“We will do what is needed to maintain price stability.”
– Mario Draghi, president, European Central Bank, March 13, Vienna
The European Central Bank recently indicated its willingness to take dramatic actions at its meeting today to prevent deflation and boost employment.
What’s the urgency? Recently released ECB data is ominous. Annual inflation is running at 0.5 percent — far below a 2 percent target — and banks have cut lending to the private sector until it is actually less than it was last year.
The ECB’s actions might include setting negative interest rates on the extra cash commercial banks park overnight. It would be the largest central bank to do so since the 2008 global financial crisis.
It also might start buying government and private-sector debt to keep long term interest rates low, in a tactic called quantitative easing. The technique once was considered a radical and potentially dangerous step but has become part of the normal monetary-policy toolkit since the U.S. Federal Reserve, the Bank of England and the Bank of Japan all have used it.
Bank of Finland governor Erkki Liikanen, who is on ECB’s 24-member governing council, suggested that quantitative easing and setting negative deposit rates would encourage banks to make more loans to the private sector and lower the euro’s exchange rate, making European exports more attractive.
Many U.S. economists, such as former Federal Reserve vice chairman Donald Kohn, have criticized the ECB for being too slow to act, given the zone’s 12 percent unemployment rate and precipitously low inflation rate. Europe also has dragged down global growth.
“So seeing the central bank take some action to make sure inflation does not fall further and begins to rise again towards its target would be helpful to Europe, and it would be helpful to the global economy,” Kohn said in an interview with the Wall Street Journal.
Draghi has admitted that, although the risks of deflation were “quite limited at present, the longer inflation remained low, the higher the probability of deflationary risks emerging. … Any material risk of inflation expectations becoming unanchored will be countered with additional monetary policy measures.”
Economists feel deflation, in which prices fall, is bad because:
The expectation of falling prices discourages spending and lessens people’s willingness to borrow. The lack of demand can become so pervasive that the economy remains depressed for an extended period. America experienced this phenomenon during the Great Depression.
Falling prices worsen the position of debtors because their debt burden in real terms has risen. In simple terms, a 5 percent decline in prices increases the real cost of borrowing by 5 percent. Debtors will then cut back on borrowing, investing and spending.
Deflation causes a decline in wages as well as prices. In general, decreases in wages are accompanied by mass unemployment.
Mario Draghi deserves praise for the effective steps that he took in 2012. He fulfilled his pledge to do “whatever it takes to protect the Eurozone from collapse — including fighting unreasonably high government borrowing costs.”
I now support his initiative to encourage the ECB to take unconventional, dramatic actions to boost European growth out of its rut. In addition to monetary policies, Europe needs to remedy structural impediments to improve the continent’s competitiveness and to reduce the debt burden of the nations on the periphery, such as Portugal, Italy, Greece and Spain.
These countrues must balance their need for growth while they struggle to stave off international creditors. They need to borrow from lenders outside their national banking system to pay for needed stimulus programs.
Europe’s financial crisis is a major drag on global growth. Left unheeded, its problems could morph into a worldwide contagion.
Originally published in the Sarasota Herald-Tribune
