The Eurozone needs to embark on monetary and fiscal expansion as well as institutional reform. But for both,it needs Germany to cooperate.
November has not been an easy month for the European Central Bank (ECB). It started with worrisome data on eurozone inflation (that dropped below 1 per cent,well beyond the 2 per cent target) and increasing unemployment 12.5 per cent. Then,the European Commission and independent forecasters seemed to agree that,while the recession may be over,growth is projected to remain very weak and jobless for two years. The latest bad news is the publication on November 28 of data on bank lending to firms and households that decreased by 2.1 per cent in October,reaching an all-time low.
While the eurozone flirts with deflation and sluggish growth,the transmission mechanism of monetary policy is malfunctioning. The European economy is in a liquidity trap,with massive liquidity injections from the ECB that hardly reach the real sector. Deflation would be catastrophic,as falling prices would increase the burden of debt for governments and the private sector alike. The more deflation there is,the more agents will hoard money,the more the economy will be stuck in a liquidity trap. This may come as a surprise in an emerging economy with positive inflation,but is unfortunately familiar for the Japanese public.
Standard textbook analysis dictates that when facing deflationary threats in a liquidity trap,monetary policy has little or no traction; the burden for sustaining aggregate demand therefore falls on fiscal policy. But there is little to be expected on that front,as European countries,under pressure from the German government and European institutions (including,somewhat paradoxically,the ECB),are all engaged in austerity programmes that further depress growth.
If November was not an easy month,the next ones may be even more difficult. With the end of quantitative easing programmes in the US (the tapering),world financial markets are likely to enter a period of turbulence and higher interest rates,and emerging economies are also experiencing some difficulties.
Faced with the threat of deflation,and with no help from fiscal policy,the ECB needs to take action. It is time for its president,Mario Draghi,to implement a more expansionary monetary policy through unconventional measures,aimed at increasing both supply and demand for credit. While rates are exceptionally low,the ECB still has some margin to act on the deposit rate,currently at zero. Faced with a negative rate,which means a cost for keeping their liquidity with the ECB,financial institutions might end up increasing their lending.
Nevertheless,there is little to be expected from further rate cuts. Two more promising options are a European version of quantitative easing that would increase the liquidity available to the private sector. First,the ECB could launch another round of Long-Term Refinancing Operation (LTRO),a massive amount of long-term loans for financial institutions at very low rates. The first one,in December 2011,kept banks afloat,but failed to boost credit as liquidity was mostly invested
in sovereign bonds. A new round of LTRO would be conditional on financial institutions passing credit on to firms and consumers. Not an easy requirement when it comes to implementation. A second way to boost credit to the private sector,which the ECB is considering,is the launching of a vast private (corporate) outstanding loans buying programme. Commercial banks,especially in the eurozone periphery,still have a shortfall of capital because of non-performing loans. By buying corporate credit from financial institutions,the ECB would reduce the amount of outstanding loans they hold,thus lowering capital requirements. This would free funds for fresh lending.
Yet,while these measures may work to increase the supply of lending,nothing ensures that a substantial increase in spending would follow. In the current liquidity trap,it is not only banks that hoard cash but also households and firms. By focusing only on the supply of credit,the ECB may end up pulling on a string. The experience of Abenomics in Japan may then teach some lessons to European policymakers. Its success so far relies on two arrows. The first is a robust monetary expansion aimed mostly at increasing expectations of future inflation. The second is a robust fiscal expansion,which supports aggregate demand while waiting for the private sector to resume spending.
A European version of Abenomics is possible. As for the first arrow,the ECB could surprise markets by announcing an increase of its target inflation rate (sometime ago,IMF Chief Economist Olivier Blanchard proposed the inflation target be raised from 2 per cent to 4 per cent in most advanced economies). But even this would most likely not suffice,if the aggregate fiscal stance for the eurozone remains restrictive and pro-cyclical. Unless Germany abandons its export-led growth model and undertakes expansionary fiscal policies,the ECB will have very difficult times ahead.
Exiting from the current liquidity trap is the ECBs most pressing task,but not the only one. The current crisis has dramatically shown that the eurozone institutional set-up is vastly insufficient in dealing with a non-optimal currency area. Institutional reform,in the medium-to-long term,should first and foremost transform the ECB into a lender of last resort for EMU governments. The sovereign debt crisis could have been substantially milder if governments in trouble had their debts guaranteed by the central bank. Countries like Japan,the US and UK have lower government yields in spite of more deteriorated public finances. This is mostly because of the role of lender of last resort played by their central banks. The second institutional reform should abandon inflation-targeting in favour of a US Fed-like dual mandate. Such a mandate would allow more flexibility in monetary policy,especially at times of high unemployment and quasi-deflation,like the ones we are living now.
Both short-term measures and the necessary long-term institutional reform face fierce opposition from the largest eurozone economy,Germany. Unless this changes,nothing will happen. The key for future growth in the eurozone is in Berlin,not in Frankfurt. And the newly formed coalition in Germany offers very little hope for change.
The writer is senior economist at OFCE-SciencesPo Paris. He holds PhDs in economics from Columbia University and the University of Rome. He served as senior economic advisor of the Italian Prime Minister (1999-2002). He publishes in the fields of theoretical macro and macroeconomic policy,with an emphasis on European fiscal rules. He teaches classes on International and European Economics at SciencesPo Paris and at the Jakarta School of Public Policy,Indonesia,where he is also head of the economics concentration. He regularly writes columns for leading French and Italian newspapers and maintains a blog on European matters. Twitter: @fsaraceno