Wednesday, November 26, 2014

The ECB’s Lethal Inhibition

BERKELEY – Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention, offering banks across the eurozone essentially unlimited liquidity against any and all collateral for an exceptional period of three years.

The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. The deterioration of economic conditions is casting doubt on their governments’ budgetary arithmetic, undermining political support for structural reform, and reopening seemingly closed questions about the stability of banking systems.

Once again, the eurozone appears to be on the verge of unraveling. So, will it be once more into the breach for the ECB?

The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. Board members may have also been concerned by evidence of cost-push inflation in Germany. The leading German trade union, IG Metall, has called for a 6.5% wage increase in the next annual round of negotiations. And German public-sector workers obtained an agreement at the end of March that boosts wages by 6.3% in the coming two years.

But this increase in German labor costs is, in fact, precisely what Europe needs to accelerate its rebalancing, because it will help to realign the competitive positions of the northern and southern European economies.

Southern Europe needs to enhance its competitiveness and export more, and has been criticized (not without justification) for failing to do more along these lines. But what matters are southern Europe’s costs of production relative to those of Germany, Europe’s export champion. That is why the prospect of rising German labor costs, after a decade of stasis, is actually one of the few positive economic developments on the European scene – hardly something that the ECB should resist.

And the fact that higher wages in Germany will be matched by lower wages across southern Europe suggests that continent-wide inflationary pressures will remain subdued. With eurozone unemployment above 10%, it is hard to see how things could be otherwise. The 2.6% headline inflation rate in March was heavily influenced by spiking energy prices, the effects of which should be transitory (events in the Middle East permitting). Indeed, the ECB’s own forecast has inflation falling in the second half of 2012 and again in 2013, suggesting that it has monetary room for maneuver.

A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. Where spending cuts should, in principle, help to dampen inflation, European governments, like that of Spanish Prime Minister Mariano Rajoy, are backtracking on their budgetary commitments. Similarly, where structural reforms should rein in price growth by encouraging competition, leaders like Italian Prime Minister Mario Monti, finding it increasingly difficult to marshal support for unpopular measures, are watering down already-modest proposals to enhance labor-market flexibility.

With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus – keeping the boat afloat with more spending – only relieves the pressure on national officials to do what is necessary.

If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.

The ECB is preoccupied by moral-hazard risk – the idea that supporting spending will relieve the pressure on governments to act. But it should also worry about meltdown risk – about the danger that its own failure to act, by leading to a deep recession, will undermine political leaders’ ability to take the steps needed to put their economies on a sound footing.

The ECB will object, not without reason, that monetary policy is a blunt instrument with which to rebalance the European economy. A cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.

True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. Without support from the ECB, both goals – economic recovery and political leaders’ commitment to structural reform – will remain purely aspirational.

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    1. Portrait of Gregor Schubert

      CommentedGregor Schubert

      This commentar yis an excellent summary of the fundamental issue in the euro zone crisis that is often lost sight of in the face of a flurry of news about fiscal authorities struggling with forces beyond their control:

      The euro zone recession is fundamentally due to a lack fo demand and the main lever to stabilize aggregate demand is NOT fiscal policy but monetary policy. However, the ECB's words and the confusing semi-federalism of EU institutions have successfully led commenters to focus on the national institutions that corresponf to the electorate's consciousness and national politics: fiscal policy, austerity, welfare states, current account deficits are all over the editorials of major European newspapers, although any commentary on the crisis should be dominated by three letters: ECB.

      This blind spot perhaps explains the only omission in this excellent essay by Eichengreen. He notes:

      "The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession"

      Most other news sources are less subtle and speak of the ghastly "financial markets" that had allegedly been lulled in by ECB liquidity operations and now, like a stunned beast whose anesthetics are wearing off, are lashing out again at struggling Southern European sovereigns. To hear intelligent people write like that, one can only surmise that the efficient market hypothesis has abandoned European journalism.

      Here is an actual theory, not based on mythical beasts, to explain the return of the recession in Europe that seemed to have been almost defeated 5 months ago: The ECB steers the nominal income of the euro zone. The LTROs signalled to market participants that maybe there was still someone in Frankfurt who cared about unemployment, misery and political unrest more than about short-term inflation being slightly above the promised level.

      Then, the LTROs stopped and it became clear that the ECB was not willing to do the right thing in the face of ideological resistance from the German economic establishment. Moreover, the ECB's unwillingness to stimulate the euro zone economy became clearer through serious, but quite laughable, suggestions by Jörg Asmussen, German representative on the ECB Executive Board, that it was time for the ECB to start raising interest rates soon (because the EU euro zone economy is flourishing ?) and that last year's interest rate rise in the spring had been just as necessary. Unfortunately, he is terribly wrong: after last year's interest rate rise, the ECB soon had to reverse itself because the economy collapse and given where we are at right now...."success" is not the word that comes to mind.

      To summarize: Bravo for a great and lucid essay by Barry Eichengreen - one of few commentators who understands that the dragon's lair may be in Frankfurt, but it is not the Deutsche Börse...

    2. CommentedMarc Laventurier

      UCBs Inevitable Inhalation

      As I write, I'm enjoying UCBs Brad DeLong and his hosts on Bloomberg TV, and he's as genial and bright as Prof. Eichengreen was when we were classmates in secondary school near Berkeley, back when you could buy a schwarzer Kaffee for DM 3, and hear the MC5 in People's Park for free.

      Just as Barry does here, just as every economic commentator is compelled to do by the conventions of their discourse, Prof. DeLong resolved his conversation about Greece et al by invoking the great nostrum, growth.

      But then something subtle and marvelous seemed to happen; perhaps because there was some salesman in a kilt on the set plying the panelists with snifters of scotch, at once everyone seemed to recognize that such growth would be not be forthcoming, that the whole scheme would fail in those terms.

      So as Prof. Eichengreen has it here, only by reigniting at least nominal paper growth through printing money by the trillions can the preferred economic model animate a world that has lost its' way. Everyone should shape up and work harder, mach schnell - especially the printers.

      Well, the one economist I've come across who has accurately predicted this scenario from the beginning is the pony-tailed Marc Faber, reputed 'shroom eater; maybe there is something to the reported divinatory capabilities of the fungus. Or maybe it's the Laotian hillside weed. Whatever it takes to see clearly, in advance. And not to get lost in the weeds of formulaic concepts of growth.