Core Europe in the periphery

 This article was published in The Malta Independent on Sunday 23 03 2014
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If the Economist Business Round Table held in Malta earlier this month served for nothing, it served to raise awareness among international speakers and delegates that Malta is an island of stability representing the best of core Europe in its periphery.

Given the problems encountered by periphery countries like Greece, Cyprus, Portugal and Ireland (who all had to seek bailout from the EU) as well as Spain and Italy (who avoided full scale bailout but have been subjected to strict austerity measures and have seen their banking sectors seriously impaired by the financial crisis) Malta was often unfairly grouped with this sickly grouping. 

As it so happened practically a couple of days before the Malta Round Table the International Monetary Fund (IMF) posted on its web-site an article titled "Euro Area: Deflation versus Lowflation".    IMF posted the chart below which shows the countries on the left half of the chart with an inflation rate higher than 1%. Malta is in this group with the best of the breed i.e. Finland; Austria; Germany; Belgium and The Netherlands.    In the right half there are the countries experiencing inflation lower than 1% and causing apprehension about the risk of their flirting with an outright deflationary environment.

Not only Malta is on the virtuous page but we are the country with the most normal rate of inflation giving a real interest rate of about 2% which all economic text books would define as having the optimum position often referred to as Goldilocks economics i.e. not too hot causing high inflation and price bubbles and not too cold causing risks of stagnation and deflation. Our net debt as a percentage of GDP is also healthy.

 

If you should be wondering why having real inflation less than 1% is bad, it is because very low inflation ( or possibly negative i.e. prices falling rather than rising) as being experienced in Spain, Italy, Latvia, Slovenia and Portugal, all on the top right half of the table, means these countries are suffering high real rate of interest ( i.e. nominal rate adjusted for inflation/deflation) which scares away investment and keeps down economic growth.    In Malta because we have very moderate but positive normal inflation,  the real rate of interest is lower and this stimulates investment and economic growth.

During last week’s European Central Bank (ECB) press conference, President Draghi described the Eurozone as an “island of stability”.   If he were referring to Malta he would be right as we have stable inflation in the context of healthy economy growth.  But calling the whole Eurozone an “island of stability” may be a bit of a stretch. With Eurozone inflation well below the 2% target for over a year and projected to stay so until at least 2017, the Eurozone can aptly be described as the “island of price stability”. But price stability at a level well below the 2% gives the stability of the cemetery rather than the stability of economic growth needed to address chronic unemployment.

Very low inflation may sound like a good thing, but one of the risks of prolonged low inflation is that it could become entrenched in inflation expectations and people’s behaviour, thereby becoming the new norm. President Draghi knows this, but perhaps because the current ECB configuration does not allow enough room to manoeuvre with symmetry when inflation undershoots as when it overshoots, the ECB is pretending that low inflation is not a problem. 

It definitely is a problem and the point was made emphatically by Martin Wolf, chief economic editor of the Financial Times this week in an article titled "The spectre of eurozone deflation".   The main points/quotes of the article are:

·         ECB should announce a symmetrical inflation target of 2% indicating it will henceforth treat excessively low inflation as a problem no less serious than rapidly rising prices.

·         Ultra low inflation is dangerous. If inflation in strong core countries is low then inflation in crisis hit countries must be close to zero or negative.

·         If average inflation stood at 2% with the surplus countries at say 3% and adjusting countries at 1% the Eurozone would be in far better shape.

·         ECB should implement a programme of quantitative easing; negative deposit rates should also be considered.

·         ECB would suffer a deep split if it sought to adopt such a policy.

·         The fear (is) that the ECB may be forced to pretend that low inflation is not a threat because it cannot agree on what to do about it.

·         ECB might do little about it (fragile economic recovery of the Eurozone) because the measures it would need to take are controversial (with the Germans).

·         ECB's job is to stabilise the Eurozone not the German economy.  If the ECB's policy takes care of the latter rather than the former than the Eurozone is not a currency union, it is something quite different altogether.
 

Personally I do not agree that ECB needs to do something as controversial as quantitative easing or as risky as negative deposit rates.   ECB needs to license the ESM as a bank, give unlimited liquidity access to the ESM through its discount windows, widen the eligibility of assets available for discount and force the ESM to use this liquidity to recapitalise massively fragile banks in periphery Eurozone so that the banks can start acting as banks and no longer as zombies.  In so doing it would strengthen the transmission mechanism for ECB's monetary policy.   SME's in Italy, Spain, Portugal Ireland and Greece must find the necessary bank credit support and at a comparative price as much as SME's anywhere else in the Euro area.

Malta should be proud of being a sample of core Europe in its periphery, but we would be much better off if other countries around us are truly helped by the ECB to heal rather than merely being kept alive by artificially low interest rates.