The euro fell to a two-year low overnight against the US dollar after European Central Bank President Mario Draghi reiterated the ECB’s commitment to expand its balance sheet and fight off the increasing threat of deflation. But it is unlikely that the ECB’s policies will gain much traction without a co-ordinated effort through the eurozone to increase fiscal spending and improve aggregate demand.
The ECB left its three interest rate levers -- the deposit rate, main refinancing rate and marginal lending rate -- unchanged at its November meeting. Draghi has already indicated that interest rates cannot go any lower, particularly after the ECB shifted its deposit rate to -0.2 per cent earlier this year.
The next step for the ECB is unconventional monetary policy. In October the ECB started purchasing covered bonds under a new program designed to boost bank lending and economic output. Draghi has also announced plans for a massive expansion of the ECB’s balance sheet.
“We will also soon start to purchase asset-backed securities. The programmes will last for at least two years,” Draghi said. “Together with the series of targeted longer-term refinancing operations to be conducted until June 2016, these asset purchases will have a sizable impact on our balance sheet.”
The move is straight out of the Federal Reserve playbook but we also know that quantitative easing programs struggle to gain traction. If the US is any example, very little of the support provided by the ECB will flow through to the real economy.
“Our measures will enhance the functioning of the monetary policy transmission mechanism, support financing conditions in the euro area, facilitate credit provision to the real economy and generate positive spillovers to other markets,” Draghi said.
Instead asset prices will boom -- mainly those held by financial institutions -- and profitability will rise. Quantitative easing will support speculation but with the outlook in the eurozone so dire, why would financial institutions lend to households and businesses? More importantly, why would households and businesses borrow when aggregate demand is so weak?
The ECB is hopeful that a quantitative easing program -- introduced as other advanced countries move towards policy normalisation -- might have a more significant effect on capital flows and investment.
That does provide some upside risk to the program but it almost appears to underestimate the magnitude of the euro area’s economic and financial crisis. The truth is that the solution to the euro crisis does not rest in the hands of Draghi or the ECB.
The euro crisis is not simply a problem emanating from the financial system -- though it has certainly played a role -- and instead reflects a range of cyclical and structural factors. Structurally the euro is flawed; consider, for example, the fact that it has been in crisis for almost half its existence and with no end in sight.
The reasons for this are complex but if I had to isolate just two they would be: first, there is no central government to redistribute funds from high performing to low performing states -- as is the case with federal systems such as Australia and the US; second, there is limited labour mobility between states due to cultural and language barriers.
As long as that remains the case, economic and financial imbalances will be present and, as a result, financial crises will be a perfectly natural part of the euro zone. Unfortunately, many countries in the region would be better off in the long-term by leaving the currency.
But in the absence of that option or plans to reform the eurozone, the best approach to solving the current problem is a round of co-ordinated fiscal policy. The ECB can’t do all the heavy lifting and it is time that the eurozone shifted away from austerity -- which hasn’t succeeded in reducing debt anyway -- and took a co-ordinated approach to boosting demand.
The ECB’s quantitative easing program, combined with fiscal expansion, would be a powerful combination for the eurozone and perhaps even sufficient to get businesses hiring and households spending. But as long as the euro zone relies solely on the ECB, we shouldn’t expect conditions to improve a great deal.