New perspectives for the ECB
Now that the worst of the debt crisis is over, the ECB is once more in the news. The fragile growth that is being generated in Europe may have come up against a surprising obstacle: deflation.
Since the beginning of the financial crisis, the European Central Bank‘s role has been much discussed. The most indebted countries sought a solution from the ECB by purchasing public debt, which would have been much less painful for them than reducing public spending. Regrettably, that help never came about, at least not in the way that was expected. The ECB has followed the script of keeping inflation low and has worked tirelessly in order to achieve this task.
It is true that the ECB offered an alternative pathway that has helped enormously in reducing tension in the European banking system. By means of this system, which consists of almost unlimited lending to the European private banks, it has supported their stability thus allowing them to fulfil the requirements of solvency; and it has indirectly financed the debts of many States owing to the fact that these banks are holders of large proportions of public debt. The process has been especially beneficial to the banking system as it has allowed banks to accrue a profit, even at low levels, despite the huge reduction in economic activity. We must acknowledge that the modus operandi of other central banks has been totally different and that, seen in perspective, it has been more successful than the European one. What is more, it can explain the renewed pressure on the ECB to shift its policy.
The Fed—the US Reserve—operated in a totally different way: the U.S. created a public fund to recapitalise banks and nationalised two large mortgage agencies. Then the Fed carried out stress tests in 2009 and forced the recapitalisation of banks. At the same time, Obama approved a fiscal stimulus to get the economy moving and, after all of this, the Fed announced the purchase of bonds to avoid upward pressure on interest rates and long-term appreciation of the exchange rate.
The Euro currency has reduced the room for manoeuvre of the central banks of EU Member States. Without the option of devaluing the currency, the recovery is restricted to fiscal measures. But these tax measures also have limitations. States cannot borrow more, because that has been the cause of the problem, so the choices are reduced to increasing taxes or reducing spending. Tax increases have a limited track record: they cause contractions in demand by reducing disposable income, thus reinforcing the cycle of economic depression. The tax increase delays the start of the recovery. The other option, which is more widely followed, has been to reduce public spending —sometimes dramatically. The impact has fallen on civil servants (freezing their salaries), pensioners and all beneficiaries of public policies: health, education, elderly care and research.
Now that the worst of the debt crisis is over, the ECB is once more in the news. The fragile growth that is being generated in Europe may have come up against a surprising obstacle: deflation. Whilst the major threat has always been inflation, efforts to reduce costs and stimulate price competition cause small price increases or even price reductions. So low inflation rates will slow the recovery process, putting more pressure on expenditure side of budgets and the also on government incomes (via taxes).
As happened in July 2012, the ECB President has again publicly expressed his decision to actively intervene. In 2012 the words of Mr. Draghi, indicating the ECB’s decision to intervene if necessary, were enough to calm the markets and restore confidence in the risk premium. It would seem that once again President Draghi’s expression of his willingness to intervene seems to have had a beneficial effect but what is still missing, following this statement, is real substantive intervention. The ECB, however, continues to play it in the same way: warning but not acting. And credibility is a fragile item.
Now it seems that the measures have been delayed until June and will probably not be implemented before the autumn. The most persistent commentary is that the ECB could finally adopt the policy of buying debt, as the Fed has done; but only after the stress tests of the European banks and the trend towards low inflation or quasi-deflation has been confirmed. The threshold of inflation has been set by Mr. Draghi at a critical 1%. But perhaps the push for this shift in ECB policy results from the strength of the Euro currency against the dollar —stabilised for a long time at 1.40 and without any sign of weakness— which makes it more difficult for exports to become the engine to boost the economy of the Euro area. The second strong argument is France’s entry into the group of states which are severely reducing public spending. The €50billion cut announced by Prime Minister M. Valls is the prelude to troubled times in French society and the most telling sign that we are far from achieving a sustained recovery.
The change in policy at the ECB can bring relief for many European citizens who fear or are suffering cuts in social protection. The situation is especially dramatic for families where no family member is in employment and yet unemployment benefits are being cut. Even if these measures seem to be adequate in the short term, there are still risks if we do not make the necessary changes in economic life in Europe and instead we remain trapped by an uncontrolled and intrusive financial sector.
José Ignacio Garcia SJ