The minutes of the Bank of England monetary policy committee's November meeting revealed a little bit of division on quantitative easing, seven members voting for a £25 billion increase to £200 billion, one (Spencer Dale) for no change and another (David Miles) for a £40 billion increase to £215 billion. The minutes also suggested that there will be no addition to the agreed amount (£25 billion) until February.

The markets were also interested in the fact that the committee discussed a cut in the rate on commercial bank reserves at the Bank, which it suggested "would bear down on short-term market rates, and could ease monetary conditions further". While concluding that the impact would be small and that QE was a more effective way of operating, this is one to look out for. The minutes are here.

Also today, the Bank released the numerical parameters of its new forecasts. Growth will peak at 4.3% in the second quarter of 2011, its modal projections suggest. The mean is lower, 3.3%, but still pretty healthy. The projections are here.

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The widespread feeling after the November ECB meeting was that we should prepare for the beginning of the central bank’s exit strategy possibly, at least in terms of announcements, already at the December Governing Council (GC) meeting. The rationale for this is that on November 13 we will have the final confirmation that in 3Q 2009 the euro area emerged from the recession and we keep witnessing signals of stabilization in financial markets, with figures on 3Q earnings by major European banks being the most visible sign.

Although the ECB is under no pressure to hike the refi rate – the growth/inflation outlook and our Taylor Rule suggest that aggregate conditions do NOT call for a classic tightening anytime soon – the central bank is increasingly feeling the need to regain control of market interest rates via a progressive mopping up of excess liquidity. What we have seen so far is a swift and bold ECB reaction to deteriorating conditions in the financial and macroeconomic landscapes since October 2008 that triggered a significant reduction in money market interest rates. In addition, and this is something that is underestimated in comments on recent ECB policy, the unlimited cheap financing to banks has caused a massive rebalancing in banks’ balance sheets in favor of government bonds, helped also by European Commission statements that no single country would have been left to its own destiny. As a result, ECB figures confirm that banks’ net asset purchases of government bonds more than tripled and now stand at EUR 150bn: banks enjoyed a positive carry which was much needed for their impaired bottom lines, and governments were able to finance the heaviest supply in history which allowed them to undertake a significant (though not dramatic) fiscal easing. Something for everyone. Faced with a stabilizing macro and financial picture, the question is: what’s next?

What to expect in December and afterwards

The starting point for the ECB when they meet in December is a total liquidity outstanding of about EUR 686bn, with an excess surplus of about EUR 100bn. This surplus has been constantly declining since last June’s 12-month LTRO, but it is likely to increase again after the December operation. Let’s be clear from the beginning: the low September allotment (circa EUR 72bn) shouldn’t fool anybody. With the ECB already announcing that this is going to be the last auction at that maturity and with all the liquidity issues and balance sheet dressing needs which arise at the turn of the year, we expect a number definitely higher than two months ago. An allotment in the EUR 150-200bn neighborhood seems to us pretty reasonable. In this respect, it is important to note that at this week’s long-term refinancing operations the demand of liquidity was quite low with only EUR 0.8bn of bid at the 6M LTRO (vs. EUR 21bn of expiring liquidity), EUR 11bn of bid at the 3M LTRO (vs. EUR 13bn expiring), and EUR 2.5bn of bid at the 1M LTRO (vs. EUR 7.7bn expiring). In our opinion, this is a sign that institutions are shifting their interest to the December 12M LTRO.

This view is underpinned by the recent increase in the 12M OIS rate, which is now at 0.70% (30bp below the refi rate). The spread vs. refi represents the cost of getting 12M liquidity from the ECB instead of funding on the secondary market. The lower the spread, the higher the incentive to go to the ECB. It is interesting to note that since the June auction this spread has moved in the 20-40bp range. As of today, the spread 12M OIS vs. refi is in the middle of this range, and, importantly, lower than at the September auction (40bp). Should it move below the lower end of the range, it is likely to be a further sign of strong demand in December.

Clearly, the ECB would be pleased with a lower figure and, in order to achieve that, may even decide to apply a spread on the allotment rate. But we keep thinking that this is not going to be the case for a couple of reasons: 1) it’s an undesired arbitrary element in a procedure that so far has worked perfectly; 2) it would send a misleading signal to markets: is the ECB applying a spread only for the pure need of draining liquidity and regaining control of market rates, or is it a signal of a higher refi earlier than expected (this motive heavily clashing with the present cautious central bank’s reading of the cycle juncture)?

