Monetary Policy – Germany to feel the pinch

A taste of its own medicine may prompt Germany to rethink its tough guy approach to Europe

No one like a bully but that seems to be Germany’s role in Europe.  It makes other countries walk the line in policy terms (for their own good) even amid simmering discontent among its neighbours.  Germany has been mean in terms of pushing for monetary policy to be less expansive as elsewhere in spite of struggling countries needing help.  Yet, things may change as the German economy is starting to suffer from similar problems to those it bullies.  Germany is likely to be stuck with monetary policy that is too harsh for even its own economy and this may result in it softening up its approach to others in Europe.

Help wanted

It is a given that the economy in Europe could do with a boost.  Weak demand from consumers and firms means that unemployment remains stubbornly high and inflation for Europe as a whole is not far off zero.  But Germany continues to push its policy of tough love onto Europe.  As with most other developed countries, fiscal stimulus is not an option as governments deal with high levels of public debt.  Germany has gone further in cajoling other governments in Europe to sort out their budget deficits despite the likelihood of adverse economic effects.  

Germany has also not allowed the use of monetary policy as an alternative means of stimulating the economy.  Measures such as quantitative easing have been utilised with some benefits in the US and in Britain but not in Europe even though Europe needs a boost more than anywhere else.  The reasoning behind this approach by Germany is that, by offer laggards in Europe an easy way out, the current problems which are holding them (and Europe as a whole) back will remain in place.  As a result, the European Central Bank has had to be creative and try other measures such as negative interest rates.  But it is difficult for monetary policy to have much effect when its scope is limited.

Turning the tables

Germany may have been able to bully others in Europe but it may be the Germans turn to feel the pain.  The German economy is beginning to flag amid weakening demand for its exports from places such as China.  Forecasts for economic growth in Germany are being cut as its prospects deteriorate while inflation has fallen to below 1%.  The normal response to a weakening economy anywhere else would be for looser monetary policy.  But having not allowed other European countries this option, Germany’s tough stance on others may result it also being tough on itself. 

It is funny to think that the Germans would have likely allowed itself to have more stimulus via monetary policy if there was just a German central bank looking after just the German economy.  But its own actions in influencing monetary policy will mean that Germany may have to endure monetary policy that does not reflect the weak state of its economy (along with most everyone else in Europe).  When framed in this way, Germany must rethink its ideas on economic policy for Europe if just for its own good. 

Continued stubbornness by the Germans would be unconstructive even in comparison to the often dysfunctional politics in Europe.  Deflation is another concern that will only get worse with the current policy measures.  Germany was never going to go easy on others in Europe while its economy was riding high.  It is only a Germany that has been laid low that may soften up and be more willing to help itself by helping others.

Quantitative Easing – Waiting while Europe Sinks

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.

Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.