What more can the ECB do? | Business| Economy and finance news from a German perspective | DW | 09.03.2016
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What more can the ECB do?

The European Central Bank is running out of monetary policy options as it tries to prevent deflation. Neither ultra-low interest rates nor massive bond buying have worked yet. Is the ECB's arsenal running low?

The ECB pulled out even bigger monetary policy guns on Thursday, eager to boost inflation, lending and consumption in the stagnant eurozone economy. But doubts remained over whether its actions would have the desired effect.

The bank's chief, Mario Draghi, insisted the ECB was "not short of ammunition," but a slight drop in consumer prices across the eurozone in February obviously had officials in Frankfurt worried.

The most recent moves, aimed at fending off a dangerous cycle of deflation in the 19 countries that share the euro currency, raise the question: Why doesn't the ECB think consumers should get more bank for their buck? Isn't inflation the thing to be avoided?

Seeking illumination, DW asked a number of economists four questions: Why are consumer prices declining? Why is the ECB nervous about consumer price deflation? What has the ECB been doing to try to increase inflation and why has it been failing? And finally: Is there anything else the ECB could or should be doing?

Prices holding steady

In February, according to Eurostat, the weighted average of consumer goods and services prices in the 19-nation euro area declined by 0.2 percent compared to a year earlier. It's part of a trend - the eurozone inflation rate has been falling since late 2011, when it hit a post-2008 peak of 3.0 percent. It dropped below 1.0 percent in late 2013, and it's been hovering in a narrow band either side of zero since late 2014.

Inflation has been low, according to Berlin-based monetary economist Dirk Ehnts, in part because of low oil prices. But the main reason, he told DW, is that most people don't have very much money to spend. In economists' jargon, this is called "weakness in aggregate demand."

Weak demand

There are several underlying reasons for weak demand. One is the mass unemployment that resulted after debt-fueled real-estate bubbles in various European countries burst in 2008, and new housing construction collapsed.

Another factor is that much of Europe has an aging population with a below-replacement birthrate, so the pace of new household formation is slowing. Older people generally already have homes, furniture and cars. Meanwhile, large numbers of unemployed young people in southern Europe don't have the money to buy these things.

Once a cycle of high unemployment, reduced creditworthiness, and low demand has been established, it can be difficult to break, because there are feedback mechanisms that tend to make the problem worse.

Weak demand, low prices

"Small and medium-sized enterprises (SMEs) generate the bulk of employment in the eurozone. They complain there's a dearth of demand for their products and services. The purchasing power of consumers isn't high enough to justify any increase in production, so business owners aren't investing," Ehnts said.

If SMEs aren't investing, they aren't buying much new equipment or hiring new employees. Given that SMEs employ the bulk of the workforce, their employees' paychecks are also the main channel of household income that underpins consumer demand.

Shopping bags

In most of the eurozone, consumers' willingness to spend more has declined, with Germany being an exception

Faced with slow sales, SMEs keep their prices steady or even reduce them to try to keep inventory moving out the door. But low prices and consequently low revenues mean SMEs can't afford to hire new staff or increase workers' wages, so families have less money to spend.

Thus lower prices lead to lower wages and lower employment, leading to even lower prices, and so on. It's a dog chasing its own tail.

There are additional reasons why deflation is harmful. One is that if people get used to the idea that prices are declining, they may put off purchases and wait for a better price - which further reduces economic activity.

Another factor is that if money gets more valuable, accumulated debts implicitly get more burdensome.

This explains why ECB President Mario Draghi is terrified of consumer price deflation: GDP deflation and mass unemployment can result. In an extreme case, self-reinforcing deflation can generate an economic depression that lasts for years, like the Great Depression that started in the US in 1929.

That's why central bankers aim for an inflation rate that's low but positive - far enough above zero to avoid the risk of deflation setting in.

What the ECB has been doing against deflation

Since mid-2013, eurozone inflation has been dangerously low, and the ECB has been using increasingly aggressive monetary policy measures to try to get it moving back upward. In essence, it has been trying to reduce the price of money - i.e., to reduce the interest rates charged on both short-term and long-term loans - in order to get people and businesses borrowing and spending more.

The ECB has used three mechanisms for this purpose. First, it has reduced the interest rates it charges to commercial banks when they want to borrow from it. Second, it has flooded central bank money into financial markets - 774 billion euros' worth so far - by buying up huge volumes of long-term corporate and government bonds from secondary bond markets. That has left investment managers facing the challenge of finding some other investments to put the money into.

Watch video 01:28

Much fuss about ECB’s negative interest rate

Recently the ECB has even taken to charging commercial banks for their holdings of excess "reserves," or central bank money, in their accounts at the central bank, in an effort to try to pressure them into investing it elsewhere.

These moves have indeed caused both short- and long-term interest rates to decline to record lows. However, they haven't caused nonfinancial corporations or households to engage in a lot of new borrowing and spending.

A world drowning in debt

Lord Adair Turner says he knows why. Turner is a former head of the UK Financial Services Authority. From 2009-13, Turner was chairman of a key regulatory committee of the Financial Stability Board, a group composed of senior officials and governors of the world's central banks and finance ministries. As a result, he has gained uniquely deep insights into how the banking system works - or fails to work.

In speaking tours connected to his 2015 book "Between Debt and the Devil," Turner has explained that banks don't take money from savers and lend it on to entrepreneurs; rather, "banks create credit, money, and purchasing power that didn't previously exist."

In so doing, they also create bank debt - and nowadays, people don't want more of that, Turner says. Households' private debts to the banking system have been building up relentlessly since shortly after the end of the Second World War. In the aftermath of the mortgage and consumer debt-fueled spending binge that led to the 2008 financial crash and Europe's economic crisis, most debtors want to "deleverage," or reduce their net debt, not build it up even further.

That's why various interventions aimed at driving interest rates down to record lows haven't led to more borrowing or spending, Turner says.

What more can the ECB do?

Is the ECB out of ammunition? Independent banking analyst Miguel Carrión Álvarez told DW that no, it isn't, but "to hit its inflation target it needs to be bolder." For example, "it could increase the volume of its bond-purchasing program by making synthetic bonds backed by nonperforming loans eligible for its asset-backed securities program," he said.

This would be a way of helping Italian banks in particular, which are weighed down with about 350 billion euros in bad debt. By helping them clear nonperforming loans off their balance sheets, ECB could put Italy's banks in a better position to get back to lending to businesses and consumers, which have had a hard time accessing credit in recent years.

Carrión Álvarez also observed that while Article 123 of the "Lisbon Treaty" on European Union prohibits the ECB from funding governments by directly buying sovereign debt, the Treaty "says nothing of direct transfers to private sector entities or people."

He suggested that the ECB should consider trying to find a way to directly grant judicious quantities of newly created, debt-free money to eurozone citizens - perhaps several thousand euros per adult citizen - in order to stimulate spending, consumption, GDP and employment.

What the ECB cannot do, someone else must do

According to Dirk Ehnts, "the ECB has understood that it cannot really do more. In February, Mario Draghi told the European Parliament that "fiscal policies should support the economic recovery." The ball is now in the court of the national governments." Ehnts added: "In my opinion, the ECB is currently doing everything right. But it isn't responsible for fiscal policy."

Fiscal policy - i.e., a massive dose of government stimulus spending - is, in Ehnt's view, what's needed to get Europe's economic engines revving again.