Euro zone needs better protection from rising risks

Europe will not be spared as world economy heads for another crash, with the return of deflation and slowdown in China and the US

PUBLISHED : Sunday, 11 October, 2015, 10:42pm
UPDATED : Sunday, 11 October, 2015, 10:45pm

Storm clouds are gathering over the euro zone, deepening the economic gloom. It is not just the International Monetary Fund that is warning the world risks sliding into a fresh crisis. There is a growing consensus among forecasters the global economy could be heading into another fatal crash before too long. The euro zone will not be spared.

The euro zone needs much better policy protection. The European Central Bank may have helped shore up the zone's economic defences with its €1 trillion (HK$8.8 trillion) quantitative easing programme, but these could easily be overwhelmed in a worst-case scenario of global recession and financial crisis. Euro zone policymakers need to pull out many more policy stops.

The euro zone economy is failing on many fronts. Despite the ECB's efforts to reflate recovery through QE stimulus, the zone has slipped back into deflation and leading indicators show it is losing vital forward momentum.

Euro area headline inflation turned negative again last month, with consumer prices down 0.1 per cent from a year earlier. Meanwhile, Germany, the zone's main growth driver, is feeling the pinch of weaker global growth, with orders, output and exports suffering setbacks from the downturn in global demand.

Increasing fragilities in emerging markets, the risks of a slowdown in China, signs robust US growth is starting to stall and declining investor appetite for riskier assets are all early warning signs of deeper threats to global financial stability. As a major trade surplus bloc, the euro zone is already starting to feel adverse effects.

With net exports worth about US$500 billion this year and world trade flows down 10 per cent from a year ago, it is no surprise euro area demand is suffering. There is little policymakers can do to spur faster export-led recovery, short of a massive devaluation in the euro. It means recovery efforts must be focused on promoting stronger internal demand.

This is a big problem considering chronically high unemployment across a swathe of weaker economies, especially Italy, Spain, Greece and Portugal. Weak employment demand is depressing incomes and wages, hitting consumer spending power especially hard. Consumer confidence is already at a very low ebb, thanks to deepening austerity cutbacks.

The trouble is policymakers are operating at odds with each other. The ECB is busy trying to pump monetary stimulus to boost growth, while governments continue to withdraw much-needed recovery stimulus due to budget deficit cuts under the European Union's fiscal stability pact.

At the same time, Germany is operating an extremely restrictive fiscal policy, running a budget surplus worth 1.5 per cent of gross domestic product so far this year. It contrasts dramatically with Greece, which is struggling to eradicate its budget deficit from a peak shortfall of 15 per cent in 2009. Since the height of the 2009 financial crisis, budget cutbacks have drained the equivalent of 5 per cent of euro zone output, which would have been better applied to bolster recovery.

Time is running out and euro zone policymakers need to draw up an action plan for growth.

There is clearly a case for an enlarged QE plan. The ECB has to expand its asset base to at least €4 trillion to fulfil its pledge to do "whatever it takes" to boost growth and beat deflation.

It must ensure the extra liquidity generated by QE ends in the hands that need it. Statutory targets should be enforced to ensure banks lend the extra cash to consumers and businesses. Interest rates also need to go deeper into negative territory to deter banks from hoarding reserves held on deposit with the ECB.

Governments must abandon budget austerity in favour of fiscal reflation, with increased deficit spending and greater public investment as vital front-line tools to fuel faster growth.

The principle of fiscal union must be embraced to ensure equitable transfers between the economically privileged and less well-off nations. A fairer distribution of productive capacity and economic prosperity can only strengthen political cohesion. As the zone becomes stronger, it can give more back to global growth and save the euro.