A shorter version of this commentary appeared in the Financial Times on July 22, 2019.
A specter is haunting Europe – the specter of anemic growth. Ten years have passed since the global financial crisis and while unemployment in the U.S. has recovered to the best levels in nearly 50 years (3.6%), those gains have not been replicated in Europe. 10.4% of the Italian labor force remains unemployed; that number rises to 14.7% in Spain, and the unemployment rate in Greece is a whopping 18%, with an unhealthy skew in most countries toward youth unemployment. Wage growth patterns between the U.S. and Europe display similar disparities.
Why Europe suffers stagnant growth?
Much of the problem boils down to lackluster expectations about forward growth (the European Central Bank itself recently lowered its 2019 growth expectations in the EU by almost 40%, from 1.7% to 1.1%). But there’s also something to be said about regulatory burdens in some locales that reward the status quo and inhibit change. Think about the size and scale of the “Diesel-gate” scandal, without which German automakers may never have embarked on electric vehicle programs, and even so only long after U.S. and Chinese peers had started down that road.
The fact is that European companies are losing ground to their American and Chinese counterparts as persistently torpid domestic growth stifles both innovation and investment -two desperately needed competitive stimuli. Remarkably, in a 2019 ranking of the world’s largest “unicorns” (private startups valued over $1 billion), only 15 of the top 250 were domiciled in the Eurozone (versus more than 175 in the U.S. and China combined). The ECB has not been sitting idle, and in fact it has rightfully been one of the most dovish central banks in the world over the last decade, accumulating trillions of euros in public and private debt in order to keep key borrowing rates at, or below, 0%. Yet, despite some cyclical bounces, the structural trajectory of the region’s economy remains woefully unimproved.
In our view, this is due to a few critical factors. First, policy makers underestimate the damage that the current policy mix of abnormally lower-for-longer interest rates causes to the banking system. European banks today are being punished by negative rates, which compress net interest margins and hinder economic multipliers. Second, ECB bond buying policies have also been incredibly challenging to reconcile with the Solvency II insurance industry regulatory framework, which has been stressed in an environment of negative yielding government debt; against the systemic liability stream for entities with long-term funding needs. Finally, while extraordinarily low rates and central bank bond buying present challenges in and of themselves, they have also provided dramatically needed liquidity to markets. Yet, over the last year or two the Federal Reserve’s balance sheet runoff program has reduced global liquidity from the financial system, and the ECB has not stepped in to shore up the liquidity drain, so the timing of its program shifts can also be seen as unhelpful (see graph).
What policy measure might help?
All this raises the key question: how can the ECB positively influence the private sector and improve the growth outlook for all Europeans via monetary policy? We believe that the exceptionally high burden placed on the ECB to stimulate growth requires an exceptional solution. The key element of such a solution would be to stimulate a demand for capital, not to further lower the cost of debt and hope that an already over-levered region will seek out new leverage at an ever-decreasing cost. Having nearly exhausted its options on the debt side, the ECB should consider buying equities to lower the cost of equity for European enterprises and narrow the abnormally large spread between the cost of capital and the economic growth rate. Lowering the (currently uncompetitive) cost of equity in this way would stimulate growth through the more appropriate organic channel of investment, including research and development (R&D), which may provide more durable economic gain.
While this policy prescription is not without controversy, and some may point to the fact that the Bank of Japan has also purchased equities as a policy tool, with seemingly little benefit, we think that comparison is a false equivalency. The fact is that the European economy is in many respects more like that of the U.S. than it is like Japan. For instance, Europe has attractive terms of trade and strong capital inflows, both wage inflation and the employment trajectory are better in Europe than they are in Japan, and while European demographics are a headwind relative to the U.S., they are not nearly as bad as those in Japan, especially in some key core countries, like France. In recent years, the set of well-designed and well-executed policies put forward by ECB policy makers have been hamstrung by the lack of national fiscal follow-through. President Draghi has repeatedly called for greater fiscal aid for the continent, as the central bank kept real rates low, but meaningful help never arrived.
Therefore, we think these equity investments should be undertaken in partnership with regional governments; tailored to the state of economic development, growth, inflation and business climate of differing parts of Europe. As such, in addition to attempting to reduce the European corporate cost of equity, we think the ECB should work more closely with member country governments, and with key corporations, to encourage corporations to think and invest longer-term in their businesses, and particularly in emphasizing the technology sector, targeting education/training, innovation and entrepreneurialism. By partnering with educational institutions the central bank could help target the youth unemployment problem and prevent a “lost generation” from becoming an intractable issue for the next fifty years. President Draghi has shown a willingness to be bold in the face of crisis, and we greatly hope that in the years ahead his successor can be farsighted and courageous to help the region break out of its longstanding stagnation.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team.
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