Mario Draghi and the European Titanic

This morning’s sanguine steady-as-you-go press conference by European Central Bank (ECB) President Mario Draghi has to remind one of the apocryphal story about the Titanic’s captain. When asked why he did not swerve the ship to avoid the iceberg, the captain asked “What iceberg?”

Like the Titanic’s captain, Mr. Draghi sees no need for the ECB to change course from its earlier decision to withdraw monetary policy stimulus by ending its bond purchasing program as planned by year-end. He does so despite growing signs of real vulnerability in the European and global economies. In his view, the European economy is recovering at a satisfactory pace, inflation is rising, and the risks to the European economy remain balanced. This leads him to conclude that there is no need for the ECB to change policy course.

Surprisingly, it seems to have escaped Mr. Draghi’s notice that since the ECB’s last meeting dark storm clouds have gathered over Italy, the Eurozone’s third largest economy and the world’s third largest sovereign bond market. Indeed, over the past two months there have been the clearest of signs that Italy is on a dangerous collision course with its European partners that could have major implications for the European banking system.

Italy’s populist government is making it clear that it has no intention to accede to Italy’s European partners’ demand that it revise its expansive budget. That budget is in flagrant violation of the Eurozone’s rules and it threatens to put Italy’s public finances on an unsustainable path. Meanwhile, as underlined by an unprecedented letter of complaint that it sent to the Italian government earlier this week, Italy’s European partners are showing no signs of giving Italy a pass on the Eurozone’s rules for budget discipline.

While Mr. Draghi might be choosing to turn a blind eye to Italy’s escalating budget crisis, the markets are not. Already Italian bond spreads have risen to over 300 basis points and capital is flowing out of Italy at a rapid rate. This risks throwing the Italian economy into yet another recession that would only exacerbate its public debt and banking sector problems.

While Italy would seem to be the most serious risk to the European economic outlook, it is not the only major risk that has increased since the ECB’s last meeting. In the United Kingdom, Theresa May’s government is now preparing for the possibility that the UK might crash out of the Euro without an exit deal by the end of March 2019 when the two year Article 50 negotiation deadline expires. Meanwhile risks of a marked German economic slowdown have risen as a result of ongoing trade tensions with the United States and of the growing political difficulties for Angela Merkel and her coalition government.

If it does turn out that Mr. Draghi is now ignoring clear warning signs and the European economy does again succumb to a slump, he will not be the first central bank president to make an egregious policy error. After all in 2008, on the eve of the world’s worst economic and financial market crisis, Ben Bernanke dismissed the sub-prime crisis as a non-event. Meanwhile Jean Claude Trichet, Mr. Draghi’s predecessor at the helm of the ECB, went one step further by ill-advisedly raising interest rates in the months immediately preceding the September 2008 Lehman bankruptcy.

Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.