Stopping Europe's Descent Into Deflation
Until recently it was debatable whether Europe's economy was recovering. No longer. Its recovery has stopped. The question now is whether the stagnation will tip over into something worse.
In an Aug. 22 speech, European Central Bank President Mario Draghi moved a little closer to acknowledging the danger. This aroused hopes that he would announce decisive action on Sept. 4, after the next meeting of the bank's policy committee. For Europe's sake, he'd better deliver.
The preliminary estimate of euro-area inflation in August from a year earlier is 0.3 percent -- yet another drop. Recall that the ECB's target is "close to, but below, 2 percent." Outright deflation, with all the perils that brings, is an imminent threat. In the longer term, inflation expectations also seem to be slipping: The standard measure of expected inflation five years ahead has dropped to less than 2 percent.
Meanwhile, there's no growth in the euro area. France is stagnant, Italy is back in recession, and even Germany, according to revised figures, shrank in the second quarter. Admittedly, that's partly because of the effect of sanctions against Russia -- but the economic drag from the crisis in Ukraine isn't about to end soon. Conditions are increasingly aligned for deflation.
What can the ECB do? Draghi says the bank has already acted to stimulate demand, and in time the economy will see the benefits. Yet the package of measures the ECB unveiled in June didn't amount to much. Europe needs quantitative easing of the kind the U.S. Federal Reserve has used to good effect -- that is, bond purchases financed with newly created money. For months, Draghi has said that the ECB is looking into it. There are legal obstacles and, even now, the policy would be controversial.
But it's past time for Draghi to push through those difficulties and test the limits of what politics and the law will allow. Forthright action can't wait any longer.
Europe also needs to rethink its fiscal policy. That's beyond the remit of the ECB, though it wouldn't hurt for Draghi to demand changes. Again, he took a step in that direction in his recent speech, saying that fiscal policy should "play a greater role" in boosting demand. Then he took a step back by saying that Europe's Stability and Growth Pact allowed sufficient room to maneuver, and that it would be "self-defeating" to abandon it. No. It isn't a matter of finding room for maneuver. This pact, which tells governments to cut government borrowing regardless of impending deflation, needs to be scrapped.
In public at least, Draghi remains committed to the macroeconomic principles that have brought Europe to the brink of deflation. Accordingly, he continues to emphasize the need for structural, or supply-side, reform -- especially deregulation of labor markets and investment in education and skills. He's right that the euro area needs such reforms, but wrong to suggest they're a higher priority than stimulating growth right now. Supply-side reform is a long-term undertaking. Europe's immediate problem is lack of demand.
Monetary policy can and should do more. That's the responsibility of Draghi and his ECB colleagues. If they want to, Europe's governments can repair their fiscal policies, as well -- by scrapping the fiscal pact rather than fiddling with it. If Europe's long recession gets worse, it will be because its leaders saw what was happening yet chose not to act.
--Editors: Clive Crook, Michael Newman.
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