Thursday, 13 March 2014

Letting Rome burn

If Rome is burning and you can do nothing about than you may be entitled to claim that there is no problem or that it is not your problem.

This seems to be the attitude being adopted by the European Central Bank (ECB) when faced with the threat of disinflation or deflation, or more simply the stark undershooting of the average inflation in the Euro area from their just below 2% target.

Ingram Pinn illustration

        If the average inflation rate was missing the target inflation rate on the upside i.e. if it were exceeding 3%, you can rest assured that the German driven ECB would have raised interest rates, even if faced with evidence that going forward the economy would slump.   They did it twice under Trichet's leadership and in both cases they had to reverse their decision as soon as crisis struck.

But there is evidently great asymmetry in the way the ECB operates when inflation undershoots target.   Rather than take action based on the average Euro area inflation it is quite evident that the ECB is forced to model it policy on the basis of the inflation rate in Germany, and to hell with the rest.

Because Germany can live with a Euro exchange rate of US$ 1.40 the ECB does nothing about it, not even verbal intervention, even though this rate of exchange nullifies the sacrifices being made by periphery countries to regain export competitiveness through harsh internal devaluation ( involving lowering wages, pensions and social payments).

These observations were eloquently spelt out in an op-ed by Martin Wolf, chief economic editor of the Financial Times in yesterday edition with a column 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 quantitive 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 avaliable 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 strenghten 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.

And all this is unquestionably within the ECB's mandate no matter how distasteful it would be to the Germans who mistakenly think they can keep the Euro project on track if all countries become carbon copy images of mutterland.

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