Draghi’s Desperation

The European Central Bank (ECB) faces a desperate situation. Remarkably low inflation is stealing its ability to ease the euro zone’s fiscal-financial strains and, consequently, its ability to buy time for the zone’s governments to implement desperately needed budgetary and economic reforms. If markets do not show it yet, the pressure of this crisis is intensifying on every front.

Economic reports from the euro zone are universally ugly. Germany’s economy, until now the major source of strength in the euro zone, declined during the second quarter. The Italian economy also declined. France, the zone’s second largest economy, has stagnated. Perhaps even more threatening than the prospect of a generalized recession are the inflation figures. Zone-wide prices have risen a mere 0.3 percent during the past twelve months, far below the 2.0 percent ideal identified by the ECB and perilously close to deflation, a frightening condition widely associated with Japan’s more than two decades of economic decline.

Beyond such vague associations, deflation threatens a concrete policy problem. An element of inflation was always an essential part of the ECB’s efforts to resolve the crisis. Because rising price levels reduced the real value of outstanding debt, they put time on the side of relief. Outright deflation would actually make it an enemy by raising the real value of outstanding debt. Inflation also helped reduce real financing costs. Two years ago, for instance, zone-wide inflation of 2.5 percent cut that amount annually off the real burden of interest expenses. Combined with the then prevailing 1.5 percent benchmark short-term interest rate, this inflation effect actually took real financing costs into negative territory, to -1.0 percent, in fact. Now, though the ECB has decreased the benchmark interest rate to only 0.05 percent, inflation of only 0.3 percent does that much less to ease real financing costs, which, though still negative, have risen 0.75 percentage points to -0.25 percent. It is as if the ECB had tightened monetary policy.

Well aware of their predicament, policy makers at the ECB have turned to unconventional means in what looks like a desperate effort to continue some level of financial relief. Near zero-rate policies are themselves indicative, especially since the ECB until recently resisted such policies. The bank has also decided to stop paying commercial banks interest on reserves left idle with it and has begun to charge them, raising that cost recently to 0.2 percent a year. This novel, negative rate policy, they no doubt hope, will spur commercial banks to use their idle reserves for lending, stimulate economic activity, and help block any drift toward deflation. It might work, but it is hardly in the character of the old, conservative ECB. Still more, ECB President Draghi announced that the bank would earmark close to €500 billion euros to buy asset-backed bonds in European financial markets and so channel funds directly to borrowers, again to stimulate economic activity and generate inflation instead of deflation. This quantitative easing, too, was something the bank had resisted. It speaks to how far the ECB has come, and to its desperation, that Germany’s Bundesbank has overtly criticized these policies.

Matters are that much more intense because few governments have used the past relief bought for them by the ECB to do much of anything to make their economies more dynamic, efficient, and competitive. It speaks to this problem that the deflationary threat itself has roots in the failure to reform. Had they proceeded with the kinds of changes pressed on them by the ECB and Germany, they would have long since dispensed with the subsidies they use to prop up inefficient and unprofitable operations and used the savings to offer tax relief to effective producers. But the taxes remain high and these props remain in place. These unprofitable operations have accordingly glutted markets and driven down prices. Italy, for instance, has kept open a large Sicilian oil refinery even though it has accumulated €10 billion in operating losses during the last five years and the country uses 30 percent less gasoline than it did eight years ago. France and Italy have used subsidies to keep open 18 auto plants that also run losses. Italy still provides tax subsidies to keep open factories producing household appliance that the Swedish owner, Electrolux, has identified as unprofitable.

The picture looks bleak. Things seem poised to fly apart at any moment. They may well hold together for longer than seems possible, if only because people want them to do so. If Europe’s periphery now uses the remaining breathing room offered by the ECB’s redoubled efforts and implements needed reforms, this can yet work out. If, as it seems, these governments are determined to waste the opportunity, the euro zone looks scheduled for renewed upheaval.

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