We are inclined to think that a spread may be applied only if Eurosystem’s staff GDP forecasts in December are way higher than in September, with an inflation projection for 2011 higher than 2%, implying a central bank willing to act on the refi in 1H 2010. However, recent remarks by Mersch and Nowotny imply that the upward revision to growth will be relatively contained. Faced with a strong EUR and a still-wide output gap, the ECB cannot see upside risks to inflation in the medium term.

It is clear that the only ways that the ECB has to regain control of market rates is: 1) to wait until excess liquidity declines significantly (evidence suggests that this cannot happen with a liquidity surplus higher than EUR 80-90bn), and 2) that the “full allotment” procedure is no longer in place.

With respect to the first point, several aspects are worth stressing. First, all the liquidity that will be allotted at the December 12M LTRO will remain in the system until the end of 2010. This holds particularly true if the ECB decides to cancel the other extraordinary operations, as we expect (1M and 6M). Second, autonomous factors are an important component of liquidity demand: they are an important liquidity-absorbing factor but out of the ECB’s control. Namely, they correspond to the sum of: 1) banknotes in circulation; 2) governments’ deposits at Eurosystem central banks; 3) the investment portfolio of euro area central banks (due to an accounting reclassification enforced at the end of 2008). It is worth noting that in October 2008 autonomous factor jumped sharply, as a consequence of: 1) higher demand for banknotes, especially the high-denomination ones, related to a lack of confidence in the banking system at that time. According to ECB statistics, the level of currency in circulation has remained above its long-term average, despite government interventions in support of banks; 2) increase in the size of the deposits by euro area governments at the Eurosystem, mostly due to the various government programs introduced in response to the crisis; 3) increase in the euro area central banks’ holdings of government bonds.

In the medium term, autonomous factors could decline, returning to the level prevailing before October 2008. As stressed before, the increase in such a component is mainly due to crisis-related factors. Hence, it is reasonable to expect a decrease in such sub-components when the crisis is over. Ceteris paribus, the decline in the autonomous factor would mean a corresponding increase in the excess liquidity, thus putting downward pressure on overnight rates.

To this extent, recent remarks by Weber and Trichet suggest that the ECB is fine with an EONIA “fairly” lower than the refi rate for some more time, and that the full allotment procedure – at least at the weekly MROs – can be kept in place for longer. In order for the first condition to be met, especially if we are right on the allotment at the December 12-month LTRO, the ECB has to wait until July 1 when the massive June’s 2009 EUR 442bn will expire.

Given that the GC meeting in December will take place before the 12-month LTRO, the ECB would probably decide to err on the side of caution and leave some important decisions to be taken in January or throughout 1Q 2010, once the excess-liquidity picture will be clearer. Hence, at the December meeting we expect the ECB to announce:

• The end of 12-month LTROs; 
• No spread on the December 12-month LTROs; 
• Return to the normal “fixed amount/ variable rate” procedure for all the other LTROs from January (or a bit later in 1Q), with a high chance that 1M and 6M operations are canceled; 
• Extension of the “fixed rate/ full allotment procedure” for the weekly MROs at least until the end of 1Q or sometime in early 2Q; 
• A more detailed communication set (calendar, etc.) in January with a clearer excess liquidity information. 

The trickier question is to define a reasonable EONIA path. However, under the working assumption of a resurging liquidity surplus in December and assuming that our bets are correct, we expect the EONIA rate to stay around current levels until July 1 2010 when the huge impact on excess liquidity of the first 12-month LTRO fades away. If the bidding at the December 12-month operation is not very sizable, then the situation will dramatically change after July 1, and the EONIA will jump toward the refi again, reversing the drop of last June. In the light of recent rhetoric, aimed at stressing the willingness to keep the EONIA lower, that would probably be the perfect outcome for the ECB. Indeed, under this scenario, the ECB would have ensured the beginning of the exit strategy without triggering any abrupt market reaction: as a matter of fact, investors would have plenty of time to prepare for the rise in EONIA of next summer.Two things may alter this unfolding of events: 1) as already argued, a heavy allotment in December. In this case, the exit strategy would start as well but it may last longer than the ECB desires, because the EONIA would stay lower for longer. Under these circumstances, the ECB may be forced to return to competitive auctions for the weekly MROs earlier (already in 1Q 2010?), or decide to lift the deposit rate, thus narrowing the corridor. 2) A stronger-than-expected recovery, coupled with upside risks on inflation that would significantly alter the ECB stance on the “traditional” refi rate policy. It’s difficult to gauge on point 1), whereas we feel more relieved on point 2). In our 2010 Outlook to be published at the beginning of December we’ll largely argue why.

