The European Central Bank (ECB) has unveiled new stimulus measures aimed at trying to avert a dangerous deflationary spiral in the euro area. Can it succeed?
As was widely anticipated, the ECB’s president Mario Draghi (aka ‘Super Mario’) has unveiled on Thursday 10 March a raft of new stimulus measures including:
- a cut in all three of the ECB’s key policy rates, in particular a 10 basis point (bps) reduction in the deposit rate to a historic low of -0.4%;
- an increase of the monthly asset purchase programme by 20 billion euros to 80 billion euros per month, plus an expansion of the assets being purchased to include corporate bonds;
- and a series of four targeted longer-term refinancing operations (TLTRO) to provide additional liquidity to the European banking system.
These measures are aimed at supporting European banks, whose balance sheets are still burdened by troublesome loans and whose profits are being squeezed by low or negative interest rates. They are also aimed at staving off the threat of the deflation monster (aka ‘Deflationzilla’) in the eurozone, where cheaper oil and sluggish economic growth continue to weigh on prices. In February, consumer prices in the currency union fell by 0.2% from a year earlier.
The measures announced by Mr Draghi surpassed expectations and initially sent stocks soaring and the euro tumbling, before investors realised that Super Mario had also suggested that there would probably be no further rate cuts. The euro then reversed initial losses to post its largest one-day gain versus the dollar since December. This prompted criticism from some that Draghi, who had already disappointed markets last December by failing to deliver more monetary stimulus, had once again botched his communication.
If the markets have given Mr Draghi’s package a somehow cool reception, German economists on the other hand have attacked him for going too far. There is obviously no sign of deflation in Germany, which thanks to the euro’s design flaws has been able to improve its competitive position at the expense of its neighbours for years, and where there are mounting fears that negative interest rates may be putting at risk the savings that German citizens hold dear as well as the financial institutions that collect and manage them. Deflation signs, however, are still everywhere in the eurozone’s ‘periphery’ economies, and Mr Draghi probably had no choice but to expand the flood of cheap money to try to keep the illusion of an economic recovery alive and to prevent a deflationary psychology from taking hold. He presented the new stimulus package as “comprehensive” and said that it would help spur growth in the euro area. “We have shown we are not short on ammunition”, he insisted.
Of course, what else could he say at this point?
He couldn’t say, for example, what is becoming increasingly obvious to anyone who wishes to see, namely that the ECB’s monetary stimulus is unable to significantly boost economic growth, and that it is not even really aimed at doing so.
The monetary stimulus conducted by the world’s major central banks in recent years, in the form of ultra-low interest rates and of ‘Quantitative Easing’ (QE) – i.e. the purchase by a central bank of government securities or other securities from the market using newly created money, with a view to lower long-term interest rates and increase the money supply – is seen by many as having helped to prevent the financial crisis from spiralling out of control. In particular, the unorthodox monetary policy of the U.S. Federal Reserve (Fed) after the crisis may have helped to prevent a complete collapse of the American and global financial systems. Similarly, the launch of the ECB’s asset purchase programme in early 2015 may have prevented the euro area from descending into an outward deflationary spiral so far. However, there is mounting evidence that this unprecedented monetary largesse has done little to stimulate the productive economy.
As a result of QE, the quantity of reserves in the global banking system has risen dramatically, and financial markets have been ‘reflated’ and then continuously propped up to record levels for several years. Interest rate suppression and massive liquidity injections may have contributed to ‘easing’ credit conditions and thus to re-starting credit flows across the financial system. In countries like the U.S. and the UK where a non-negligible part of household wealth is exposed to financial markets (either directly or indirectly through pension funds), they may also have contributed to increasing consumer and business confidence through a so-called ‘wealth effect’.
Overall, the massive amounts of liquidity that have been injected in the global financial system for several years seem to have succeeded in containing the deflationary forces that were threatening in the aftermath of the financial crisis, while the potentially damaging inflationary consequences of what some consider as mere ‘money printing’ have so far failed to materialise.
However, little of the new money created through QE has ‘trickled down’ to the ‘real economy’, i.e. the part of the economy that is concerned with actually producing goods and services, as opposed to the part of the economy that is concerned with buying and selling on the financial markets. On the contrary this flood of cheap new money has largely remained in the financial circuits, where it has served to fund levered speculative ‘high yield’ trades rather than productive investments. This has not only propped up financial markets – making them ever more disconnected from economic fundamentals that have failed to improve markedly – but also led to widespread risk mispricing and capital misallocation and to the creation of multiple new asset bubbles. It has left economies increasingly deformed and unbalanced, and transformed the global financial system into an increasingly fragile and volatile speculative carry trade. It has also contributed to exacerbate inequality – now reaching record levels globally – by concentrating income and wealth in the hands of holders of financial assets.
