In 1922, a German
couple decided that the new government of the Weimar Republic was not creating the
right environment in which to bring up their children, and that they would move
the family to America. So they sold their house and set off with all their
worldly possessions. But when they arrived at the port town of Hamburg, they were
told that the money from the sale of their house would not be enough to cover
the cost of the voyage to America, and in fact it would no longer even be
enough to get them back home. Such was the speed with which money depreciated
in the hyperinflationary environment of Germany in 1922-23. This period of
German history has haunted the national consciousness of Europe’s dominant nation
ever since, leading to an exceptionally cautious monetary ethos. But recent low
growth has led economists to speculate that a more urgent danger is of the
Eurozone slipping into deflation, pointing at the cautionary example of Japan
after 1990.
In order to
understand European monetary policy it is necessary to look at the history of
money in the region. Until the advent of the First World War, the currencies of
Western Europe were tied to the price of gold; this provided very little scope
for inflation. As the costs rose in the great war of attrition, the various
nations ran up massive debts in their attempts to pay them. One by one they
turned to the printing press for a solution to their financial needs,
abandoning the gold standard and printing large quantities of money, sending
inflation soaring; this was particularly true in Germany and France. As Thomas
Picketty writes in Capital in the Twenty First Century, “between 1913
and 1950 inflation in France exceeded 13% per year....inflation in Germany
exceeded 17% per year so that prices rose by a factor of more than 300”. This
experience created in France and particularly Germany a deep aversion to inflation
and ‘racier’ monetary instruments, and the Deutschmark subsequently became a bastion
of stability after it was established in 1948. When Germany and France created
the Eurozone in 1999, it was, according to Picketty, “based almost
entirely on the principle of combating inflation”.
Up until the present
day, the ECB has been following traditional policies to stimulate growth.
Interest rates have dropped to almost zero (0.25%), and the central bank has
been resisting temptation to join its Anglo-Saxon peers on the quantitative
easing bandwagon. But inflation rates in March were just 0.5%, substantially
below the target of 2%, and even though April’s minimal rise to 0.7% has taken
the pressure off slightly, another drop in May and storm clouds will begin to
gather again.
So what are ECB Head
Mario Draghi’s options? He could choose to bluff, to undertake QE, or to
experiment with negative interest rates:
1)
The Bluff – in this course of action, Draghi makes the market believe that he
intends to implement QE, whether or not he actually does intend to. Last month,
Draghi made a show of publicly discussing the possible ways in which QE could
work. As we have seen in the Eurozone over the past five years, sentiment can
be just as important as fact, and the belief that QE is imminent could be
almost as effective at changing behavior as actually implementing it. Rather
like a sheepdog, he manipulates the flock merely by his positioning. One problem
with this course, however, is that Draghi has already done it once before – his
claim back in 2012 that the ECB would do “whatever it takes” to prevent the
Eurozone from collapse meant that the fraught situation resolved itself without
him having to spend a cent. The question is whether words will always be
enough, or if the market will one day call his bluff. Even the most effective
sheepdogs sometimes have to nip the odd leg to be taken seriously.
2)
Undertake QE – This course is littered with obstacles:
a)
Germany. As explained above,
Germany has a longstanding mistrust of racy financial instruments, especially
ones which involve printing money. In addition, recent crises in the European
periphery have hardened the German position against any kind of financial
re-distribution. A German court recently took the controversial step of
analyzing whether a 2012 ECB bond-buying policy (named OMT) had been illegal
under Eurozone rules; it ultimately returned a disputed verdict and referred
the case to the European Court of Justice. Though the head of the ECB is
Italian, the Germans command a great deal of influence due to their political
and financial clout in the Union.
b)
How to do it? The US, UK and EU
economies are all differently structured. Before you decide to implement QE,
you must first work out how it will be done. In order to stimulate growth you want to place
money into the hands of companies themselves, which they will then be able to
invest into their own development. The most obvious way to do this, buying
shares or bonds in the companies, is unsatisfactory since it leaves the state
holding a direct stake in a proportion of its own market. Thus the location of the
money injection becomes key.
In the US, companies receive their funding largely from the open market
in the form of corporate bonds, so the American challenge was to drive
investors into buying these. This was achieved by buying US government bonds
which thus drove down their yields, and had the double effect of lightening the
government debt repayment burden and driving investors out of the now
unprofitable sovereign bonds. Starved of yield in their safe havens they were
forced to buy the riskier corporate bonds.
