In this kind of situation, only fiscal policy could be able to give a proper answer, but the special situation of the monetary union is making this slow, late or even completely impossible.

More from Koo:

“When the private sector as a whole is paying down debt in spite of zero interest rates, the government is the last borrower standing and must borrow and spend the private sector’s excess savings. If it does not, not only will the effectiveness of monetary policy be undermined, but the broader economy will fall into a deflationary spiral because the saved funds are not returned to the economy’s income stream.

Today government is the only (net) borrower remaining in virtually all eurozone economies where the private sector as a group is saving 5% of eurozone GDP at zero interest rates. If the governments relinquish their role of borrowing and spending the private sector’s surplus savings, more savings and funds supplied to financial institutions by the ECB will remain trapped in the financial sector since there will be even fewer borrowers available.

The ability of ECB monetary policy to stimulate the economy is therefore entirely dependent upon government borrowing. Monetary policy will lose its effectiveness if governments reduce their borrowing. Talk of a “bargain” between national governments and the central bank on the use of monetary easing to ease the pain of fiscal consolidation is therefore nonsense.

But the ECB president, who does not understand this critical point, argued again at the recent press conference that national governments need to push ahead with aggressive fiscal consolidation.”

Actually it is possible that Draghi is starting to understand this difficult situation. At his most recent press conference, he also acknowledged both the limitations of monetary policy and the need for fiscal policy. Especially noteworthy was his remark that “It’s very difficult for us to reach the objective of an inflation rate which is below, but close to, 2% only based on monetary policy.” He then added, “You need fiscal policy.”

This suggests that Mr. Draghi is starting to lose confidence and is considering a change of course. If he continues along this path, he may alter his stance on fiscal policy in a not too distant future.

Few more months of financial assets support, but the real economy is in deep trouble

ECB monetary activism is undoubtedly good for financial assets. Since unconventional monetary policy will have an hard time in achieving its reflationary targets we will likely get more of it in next few months. But, at this juncture, Germany stance on fiscal policy is more important than Draghi’s determination, at least for the real economy. Will they soften their stance, understanding that such a path is the only possible at the point we are in? It is really impossible to answer to this question now. Unfortunately, recent developments in the German political arena are not positive.

From The Telegraph (notoriously not a soft voice towards EuroZone problems):

Alternative für Deutschland (AfD) has swept through Germany like a tornado, winning 12.6pc of the vote in Brandenburg and 10.6pc in Thuringia a week ago. The party has broken into three regional assemblies, after gaining its first platform in Strasbourg with seven euro-MPs.

S&P has warned that AfD’s sudden surge has become a credit headache for the whole eurozone, forcing Chancellor Angela Merkel to take a tougher line in European politics and risking an entirely new phase of the crisis.

 The report warned that AfD has upset the chemistry of German politics, implying even greater resistance to any loosening of EMU fiscal rules. It raises the political bar yet further for serious QE, and therefore makes the tool less usable.

“This shift in the partisan landscape could have implications for euro area policies by diminishing the German government’s room for maneuver. We will monitor any signs of Germany hardening its stance” said the rating agency.

The political climate in the eurozone’s two core states is now extraordinary. A D-Mark party is running at 10pc in the latest polls in Germany, while the Front National’s Marine Le Pen is in the lead in France on 26pc with calls for a return to the franc. One more shock would test EMU cohesion to its limits.

Trying to put the eurozone situation under an optimistic light I have often said in the past: “we live in interesting times”. Well… there are more interesting times ahead, apparently.

Alessandro Balsotti
FX Portfolio Manager,
JCI Capital