Sorry, and I apologise in advance: in this post I'm going to be a nit-picker. The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories. So maybe I should have titled the post "all about inventories", following Pedro Almodovar's cinematographic lead in cycling and recycling that old "all about Eve" metaphor - necessity is the mother of invention, and movements in inventories are progenitors of both growth, and of that notorious double dip difficulty. So just which one of these is it that we have on our hands here?

Indeed, the fact that the devil, as always, lies in the details should not really surprise us since economics isn't that different from other sciences, and isn't such a difficult subject to work with - even if some journalists and lot of bank analysts are able to make it look like it is by managing so frequently to make a dogs dinner out of what should really been an ever so plain, ordinary, and simple vanilla-flavoured ice cream. Let me explain.

Before getting bogged down in all that horrid detail let's register a very simple plain, evident, and totally undisputed item of fact - the "eurozone sixteen" economy (whatever that rather nebulous concept actually refers to, when you dig down a little below the surface) poked its nose timidly out of recession in the third quarter of this year, with gross domestic product in the 16 countries using the euro rising 0.4 percent from the previous quarter (see chart below). This return to positive headline growth technically brings a recession which lasted five consecutive quarters of shrinking output to a close - even though output was still four percent below that registered in the same period in 2008. So evidently we are out of recession, but are we out of the woods yet?

Well, basically I think we aren't, and to explain why I think we aren't I'm going to pick (yet one more time) on poor old Frank Atkins of the Financial Times. It almost hurts me to do this, since I am not trying to say that Frank is an especially bad example of economic journalism (far from it), even if he is sometimes very badly served by his headline writers, writers who over the weekend managed to switch what was Friday's declamatory "Germany powers eurozone recovery" version (and for those who like twitter here) to Sunday's much more modest "European recession ends with a whimper" one. However since this is now the second time in just over as many months that Frank has wheeled out the German economy "powering" something or other word out, I cannot help concluding that either he really likes the expression, or that he must know something I don't about what is actually going on in Germany, since structurally speaking it would seem to me that such "powering" is now completely impossible, given the economy's evident export dependence.

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Nouriel Roubini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

The dollar has fallen by about 12 percent (in relation to a basket of six major currencies) in the last year as the Federal Reserve has cut interest rates to a record low of around zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. The problem is that this has created what Professor Roubini rightly terms the mother of all carry bets against the US dollar, and lead to all kinds of speculation that we are at the dawn of a new era, one which will have the “death of the dollar” as its defining characteristic, and where in the dollar will no longer serve as the world’s reserve currency of preference.

Well, as someone once said, rumours of my imminent demise are somewhat exaggerated. The greenback is still alive and kicking, and will be for many years to come, although we also need to be realise that structural changes are underway. So while in the short term we should not really be in doubt that the decline in the dollar will eventually “bottom out” as the Euro-USD crossover reaches ever more painful levels for the eurozone’s heavily export dependent economies while the Fed will at some point begin to hint that it is considering raising borrowing costs and start to with draw some of the “quantitative easing type” stimulus measures, including, of course, those large scale purchases of US government debt. But this is not likely to happen rapidly, or in a disorderly fashion, so in many ways investors will have time and space to reorganise their betting card.

This was once more made plain this week, when Federal Reserve decision makers signaled quite clearly that a simple return to economic growth alone won’t justify higher interest rates on their part, stressing that any future increase will depend on the labour market and inflation trends, and indeed the Fed’s rate-setting Open Market Committee resasserted its pledge to keep rates “exceptionally low” for an “extended period.” Following these comments traders began to pare back their bets that an increase in borrowing costs will come in the first half of 2010, the dollar weakened and short-term Treasury yields fell.

