Sliding Towards Deflation

by Andrew Stuttaford

Writing in the Financial Times, Wolfgang Münchau frets that the euro zone is sliding towards deflation, and observes that while the 2012 promise by European Central Bank president Mario Draghi to buy euro zone government debt in the secondary markets (‘outright monetary transactions’) had “taken the heat out of the euro zone crisis” it had created the false impression that nothing more needed to be done to restore growth to the countries of the troubled currency union.

Münchau argues:

The ECB should starting buying equities and junk bonds. It should subsidise mortgages and consumer credit. It could fund an investment programme in transport infrastructure, energy networks and scientific research, by buying debt to fund such projects at zero interest rates. All these measures would be effective.

But there’s a catch:

Most would be illegal.

I’m not entirely clear how much this little detail really troubles Mr. Münchau, but then again let’s remember what Christine Lagarde, then the French finance minister and, disgracefully, now running the IMF said back in 2010:

“We violated all the rules because we wanted to close ranks and really rescue the euro zone. The Treaty of Lisbon was very straight-forward. No bailout.”

The rules that bind the European Central Bank were put there as a recognition of the concerns of German voters. Had these voters been asked, they would have had nothing to do with the euro. That’s why they weren’t asked, but they were promised that the new European Central Bank would be operated in a way that reflected the discipline of the old German Bundesbank, a promise, secured by a supposedly binding set of rules, that was a demonstration that German public opinion—German democracy, if you like—still counted for something.

Then came the bailouts, and then came everything else. When it comes to the euro neither democracy nor the rule of law, it seems, count for very much: the European political class will do what it takes to keep their nightmare currency alive.

Back to Münchau:

The one thing the central bank can do without any legal problems would be to drop the silly macroeconomic model – known as the Smets-Wouters model, after its authors – on which it has been relying for too long.

My guess is that the ECB will not do any of these things. It will continue blaming eurozone governments for not implementing structural reforms. Eventually, it will adopt a programme of asset purchases that is too small, which it will abandon prematurely at the first sign of recovery.

The result is that the eurozone will end up looking like Japan, but with one difference. Countries whose policy goes off track have nowhere to go. The member states of a monetary union have alternatives. By failing to deliver on its inflation target, the ECB could give member countries a good reason to leave the eurozone: they could have a better central bank. My advice to the ECB: do not let that happen.

My advice to the member countries: make that happen.

(And begin by dividing the euro into stronger and weaker halves).