Tuesday, 15 April 2014

Conventional, unconventional and common sense

A vibrant debate is going on about what the ECB should do to address the fact that inflation in the Euro area is falling way below the target of 2% and that the latest reading of 0.5% for  March 2014 sits deep into disinflation territory and uncomfortably close to deflation.

Given that 0.5% is the average, there are Euro countries already operating with negative  inflation and this is dangerous.

Disinflation could be evil or benign. It would be evil if a low reading of inflation is due to a downturn in economic activity and is the result of a contraction in the rate of growth of the GDP or indeed an outright contraction.   It would be benign if low inflation is the result of a drop in external prices, like lower prices of imported food and energy, which as they unfold will leave more spending power in the hands of consumers who can spend on other goods and services so that the low inflation reading is accompanied by economic growth.

Whether it is evil or benign,  it is important that a period of low inflation or deflation is considered as a temporary phenomenon and that it is not permanently anchored in consumers' psyche.   The danger of an extended period of low inflation is that if it enters the general mindset of consumers it acts as negative stimulus through postponement of consumption and could drive the economy into a vicious spiral of falling prices and falling demand,  building momentum on a mutually reinforcing slippery slope.

The vibrant debate is between those in core Europe whose domestic inflation is above the average and who tend to consider the average reading as caused by benign reasons of falling prices for imported food and energy and who generally press for the ECB to do nothing until there is more evidence of the permanency of disinflation.    On the other side there are countries in periphery Europe, generally those countries coming out of atrocious austerity programmes, where inflation is below the average or outright negative, and who are pressing the ECB to take extraordinary unconventional measures as an insurance policy against the risk of falling deeper and irreversibly into lowflation or deflation which makes debt servicing more burdensome impinging negatively of their pace of recovery.

Caught between these two forces the ECB governing council has decided to do nothing but launch a verbal barrage delivering expectations that they will adopt unconventional measures as necessary if further evidence emerges of  deepening risks of disinflation.  

What sort of unconventional measures can the ECB take to address the risk of disinflation?

There are two categories which both come with a lot of ifs and buts, with absence of evidence about their effectiveness in a Euro area context, with great potential for dangerous unintended consequences,  and given the divisions within the ECB, with a risk of being adopted in mild doses which will be considered by the market as too little too late.

The most logical category is overcoming of the zero bound for interest rates and cross over to negative interest rates forcing banks to invest their excess liquidity rather than incur charges for parking it at the Central Bank.   If banks pass the reduction down the line to their depositors, would depositors be tempted to keep cash rather than bank deposits and thus neutralise the effectiveness of the policy?    Would it be fair to force old age pensioners to pay a 'tax' on their deposits  to help economic recovery?

The other category is QE - quantitative easing - the increase in money supply ( to overcome the fact that reduction of bank lending is shrinking the money supply) by purchases by the ECB of bonds or other assets on the secondary markets.   The risk here is that without a single Treasury supporting the Euro, the ECB will have difficulty in buying sovereign bonds of member countries and there could not be enough private bonds and assets to buy on the secondary market in order to deliver QE on the scale required to make a difference.

I am sceptical of both solutions, and would argue that the benefit of adopting either would be indirect - the softening of the value of the Euro on the F/X markets - which could be obtained by other less unconventional means including verbal and if necessary direct intervention on the F/X markets by Euro governments, co-ordinated by the ECB and supported by other main Central Banks.

But there is a much more, simple, conventional and effective solution which the ECB can mebark upon if the Euro governments were to give their political support which unfortunately is lacking due a mindset by the Germans in their misguided belief that the German taxpayer would be prejudiced by the adoption of true measures that could stabilise, indeed save, the financial system and the monetary union.

This is the direct recapitalisation by the ESM of under-funded Euro area banks.   Such recapitalisation would be forced on all banks found wanting through the AQR and stress tests.  Capital would be generously provided to render Euro area banks well funded and capable of repairing the money transmission mechanism of the ECB monetary policy to deliver the bacon where it is most needed;  to SME's in Euro area countries especially in the countries in distress, where SME's are dependent on bank credit for their growth and where bank credit is just not available.

To render the arrangement more effective and less depending on funding the ESM by member countries, it should be accepted that ESM is considered as a licensed banking institution and the ESM can use its equity investments in capitalised banks at the discount window of the ECB to monetise the massive capitalisation without being a burden on the fiscal position of member governments.

Once the situation gets stabilised and we start seeing real growth in the Euro area the whole process will be reversed by the ESM selling back their investments to the Banks or to private investors.  As the US reversed the TARP programme and profiting from it,  so would the ESM, so would the ECB and so would the entire Euro area.

What is needed is just a change of fossilised mindsets, creative thinking and leadership to follow this through until the unemployment problem in the Euro area is resolved and strong growth becomes the norm rather than accepting present stagnation as the new normal.

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