The End of ECB Restraint
Outgoing European Central Bank President Mario Draghi has indicated that the bank is planning a new round of aggressive monetary stimulus. Such measures will most likely have negative economic consequences – not least by further increasing the cost pressures weighing down German industry.
MUNICH – Expectations – and, for many economists, rather bad ones – have been confirmed: the European Central Bank has decided to inflate the eurozone. Following the ECB’s latest policy meeting on July 25, outgoing President Mario Draghi made it clear that the bank’s seemingly harmless inflation target of 1.9% will in fact be the basis for a new phase of expansionary monetary policy over the next few years. This will go well beyond the ECB’s stimulus measures to date, and is likely to pose further risks to the European economy.
We should remember that the Maastricht Treaty assigned the ECB the single, non-negotiable goal of maintaining stable prices, which, if taken literally, would mean an inflation rate of zero. This is very different from the mandate given to other central banks. The introduction of the euro, however, caused interest rates in southern Europe to fall, leading to an inflationary bubble that raised annual price growth to well over 2% in some countries. The ECB’s Governing Council then argued that the goal of price stability could not be achieved exactly, and also pointed to several measurement errors that complicate policymaking. So, the authorities said, they would tolerate average inflation of up to 2% for the eurozone as a whole.
The Governing Council did not fancy a restrictive monetary policy aimed at reducing inflation, as it gave only little weight to the risk of reducing competitiveness in some countries and did not want to slow down countries in stagnation such as Germany.
Then came the euro crisis. With inflation plummeting, the ECB turned the still-tolerable upper limit for the inflation rate into its target. Suddenly, it was argued, the bank would seek to achieve inflation of “close to, but below 2%.” Draghi even went before the television cameras to claim in all seriousness that this was the ECB’s mandate.
And now, at the end of his term of office, Draghi is seeking to bind his successor, Christine Lagarde, to a Council decision that will force her to aim for 1.9% inflation with a symmetrical concern about potential deviations. In plain language, this means that the ECB will try to achieve this figure on average over time, netting out future above-average inflation rates with below-average inflation in recent years.
In seeking to justify the ECB’s new phase of expansionary monetary policy, Draghi referred several times to the rapidly deteriorating situation in Europe’s manufacturing sector. He wants monetary policy to come to the aid of a more expansive fiscal policy needed to revitalize the European economy.
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Here, Draghi was probably mainly focusing on Germany, whose manufacturing sector has been in recession since the summer of 2018. And the ifo Business Climate Index, published on the same day that Draghi announced the ECB’s new policy, added to the pile of bad economic news. It appears that the years of plenty for German industry are probably over for now. Looming Brexit, US President Donald Trump’s imminent imposition of tariffs on more European goods, and the European Union’s new CO2 directive (which will require electric cars to account for one-half or more of some carmakers’ output by 2030), are significantly increasing costs for German (and European) industry.
But monetary and fiscal expansion in the eurozone cannot help the many manufacturing firms that do most of their business globally these days. Moreover, domestic demand in the eurozone is strong. Construction is booming in most countries, demand for services is strong, and wages are increasing rapidly, as Draghi noted with approval. Introducing further stimulus measures on top of that would create additional cost pressures that will make life even harder for firms facing both tough international competition in goods markets and domestic competition in labor markets. Stimulating the non-traded goods sectors through cheap credit typically incurs negative factor market effects for the traded goods sectors that are similar to those fueling the so-called Dutch disease – a term referring to the problems of Dutch manufacturers in the 1970s after gas revenues rapidly elevated the wage level.
Draghi complained in his speech that the passthrough of rising wages to prices was insufficient. But more wage pressure and increased passthrough would be poison for the global competitiveness of the manufacturing sector. It is not convincing to use the weakness of German manufacturing as an argument for looser monetary policy, for such policy will primarily stimulate those sectors that are in competition with manufacturing, such as construction and government.
True, industry must innovate to maintain its competitiveness, especially in turbulent economic times. But this will require measures that go far beyond the policy toolbox so revered by the New Keynesians who now populate central banks and international institutions. Europe needs structural policies that liberate market forces rather than continuing a policy of sustaining zombies and financing a new housing bubble and over-indebted government sectors with ever-cheaper credit. These sectors will not enable sustained economic growth for the continent.
Nor is it clear where the ECB will find the ammunition for the new battle it wants to fight. In the past four years, the bank has increased its money stock from €1.2 trillion ($1.3 trillion) to €3.2 trillion. It has bought securities worth another €2.6 trillion, including €2.1 trillion of public sector bonds – a policy that is in conflict with article 123 of the Treaty on the Functioning of the European Union. And interest rates are currently zero and negative.
All this is adventurous enough. If the ECB now wants to go even further, Europe’s economic system could become weaker and less sustainable.
Update: July 30, 2019
The author revised the third paragraph and updated the volume of bonds in paragraph 11.