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Eurozone in Denial

The ECB's Flawed Analysis

July 9, 2013

Last week’s decision by the European Central bank (ECB) to maintain current interest rates at 0.5% was no surprise. Market expectations were that there would not be sufficient support for additional monetary accommodation. Still, European markets reacted positively, because the ECB’s President, Mario Draghi, also announced that he expected interest rates to remain at such record low levels for a while.

It is the reasoning by the Governing Council of the ECB that seems troubling as it ignores the fundamental structural crisis reverberating through the Eurozone.

As Mr. Draghi stated, real GDP in the Eurozone fell by 0.3% in the first quarter of 2013. He failed to note, however, that this contraction is very asymmetric and that it has lasted for up to five years in some of the member states. Furthermore and throughout the statement as well in answering questions from the press, Mr. Draghi did not truly acknowledge the structural nature of this permafrost, but continued to treat the recession as if it were cyclical. In fact, he pointed out that “recent developments in cyclical indicators … indicate some improvements from low levels”.

Obviously, nothing could be further from the truth. In fact, the only reasonable justification for the Governing Council’s inaction on interest rates, not to speak of quantitative easing, is if the ECB underlined – correctly – that the crisis is structural not cyclical in nature, which renders low interest rates and the injection of more liquidity largely ineffectual.

Of course, admitting the structural nature of the crisis and, hence, the limited effectiveness of monetary policy would then have to lead the Council and Mr. Draghi to encourage expansionary fiscal policy in the Eurozone. However, such encouragement is a political taboo given adamant German opposition to Keynesian policies.

Furthermore, it is very unsettling that the Governing Council continues to be absorbed by inflationary prospects. It is true that the Charter of the ECB provides that price stability is the only major mandate for the central bank, but given chronically low inflation rates in the Eurozone, one might wish that the bank focus on other aspects for the economic standstill.

Moreover, the Governing Council did not even mention core inflation (excluding food and energy prices). If it did, the picture would be far more concerning, highlighting the imminent risk of deflation as well as a medium-term growth outlook for the Eurozone not unlike Japan’s experience since the early 1990s. 

Mr. Draghi’s hopes of a pickup in growth are solely pinned on a miraculous recovery everywhere else in the world in 2014 in order to increase the Eurozone’s exports. It is the ultimate dream of Eurozone policy-makers that every member country accrue current account surpluses just like Germany. But it is a fantasy to believe that all countries in the world can run such surpluses. The global balance sheet of all imports and exports has to show the same number on both sides of the ledger.

To make things worse, Mr. Draghi expects domestic demand in the Eurozone to grow due to “recent gains in real income owing to generally lower inflation.” This is most certainly a recipe for deflation.

The Governing Council also gave no explanation for its assertion that fiscal consolidation and balance sheet repairs would “work their way through the economy”. This is in stark contrast to the numbers on credit growth (or rather contraction) that Mr. Draghi shared. Credit to non-financial corporations fell more in May 2013 (-2.1%) than in April (-1.9%).

These are hardly “green shoots”, which Fed Governor Ben Bernanke once famously and mistakenly saw sprouting in the U.S. economy in 2009.  Moreover, this contraction of credit against the background of loose monetary policy indeed confirms that the current crisis is not one of lack of “supply” (cured by injection of liquidity or in other words through monetary policy), but lack of “demand” (addressed primarily by fiscal expansion).

However, Germany, the Governing Council’s dominant force is deeply wedded to supply-side economics, even when it is not applicable. To be sure, both Milton Friedman and John Maynard Keynes have made good, albeit largely opposing, arguments. In fact, the disciples of Friedman and Keynes are doing a disservice to their teachers by claiming exclusivity of either monetary or fiscal policy in solving problems. Both have their place and time in managing economies. It just so happens that this crisis is a Keynsian moment.

All-in-all, the Governing Council’s statement failed on July 4th, once again, to identify the core reasons for the crisis. It is understandable that the ECB, as the key representative of the monetary union, cannot acknowledge the flaws of this union and the political inability to address these flaws effectively, expeditiously and with finality.

That being said, the ECB should not treat this chronic crisis as business as usual. Political destabilization and social erosion is spreading throughout many countries of the Eurozone.

Last week’s political crisis in Portugal is just the latest reminder of that and it will not be the last. Never-ending austerity with unemployment numbers and youth unemployment numbers in some countries above those experienced during the Great Depression are simply unsustainable and will have grave political consequences. The demonstrated emotional detachment of technocrats from these brutal realities only enhances peoples’ distrust of the legitimacy of their decisions.

An outright acknowledgement by the ECB of the deeply structural nature of the crisis, rather than being caught up in cyclical analysis, would have gone a long way.

Nobody expects of Mr. Draghi that he address potential political solutions to this situation. Such solutions would include the mutualization of Eurozone debt or debt forgiveness by the so-called troika of creditors (the European Union, the ECB and the International Monetary Fund) as well as quick and permanent surrender of sovereignty by all Eurozone members in fiscal affairs as well as control of their banking systems.

Failing to truly make inroads on these issues instead of issuing pointless summit resolutions means that we will hobble along with no exit to the crisis in sight, while patching up the potholes in the road of the Eurozone economy. Eventually, that will prove to be too little. The only question that remains, is: When? 

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