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How to deal… when there’s no deal (?)

May 8, 2014

OK, we got it.

There was that much that the Greek government could do vis-a-vis its EU partners at the midst of the euro area financial crisis. But have things remained at a constant state of shock and dubious inactivity as had been the case in the initial post-2008 crisis period? Quite obviously, not!

The euro area is verging on disinflation and the ECB (via its rather pro-active, for a central banker, president Mario Draghi) shows clear signs of intent toward meaningful counter action. The love (sorry, policy) that dared not speak its name in the stringent infant EU central bank’s corridors, namely QE, is actually being spelled out all too often, as of late. True, bond buying from a central bank overseeing a large number of divergent national economies in the absence of both a meaningful banking union and, most importantly, fiscal harmonisation is no less than a tricky business, should it be its business at all… Still, one begs to ask the obvious question: what is the alternative?

Unfortunately, there appears to be none! After all, when the going gets tough, the tough get going… Or not?
Let’s review some basic facts.

Euro area inflation has been below 1 percent since October 2013 and medium term inflation expectations are well below 2 percent. Forecasts of the return to target inflation have been proven wrong. The ECB was forced to downward revise its inflation expectations twice this year alone. Surveys of economic activity (out this week) show tertiary sector contributing more to the region’s health at the same time that German factory orders fell unexpectedly in March.

So, what should the European Central Bank do?

It should act tough. In our case, that translates into acting forcefully. In other words, while bearing in mind not to mess with either the admittedly major relative price adjustments that are needed between the core and the periphery EU economies or the ongoing process of evaluating and addressing the weaknesses in Europe’s banking system (all of it!), it should embark on a meaningful (ie, substantial) programme of Quantitative Easing.

Reducing the deposit rate or introducing another long term refinancing operation could be beneficial but at this point would be most unlikely to change substantially inflation expectations. And although bond purchases distort incentives and make the ECB subject to private and public sector pressure, with potential consequences for inflation, such risks need to be weighed against the risk of persistently low inflation. The tough ought to take that risk. The alternative could well be a downward “economic psychology” spiral into disinflation. The Japanese know the sort…

It is of course tricky to manage government bond purchases in a monetary union with 18 different treasuries. To overcome the economic and political, let alone legal, mess that such purchases could entail, the ECB should opt for a month-by-month asset purchase programme of EFSF/ESM/EU/EIB bonds, corporate bonds and asset backed securities as well as sound commercial bank notes, following completion of ECB’s assessment of bank balance sheets (expected to be concluded by October 2014).

And that takes us back to the Greeks entering a meaningful deal with their EU partners when there appears to be none to be made. Were Europe to opt for a pro-active ECB involvement as the solution to its present economic predicaments then the road is open for the Greek government to negotiate a truly viable exit from its own prolonged crisis. But more of how that might actually come about at a later post… After all, it is election time in the sunny member-state!


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