The ECB would struggle to copy the US’s QE policy, in the first place
because there would not be one clear sovereign bond to buy, since the eurozone
is made up of many different sovereigns. Additionally, if the ECB did start
buying sovereign bonds in the periphery it would alleviate some of the
financial pressure on those governments; this would be counter-productive since
it is that very pressure which has been driving reform in Portugal, Spain and
Greece. The European economy is
dominated by small and medium-sized companies (SMEs), which are often too inconsequential
to have a corporate bond underwritten by their assets. The debt of several of
these companies can however be pulled together into a tradable ‘Asset-Backed
Security’ (ABS), which would be an ideal market for the ECB to invest in if it
wanted to stimulate SMEs. Unfortunately, the ABS market is much smaller in
Europe than in the US, and lacks the prerequisite depth to be able to have a
significant effect on the bigger picture. In fact, EU companies actually tend
to receive their funding from banks, and this is where the added complication
comes in. After the crisis it was decided that Europe’s banks were
undercapitalized; that is, they did not have enough money held in reserve in
case of disaster. New regulations require that banks raise their capital
levels, which is a process that is currently under way, and is partly
responsible for the lack of loans to the SMEs which caused the low growth in
the first place. If money were to be given to banks to encourage them to lend
more, there is a danger that it would just be absorbed into their new larger
pools of capital, and would never make it through to the companies themselves.
For these reasons it
remains very unclear as to how the ECB would be able to efficiently undertake
quantitative easing. When this is taken alongside German resistance to
experimentation, it becomes an extremely unlikely course of action given the
current circumstances.
3)
Negative Interest
Rates – With interest rates currently at 0.25%
and the deposit rate at 0%, there is not much further the ECB can go within
conventional monetary policy, but continuing through zero and into the minus
figures is a course of action which does have a precedent. A negative rate on
the Deposit Facility would mean that banks would find themselves actually
paying interest for the privilege of keeping money with the central bank, the
aim being to incentivize them to do something more productive with it. This
policy was adopted in the 1970s by Switzerland, when it was trying to reverse a
surge in its currency price in the wake of the OPEC Oil Crisis, and by Denmark
in 2012 under similar circumstances, but it has never been attempted by a major
global economy. One worry is that banks will simply pass this extra cost onto
their customers, providing the complete opposite effect to that which was
intended. Once more, if there is to be a pioneering maneouvre in monetary
policy, it is unlikely to come from a central bank that is heavily influenced
by Germany.
The German-dominated
ECB remains unlikely to pursue any course which might be considered reckless or
untested, with the Euro being treated very much like the Deutschmark that
preceded it. The difference of course is that the Deutschmark represented the
finances of one relatively homogenous country, while the Euro is the currency
of an experimental union of widely varying economies. Are the tried and tested
methods sufficient to maintain a successful Eurozone? Time will tell. But the
example of stagnant Japan between 1990-2012 confirms that the dangers of
deflation should not be taken lightly.
Appendix – Japanese
example
To some, the Japanese
experience might not seem that bad. The so-called ´lost decade´, which began in
1990 and has ultimately stretched to over twenty years, has been a period of
low growth and stagnation (an economist´s nightmare), but to the man on the
street the idea of getting richer every day, as prices decrease, might actually
sound quite appealing. Japan has not been hit by famine, disease, or any other
side-effects associated with poverty, it is still the world´s third largest
economy and quality of living is high. The problems, such as they are, bubble
under the surface, and have been growing continuously. Over the last twenty
years Japan has been steadily accruing government debt, to the point that it is
now the most indebted country in the world (when viewed as a percentage of GDP).
The reason it has not suffered greatly from this growing burden is that it has
been paying very low levels of interest on the debt, as a result of strong
investor confidence and high demand for its bonds. The end to this benevolent arrangement
comes when faith starts to waver, and investors begin to sell their government
bonds; at that point Japan finds itself paying a rising yield on a giant debt
pile, and the subsequent financial problems undermine the confidence of
remaining investors, creating a self-perpetuating downward spiral. Something
had to change before this tipping point was reached, and President Shinzo Abe
has emerged with a risky plan. His ´three arrows´ strategy involves stimulating
the dormant Japanese economy with quantitative easing, and making structural
changes to create the growth which can begin to shrink the Japanese debt. If
this strategy succeeds, Abe will have hauled Japan out of its ever deepening
hole; if it fails, he might have created the low-confidence tipping point he
was trying to avoid, or perhaps inflation will career out of control, the risks
are very significant. This strategy is uncharacteristically reckless, but the
Japanese have been driven to it by their earlier complacency.
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