The impression that the Fed will not be the first out of the box among the major central banks was only reinforced today as the European Central Bank seems to have hesitatingly taken its first step toward removing emergency stimulus measures by indicating it won’t be continuing to provide commercial banks (and of course the governments whose debt they are buying) with the current 12-month loans as 2010 advances - although no timetable for phasing them out has so far been provided. Nor has it been made plain what structure will replace them. Jean Claude Trichet seems to have contented himself with enigmatically teasing the assembled journalists by stating “Not all our liquidity measures will be needed to the same extent as in the past” and pointing out that since market sentiment didn’t expect the ECB to prolong its offer of 12-month long term funding beyond December he was going to “say nothing to dispel this present sentiment.”

Assessing what exactly is happening here is difficult, since in the world of central bankspeak it would be a mistake to think that expressions mean what they actually normally mean in everyday discourse. So it is not clear whether or not the strategy between the Fed and the ECB is coordinated at this point or not, and if it is, to what extent. Certainly despite Timothy Geithners insistence on the US Treasury's strong dollar policy, it is hard to imagine that anyone (not even the Chinese) actually take him at face value here, and indeed, if you read the reports carefully, Trichet is only complaining about excessive volatility, and not about the level of the Euro in and of itself. This impression, that those taking decisions accept that the dollar needs to stay down to allow the US economy to correct itself is only reiforced further by concerns expressed only today by Kenneth Rogoff, Raghuram Rajan and Simon Johnson (all economists who have previously worked for the IMF) as to whether the IMF and the G20 actually had the wherewithal to address the global imbalances problem. It should not escape our notice that this "concern" was expressed just one day before G-20 finance ministers and central bankers, including U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet, are to start two days of talks in St. Andrews, Scotland.

In fact, there is some evidence of progress being made, since the U.S. current account deficit narrowed in the second quarter to its lowest since 2001, and I'm pretty sure a solid majority of Europe's leaders accept the need for the deficit to be allowed to correct further if future growth is to be put on a more solid footing.

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Though Mervyn King sounded downbeat at the press conference and refused to rule out further asset purchases under the quantitative easing programme, the Bank's new forecasts are more upbeat and predict higher inflation, compared with three months ago. In particular, the Bank's fan charts suggest growth will recover to around 4% over the next couple of years. But it seems to be retaining its dovish stance on policy. The inflation report is here.

Unemployment figures, meanwhile, continued the very encouraging recent pattern. The new Labour Force Survey total for July-September, 2.46m, suggests unemployment fell in both August and September, The LFS rate dropped from 7.9% to 7.8%, and employment rose by 6,000 over the latest three months. Pay growth was very weak at 1.2% but these numbers represented very good news. More here.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.   

Editor's Note: The following is excerpted from RGE premium content. The full analysis, "Germany, 20 Years On: Goals Reached?," is available to paid clients.

When the Berlin Wall fell twenty years ago, it began a process, which culminated in the reunification of Germany. The merger between East and West Germany ended a four-decade division imposed by the Soviet Union and its East German communist allies, a split literally cemented into history during the 28-year life of the notorious Berlin Wall. The Wall’s destruction led to an eruption of euphoria and optimism. With discredited communists unable to put up resistance, West Germany’s Chancellor Helmut Kohl and his democratic allies in the east promised a swift convergence between the two regions. Expectations skyrocketed, yet the task was not a minor one. Differences between the two Germanys were fundamental at the time, extending beyond psychology or politics to basic economic realities. The post-war West German state pursued social market democracy – the “Soziale Marktwirtschaft” -- engendering the famous “Wirtschaftswunder” which catapulted Germany’s capitalist half into the league of the richest countries in world. East Germany, however, suffered heavily under Soviet occupation as entire factories were dismantled and transported to the USSR, and even after the occupation period Soviet inspired central planning quickly led to problems. By the early 1980s, the DDR’s economy had become an economic laggard, depending heavily on subsidies from Moscow and the largesse of its rival in the West, which during the 1970s had opened economic ties as part of Chancellor Willy Brandt’s conciliatory Ostpolitik initiative.

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-.  That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin’s finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit.  It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland’s rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month’s Budget may set the economy back further, but without it the country’s national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month’s Budget into account, because the details are not yet known.

"Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded," the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy’s problems might give more support to consumption and investment by helping confidence.

The Government’s plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission’s estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn’t rule out temporarily nationalising the country’s banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

“Further recapitalisation may be necessary as assets are being purchased below book value,” the Paris-based OECD said in a report today. “Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether.”

