A bank-led credit crunch, a newly strong euro and the shrinking of the European Central Bank's balance sheet are tightening conditions in the euro zone at just the wrong time.
This should heighten pressure on the ECB to cut rates or take other measures when it meets next week. Just don't count on the central bank doing much.
A confluence of forces, some positive, are combining to effectively tighten financial conditions in the euro zone, even as the continent struggles with unemployment and recession.
Healthier, more stable banks are repaying longer-term funds borrowed from the ECB, an encouraging development but one which has as a side effect higher market interest rates.
At the same time, banks continue to be fearful and stingy about making loans, both to consumers and businesses.
Finally, and perhaps most damagingly, the euro is shooting up in value against the currencies of major trading partners, driven partly by relief that the euro project seems less fragile and partly by conviction that the ECB will be less generous than its peers.
The net result is that Europe is suffering from tighter conditions at just the juncture at which money should become cheaper.
And yet not one of the 75 economists polled by Reuters recently expects the ECB to cut rates at its February 7 meeting. If they don't we can expect more euro strength and more economic weakness.
Banks taking part in the ECB's quarterly lending survey said they found it easier to raise funds themselves. When it came to lending the money on, however, they continued to ratchet lending standards tighter at roughly the same rate as the quarter before. Credit standards for households tightened at an increased rate. Demand for loans also fell, a decrease that probably allowed banks to be more generous than they otherwise would be. here
Even so, corporate loans outstanding in the euro zone declined by 52 billion euros in December alone, falling by more than 9 billion euros just in Italy. In an economy with a less deep public capital market, and one with a huge host of loan-dependent small and medium-sized business, this picture of a lending drought is very negative.
BANKS RECOVERING, ECONOMY NOT SO MUCH
Banks clearly are doing better than they were months ago, helped immensely by the ECB's effective backstopping of sovereign creditors and the euro project as a whole. The problem is that while banks and countries are finding it easier to borrow, people and businesses are not so lucky.
The huge rush to repay funds borrowed from the ECB in the Long-term Refinancing Operation is a case in point. The ECB said last Friday that 278 banks would repay early a total of 137.2 billion euros of three-year loans they took out in December 2011, funds actually repaid on Wednesday.
That was far more than markets expected, and showed that the banks were finding their own funding conditions to be more stable. The repayment, though, is having a paradoxical effect, being in itself a draining of liquidity from the financial system.
That could be seen clearly in Euribor bank-to-bank lending rates, where three-month money inched up to 0.23 percent, a seemingly minuscule amount but nonetheless more than 20 percent higher since the first of the year. Not a big move in absolute terms, but hardly one justified by the economic fundamentals.
The other vexing issue is the strength of the euro, up more than 2 percent against the dollar year-to-date and more than 12 percent since August. Again, we have the paradox of the explicit ECB insurance policy: in promoting confidence they produce a tightening of conditions. Euro zone exporters will be feeling the pinch, nowhere more than in the less competitive areas like Portugal and Spain, whose situation begs for a devaluation, not a revaluation.
Don't expect the pressure to ease. The Federal Reserve announced it will continue with its extraordinary policies, the Bank of Japan has unveiled a new, higher inflation target and plans for more asset buys, and the Bank of England may well do more as Britain's third recession in recent years looms.
If the ECB does react by easing, or for that matter by talking the euro down, it would be a net positive for global markets which are already floating on a cloud of optimism and central bank largess.
That said, nothing the ECB has said, much less their track record, indicates they are close to cutting rates, no matter the damage. Rescuing the euro, if that indeed is what they have done, was painful, divisive and forced the central bank to do things far out of its comfort zone.
For Europe's real economy, that means more pain to come.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)