Europe Needs the Fed’s Medicine
One of the great ironies of the post-Lehman Brothers financial crisis is that the euro, a currency much of Wall Street thought unable to survive the storm, became a haven.
The reason was simple enough: The European Central Bank was the only one in a major developed economy to abstain from quantitative easing. By refusing to follow the U.S. Federal Reserve, the Bank of England and Bank of Japan in flooding markets with the currency that it managed, the ECB ensured that the euro remained strong, even when its future was in doubt.
That decision -- Paul Krugman and other advocates of stimulus always and everywhere aside -- was a good one, given the risks the euro faced. Now that fears of a euro-area implosion have receded, however, it is time for a little flooding. Having a haven currency is no longer beneficial to Europe.
A strong euro would be welcome if the euro area were struggling with inflation, because a high exchange rate puts pressure on domestic prices on fall. But the euro area has the opposite challenge, a 0.7 percent inflation rate that’s so low it poses a risk of deflation.
Think of the ECB in Frankfurt as a group of surgeons trying to remove a cancerous tumor from a patient. The bank has been trying to use interest rate reductions to cut out the unwanted growth -- in our analogy pushing down domestic prices. The hope was that lower rates would drive down the euro’s exchange rate against other major currencies. So far, the surgeons have failed, though, because they have not reached the root of the problem: a lack of monetary stimulus relative to the euro area’s trading partners.
One would also expect Europe’s robust current account surplus to lead automatically to increased domestic prices, as exporters bid prices up to meet demand for their goods. Higher euro-denominated costs should then make it harder for German and other euro-area exporters to compete around the world and, for the same reason, boost imports, causing the external surplus to self-correct. This rebalancing of the current account surplus should in turn cause the value of the euro to fall.
These, however, are not normal times. Insufficient monetary stimulus in the euro area is causing prices to go down, not up. As a result, exports remain high, imports subdued and the euro strong, holding back economic growth.
The answer to this problem is for the ECB to join other central banks in buying bonds or other asset backed securities, even if the exercise proves distasteful to some members of the bank’s governing board. Europe can no longer afford to be the odd man out. Euro-area deflation is too high a price to pay just to keep the folks at the German Bundesbank happy.
Closing the gap with the policies of central banks in other big developed economies doesn’t mean copying them. The ECB must have its own style of quantitative easing, custom made for Europe’s needs and institutions. ECB President Mario Draghi spoke during the World Economic Forum meeting at Davos, for example, about the potential for the bank to buy packages of commercial bank loans. Just a promise to buy the loans should be enough to encourage euro-area banks to start using the cash piles they have been holding onto as a hedge against risk. If the ECB is willing to provide that hedge instead, the banks can be freed to make higher-yielding loans to businesses, maybe even without the ECB actually having to buy any of the packaged loans.
This is precisely how the ECB’s Outright Monetary Transactions bond buying has program worked. Once Draghi made the pledge in 2012 to intervene in bond markets to prevent any euro-area sovereign default, borrowing costs for vulnerable economies such as Spain plummeted. Today, the ECB still hasn’t bought single bond, yet the yield on Spanish 10-year bonds is at half its 2012 peak. The credibility of the offer got the job done.
To guide the flow of loans in the right direction, the ECB would have to draw up a list of particulars that packaged loans must meet to qualify for central bank purchase. Only these loans would have their risk premiums removed.
Draghi has a knack for coming up with programs that use the bank’s credibility to do what’s needed for Europe without risking the health of the ECB’s balance sheet. He has a chance to show it again now, and he should do so soon -- as early as tomorrow’s monthly meeting of the governing council. The surprise fall in euro-area consumer price growth announced last week -- to 0.7 percent in January from 0.8 percent in December -- brings Europe that much closer to deflation.
The timing is good for the ECB to begin an experiment with what might be called quantitative-easing-lite. The combination of the Fed scaling back its easing program, just as the ECB starts one of its own should narrow the gap between the levels of stimulus in the world’s two biggest economies. That in turn should help break the back of the euro’s strength, boost inflation toward the ECB’s target of just below 2 percent, and spur Europe’s economic recovery. Losing haven status would also protect the euro from investor inflows, in case a new emerging market currency crisis develops.
So yes, there was a time when being the odd man out on quantitative easing was good policy for the ECB, because it shored up the value of the euro when markets doubted its ability to survive. That risk has receded, and the blessings of haven status have become a curse, which should now be exorcized.
(Melvyn Krauss is an emeritus professor of economics at New York University and senior fellow at the Hoover Institution, Stanford University.)
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