Europe Needs Stimulus. Just Not Draghi's Kind
Mario Draghi warned last week that the European Central Bank will have to be even more vigilant in pursuing its mandate, thanks to new “downside risks.” That seemed to be central-banker speak for another round of stimulus, possibly as early as its next meeting in March. He spent some time this week fending off criticism that his single-minded pursuit of the ECB's "near 2 percent" inflation target is folly.
His critics are right. The ECB's quantitative easing campaign has had little effect to date and more of the same won't produce different results. Instead, euro zone governments need to find a way to raise demand and stimulate credit.
Thanks to some comprehensive new research and recent experience, the limits of QE are now better understood than they were in 2008; and the implications for the ECB's program are quite clear. Stephen Williamson, the author of a recent study for the Federal Reserve Bank of St. Louis, reviewed the measures taken by the Fed during the Great Recession (2007-2009), including zero interest rates, large-scale quantitative easing and forward guidance, and concluded that “there is no work, to my knowledge that establishes a link from QE to the ultimate goals of the Fed -- inflation and real economic activity.” On the contrary, he found that the available evidence "suggests that QE has been ineffective in increasing inflation.”
The work goes on to review how several countries (the U.S., Switzerland, Japan) that experienced “massive central bank purchases” had very low inflation or deflation. QE was helpful in providing liquidity to financial markets and temporarily increasing some asset prices. But its impact on inflation indeed appears to have been limited. Williamson doesn't explain why this is so; I suspect that what little inflation we saw at the start of QE was caused by investors seeking refuge in oil and other commodities in expectation that QE would be more effective.
Europe today bears much in common with the situation facing the U.S. during that period. Deflation, or slow inflation, is considered benign when price decreases are caused by an increase in supply and not simply reduced demand. Today’s low inflation trend has its roots in the liberalization of trade together with the inclusion in the international economy of China and Russia as massive new suppliers of industrial goods and commodities. But this extra supply has coincided with stagnant demand, trapping credit; a further round of stimulus in March will have no major impact.
While Draghi overestimates the ability of the ECB to meet its inflation target, he underestimates its potential for doing harm while trying. In a benign low-inflation (or even deflationary) environment, central bank purchases of debt are like steroids for financial markets: They enhance volatility by encouraging ever-larger sums of money to shift from government bonds to high-yield debt and shares. After an initial uplift, these inflated assets prices will then correct, destroying the illusionary wealth that money printing provided. The long-term economic damage created through this misallocation of resources eventually has to be unwound.
What Europe needs is a demand-side push of the kind the U.S. had under the American Recovery and Reinvestment Act -- that is, a European version of the 2009 fiscal stimulus that provided $830 billion of stimulus to the U.S. economy and which the Congressional Budget Office estimates increased GDP by about an average of 1 percent a year for five years.
The problem with this solution is that the European institutional constraints work the wrong way around: Individual member states are bound by the Maastricht criteria on deficit and debt spending, which they often comply with by limiting investment rather than by curbing bad spending habits. The European Commission, for its part, has a budget of about 1 percent of Europe’s GDP and is in no position to support a Continental-type stimulus of this kind. The EU does have the European Investment Bank, which is projected to lend 71 billion euros ($76.99 billion) in 2016 for various EU-supported projects. Enhancing the role of the EIB to focus on growth-producing, demand stimulating investments could help -- provided the scale of the financing is made available.
As the St. Louis Fed report helps demonstrate, the economics of this period call for the right kind of fiscal action rather than monetary stimulus. Despite Draghi's best intentions, it is governments, not the European Central Bank, who need to answer the call.
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Jean-Michel Paul at JPaul@acheroncapital.com
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Therese Raphael at email@example.com