What a bunch of Praets!

By Filipe R. Costa

On November 7^th the ECB cut eurozone interest rates to 0.25%, their lowest level ever. OK, so eurozone rates have only been around for the last fifteen years or so, but in the context of current policy of the other major OECD nations this fits the pattern of historical lows.

With official inflation at 0.7% in the eurozone, policy makers at the ECB are apparently as concerned with deflation as their American counterparts. As in America, Europe’s official inflation target is 2% and as with the Americans it looks like the Europeans could be gearing up to do more of “whatever it takes”. Last week, Peter Praet, chief economist of the ECB, admitted that this central bank was considering alternative unconventional monetary policy measures to combat deflation.

The route Europe is following is dangerous. The IMF imposed strict austerity conditions on southern economies and pushed them to make harsh internal devaluations. The goal was to let wages drop and make these countries more competitive. This is not a quick solution and is fraught with risk. While it could take 5 or 10 years to accomplish a 10% decline in production costs (through lower wages), it could take just weeks or even days for the currency exchange rate to unravel the whole process. All it would take would be a 10% increase in the Euro to undo a decade’s worth of policy effort.

The key concern for the ECB is the effects they are suffering from the policies of the Fed and the BoJ. The easy money policies of the latter two are pushing the Euro higher and undermining the efforts in southern Europe, as well hurting manufacturing competiveness across the rest of the Eurozone;

From July 24^th 2012 to November 13^th this year, the Euro rose about 20% against the dollar. This rise has exposed the deep flaw in European policy. By focussing on Europe’s exports, at the expense of improving internal demand, this ties Europe’s future wellbeing directly to the exchange rate of its currency. This is amplified by the lack of any adjustment mechanism to compensate for the reduction in the Euro.

Europe’s policy makers have boxed themselves into a corner. By getting involved in the “race to the bottom” game they now have to try and turn the Euro’s chart on its head. The first attempt at this inversion was last week’s sheepish 25 basis point cut. This really didn’t amount to very much at all and when Mr Praet says there’s more to come, I believe him.

At the moment the ECB is firing blanks, but it has proposed a radical step even the Fed and BoJ haven’t yet contrived to do. According to Pr Praet, the ECB is prepared to decrease the rate on its deposit facility to a negative number and even to monetise government debts indirectly by acquiring commercial banks.

As in America, the ECB’s overnight deposit facility is used by commercial banks to hold their excess reserves at the central bank. By charging a negative rate on these deposits the ECB would seek to encourage the banks to use the money (lend it) rather than store it. The reason this probably won’t work is that with borrowing costs so low companies are repurchasing stock with new debt. While this might be great for capital optimisation, it does nothing for the real economy. Stock repurchasing does little for widespread wealth creation.

But of course policy makers care little for this. As long as stock markets keep moving higher all is well with the world. When the ECB starts on its new path to QE we can be pretty certain of the script that will play out. It starts with a new “Operation Twist”, then leads to bond purchasing and, before you know it, ends with an infinite printing programme. However, in the “printing war” no one can really compete with the Fed, but just you watch Europe try!