There are few things that destroy an economy as thoroughly as deflation. When prices are expected to fall, spending is delayed. As spending is delayed, prices fall further. In a heavily indebted economy, the real cost of debt goes up. It’s a corrosive spiral that’s presently threatening one of the world’s largest economies, the euro area.
Prices in the euro area have fallen for the past three months and fell 0.3% in February. They’re expected to fall by as much as 0.8% in 2015. This lurch into deflationary territory is mainly explained by the sharp fall in global oil prices. Although the effect on headline inflation is likely to be temporary, there’s a risk that in such fragile conditions falling prices could cause expectations of inflation to slip downward.
Core inflation, which excludes more volatile components such as food and fuel, hasn’t turned negative yet, coming in at 0.6% in February, but this is still significantly below the European Central Bank’s (ECB) mandated target for inflation of just under 2%. This has reinforced the need for the ECB to act.
Back in 2012, Mario Draghi, president of the ECB, famously promised to do “whatever it takes” to save the euro. Through a number of measures and announcements, Draghi managed to stabilize the banking sector and calm capital markets. Even so, the economy has remained in a slough, with demand persistently weak.
In January, the ECB decided to confront more directly the risk of deflation, announcing what seemed a bold program of quantitative easing. The plan is to spend €60 billion a month by buying a mix of government bonds and asset-backed securities (ABS) for 19 months, from March 2015 to September 2016, for a total of €1.1 trillion.
Is it enough? Will it work?
One self-inflicted weakness of the policy is that although bolder than expected and launched at scale, the €1.1 trillion of asset purchases will only take the ECB’s balance sheet to €3 trillion. At around double the size of the pre-crisis balance sheet relative to euro area GDP, this is less than half the four-to fivefold increase implemented by the Federal Reserve and the Bank of England.
Another reason why the ECB’s quantitative easing (QE) program may not be as effective is the difference in the transmission system. In the United States and the United Kingdom, capital markets provide a large proportion of funding for nonfinancial companies. In the euro area, nonfinancial companies tend to borrow from banks. Given the ongoing capital deficiencies of European banks, and the inherent inefficiencies of a bank-lending model, this is likely to reduce the impact of the program.
Fortunately, there are some reasons to be more optimistic. The euro area exports 27.5% of the goods and services it produces, a far higher proportion than the United States. QE should give exports a boost as the euro is expected to depreciate significantly. Already, having fallen 3.5% against the dollar within a couple of days of the announcement of QE, the euro is now hovering around its 12 year low.
Experience has shown that QE raises the value of financial assets and boosts spending via so-called wealth effects. The problem for the ECB is that these effects may not be as large in the euro area as in the United Kingdom and the United States. However, by including asset-backed securities (ABS) (and also covered bonds), vehicles used to package consumer and small business loans, the ECB hopes to push the impact of the program deeper into the “real economy” and across a broader field of industrial sectors. The hope is that as the cost of borrowing falls, new investment will become more attractive. Smaller and mid-sized enterprises tend to be more sensitive to interest rates and to be the most dynamic engines of growth.
Breaking the cycle
The ECB’s mandate is price stability, not economic growth. But if inflation is to be returned to target, excess capacity must be squeezed from the system. For this to happen, it may be necessary for fiscal policy to start stimulating growth rather than acting as a drag, as it has during the years of austerity. Indeed, Draghi has personally endorsed the need for a more growth-friendly fiscal approach, pointing to the leeway offered by the new strengthened Stability and Growth Pact (SGP), which constrains government deficits to below 3% of GDP per year.
Again, the euro area’s fragmented nature is an issue. A number of the larger economies continue to run afoul of the SGP rules, including France, Italy, and Belgium. Germany has significant scope for fiscal expansion and was recently encouraged by the International Monetary Fund to pursue stronger public investment, particularly in transport infrastructure. This would likely have only a minor impact on its debt-to-GDP ratio given the likely strong positive growth effect. It’s especially pertinent given Germany’s current low borrowing costs and the likely positive spillover effects for the rest of the euro area. Political resistance, though, remains entrenched and there’s wide support in Germany for maintaining a balanced budget. At this point, policy ideas seem to peter out. A European Union plan to provide €21 billion in seed finance for €315 billion in private sector investment feels like wishful thinking.
Looser monetary and fiscal policies should boost growth in the euro area, but when it comes to generating higher growth over the medium to long term, there’s no doubt that structural reforms are needed. Sustaining strong performance will only be achieved by confronting supply side reforms such as labor laws, obstacles to business formation, bureaucracy, and high taxes. Unfortunately, by suppressing the cost of borrowing, QE creates an environment in which member states can delay reform.
QE is an important policy if we’re to return the euro area to sustainable growth and kill the demon of deflation. But if it’s necessary, it’s not sufficient. Fiscal and structural reform need to be part of the package, too.
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