The monetary policy of the European Central Bank has been too tight. This is shown in the fall of core annual inflation to just 0.8 per cent in the year to October 2013. The case for the monetary easing undertaken last week was overwhelming. Indeed, it was long overdue.
Yet, it has been leaked, the decision to cut the refinancing rate from 0.5 per cent to 0.25 per cent split the council. Both German representatives – Jörg Asmussen, a member of the ECB’s board, and Jens Weidmann, head of the Bundesbank – as well as the heads of the central banks of the Netherlands and Austria voted against this move.
Open splits on national lines have emerged previously, but only over controversial programs such as the Securities Markets Program, launched under Jean-Claude Trichet, Mario Draghi’s predecessor as president of the ECB, and the Outright Monetary Transactions program, launched by Draghi in the summer of 2012. Both of these initiatives were intended to relieve market pressure on sovereign bonds. That was bound to be controversial, given German hostility to monetary financing of governments. But such splits over standard monetary policy decisions are new. This matters: they endanger the legitimacy of the ECB – and so of the monetary union.
Some have even accused Draghi of acting in the interests of Italy – and the objections of German representatives to the easing are bound to stimulate such suspicions. Yet the case for a cut in the ECB’s standard policy rate is, in truth, overwhelming: core inflation is now less than half the ECB’s target of “below, but close to, 2 per cent”.
As Draghi argued, there are compelling reasons for not putting up with inflation below that level. First, an inflation rate recorded at 2 per cent might, in truth, be close to zero: inflation is almost certainly exaggerated at the moment in conventional measurements.
Second, needed changes in competitiveness inside the eurozone would be difficult even if average inflation were 2 per cent. They would be far harder at close to zero, given the resistance of workers to nominal wage cuts.
Third, monetary policy tends to be more ineffective the closer inflation comes to zero, partly because depressed economies may well need negative real interest rates – which are much easier to implement when inflation rates are positive.
To these I would add a fourth: the eurozone risks falling into deflation, given excess capacity and high unemployment. The ECB says that inflation expectations are anchored. That might prove hubristic.
It is easy to identify other reasons why policy has been far too tight. Between the first quarter of 2008 and the second quarter of 2013, nominal eurozone demand expanded by just 1 per cent. Nominal gross domestic product grew by a mere 3.4 per cent. Moreover, so-called M3 money – a measure of the “broad” money supply – has been virtually stagnant since late 2008.
What, then, are the arguments against last Thursday’s decision? One was that the decision could well be postponed. But it has already been postponed too long: the longer the delay, the greater the danger. A second concern is that this move brings unconventional measures even closer. But the less promptly the ECB uses conventional measures, the greater the likelihood that extreme ones will be needed. If the ECB had moved rates decisively towards zero in 2010, it might have avoided at least some of today’s difficulties.
Another complaint is that interest rates on German savings are too low. As Benoît Cœuré, a member of the ECB board, has argued, this is wrong. First, savings have little value during a deep slump, such as that in the eurozone. Second, the principal determinant of the return on German savings is the long-term yield on German Bunds, which is now 1.8 per cent on 10-year debt. But it is the slump, plus Germany’s role as a safe haven, that creates such low rates. The less effective is the support provided to the eurozone economy, the more Bunds will stay a safe haven and so the lower the return on German savings will be.
A final concern is that the monetary policy of the ECB is unsuitable for Germany and might even cause asset price bubbles. This is surely true, just as the monetary policy pursued before 2007 was unsuitable for Ireland and Spain, and did indeed drive asset price bubbles. A central bank called upon to deliver a target rate of inflation in a union of diverse economies will destabilise nearly all the members at some time. But that is what joining a currency union entails for members, including even the largest.
Between 2001 and 2007, the average core inflation rate of the eurozone was 1.8 per cent, with Germany on 1.1 per cent and Ireland, Greece, Portugal and Spain close to 3 per cent. If the overall inflation rate is to remain close to 2 per cent, while the inflation rates of the latter four countries, plus Italy, are to be well below this average, that of Germany and other surplus countries needs to be well above 2 per cent. Otherwise, overall inflation will be far too low.
Moreover, real short-term interest rates are likely to be negative in these higher-inflation countries, just as they were for those now in such difficulties, before 2008. Efforts to resist such adjustments guarantee a persistent crisis and so the low interest rates the critics detest.
Many in Germany might conclude that they would be better off outside the eurozone. I sympathise, but they should be careful what they wish for. In the absence of a currency union, a putative D-Mark would soar. The impact of a large real appreciation of the new currency would be similar to what has befallen Japan: large parts of German manufacturing output would shift into neighbouring countries; the economy would surely be pushed into a recession; and domestic prices would probably fall.
Without heroic, unconventional measures, to which the Bundesbank is fiercely opposed, the deflationary spiral might be steep. Some Germans would benefit. But the dislocations could be huge. Compared to that, the costs associated with a successful eurozone adjustment, including a period of, say, 3 per cent inflation in Germany, would hardly be excessive.
Yes, the ECB cannot deliver optimal monetary policy for Germany: it is not supposed to do so. But its easy money policy might still be far better than the alternatives.
Copyright The Financial Times Limited 2013