European Central Bank (ECB) President Mario Draghi has maintained his poise and exuded confidence. It is after all part of his job to do so. Underneath, however, he must feel panicked. Remarkably low inflation throughout the euro zone and threats of deflation are stealing the ECB’s 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. 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 and a natural association with Japan’s more than two decades of economic decline.
Deflation threatens the specific policies on which the ECB has relied in at least two ways. Policy makers had counted on rising general price levels to reduce the real value of outstanding debt, effectively putting time on the side of relief. Outright deflation would actually make time 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 cut 2.5 percent 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 its predicament, the ECB under Mario Draghi’s guidance has 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. It 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, Draghi announced that the bank would earmark close to €500 billion to buy asset-backed bonds in European financial markets and so channel funds directly to borrowers, again in the hopes of stimulating economic activity and generating 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 this failure to reform. Had these countries 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 encourage effective producers with tax relief. But the taxes remain high and these props remain in place. 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 household appliance factories that the Swedish owner, Electrolux, has identified as otherwise unprofitable.
The picture looks bleak. Things seem poised to fly apart at any moment. They may 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 and ultimately a breakup of sorts.