As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse
It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe. The situation in European grows continues to get worse as economic growth stagnates and deflation sets in. Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high. This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place.
Politics muddies the water
Monetary policy is tough enough in one country, let along for the 18 countries which use the euro. The European Central Bank has acted boldly when given the chance. It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone. This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil. But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro.
Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks. Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement. Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion. The problem is the rules and regulations that get in the way of more efficient ways of doing business. Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.
Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show. So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is. Instead, it has been easier to blame others and wait in the hope that economic growth will return. This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.
The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others. Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain. Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy. The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.
Waiting until things get worse
The central bank has already responded to the threat of deflation through a policy of negative interest rates. Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy. This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans. Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act.
Yet, even the Germans will eventually have to see deflation as the greater threat. But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack. Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant. So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.