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

“Substantial” banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the “utmost reluctance,” the OECD said.

The FT’s Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today’s bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.  

The WSJ reports (on-line): “The U.K.’s top treasury official Sunday said the government is starting a process to rebuild the country’s banking system, likely pressing major divestments from institutions and trying to attract new retail banks to the market.”  The British style is typically understated and policymakers always like to play down radical departures, but this is huge news.

Pressure from the EU has apparently had major impact – worries about unfair competition through subsidizing “too big to fail” banks are very real within the European market place.  Also, strong voices from within the Bank of England have helped to move the consensus.

The US position on protecting everything about our largest banks is starting to look increasingly isolated and out of step with best practice in other industrialized countries.  Time to start planning for the break-up of Citigroup.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE. 

Well, I never thought I would have to wait very long to get some confirmation of my last post on things that could go bump in the night in France, but even I wasn't expecting confirmation of what I was trying to get at so quickly. Now, according to Frank Atkins in The Financial Times this morning:

The eurozone has reported the first year-on-year fall in bank lending to the private sector, strengthening the case for the European Central Bank to maintain its ultra-loose interest rate policy. The latest eurozone credit statistics indicated lending had been scaled back at an unprecedented pace, even though signs have become stronger that the 16-country region’s economy has stabilised.

What are we talking about here?

Basically bank lending to the euro area private sector shrank by an annualised 0.3 percent in September, according to the European Central Bank's monthly report, making for the first contraction in lending since the series began in 1992. In fact, as Frank Atkins points out, there is some positive gleem in the data, since month-on-month there was €14bn pick-up in lending to households in September. Nevertheless lending to households was still 0.3 per cent lower than a year before. That compared with a year-on-year contraction of 0.2 per cent in August. However, before we start talking about whether to put a positive spin on the tealeaves we should make ourselves awar that this entire way of reading things is deeply problematic, since it ignores two vital points (which is why I head this post "beyond the consensus", since from time to time you can read things here on this blog that you normally won't even find in the analyst surveys):

i) when you get near turning points inter-annual data becomes increasingly inadequate, and hence we now need to follow quarterly and even monthly data, or we will miss the turn.

ii) aggregate data masque the big differences we have between the different euro area economies, and this is how Spain and Ireland got into the mess they are in. The big news of the moment, I would argue, is that the credit cycle has clearly TURNED in France, as I will show in the accompanying charts below indicating quarterly annualised movements. In other countries (and particular Spain) the downward drift continues. So basically relying on the average number hides a multitude of sins, as it did last time round when Spain got into the mess it is now in, and this is one of the things I think we should be learning this time round, since if not,..................

The French Credit Cycle Turns

The chart below (which comes from the Bank of France, based on data to September) shows total credit to the private non financial sector. As we can see, on a year on year basis, the rate of credit increase continues to fall (thick blue line). But if we look at the three month annualised rate, we will see that this rebounded after June (narrow black line). What I interpret this to mean is that the credit cycle in France has now turned, and looking at the interannual data you miss the bottom. This finding is pretty important I would say.

Corporate borrowing (SNF) has also bottomed, although even on a quarterly annualised basis it is still negative. Even corportate borrowing should turn positive in the next quarter, and it will be this that should allow the government to take the hand of the "G" button and start to rein-in the fiscal deficit, as win-win growth and inflation dynamics start to set in. But what this also will mean is that the ECB, at least in the case of France, now need to start take off the ultra-loose monetary policy. What a dilemma!

Household credit growth never even reached negative in France, and is now clearly on the rebound too, and with it the French housing market. (Menages in French is households).

For fuller explanation of the deep significance of having the credit cycle turning in France significantly ahead of the rest of the euro area see The French Rebound Continues In October While Germany Moves Sideways.

Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.       

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics - the theory and practice of central banking - seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still - truth be told - prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.

The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious - since with 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain's economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where - as Bloomberg inform us this morning - central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) - France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday's Flash Markit PMI readings (see detailed breakdown below). Now those who regularly follow this blog will know that this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some of the theoretical justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might conceptualise the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. To summarise briefly the argument which will be presented below, there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the "exit thinking" kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain's seemingly intractable difficulties only increase. In other words, what will happen if - as seems obvious - the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

As we will see in the charts which follow the long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit there, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

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