What this unprecedented global monetary stimulus has not done, however, is to trigger the kind of economic recovery that was hoped for and expected after the ‘Great Recession’, or even the low-level inflation that has come to be considered as ‘healthy’ in a modern economy. Despite massive increases in the base money supply, most major economies remain at risk of deflation, and the velocity of money – i.e. the rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time – keeps going down. In advanced economies, business investment – the largest component of private investment – remains ‘depressingly depressed’, and consumption remains sluggish. Manufacturing and industrial output are heading down, and global trade is slowing down. Deflationary forces may have been contained, but they have not been defeated, and they are still hovering around. The flood of new money may even be feeding the deflation monster by depressing bond yields and encouraging unproductive investment and reserve hoarding. As a result of this deflationary pressure, nominal interest rates on a range of debt (mostly government bonds from a number of European countries and Japan, but also some corporate bonds) have entered negative territory – something economists thought was impossible. This is actually only one of several key rules of the economics textbook that seem to no longer apply, leaving a lot of economists and policy makers increasingly baffled.
The world’s central banks’ monetary activism, in other words, may have ‘saved the day’ for the global economic and financial system in the wake of the Great Financial Crisis. Monetary ‘reflation’ through zero interest rates and QE has probably created the conditions for the global financial system to hold, inflating various classes of assets that make it possible for the credit creation mechanism to keep functioning while also effectively ‘cancelling’ large amounts of public debt. However, it has not solved any of the fundamental economic problems that led to the crisis and the Great Recession and has even reduced the pressure for governments to address them. These problems have just been palliated, and new problems have been piled up for later. As China’s runaway debt build-up – the other factor that has kept the global economy going in recent years – comes to an end and starts unravelling, the deflation monster can only keep strengthening, rendering further monetary easing inevitable.
Of course, Mario Draghi will not say any of this. Nor will he say that easy money policies, once enacted, are a trap from which it is almost impossible to escape. The Fed may have stopped its asset purchase programme in 2014, but only because the job of flooding global financial markets with liquidity was then being taken over by the Bank of Japan (BoJ) and the ECB. In addition, any funds associated with purchased bonds maturing have been reinvested, so the total stock of the Fed’s QE remains almost unchanged and its balance sheet has yet to start shrinking down. A timid rate hike was made in December 2015, which unleashed more volatility on financial markets in early 2016, but serious doubts remain over any real prospects of rate ‘normalisation’.
Mario Draghi will also not say that the ultra accommodative monetary policies conducted by the world’s major central banks are not designed, as some still want to believe, to fire up the growth engine through boosting aggregate demand. Nor will he tell what they are really designed to do, which is to provide a backstop for the world’s debt-based monetary and economic system. This system, in which most money is created as debt, imploded in 2008-2009 and is since then only being maintained on life support by the massive liquidity injections made by the world’s major central banks, as well as by the blowing of massive and compounding asset bubbles that they have generated in developed as well as emerging economies. These injections and bubbles have so far prevented a brutal deflation of the financial assets that underpin the entire global financial and economic system, but the ability of central bankers to contain this deflationary spiral is dwindling as time passes and as genuine economic growth continues to be lacking.
Mario Draghi will not say any of these things, of course, even if he perfectly knows them. He also perfectly knows why he has no choice but to do ‘whatever it takes’ to maintain this failing system on life support. He has to do it not only to prevent Europe’s dysfunctional monetary union from unravelling, but more generally to prevent the economic and political power structures that are reliant on the permanence of this debt-based monetary and economic system from collapsing.
What Mario Draghi may not really know or understand, though, is why economic growth still refuses to come back despite his’ and his peers’ best efforts at keeping the system alive. Of course he probably believes that European governments still need to do their part and to support the investments or enact the ‘reforms’ that will ‘unlock’ growth. He also probably believes that the ‘digital revolution’ will at some point finally start fulfilling its promise of higher productivity and explosive growth. It has become a defining feature of Western elites to keep believing in failed economic theories and policies no matter what amount of evidence of their failure is in plain sight.
What Mario Draghi may not really know or understand is that the capacity of an economy to ‘grow’ and create wealth depends on a production process that, contrarily to what most economists believe, cannot be analysed solely in terms of the supply of labour and capital inputs and how productively they are used. The production process is in fact a much more complex metabolic process whereby energy and matter get procured and then converted – using labour and capital inputs, among others – into a set of goods and services that can be consumed and exchanged by a population, creating various types of wastes at all stages. At local, regional or national level, the capacity to create wealth can be hampered by labour- and capital-related constraints – as well as by various types of social and cultural factors. At global level, though, this capacity to create wealth is primarily constrained by biophysical boundaries that tend to erode and alter overtime the flows and energy and matter that can be delivered to the economic process, as well as by the constantly increasing costs of some of the production process’ side effects (what economists call ‘negative externalities’) and the growing need to internalise and monetise some of them.
The world’s debt-based monetary and economic system ignores those constraints, and structurally produces more claims on wealth (money and debt) than what genuine wealth can be generated by the economy. As the gap grows ever wider between the quantity and valuation of claims created by a financial system that is based on the mass commoditisation of debt and debt-based financial instruments, and the genuine wealth created by a productive system whose capacity to expand is being eroded as a result of biophysical constraints, the world navigates from one financial crisis to another, building up in the process an ever growing debt burden that itself reduces the economy’s growth potential. This, obviously, is not an evolution that can be sustained forever. At some point something will have to give. One way or another, the world economy, or the stock of claims on wealth that we have come to account for as the world economy, will have to be ‘deflated’. One way or another, deflated it will be.
Meanwhile, Super Mario will take on Deflationzilla. You can place your bets.