European economic focus: Time running out for ECB
INSIGHT ARTICLE |
The European Central Bank rarely misses an opportunity to miss an opportunity. From the ill-timed 2008 rate increase under then-President Jean-Claude Trichet to the inability of current President Mario Draghi to gain support among the northern European contingent inside the policy council to move beyond covered bond purchases, Europe's monetary authority has been consistently behind the curve. Now, given the growing likelihood of a triple-dip recession with deflation at its doorstep, the time for deferring hard decisions at the ECB is over.
Secular stagnation -- an extended period of low growth, low rates and low inflation -- has ensnared the euro zone economy, requiring a forceful and unorthodox monetary response. The ECB will need to act in a decisive and sustained fashion to ensure the viability of the euro zone and to ward off deflation. The 1 trillion-euro purchase program that the ECB has hinted at is insufficient. An estimate of the central bank's reaction function that targets the depression in the southern economies of Europe, rather than giving preference to the Northern economies, suggests a far larger program is needed, something probably in the range of an additional 2.5 to 3 trillion euros.
ECB Must Act Decisively and Overwhelmingly
Source: McGladrey, European Central bank
While a coordinated fiscal and monetary policy response is optimal during conditions of secular stagnation, the central bank will have to act ahead of a fiscal response because of institutional constraints within the euro zone. By targeting financial conditions through its asset purchase program and altering the interest rate on long-term government debt, the central bank will hope to shape choices about investment, production and consumption by both firms and households.
The prospect of a one trillion-euro purchase program represents only a down payment. The ECB will need to implement a large scale asset purchase program that moves beyond covered bonds and which will probably include corporate debt and, eventually, government treasuries. The ECB will also need to add an additional 2 trillion euros to its balance sheet, which currently stands at about 2 trillion euros (down from 3 trillion when compared to its June 2012 peak), to address the risks to the European economy.
By acting forcefully in a sustained fashion, the ECB may be able to change financial conditions. In turn, economic activity may be boosted and inflation may increase to help prevent a deflationary shock from hitting the broader continental economy and leaking into the global financial system.
The thread that binds together households and firms across the income spectrum, whether they are small, middle market or large multinationals, is financial conditions. Because a powerful fiscal response from Europe's beleaguered economies is probably not forthcoming in 2015, this is the last remaining policy tool left in the toolbox to help jump start growth and address the disinflation that may turn into deflation.
Deflation at Euro Zone Doorstep
Source: McGladrey, European Central bank
The current disinflation in the euro zone differs from that in the U.S. The U.S. will see benefits for many years to come from the shale revolution and ongoing technological shock that is probably currently underestimated by U.S. productivity figures. This is one reason why U.S. policy makers have a much wider berth in addressing deflationary concerns and the luxury of increasing rates in a gradual and orderly fashion in 2015.
In Europe the problem is linked to an aggregate demand shock caused primarily by the combination of internal devaluation (letting real wages decline to improve competitiveness), fiscal austerity programs and the lagged impact of the financial crash and sovereign default crisis. Europe's economy and the legitimacy of the euro require a robust monetary and, eventually, fiscal expansionary policy that will need to move beyond Northern Europe's preference for austerity policies.
The policy arguments against such robust action are typically organized around a preference for a strong euro, the necessity for structural reforms, improved competitiveness and fiscal prudence. However, policy paths that worked in the past, such as the austerity imposed in Germany during the integration of the former East Germany into the West, are unlikely to work in the present context of secular stagnation.
Under such conditions, the implementation of additional fiscal austerity programs and the improvement of intra-European competitiveness through internal devaluation via falling real wages are counterproductive and will result in further declines in social welfare and rising policy tensions that in time may directly undercut the legitimacy of the euro itself.
The time has come for the Northern European contingent at the central bank to decide if they are making monetary policy for their country of origin or for Europe as a whole. That decision will determine the fate of the euro and greater pan-European economic project.