The Eurozone is probably in recession but recent better monetary trends suggest that weakness will abate from early 2012 – if the authorities succeed in stabilising markets.
Real narrow money, M1, is the best monetary leading indicator of the economy and contracted in late 2010 and early 2011, warning that activity would slump this summer (allowing for the typical six-month lag). Economic weakness, in turn, has undermined fiscal consolidation plans, worsening perceptions of sovereign solvency. Tight money, in other words, has been a key driver of the developing crisis.
Nominal M1, however, rose by 1.1% in August following a gain of 0.3% in both June and July. With inflation slowing, the six-month change in real M1 has recovered from a low of -1.8% in February (not annualised) to 1.1% in August – see first chart. This is still modest by historical standards but suggests that the economy will return to slow expansion from early 2012, barring further negative shocks.
Real broad money, M3, has also picked up, its six-month change rising from -1.4% in March to 1.4% in August. The counterparts analysis shows that this improvement has been driven by foreign and government net lending rather than private-sector credit. The positive foreign contribution casts doubt on claims that large-scale capital flight from the Eurozone to the US has boosted US monetary aggregates. The government contribution was particularly significant in August alone – states borrowed €33 billion from banks while running down their deposits by €50 billion, probably reflecting funding difficulties.
The bad news in today’s numbers is that the M1 recovery has been focused on core economies, with real deposits still contracting in the periphery – second chart. (M1 comprises currency in circulation and overnight deposits. The ECB publishes a country breakdown of deposits but not currency.) An end to the crisis depends on a loosening of monetary conditions in peripheral economies to restore growth. ECB rate cuts and enhanced liquidity provision, in other words, are urgently required – hawks, however, may use the recent Eurozone-wide monetary pick-up as an excuse to delay action.
Within the periphery, real M1 deposits are holding up better in Italy and Ireland than Spain and Portugal, while continuing to contract rapidly in Greece – third chart. The Italian / Spanish divergence questions recent outperformance of Spanish bonds and equities.
