The ECB delays at Europe's peril

Article Highlights

  • A lesson from Japan’s 2 decades of struggling with deflation is a central bank pays a high price for falling behind the policy curve.

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  • While discretion might be the better part of valor for the ECB, it is not without its costs.

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  • To its credit, the ECB does not paint a rosy picture of Europe’s economy in the months ahead.

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The European Central Bank’s recent behavior is all too reminiscent of the Bank of Japan’s past passivity in addressing that country’s deflation problems, for which Japan has paid a heavy price. Like the BOJ before it, the ECB is now sitting on its hands, despite the European economy’s continued deterioration and the rising risks of European deflation. This does not bode well for an end to Europe’s longest postwar economic recession or for the early resolution of the European sovereign debt crisis.

To its credit, the ECB does not paint a rosy picture of Europe’s economy in the months ahead. Rather, it envisages that the European economy will contract by around half a percentage point in 2013, after having declined by a similar amount the previous year. The ECB also acknowledges that the risks to its economic outlook are very much to the downside, that any eventual European recovery is likely to be tepid at best, and that the European economic periphery could be particularly hard hit by the continued restriction of bank credit, especially to its small and medium-sized enterprises.

Despite this downbeat assessment of the European economic outlook, the ECB was not prompted to act at its last policy meeting. Nor was it prompted by the fact that core inflation in Europe is now down to barely 1 percent, around half the ECB’s inflation target of “close to but below 2 percent.” Instead, the ECB decided to keep its policy interest rate unchanged and it eschewed any notion of joining the Federal Reserve and the Bank of Japan in another round of quantitative easing.

More troubling than the ECB’s decision not to reduce interest rates is its seeming indifference to the fact that bank credit continues to be cut in the European periphery and that private sector borrowing costs in the periphery remain much higher than in Europe’s core countries. While the ECB recognizes this problem, it takes the view that the primary cause is a shortage of bank capital in the European periphery, which the ECB considers to be beyond its remit. The ECB also doubts the effectiveness of buying asset-backed loans of small and medium-sized enterprises in the periphery, as is now being recommended by an increasing number of private analysts.

A generous assessment of the ECB’s present passive monetary policy stance in the face of a rising risk of a European deflationary trap is that the ECB might be reluctant to be too bold at this stage in the German political cycle. Germany, which is the ECB’s primary shareholder and has a traditional antipathy to monetary policy activism, is scheduled to hold elections on September 22 and the ECB might not want to insert itself into that election.

    The ECB decided to keep its policy interest rate unchanged and it eschewed any notion of joining the Federal Reserve and the Bank of Japan in another round of quantitative easing.

Meanwhile, the German constitutional court is presently considering the merits of a petition claiming that the ECB’s Outright Monetary Transactions (OMT) program is inconsistent with the German constitution’s limits on the Bundesbank’s participation in that program. The petition points out that the OMT program envisages that the ECB could buy unlimited amounts of Italian and Spanish government bonds with maturities of up to three years in order to keep government borrowing costs for those two countries at reasonable levels. Perhaps, then, it is understandable that the ECB is taking the view that it might be better to wait for a more propitious moment in the German political cycle before risking a renewed German controversy on any new ECB policy initiative.

While discretion might be the better part of valor for the ECB, it is not without its costs. Absent bold ECB policy action to get bank credit flowing again and to reduce private sector borrowing costs in the European periphery, it is difficult to see how the periphery can avoid sinking ever deeper into economic recession in the months ahead. After all, the European economic periphery is still being required to implement budget austerity, albeit at a more moderate pace than in 2012, within the straitjacket of the euro. And it is being required to do so at the same time that its external economic environment is deteriorating and that the euro is appreciating against the currencies of Europe’s main trade partners.

The ECB’s present passivity in the face of a distinct deflationary risk could complicate the European debt crisis. A prolonged period of deflation would make the European periphery’s efforts to restore order to its public finances all the more difficult since it would increase its real borrowing cost. Given the fact that countries in the European periphery are flirting with deflation if not already experiencing it, the ECB would be ignoring the risk of a deflationary trap for the European periphery at its peril.

A clear lesson from Japan’s two decades of struggling with deflation is that a central bank pays a very high price for falling behind the policy curve. Hopefully, that lesson will not be lost on the ECB and it will become more proactive in its policy decisionmaking once the German elections are out of the way.

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