Published in Business Spectator (Melbourne), 14 November 2013
It is a strange world. Even the most ardent defenders of the European Central Bank’s interest rate cut last week do not claim it will have any effect. All they say is that it underlines ECB President Mario Draghi’s commitment to save the euro “whatever it takes”. It was a psychological signal to markets rather than a meaningful change of policy, so they argue.
Indeed, the rate cut will not have a material impact on lending conditions in the countries in which it matters most. How could it? Reducing the ECB’s rate to 0.25 per cent may have been a historic step – but it was cutting rates from an already low 0.5 per cent, and it may not even be passed on.
On the other hand, ECB critics are complaining that by cutting rates the bank may have given deflation fears further support. Put differently, fighting deflation might actually increase the risk of deflation because market actors take the ECB’s deflation fears seriously.
Other critics still believe that short-term deflation or not, the real long-term result will be inflation – maybe not in consumer prices, but at least in asset prices. In any case, the ECB may be once again overstepping its mandate, other critics warn.
Once upon a time, Winston Churchill joked that he would like to see a single-handed economist. Why? Because the economists of his time always argued “one the one hand, on the other hand”. These days, it appears economists have grown even more hands than that. Fighting deflation leads to deflation. But it may also conjure up inflation. Or it might not achieve anything at all. And yet it may at least send the right signal. Or not.
The reason commentators are so divided over the ECB’s interest rate cut is that it has led the ECB into uncharted territory (Draghi was right to brush of a rates rupture, November 13). Of course, the world has seen similar zero-interest policies before. The whole Japanese experiment of the past two decades is the prime precedent.
However, Europe is obviously different. It is more complicated than Japan because of the construction of the eurozone, which binds economies together that do not share too many features – except their helplessness in the face of the continent’s economic crisis. It is also different because at least Japan was a highly developed, high-tech economy when its crisis struck. The same cannot be said of countries like Greece or Portugal.
The latter point leads to the heart of the euro crisis. It remains a structural crisis of many of its economies. The problems are well known but easily forgotten when discussing monetary policy. To deregulate Italy’s labour market, curb Greece’s corruption, increase Portugal’s productivity and reduce France’s bureaucracy, it takes more than an interest rate cut. It would need decisive action and genuine economic reforms.
Europe is not getting such reforms, so what remains to counter the continent’s economic malaise is another dose of aggressive monetary policy. It will not be the last one, and the next prescriptions (say, outright quantitative easing) may be more potent still. The question remains whether this is little more than life support for a dead corpse.
In a way, it is only consequential that monetary policy seems to have become Europe’s last hope. For decades, many European economies have resorted to all sorts of policies to stimulate economic growth without economic reform.
The classic recipe to get an economy to grow without inflicting pain on anybody was deficit spending. Europe saw a lot of it since the mid-1970s. Back then, most European governments had net debt burdens of around 30 per cent of GDP. In the eurozone, it currently stands at 90 per cent of GDP. The growth that such deficit spending has produced was typically a flash in the pan. Its legacy, meanwhile, was a growing mountain of debt.
Another measure to artificially boost mainly southern European economies was constant devaluations. For countries like Italy, reductions in the exchange rate of the lira were a convenient tool of remaining competitive in export markets without tackling any of Italy’s actual problems. But because the competitiveness problems were never solved, the next devaluation was never too far away.
Both policies, deficit spending and devaluations, have run their course. Debt levels have reached such high levels that it makes further debt financing almost impossible. Devaluations, meanwhile, are problematic not only because of fixed exchange rates between the eurozone economies but also because other non-Euro economies are also engaged in weakening their currencies.
This only leaves monetary policy as a relatively painless way of stimulating Europe’s economies without actually reforming them. And this is what the ECB does with its loose monetary policy. It is the last remaining option to kick-start economic growth without change.
The basic problem for many European economies is that they have forgotten how to generate decent growth without debt, devaluations or cheap money.
Real growth would result from getting the basic economic policy settings right: a functioning legal system; defined and stable property rights; limited size of government; low and predictable taxes; low regulatory burden. As the World Bank’s new Doing Business 2014 report shows, Europe is still a long way away from meeting these criteria. France is currently ranked 38th, Spain 52nd, and Italy 65th (the worst ranked eurozone economy is Malta, at 103).
If Europe does not reform, then monetary policy may remain the only chance of stimulating the economy. Of course, this is not a sustainable solution but just palliative care.
This may explain why the judgments on the ECB’s historic rate cut differ so much. If you are concerned just about the next quarter’s growth figures, or indeed tomorrow’s stock market, then maybe the ECB has done the right thing in your eyes. If however you are asking the more fundamental question of whether Draghi has done anything to solve Europe’s structural problems, the answer would have to be negative.
For decades, Europe has tried alternatives to economic reform. (Near) zero interest rates are just the latest episode. They will fail like all other preceding pseudo-solutions.
