Deflation leads to debt trap

My Letter featured in today's  (2nd October, 2014) FT



Deflation leads to a debt trap, not competitiveness

   Sir, Hans-Werner Sinn (“Merkel has a duty to stop Draghi’s illegal fiscal meddling”, September 30) contends that “deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness”. I had to read this more than once to believe my eyes. Dr Sinn needs to read some history books to be reminded of where the deflation of the 1930s led us.

   His assertion flies in the face of all economic data, which prove that deflation leads to a debt trap and more deflation, not to competitiveness. Mario Draghi has been a superhero as the head of the only institution that can keep the monetary union together, taking measures to give political leaders time to do what needs to be done so that the effectiveness of monetary policy is reinforced by fiscal policy action. Angela Merkel’s support for Mr Draghi, sometimes even overruling the German central bank, shows the pragmatism that has made her the longest-serving and most successful European political leader.

   As to the German constitutional court, it is worth remembering, as the current president of the European Commission once quipped, that Germany is not the only country with a parliament, to which I would add: nor the only one with a constitutional court. If Mr Draghi’s efforts to keep the monetary union together are obstructed by beggar-thy-neighbour policies among eurozone members, the major losers would be those that have benefited most from the single currency.

   Alfred Mifsud

   Balzan, Malta

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This in answer to the following Opinion published in the FT on 30th September 2014:

Merkel has a duty to stop Draghi’s illegal fiscal meddling

Hans-Werner Sinn

   Despite the Bundesbank’s protests, the European Central Bank is giving Europe’s banks a leg-up. To make them fit enough for the proposed banking union, the ECB proposes to relieve them of some of the potentially toxic loans they have extended to the private sector, which will be bundled into asset-backed securities and taken on to the central bank’s balance sheet. The ECB’s preference is to purchase the better tranches of these securities and leave the junk for the European Investment Bank. But since politicians are not playing along, the ECB will have to hold its nose – and complete its conversion into a bailout agency.

   The ECB began as a central bank that carried out monetary policy, providing liquidity for domestic uses. But when the financial crisis hit in 2008, banks in Ireland and southern Europe faced a dearth of foreign loans, on which they had come to depend. The ECB allowed national central banks in these countries to end the drought by lending even more money against ever-weaker collateral. This exercise in money creation went beyond what was needed to ensure domestic liquidity; €1tn in central bank credit was created out of thin air to settle foreign bills. The citizens of the six countries that were indulged in this way used the money to pay off their foreign debts and to purchase foreign goods.

   The ECB went on to instruct national central banks to grant crisis-afflicted states credit totalling €223bn under the so-called Securities Markets Programme. Mario Draghi, the ECB president, moreover offered unlimited protection for their government bonds, formalising his vow to do “whatever it takes” to save the euro under the rubric of “outright monetary transactions”. This lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge.

   As comprehensive as these measures seemed, they may pale in comparison to what is now being considered. By directly granting credit to the private sector the ECB will enter a far larger arena. Mr Draghi has said that, as a first step, he intends to expand the ECB’s balance sheet by €1tn. The end of the property boom has left many private borrowers in southern Europe close to bankruptcy. The ECB’s plan to purchase their debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies. As UBS chief executive and former Bundesbank president Axel Weber has noted, the ECB is turning into a bad bank.

   The ECB says these unorthodox measures are needed to combat looming deflation. Given that prices are still rising (albeit slowly – core inflation stands at 0.9 per cent) this seems little more than a fig leaf. Anyway, deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness. This is nothing less than a fiscal bailout – something the ECB has no right to undertake, as the German constitutional court implied when it declared OMT unlawful.

   Yet politicians may again keep their mouths shut about the ECB’s transgressions. Eurozone governments might even be thankful that the ECB is doing by stealth something for which they would otherwise have to seek permission from tight-fisted parliaments. Mr Draghi would never have dared to promise to do “whatever it takes” without the backing of the government heads of the day, and especially of German chancellor Angela Merkel. Mario Monti, Italy’s former prime minister, said as much this month.

   But Germany’s constitutional court has expressly prohibited the German government from sitting back while the ECB oversteps its mandate. If politicians do nothing, any German citizen can petition the court and force them to act.

   The writer is president of the Ifo Institute for Economic Research