In the second quarter of this year, real domestic demand in the euro zone was 5 per cent lower than in the first quarter of 2008. The euro zone's unemployment rate has risen by just under five percentage points since 2008. In the year to July 2014, consumer price inflation in the euro zone was 0.4 per cent. From these telling facts one can conclude three simple things: the euro zone is in a depression; lack of demand has played a crucial role; and the European Central Bank has failed to deliver on its own price-stability target.
This is not just sad. It is dangerous. It is folly to assume continued stability if economic performance does not improve.
A necessary, though not sufficient, condition for grappling with these challenges is understanding them. In this regard, Mario Draghi, ECB president, and the one senior euro zone policymaker who shows a grasp of the issues, made a vital contribution at this year's Jackson Hole symposium for central bankers. Two points need stressing. First, he stated "we need action on both sides of the economy: aggregate demand policies have to be accompanied by national structural policies". Second, he made a new promise: he remarked, off text, the ECB "will use all the available instruments needed to ensure price stability in the medium term".
Choirs of angels must have sung over the statement that the euro zone has a problem with demand. Hitherto, euro zone orthodoxy has treated this truth as unmentionable.
No less important might be the promise of action. It reminds us of the celebrated “whatever it takes”, delivered by Draghi in London in July 2012. This led to the announcement of the ECB’s outright monetary transactions programme, which defeated pervasive panic without firing a shot. Astonishingly, yields on Italian and Spanish 10-year debt have fallen from 6.3 per cent and 7.0 per cent, respectively, at the beginning of August 2012, to a mere 2.3 and 2.1 per cent early this month. That is below the yield on UK gilts.
Boosting demand
At Jackson Hole, Draghi stated he was “confident” the package of measures announced in June and now being implemented would deliver the “intended boost to demand”. It is reasonable to be sceptical. In the six years to the second quarter of 2014, nominal demand rose a mere 2 per cent. Credit channels remain impaired. Fiscal policy also continues to tighten, even though interest rates are at the zero bound: the OECD has forecast the cyclically adjusted fiscal deficit of the euro zone would shrink from a mere 1.4 per cent in 2013 to an even more austere 0.9 per cent in 2014.
Huge divergences in competitiveness remain. These are more difficult to rectify when inflation is so low. This is forcing vulnerable countries into deflation, which raises the real level of their debt. Meanwhile, creditworthy core countries are black holes for demand: this year Germany’s current account surplus might be as big as 8 per cent of gross domestic product. Last week, the ECB promised to purchase a broad portfolio of “simple and transparent asset-backed securities”. This, it hopes, will improve credit intermediation inside the euro zone. It also hopes that, through this and other programmes it has announced, it will be able to expand its balance sheet back to where it was two years ago.
This makes sense. It was an error to let it shrink by about 10 per cent of euro zone GDP when other central banks, with considerably smaller problems than the euro zone’s to deal with, were avoiding premature withdrawal of such support. Moreover, the range of measures taken reinforce the ECB’s forward guidance. It has locked itself into ultra-accommodative monetary policies for years, as it should.
Yet, despite all these actions, the interlocking problems of the euro zone are unlikely to be resolved soon. Indeed, even the ECB forecasts no more than feeble growth ahead. So, should the ECB do more? And what, above all, do other policymakers need to do in support?
The immediate question is whether the ECB should begin a programme of outright quantitative easing by buying government bonds, presumably in proportion to shares of member countries in euro zone GDP. In a blog post in July, senior officials of the International Monetary Fund argued that such QE would be effective. It would, they argued, reinforce the credibility of the ECB target and have important effects on the prices of financial assets, including bonds and equities, and probably on exchange rates, too.
I agree that it should be tried. The current situation is too dire for policymakers to eschew such a valuable instrument.
But declines in bond yields have already been so dramatic that QE's effects would no longer be as startling as they would have been two years ago. Furthermore, it is clear that the ECB would be taking on credit risk. It would be charged with monetary financing of governments. I believe it should go ahead. But the row between northern and southern Europe would surely be deafening.
Fiscal manoeuvre
What else is left? One possibility, suggested in Draghi’s speech, is active use of fiscal policy. Ideally, there should be a mixture of higher public investments and lower taxes, particularly in countries with room for fiscal manoeuvre. The overall fiscal stance is too tight, with a deficit forecast by the OECD at just 2.5 per cent of GDP in a deep slump.
In return, as Draghi demands, countries need to embrace serious reforms, to raise supply potential – and, by stimulating investment, demand as well. A determination to use all instruments possible to raise demand, enhance supply potential and improve competitiveness is where the euro zone must try to go.
The new European Commission needs to take a stand for common sense and growth, instead of insisting on more misery. This is not just a matter of economics. The capacity of the people of member states to tolerate high unemployment and deep slumps has been impressive. But it cannot be unlimited. If that is what the powers that be continue to advocate, the result will probably be a populist reaction.
This, sadly, is what we are seeing in Scotland. It is what we are soon likely to see elsewhere. Who is sure Marine Le Pen, leader of the far-right National Front party, will not be the next president of France? Who would follow Matteo Renzi, Italy’s prime minister, if he failed? Yes, these member states need to act. But they surely need support. Mr Draghi has shown the way. The euro zone must follow. – (Copyright The Financial Times Limited 2014)
