By Desmond Lachman
One has to welcome the European Central Bank's bold break with tradition last week by announcing that it plans to keep interest rates low for an extended period of time. However, one has to hope that this move is only the start to further unorthodox and more aggressive European monetary policy measures. For a very much bolder ECB would seem to be required both to put an end to Europe’s longest post-war economic recession as well as to avert the risk that the European economy succumbs to the perils of deflation.
The ECB’s unprecedented move to forward guidance on interest rate policy took place against the most dismal of European economic backdrops. Over the past six quarters, the overall European economy has been mired in recession with little sign that this recession is about to end anytime soon. Even the ECB acknowledges that the European economy will contract by a further 0.4 percent in 2013 and that the risks to the European economy are very much to the downside. As a result, five years after the Lehman crisis, the European economy is yet to regain its 2008 economic peak, which makes a lost European economic decade all too likely.
Europe’s very poor economic growth performance has been accompanied by a disturbing rise in the European unemployment rate to a record 12.1 percent, which has contributed to a marked deceleration in European inflation. Indeed, core European inflation has now declined to 1 percent, which is half the ECB’s target inflation rate. Such a low inflation rate has to raise the very real risk of deflation if Europe does not succeed soon in revitalizing its moribund economy. And as Japan’s long experience with deflation would attest, deflation is the last thing that Europe needs at a time of economic recession and of very high public debt levels.
Last week’s ECB policy action also took place against the backdrop of heightened risks to the overall European economy from its very troubled economic periphery. Not only is there little indication that countries like Italy, Spain, and Portugal will emerge from their deepest economic recessions in the post-war period anytime soon. There is also every indication that public acceptance of the austerity policies being foist on them by their European partners is now being severely tested. As if to underline this point, Portugal’s most recent political crisis has now drawn attention to rapidly eroding support for government austerity policies across the European periphery.
Welcome as the ECB’s move to forward guidance might be, it is doubtful that this will be a game changer to either kick start the overall European economy or to help resolve the acute credit crunch besetting the European periphery. For a start, while the announcement of forward guidance does provide a welcome signal that at last the ECB is coming to realize the very real downside risks to the European economy and the associated risk of deflation, it only validates market expectations that European interest rates would not be raised for the foreseeable future. Further, unlike the recent aggressive monetary policy action by the Federal Reserve and by the Bank of Japan, the ECB’s forward guidance has not been accompanied by an aggressive policy of quantitative easing.
A principal obstacle to the ECB’s efforts to revitalize the European economy has been that its policy action has done very little to alleviate the credit crunch besetting the European periphery. While the ECB has lowered its policy rates and while it has been very successful in securing a reduction in sovereign borrowing rates through the announcement last year of its Outright Monetary Transaction program, these lower interest rates have not translated into lower private sector borrowing rates in the European periphery. This is especially the case for the small and medium-sized companies in countries like Italy, Portugal, and Spain, which are known to be the main drivers of economic growth and employment.
In recent months, there has been a growing recognition in European policy circles of the urgent need to do something to get credit flowing again in the European periphery. In particular it is being recognized that without such a revival in lending, it is difficult to see how the periphery can experience a meaningful economic recovery at a time that it is being required to continue implementing budget austerity within a euro straitjacket that precludes currency devaluation. One has to be encouraged that ideas are now being floated in Europe proposing that the ECB purchases asset-backed loans to small and medium-sized enterprises in the European periphery and that measures be taken to strengthen European bank capital positions.
Realistically it is unreasonable to expect that the ECB will be able to adopt a very much more aggressive policy stance before the German elections scheduled for September 22. For it is understandable that the ECB will not wish to get caught up in German politics where there is much opposition to a more proactive ECB. However, one must hope that the ECB does not postpone such a move much beyond the German election, since Europe cannot afford to run the political risks of allowing a very deep and long economic recession to get much deeper.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.