Why the euro could splinter more quickly than anyone expects

The European Central Bank is perhaps the only institution able to keep the eurozone intact. But its decision to keep interest rates at 1% makes that a much tougher prospect, says Matthew Partridge.

Imagine you are the head of the European Central Bank (ECB).

Most of the European Union is in a deep recession, with many people out of work. Berlin is trying to get everyone to stick to tough fiscal rules, which may make things worse. Citizens are protesting, or even rioting, about austerity.

Bond markets are starting to worry that a default in the Spain, or Portugal, or Greece is inevitable. This in turn causes the cost of new borrowing to rise, making the fiscal positions of these countries even worse.

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So you'd think that cutting interest rates would be a no-brainer for the ECB.

Instead, the head of the ECB, Mario Draghi, chose to keep rates at 1% yesterday. Not only that, he also threw cold water on the idea that the ECB could begin another round of either quantitative easing (QE) or LTRO (Long-Term Refinancing Operations) in the near term.

Instead he thinks that, "the full supportive impact of the euro-system's non-standard measures will need time to unfold".

Here's what his decision reveals about the ECB's thinking and what it means for the euro's future.

The ECB is in denial about growth

Draghi is much more upbeat than most experts. He expects "the euro area economy to recover gradually in the course of the year".

Indeed, if you read his speech he almost seems more concerned with inflation than a lack of growth. He also hints that the ECB is looking to a time when QE can be unwound a sign of confidence.

In contrast, forecasters such as Capital Economics believe that things are grim and will get worse. Not only do they think that euro-area GDP will shrink by 1% this year, but also they expect it to fall by another 2.5% in 2013.

You might argue that Draghi is also trying to boost confidence by talking up the economy. However, given that the ECB's thoughts on future economic growth are closely watched by European finance ministers, it will also reduce the pressure on them to rethink certain policies, such as the fiscal pact.

In other words, Draghi's view throws the ECB's weight behind those calling for austerity, rather than those who want to see the larger countries stepping in to bail out the troubled ones.

This is not necessarily all bad. Indeed, it is hard to argue with his call for "decisive structural reforms". As Draghi puts it, "policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects".

However, the impact of continued cuts and ECB inaction will have much more impact, in the short and medium term, than any boost delivered by economic reform. The crisis also risks helping extremists of both left and right. Indeed, on Sunday, French voters have a choice between Nicolas Sarkozy, who has tried to pander to Marine Le Pen's National Front, and Franois Hollande, who promises to bring in penal tax rates and repeal pension reforms.

The only way to meet both the needs of bond markets and the wider public is to take measures to increase the money supply. However, the ECB still refuses to do this, hoping that the economy will recover on its own.

You can understand why. The politics of the eurozone make it very hard for the ECB to take any action. But realistically, the ECB is the only one with the power to keep the zone intact in its current form (at least until the next crisis).

The euro endgame could play out in a number of ways, from the exit of the peripheral countries to a complete disintegration (Fitch has produced a paper on this topic). But if Draghi sticks to his current course, the process will take place much sooner than most people think.

Dr Matthew Partridge
Shares editor, MoneyWeek

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri