4 Sep 2014

ECB acts to prevent deflation, but is stagnation now a risk?

The European Central Bank (ECB) today cut interest rates so low that you would be hard pushed to insert the proverbial rizla paper between them and zero.

The base rate for European banks fell from 0.15 per cent to 0.05 per cent. In practice, banks are already paying the ECB 0.2 per cent to store money overnight.

Meanwhile in the UK they are getting ready to raise interest rates.

The Bank of England pegged rates here at 0.5 per cent, but by November many observers expect the rate to rise –  again by only a bit – but in the opposite direction to Europe.

So why?

First, Europe is facing the real threat of deflation. Its banking system – like ours – is heavily hobbled with bad debts. Unlike the UK it has not, so far, been able to print money to stimulate the economy.

Instead, faced with a bond market crisis in 2012, the ECB’s boss, Mario Draghi, had to pledge to buy up the bonds of failing countries – Spain, Portugal, Italy – to an unlimited amount.

That did the trick in stopping the bond crisis.

But absent any further stimulus, and with Euro economies required to get their deficits rapidly down to 3 per cent of GDP, effectively the central bank in Frankfurt was imposing low growth on Europe, which has now in turn pushed it to the brink of deflation.


And deflation is bad. Deflation does not only mean the value of everything gets smaller. It means that people become less and less able to pay off their debts – as the debts do not deflate in line with incomes and interest rates.

Though German, and other north European businesses have been able to recover well from the financial crisis, they cannot escape the fact that their main market is the rest of Europe.

So in the past quarter Germany’s economy actually shrank by 0.2 per cent; as did Italy’s, while France – and the entire Eurozone on balance – stagnated.

To escape deflation, the Euro authorities are getting ready to do a form of quantitative easing.

Mario Draghi

The first phase of it was launched today – the ECB will start buying asset backed securities and covered bonds – pieces of paper owned by banks. The money will flow into the banking system and – if it works – compensate for the poor flow of lending that is stifling both inflation and growth.

Later this year, if this doesn’t work, the ECB will have to start buying the bonds of Euro area states, in full blown Quantitative Easing (QE), despite the fact that Germany has opposed this since the crisis started, and it is technically not allowed.

Think about why: if the ECB – representing all the countries in the Euro – starts propping up individual countries, it immediately transfers risk from countries that are uncompetitive and in danger of going bust to those that aren’t.

It’s effectively a banking union by another name, and that’s why they’ve resisted it.


In Britain we have a different problem.

There’s £385bn worth of free money sloshing about in the economy, due to QE, and it has started to drive house prices to unsustainable levels.

While inflation remains below target, wage growth is minimal, so we risk the economy driven by central bank cheap credit getting out of kilter with the economy driven by wages and consumption, and another mini boom/bust cycle.

How does all this matter, beyond the fact that if you’re taking a late holiday your pound will buy more Euros, as the Euro falls in value because of low interest rates?

Well it means the Euro crisis is not solved.

And it means the fractiousness in European politics is going to get worse. As the Eurozone project goes on failing, it drags the institutions and economies of Europe into a zone of disrepute that will drive anti-EU sentiment here.

And it means, if you are a migrant struggling across the Mediterranean on a boat, the only place you are really going to find a vibrant, growing economy, is the one where they were able to control their own currency and print their own money five years ago – which begins at Dover.

Quantitative easing

But the zippy UK and the slothful Eurozone are only two sides of a bigger coin. If we are growing because we printed money, and they are stagnant because they did not, it’s strong proof there is a tendency to stagnation built into the post-crisis economy.

Economists call this secular stagnation. They differ on what causes it – either the exhaustion of new technologies, the rise of inequality, or the destruction of the economy’s ability to grow because of the prolonged crisis.

Anyway, in the text books, one of the definitions of stagnation is when interest rates hit zero.  Today the ECB has, on paper, come within 0.05 percentage points of that so-called zero bound, and in practice is beyond it.

As of today, the authorities in Europe are effectively paying banks to lending money into the real economy and punishing them when they don’t.

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