The European Central Bank’s decision to cut its interest rates further showed that the zero rate rubicon holds no fear, while one substantial bullet was kept in the barrel. It is a useful marker for markets of the lengths to which the ECB is willing to go as it wrestles with the Eurozone’s mess of political and economic imperatives.
In fact, while the main refinancing rate falls from 0.15% to 0.05%, the already negative -0.1% rate on deposits held with the ECB has moved to -0.2%. Official confirmation then that the once global taboo on zero nominal interest rate can now be considered just a point in a continuum of possible rates. This is good news. It allows markets to better form expectations consistent with the economic fundamentals, once the crisis-recession panic passes.
ECB president Mario Draghi’s announcement of the interest rate moves immediately impacted the dollar value of the euro, which from the onset of the US financial crisis had increased dramatically. Traders sent the euro down below $1.30 for the first time since July last year, and if the ECB moves happen in parallel with the US Federal Reserve’s tapering of its own stimulus measures, the euro could head back to much lower, pre-crisis levels. This could imply higher input prices, with some – long awaited by many – inflationary pressures, but also more competitiveness for the Eurozone goods and services.
At the same time the ECB has shown its determination to proceed with potentially massive refinancing of the banking sector and has left open the possibility of buying up government debt, another policy traditionally viewed as taboo, as least in the main core of the Eurozone.
In the Eurozone, the unemployment rate has increased pretty steadily from less than 7.5% in 2008 to 11.5% in 2014. At the same time, public debt has increased on average from about 67% of GDP in 2008 to more than 93% of GDP in 2014. Both statistics increased by nearly 50% in this period.
This means that last weapon in Draghi’s arsenal is a useful one to have in reserve. That sharp increase in public debt levels, of 26 percentage points, represents the additional money Eurozone governments now owe to creditors, and by extrapolation, what Eurozone taxpayers will eventually have to stump up. They would love the idea of having to pay a very low interest on the debts governments have piled up in the past 6 years.
So what would have happened if a more accommodating ECB monetary policy had allowed government debts to remain constant at their 2008 levels? This would have probably meant more inflation than we have now, but also that government liabilities (debt) of the order of one quarter of GDP would not have accumulated. Taxpayers would not have had to worry about that extra burden at all. Such thoughts make it tempting to recommend some bravery now on the part of the ECB in the form of wholesale quantitative easing to buy up that government debt, maybe posing clear constraints on governments not to abuse the privilege. However, the current level of political maturity in the Euro area probably suggests a more gradual and moderate approach, which is why we get the useful but restrained ECB moves that we have seen this week.
A political economy
The ECB’s latest decisions have continuity with its previous actions and with its (more or less) openly declared strategy. In fact, after German GDP contracted by 0.2% in the second quarter – coupled with a long-term contraction in Italy which has seen GDP fall by 8% since 2008 – it became clear that something had to be done to reassure the markets. Job done there, it seems, as the consensus appears to be a welcome for the measures from market players.
It is worth remembering the context for Draghi’s decision-making before we become too focused on the economic imperatives. Europe has an increasingly important role to play, especially considering the serious social, political, and military tensions which surround it. The Ukraine-Russia tensions were mentioned as a key factor in explaining the German contraction. The turmoil in North-Africa and Middle East, with its desperate massive migration towards the other shore of the Mediterranean sea is exacerbating the tensions related to the mass youth unemployment in Italy, now above 42%.
Given the more and more crucial role that Europe has to play in the surrounding regions, the ECB’s brand of credible but restrained and reactive guidance and action could be its greatest strength. In fact, it is little short of amazing that its central bankers have been able to conciliate the different positions, interests, and preoccupations of its diverse members. The Eurozone is indeed heterogeneous, but this should, and appears to, add to its strengths. Finding an acceptable compromise between different positions is the art of navigating political and economic markets. In Mario Draghi, it seems to have a capable captain.