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Coming to Europe: A 'three arrow' strategy?

Coming to Europe: A 'three arrow' strategy?

Following Japanese Prime Minister Shinzo Abe's footsteps, European Central Bank (ECB) chief Mario Draghi appears to be implementing his own three-pronged plan to rescue the euro zone economy.

"It now appears - based on European Central Bank President Mario Draghi's recent Jackson Hole speech - that the ECB has a similar plan in store for the euro zone," Nouriel Roubini, chairman of Roubini Global Economics wrote in an op-ed published on Project Syndicate's website on Sunday, referring to "Abenomics" - Abe's economic revival plan consisting of fiscal stimulus, monetary easing and structural reforms.

At the annual central bank symposium in Jackson Hole on August 22, Draghi acknowledged that inflation expectations have declined - a key pre-requisite for Large Scale Asset Purchases (LSAP), according to strategists. He emphasized the need for policies to boost aggregate demand, suggesting the European Union should coordinate higher fiscal spending. He also suggested the ECB would be prepared to conduct LSAP to support EU-administered infrastructure spending.

Read More Investors focused on ECB as Europe's health deteriorates

Roubini is not the only market commentator to point out parallels between Abe and Draghi.

"The tone of Draghi's address was reminiscent of Yellen's dovish addresses on the labor market in the past and channeled the spirit of the three-arrows of Abenomics," said Greg Gibbs, head of Asia Pacific markets strategy at RBS (London Stock Exchange: RBS-GB), referring to Draghi's Jackson Hole address.

Draghi's 'three arrows'

Roubini says the first element of "Draghinomics" is an acceleration of the structural reforms needed to boost the euro zone's potential output growth. Potential output refers to the highest level of gross domestic product (GDP) growth that can be sustained over the long term.

Read More Abe misses with 'third arrow', again

"Progress on such vital reforms has been disappointing, with more effort made in some countries (Spain and Ireland, for example) and less in others (Italy and France, to cite just two)," he said.

The second element is boosting demand, which has been suppressed by fiscal consolidation in recent years.

Now that a lot of front-loaded austerity has occurred and markets are less nervous about the sustainability of public debt, there is some flexibility in how fast the fiscal target can be achieved, Roubini said.

"While the euro zone periphery may need more consolidation, parts of the core - say, Germany - could pursue a temporary fiscal expansion (lower taxes and more public investment) to stimulate domestic demand and growth. And a euro zone-wide infrastructure-investment program could boost demand while reducing supply-side bottlenecks," he said.

The third element is quantitative easing (QE) in the form of public bond purchases and credit easing to boost private sector credit growth.

"Now Draghi has signaled that, with the euro zone one or two shocks away from deflation, the inflation outlook may soon justify quantitative easing like that conducted by the U.S. Federal Reserve, the Bank of Japan (Tokyo Stock Exchange: 8301.T-JP), and the Bank of England: outright large-scale purchases of euro zone members' sovereign bonds," said Roubini. He believes QE is likely to begin by early 2015.

Read More European bank officials weigh QE 'shock and awe'

The ECB will meet on Thursday, a key focus for investors seeking clarity on the central bank's response to a stalled recovery, disappearing inflation and the sluggish pace of reform in the euro zone.

"As in Japan, all three arrows of Draghinomics must be launched to ensure that the euro zone gradually returns to competitiveness, growth, job creation, and medium-term debt sustainability in the private and public sectors," he said.

Three arrows: the right approach?

The three-arrow strategy should be implemented in the euro zone in order to rebuild conditions for more growth and prevent deflation, said Hervé Goulletquer, head of global markets research, at Credit Agricole (Euronext Paris: ACA-FR).

Read More Sinatra's 'My Way' for France and Italy

"Of course, the best combination between the different ingredients (whether it is monetary, fiscal or structural policies) is hard to find. But it is clear that moving simultaneously on all three fronts is what has to be done. Mario Draghi is convinced that they need to go in that direction," Goulletquer said.

The situation in the euro zone deteriorated in recent months, with an expected slowdown in German growth, stagnation in France, and a contraction in Italy.

"This bleak outlook encourages observers, and among them investors, to find historical references that may bring some clarity to the current debate about Europe. Unsurprisingly, the focus is on the lost Japanese decades, to be more precise, the beginning of this sad experience. If referring to Japan makes a lot of sense, the recent experience could be more valuable than the one recorded about 25 years ago," he added.



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