Crunch time for the euro-zone economy
Aggressive reflation is needed to prevent a death spiral
The European Central Bank is heading into a crisis and running out of options on how to prevent it. Despite unprecedented amounts of monetary stimulus, euro zone economic confidence is wilting, growth is slowing and inflation is back in negative territory again. The central bank is stuck in a policy bind with little gumption about how to resolve it all.
Next week’s ECB policy meeting will probably opt for more of the same remedies. The ECB will step up its quantitative easing programme with more bond buying and press interest rates deeper into negative territory. The worry is that it is likely to make very little difference to the overall economic picture.
There are already serious doubts among the 19-member currency bloc that throwing in more monetary fuel will light up the recovery’s fire. It is leading to calls to boost growth and fight deflation in other ways, namely governments loosening budgets to stimulate recovery. Attention is also turning to a weaker euro to promote better chances of an export-led recovery ahead.
Most worrying is the deepening feud inside the ECB about the best way forward for monetary policy. The battle lines are already drawn up between the monetary moderates who want more QE and the conservative German Bundesbank, who believe that monetary expansionism has already gone too far and is putting the euro zone’s inflation credibility at risk.
That may be the case but the evidence suggests that neither the ECB’s conventional or unconventional policies are working. The recent slate of confidence surveys show euro zone economic activity starting to weaken while there are renewed signs of deflation risks, even for Germany, right now the euro area’s strongest economy.
The latest euro zone economic sentiment index shows confidence on the slide across the board. Business and consumer confidence are taking a hard knock from the downturn in global growth prospects, the slowdown in world trade and highly unsettled financial markets.
Crucially for Germany, the two leading domestic sentiment indicators, the IFO and ZEW surveys, are showing definite signs of tipping over. If Germany’s economy is starting to lose momentum, it hardly holds out much hope for the rest of the euro zone.
When it comes to inflation fears, Germany’s QE hardliners hardly have a leg to stand on. German inflation is back in negative territory again, with consumer prices in February were down 0.2 per cent from a year ago, compared with a 0.4 per cent inflation rate in January.
It is a common problem throughout the euro area. French CPI data for February last week showed France’s headline inflation rate at minus 0.1 per cent, while in Spain monthly consumer prices fell by 0.9 per cent from a year ago. Euro zone deflation risks are back with a vengeance.
Despite all of the QE-led monetary stimulus, it is clear the ECB needs to do much more to step up the policy impetus. One of the major worries is that the euro zone economy is caught in what Keynes called a ”liquidity trap”. The banks are loaded with QE-injected cash, but are either hoarding the money for their own precautionary purposes or channelling the funds into the financial markets, rather than passing it on to the real economy.
This can be remedied by the ECB forcing the deposit rate deeper into negative territory, piling pressure on the banks to lend more to consumers and business, rather than stockpile cash at the central bank. Supply side inducements are one thing, but the lacklustre demand side needs to be tackled too.
The euro zone’s policy thrust must be broadened beyond the ECB. As a priority, European governments should shelve austerity policies in favour of higher deficit spending and fiscal reflation to complement the ECB’s stimulus. This is something that supranational bodies like the International Monetary Fund and OECD have been crying out for in recent years.
There is a genuine need for a weaker euro to beef up recovery as well. The euro has held firm in recent weeks, but only thanks to the unwinding of speculative carry trades where the euro has been used as the funding currency. As soon as the market senses a change in official attitude towards the currency, the euro will begin to close in again on parity with the US dollar.
The euro zone economy is floundering and the ECB and European governments must find a quick reflation accord before the downturn turns into an unstoppable rout.
David Brown is chief executive of New View Economics