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Economic Insights

The European Central Bank’s latest policy moves are a holding action until real economic and fiscal reform can take hold.

Europe’s financial crisis seems to have quieted. It is a strange development, for the eurozone is beginning to face a new threat to its financial stability. Signs of inordinately low inflation and possibly even deflation have begun to compound all the debt and policy problems that have bedeviled the eurozone for over four years. To meet this new challenge, the European Central Bank (ECB) has promised action, but there is only so much it can do. Monetary policy, even of the most energetic kind, cannot ultimately answer Europe’s needs. The best the ECB can do is buy time for member nations to implement fundamental economic and fiscal reform, especially in regulatory, labor, and product market policies. Without this (or extraordinary good luck), Europe's problems can only become worse. 

The New Complication
The deflationary threat is clear. Recent reports show zone-wide inflation trending at below 1.0%, far below the ECB’s target of 2.0%. In Ireland and other countries of Europe’s troubled periphery, reports already point to outright deflation. Inflation has its own evils, but that does not mean deflation is harmless. On the contrary, it carries a dual threat. On an economic level stands the warning of Japan, where deflation has contributed to two decades of stagnation. On the financial side, deflation raises the already great risk of default, for falling price levels would make future real payments on Europe’s already outsized debt load that much more onerous, something these already beleaguered nations can ill afford.1    

With both these concerns in mind, but especially the implicit risk of default, the ECB atypically has promised bold action. President Mario Draghi about a month ago promised “extraordinary measures” to guard against deflation, describing the bank as willing "to act swiftly if required." He alluded to the possibility of outright asset purchases (commonly called qualitative easing)—a major shift from his past reluctance, especially since the U.S. Federal Reserve and the Bank of England are beginning to unwind their quantitative-easing programs. Draghi just last week also lowered some interest rates into negative territory. Following a policy previously used in Denmark, his thought is that deflation would have more difficulty taking root if banks lent more freely to businesses and individuals, and he is convinced that they would do so if instead of paying them interest on the spare reserves they keep on deposit at the ECB, they actually had to pay a charge on them.2     

The pressure on Draghi and the ECB is that much greater because low inflation has already blunted the stimulative effect of past policy efforts. To date, the ECB has relied mostly on low interest rates to relieve the strain on debtor nations and to generally reliquefy the financial system. But with each notch down in inflation, those rates look less low in real terms. In 2012, for instance, when the ECB held short-term interest rates at 1.5%, zone-wide inflation averaged 2.5%. The real expense of borrowing that year was actually a negative 1.0%. But in the intervening period, during which interest rates have fallen an additional by half a percentage point, the annual rate of inflation has fallen by almost two percentage points. The real cost of borrowing has accordingly risen out of negative territory, still low by broad historical standards, but clearly much less supportive than it was two years ago.3      

Only So Much the ECB Can Do
Even if the ECB performs brilliantly and stems the deflationary tide, it can still only offer Europe partial relief.  The best any monetary policy can do in Europe’s situation is to create a period of relative financial calm and reduced borrowing costs in order to give debtor nations time to reorder their finances, presumably through a combination of economic growth and fiscal austerity. The ECB, in other words, has only ever offered deeply indebted nations a kind of low-rate bill-payer loan, such as households use to avoid bankruptcy while they get their finances in order. Just like a bill-payer loan, however, such palliatives fail unless the recipients use the time to cut spending or increase income (grow in a nation’s case) or both. It was always a precarious effort now made considerably more difficult by the prospect of deflation.     

If anything, then, this latest, deflationary twist Europe’s crisis saga makes austerity and fundamental, pro-growth reform that much more urgent. Just like the household clinging to its bill-payer loan, these nations cannot abandon fiscal austerity. Some, most particularly France, have floated the idea of giving up on austerity to use government spending as a way to produce some growth momentum. Though it is true that fiscal austerity stymies growth, such an approach would ultimately defeat itself. Any letup in fiscal discipline would signal markets of a new flow of debt on top of an already huge existing supply. Bond buyers, investors, and bankers would become that much more wary. Default fears would gain greater currency. Markets would become less stable. Governments would quickly find it more expensive to finance their fiscal ease.      

Europe’s Only Real Option
If that became the case, then, the nations of the eurozone have but two options. One is to hope that somehow, with no additional policy effort, the economic situation will improve and promote enough growth to make the existing debt overhang supportable. This appears to be the French approach. The other option is to implement pro-growth fundamental reforms, even as the eurozone nations adhere to fiscal austerity. Such reform efforts have gone in and out of fashion among Europe’s periphery during these past four years of crisis. Now, as once before, those who would seek such change are watching the latest Italian experiment.    

A couple of years ago, Italy, under its interim prime minister, Mario Monti, charted this necessary course.  Acknowledging the need for continued fiscal austerity, but recognizing that the nation could never shoulder the existing debt burden without growth, he modeled his effort on successful German reforms of some years earlier, aiming to make Italian labor and product markets more flexible. Under pressure from the sovereign debt crisis and Italy’s desperation, Monti managed to enact labor market reforms that in prior years Italy had failed again and again to implement. These encourage job creation by making hiring and firing easier and less costly. By also allowing management more latitude to set work rules, his reforms promised more reliable growth by improving business’ ability to better cope with economic fluctuations. Politics, however, interfered. Monti was forced from office, and, consequently, the reform movement, if not rolled back, lost momentum. More recently, however, the country, still desperate, has revivified the effort. Its new prime minister, Matteo Renzi, campaigned on the need for such fundamental reform and recently announced a multiyear plan to promote long-term growth.4      

Whether Renzi and Italy can follow through is an open question. The country has already faltered once along this path. Still, it is reasonable that Italy should embrace this urgent need. Next to Greece, it was one of the Continent’s most deeply indebted nations, a major contributor to the crisis, and one of the most in need of debt relief. What happens with Renzi’s effort, then, has the power to create or destroy hope for Europe’s ultimate recovery, especially now in the face of deflation. But even if Rome fails, Europe still has options. Greece, Spain, Portugal, and even France have contributed mightily to the debt overhang that lies at the root of this crisis and have great potential to respond to the kinds of economic reforms adopted by Germany in the last decade and attempted by Italy more recently.

It would have a certain poetic quality if Italy, previously one of Europe’s leading examples of economic dysfunction, leads the Continent’s healing effort. But whether the Italians or some other peripheral nation takes the lead, the reform is urgent, especially now that the prospect of deflation makes it still more difficult for the ECB to buy time. If no one moves, as no one has sufficiently to date, the crisis will continue, while the monetary palliatives will become less and less effective as, indeed, the deflationary threat is already demonstrating.

 

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