Only Germany can save Europe now

The European Central Bank ramped up its battle against deflation overnight; however, without help from Germany it is a battle that the ECB is unlikely to win -- at least not anytime soon. Despite the actions by the ECB and strong comments from president Mario Draghi, it will be fiscal rather than monetary policy that will eventually turn things around.

The ECB surprised markets last night by cutting its three interest rate levers by a further 10 basis points and announcing two new stimulus programs for buying asset-backed securities and covered bonds issued by eurozone banks. These new programs will begin in October 2014 and details will be known closer to that date.

The ECB cut the deposit rate, applied on excess reserves placed at the ECB by banks, to -0.2 per cent. It also cut its main refinancing rate to 0.05 per cent and the marginal lending rate to 0.3 per cent.

After cutting rates in June, it was widely expected that the ECB would stay put this month. With rates already so low there was naturally the belief that they couldn’t really drop much further. Draghi stressed that this was as low as rates would go.

“Now we are at the lower bound,” Draghi said.

Are the new programs likely to help? If they can grease the wheels of eurozone credit markets and direct credit towards productive businesses then yes, they will help a bit. But we shouldn’t expect the rate cuts to make much difference.

Remarkably the real interest rate in the eurozone -- that is the interest rate adjusted for annual inflation -- is actually higher than it is in Australia and much higher than in either the UK or the US. The cut in September is simply offsetting the recent decline in inflation, rather than providing additional stimulus.

That really highlights the ECB’s predicament: it has largely exhausted its conventional policy options, and asset purchases and quantitative easing -- while somewhat effective -- don’t really provide much bang for their buck. Put another way: monetary policy just isn’t working.

The best way to increase inflation and boost lending to the private sector is to increase domestic demand directly. Unfortunately monetary policy is not the most efficient mechanism to get this done and steps by the ECB -- no matter how well intentioned -- will provide only minor support to an economic region that needs so much more.

The eurozone recovery will only begin to gain traction once the bigger eurozone economies begin to use fiscal policy to support domestic demand. To a large degree that requires Germany to step up and provide genuine economic leadership for the first time in years.

Draghi said as much during his Jackson Hole speech during August.

“It would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy,” Draghi said. “I believe there is scope for this while taking into account our specific initial conditions and legal constraints.”

German authorities -- who find themselves in their strongest fiscal position since reunification in 1990 -- have shown little interest in supporting the eurozone recovery. At this point their obsession with fiscal constraint is not only undermining their own economy -- which is at risk of a triple dip recession -- but also undermining the entire eurozone recovery.

The International Monetary Fund also believes that German Chancellor Angela Merkel needs to do more to support growth, noting that Germany could finance additional investment of “up to 0.5 per cent of GDP a year over four years … without violating fiscal rules”.

As it stands investment in Germany has dropped to just 17 per cent of GDP -- well below the average of 21 per cent in other developed countries – that if left unchecked will eventually begin to weigh on the famed German efficiency.

Of course this need not be a selfless act by the Germans, they would benefit as well. Faced with some truly nasty demographics and a rapidly ageing population, they could use low lending rates to fix their crumbling infrastructure and ensure their economy is well-placed to meet the needs of an older population.

Monetary policy by itself will not be enough to put this recovery on a sustainable path. Fiscal policy needs to support activity and that must start with Germany. Real economic leadership is needed and we cannot expect Draghi to do it all by himself. Monetary policy is not the silver-bullet but combined with some fiscal expansion it might just be sufficient to get the eurozone economy back on track.