In an effort to counter economic weakness throughout Europe, the European Central Bank (ECB) has made a bold move. Its outgoing president, Mario Draghi announced that the bank would bring its target short-term rate further into negative territory — from -0.4% to -0.5% — and renew its quantitative easing program, providing large amounts of liquidity to financial institutions by buying 20 billion euros a month in bonds. In many ways, Draghi had little choice. Europe’s economies all have shown discouraging weakness for some time, and of late indicators even point to recession in Germany, once the region’s center of strength.
Though the ECB had little choice but to go down this policy road, it and markets will nonetheless need to deal with three major consequences: 1. Draghi’s successor, Christine Lagard, will have little choice but to continue and possibly extend these new effects. She knows that reversing such monetary ease would cause more damage than having never introduced it in the first place. 2. The surge in euro-based debt carrying negative yields will surely redouble in coming weeks and quarters. 3. This monetary stimulus, vast as it is, will fail to answer Europe’s needs. For these economies to turn around, first the U.S.-China trade dispute must end and second, most of the Eurozone nations will have to engage in wholesale economic reform, especially in the areas of labor and product policy. The former is plausible. The policy reform is highly unlikely to occur.
Draghi no doubt had no desire to bind in his successor, but his actions will do so nonetheless. Even before this recent announcement, ECB policy was providing support to markets. Because short-term interest rates, then at -0.4%, were well below the Eurozone’s 1.0% inflation rate, they certainly encouraged borrowing. Though the ECB had ceased its earlier quantitative easing program, it had made no effort to sell off its former bond purchases. Draghi, or Lagard, could have made the claim that existing policy was stimulative enough, that Europe needed policy change elsewhere than in the monetary arena. Draghi has made such claims in the past. With the recent, dramatic action, however, the ECB has built into European finance a powerful expectation of what will likely amount to a tsunami of liquidity. Were Lagard to want even to moderate such policies much less reverse them, she would run the risk of panicking markets.
The American experience might give a sense of the difficulty involved in unwinding such stimulus actions once they are set in motion. When in 2013, Fed Chairman Ben Bernanke announced his decision to slow the bond buying of its quantitative easing program and consider raising short-term interest rates from zero, market panicked. This so-called taper tantrum caused him to postpone the measures he had outlined. His successor as chair, Janet Yellen, could only step back from the extreme ease of earlier policies very gradually. She took until 2016 to complete the effort. There can be little doubt, now that Draghi has announced his plans, that his successor will face the same tender sensibilities with European markets that the Fed did here.
Meanwhile, the policy will foster the growth of negative-yield debt in Europe. There is, of course, the negative ECB target short-term interest rate. That will set the tone for all debt from overnight loans out to those with maturities of 30 years or longer. The flood of liquidity will also create a demand for bonds, as well as other financial instruments, that will push prices higher than they would otherwise go and hence drive yields still farther into negative territory. Exacerbating the trend is how ECB bond buying of mostly government and high-quality debt will intensify the already severe shortage of such securities on European markets. Because banks and other financial institutions need this same kind of debt as collateral for the borrowing and lending of daily business practice, they will have to scramble for the same bonds that the ECB is buying, forcing up the prices of these securities and driving their yields down lower. Such a bond shortage is already evident in Europe. The new quantitative program will only make it more acute.
Nor is all this monetary effort likely to jump-start Europe’s economies. It will hardly rectify the ill effects of the China-U.S. trade war. Though the European Union and its members have no direct role in the dispute, the pressure it has imposed on China has cut into sales of European, especially German exports there. According to German government data, China consumes nearly 10% of all German exports. Those China sales have dropped nearly 4% over the seven months ended this past May, the most recent period for which statistics are available. That is a rate of almost 6% a year. European sales elsewhere in Asia have no doubt also declined, since China’s economic slowdown has spread through the region. The effects of this trade situation are far from the only cause of Europe’s economic problems, but they surely have contributed, and there is nothing that ECB policy can do to offset them. Easier credit in Frankfurt and Milan cannot replace Asian sales.
Nor can ECB monetary ease overcome Europe’s dysfunctional labor and product policies. Italy and France in particular have burdensome labor laws that make it all but impossible to fire workers, even for gross incompetence. People in those economies, and to a lesser extent elsewhere in Europe, remain at jobs to which they are ill suited. If that were not wasteful enough, the inability to fire makes employers reluctant to hire even when they need workers. That behavior, too, impedes growth. In product markets, intrusive licensing laws and subsidies, as well as huge regulatory intrusions also stifle competition and leave all business less efficient than it otherwise would be. Draghi has emphasized the debilitating effects of these practices in the past and explained how they hold back growth even when monetary policy is highly supportive. Whether or not Draghi or Lagard continue to speak out against these policies, these counterproductive policies nonetheless will likely continue in place, stymieing growth and blunting, if not entirely thwarting the stimulative intent of this latest ECB monetary effort.
Despite such headwinds, this latest ECB effort will do something to lift Europe’s economic prospects. By implication, that will help the global economy, including in the United States. But it would be a mistake to believe that the recently announced ECB measures will arrive without their own adverse implications — for future policy flexibility and in European bond markets. It would also be a mistake to believe that they have the ability to overcome the effects of trade problems or the economic policies that have thwarted the effects of monetary stimulus in the past.
