How has EMU and the euro dogged economic prosperity in Europe? Its survival in present form (a monetary union built on no protected sound money principles) has depended on perpetual experimentation in monetary inflation (negative rates, long-term rate manipulation, QE).

The essential political dynamic backing for all this in Germany has been the benefit for the exporters of a cheap euro which has more than offset (in voting scales) the opposing forces of middle-class savers resentful of negative rates and the ultimate tax burdens. German exporters can see that currency manipulation is not forever and are therefore reticent about increasing long-run investment spending.

Furthermore, monetary inflation has not brought about the flourishing of speculative narratives in Europe such as has occurred in the US economy (Big Tech, shale oil and gas, private equity, corporate tax cuts) and which have driven investment there (although overall still sub-par compared to long booms in the past and including much mal-investment which only becomes fully apparent beyond cycle end).

Yes, the US speculative narratives might eventually shift to bust and so bring on the next great recession, This week, the story has been of tabloid revelations which could spread doubt about the head of Amazon as a “messiah” who will certainly lead his enterprise’s shareholders into Eldorado. But Europe’s downturn could be just as serious without having benefited from those narratives directly given its severe financial fragility and the huge contraction possible in its export sector.

Indeed, Europe could be the region of the global economy which leads and powers (by contagion) the way into recession. How all this plays out will depend in large part on US policies (and dare we say on Trump nominations to senior policy positions).

President Trump’s China hawks could re-focus on Germany

For now, the Trump officials who are most on the ball about “the rotten euro and its use by the German export machine” are focussed on China (including prominently Peter Navarro, director of trade and manufacturing policy).

Once the “deal is done” with China this Spring – most likely the start of a long process in which tariffs will be cut only after there is much accumulated evidence of Beijing’s honouring its new undertakings (especially regarding intellectual property theft – there could well be a shift in Trump administration focus towards European and particularly German “cheating”.

Appointments will play a role in this. Many who have been concerned about European (alongside Japanese and Chinese) currency manipulation have been very disappointed in David Malpass’s performance as under-Secretary of the Treasury with prime responsibility for international economic diplomacy.

Now President Trump has nominated Mr. Malpass to head the World Bank (as under-secretary he focused on the waste and abuses at the supranational development banks) there is the possibility of a new more effective force against the currency manipulators.

An ongoing obstructer, though, is Trump loyalist Mnuchin who for now remains Treasury head and is widely seen as in cahoots with the cronies on Wall Street. Mr. Mnuchin is unlikely to back tough action on European currency manipulation by his under-secretary, unless President Trump takes the lead there.

In the market-place, understandably, investors are unlikely to focus on the scenario of the Trump Administration going after the German currency manipulators (who take advantage of the rotten nature of EMU, endorsing a negative rate regime towards sustaining Italian membership) in any serious way any time soon – though that could become more than a story line in the next recession. The more immediate issue is whether the White House will initiate action against the German automobile industry (which would sink the euro rather than lift it).

China “truce” and “Brexit delay” concerns paralyse the bears

Two big events out there which could cause risk-assets to jump – US trade war with China entering a prolonged truce and Brexit no deal eliminated – bears on these have been unusually fearful (of taking short positions). They do not want to find themselves under a stampede of risk-on speculators. The bears may question the wisdom of the crowd in its euphoria about the Powell Put – whose success beyond the immediate depends on an economic re-bound globally such as occurred in 2015/17 (and which is considered unlikely here at this advanced stage of the expansion and of asset inflation) – but they will delay action until the events have occurred or their possibility extinguished.

A China trade deal as described would be most likely prove anticlimactic as would be the increasingly probable delay to Brexit. (Why would the EU make meaningful concessions so long as delay with its promise of extended British contributions to the EU budget would be the most likely outcome of intransigence? Only a no-deal Brexit even for a few weeks would shake the EU to revise the treaty and move off their inertia plane).

Accordingly, were economic data globally to deteriorate into the Spring and most seriously in Europe, then that could well be the catalyst to a big fall in speculative temperatures.

History: A Fed put which turned into a crash within 5 months

Readers with an interest in experiments from the laboratory of history may well reflect on the lead up to the crash of late August to October 1937.

The “Fed put” (exercised under pressure from President Roosevelt in March/April 1937 and which involved intervention in the Treasury market to bring down yields which had risen in early 1937 on growing anxiety about the Fed’s normalization of monetary policy following virtual QE and zero rates through 1934-6) went along with a short-lived stock market re-bound through the Spring of that year (from an initial fall in late Winter 1937).

But as the economic bad news accumulated through the early Summer – with an accompaniment of domestic and geo-political woes – the stock market climate changed dramatically and suddenly.

Bottom line: market strategy

Distrust the risk-on rally. There is too much desperate confidence in the success of the Powell Put (not least given its potential lack of success in re-igniting economic expansion such as occurred in 2016/17 or further back in 1999 or 1988/899. The bears are paralysed (unreasonably) by looming events (their fear about China-US permanent truce and avoidance of no deal Brexit).

Europe, even more than China, could well be the catalyst to asset deflation and global recession. Along with that likelihood is a weak perspective for the euro, never mind a significant long-run probability of a DM re-birth.

Reports from Zurich as reflected in recent NZZ suggest that the Swiss National Bank is digging in for a longer period of negative interest rates. That adds to negative assessments of the Swiss currency (see last week’s Global Monetary Viewpoint).


Executive Summary

ECB independence is cosmetic; Berlin holds the reins of power. ECB Chief Draghi’s notorious boast of doing whatever it needs to save the euro was empty talk. Draghi at every stage made sure Berlin backed radical policy options. With Berlin holding the reins of European monetary power, officials in Frankfurt (ECB) do not have significant room for independent policy-making. It suits Berlin that mediocrity is the pervasive characteristic of ECB headquarters. The on-going list of euro-group nominations demonstrates this.

Bear paralysis: the likely announcement of a long China-US trade truce (already now extended) and of a Brexit delay is holding bear speculators on risk assets in check Fear of the crowd now chanting the wonders of the Powell Put also frightens the bears. This paralysis will dissipate if global economic slowdown persists.