Inflation Could End the EU

In a recent article, I had the wrong tone about future European monetary policy. I reflected what Draghi would like to do, not what is likely to happen. Draghi is in favor of extending the bond buying program, but the Germans are against it. This disagreement will cause fireworks which threatens the survival of the EU. This article is a continuation of my theme that central banks will face more political pressure in the future. It’s impossible to claim the central banks aren’t political when government officials rely on them to execute their fiscal policies. Central banks are the ultimate status quo entity who buy assets when they are declining to prevent panic in the markets.

It’s tough to say when the stock market performance became a political talking point, but you can see it in American politics today. The Obama administration uses stock market performance to bolster his economic record and Trump has already claimed to be the reason why stocks have moved higher in the past month. Considering Trump believed the market was a bubble the last time he was on CNBC during the campaign in September, I would think Trump would want to push the bubble back on Obama. However, he’s fully embracing the stock market bubble like any other politician would do.

If the stock market is used as a political talking point and the central banks are keeping it propped up with cheap money, the central banks are political. If the ECB buys Italian assets after the referendum vote to insure market stability, the central banks are political. Rising asset prices disproportionately help those who own a lot of assets (the rich), so these central bank policies are causing political pressures. The connection I am making is central bank policies are about the face more criticism in the next few years and that’s bad for the bubbles they created. If the bubble bursts under President Trump and the Fed gets the blame for the crisis, I wouldn’t expect him to give the bank even more power to buy stocks.

The point I want to correct is that I said the Mario Draghi-led ECB will always lean towards being dovish. That’s not a far stretch considering his latest action of extending the ECB bond buying another 9 months. The ECB’s balance sheet has been skyrocketing. As you can see in the chart below, the ECB’s balance sheet will surpass the Fed’s in about 8 months and may also pass the size of the JCB’s balance sheet. A central banker has never met an asset he/she didn’t want to purchase!

ecbbalancesheet

While Draghi wants to buy assets forever, the point I missed was the scrutiny which is coming from Germany. Germany has been critical of southern European countries such as Greece and Italy for their deficits. While Germany has prospered since the creation of the European Union because of its lowered currency, the German people do not like the bailouts given to these nations. They view the Greeks as lazy and the media disparages them. The media has made the connection between Mario Draghi’s policies and Italy’s economic crisis. As you can see from the German newspaper, the media is calling the ECB’s asset purchases a money bomb.

draghibomb

The German’s are correct in this case. The ECB buying corporate bonds and supporting Italian government bonds is a de facto bailout because it supports Italy’s deficits. One shocking representation of the market manipulation by the ECB is the Italian 10-year treasury yield is lower than the American 10-year bond yield. The ECB forcing the Italian 10-year treasury to be 1.874% gives the company a better chance at paying off its debt which is out of control. It’s a moral hazard to support a country’s ability to run massive deficits. It’s an incentive to continue without reform. Ironically, if the ECB didn’t support the Italian government, Italians probably would have voted against the referendum for reforms in higher numbers because it was a vote against the establishment.

The German’s already aren’t happy with Draghi’s policies, but these complaints will get louder if inflation starts to increase. Inflation is expected to increase to 1.3% in 2017. The ceiling for inflation is 2.0%, so if it starts to accelerate more than expected, the Germans will demand an end to the ECB buying in December. Inflation is already starting to creep up as oil prices today closed at 17-month highs. Oil prices hit their 17-month high in dollars. With the Euro falling versus the Dollar, this means oil prices are rising even faster in terms of Euros. As you can see from the chart below, the WTI oil price has doubled in terms of Euros in the past 12 months.

oileuro

As you can see from the chart below, copper prices have also been skyrocketing. With low inflation, it was a race to the bottom in terms of the global currency war. Each central bank wanted to weaken its currency to improve exports, but now that commodity prices are increasing the situation is changing. Inflation increasing requires tighter monetary policy which I consider to be one of the biggest ricks to bursting the asset bubbles.

copper

If inflation rears its ugly head, the Germans will threaten to kick Italy out of the European Union as a consequence for the de facto bailouts. It’s an unsustainable situation to constantly have one country taking a hit to help the other one. When Germany faced off with Greece it wasn’t a big deal because of the country’s size. Germany may not even be able to afford bailing out Italy, but if it could, there would be no motivation to do so anyway. If Italy leaves the European Union, the project dies.

The way I see the situation playing out if inflation does rise is Germany will either try to get rid of Draghi or kick Italy out of the European Union. If the ECB bond buying stops and Italy’s 5 Star Movement wins the next election, Italy’s 10-year bond will skyrocket. This will cause the government to cut spending which the Italians will blame on the Germans. This dissatisfaction could cause the country to leave the EU itself.

An analogy for this situation is a high school student who is nearly failing. If the teacher threatens him to do better, he may decide to drop out. If the teacher doesn’t threaten him, he may be kicked out. There’s pressure on the situation not ending well in both directions.

Conclusion

            I underrepresented the discontent the German people have with the ECB’s bond buying program. Usually the German’s are in favor of keeping the status quo because the country has benefited from the EU. However, in this case, inflation could motivate Germany to end the EU itself. Because the ECB bond buying is a de facto bailout for Italy, Germany being in favor of this program ending is a de facto end to the EU.

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