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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5 reader comments

  1. John Parris says:

    For me the main problem in the Euro zone is the imbalance of competitiveness between the members which outside a single currency would be addressed by exchange rate movements. If this had happened the German currency would be some 5 – 15% higher than the Euro (IMF data)and a place like Greece considerably less than a Euro (my guess is possibly half a euro!). Thus, a German car costs imported into Greece costs a Greek less than half what it should be given the competitiveness of Greece, conversely Greek Cheese imported into Germany costs 220% of what it could be. These imbalances are chocking off southern European exports and preventing their recovery – and now it looks as though they can’t afford German exports!. As I believe this is way beyond anything QE, inflation, internal devaluation could possibly achieve the crises are set to get worse!

    1. Andrew Dundas says:

      Hello John Parris,
      What’s supposed to happen is consistent with David Ricardo’s observations about trade: each person and State focuses upon whatever economic activities they each do best. And then trades those outputs with the others.
      The value of our outputs reflect our characteristics, and that variation is usually reflected in the prices/wages we can realise from our work. In a perfect world (which doesn’t exist) we’d each accept the income outcomes that arise from our own specialities. Much the same is true with whole nation States. Rivalry doesn’t get us very far.
      For that reason, Greeks would be well-advised not to compete with Germany’s car makers, nor should Germany try to compete with Greece’s merchant fleet, its ancient buildings or its sunny holiday resorts.
      So far from choking off exports from Greece, German holidaymakers should enjoy and admire the wonderful resorts of Greece which are, arguably, often pleasanter than those of Germany.

  2. Bob says:

    May I ask a question on your blog please? Paul. What would happen if the USA (not that it would ever happen of course) printed huge volumes of dollars to pay off all their debts, then switched to an entirely new currency for the future? If an ideal world does not have countries in debt, and wasn’t there some thought on something like this but not implemented? one might think there would be chaos, war, frogs falling out of the sky etc, but would there?, or is this a blog too far….

  3. Cloud shadows says:

    Not sure about talking up the UK compared to the Eurozone Paul, freedom from the Euro merely gave them the opportunity to create another bubble, hardly call for celebration, it is not progress towards a new system its just hanging on to the outdated one.

    Meanwhile the populous seems to be suitably occupied by other things in a Huxley like distraction based dystopia to barely notice well…anything, let alone do anything.

    Journalism which promotes non mainstream views may help a little.

    Totally agree with Jon Parris and well put, been saying it for years, so obviously the heart of the Eurozone flaw, no amount of lever pulling by eurocrats to save their own skin will ultimately change that and they will therefore fail. But what will be the mechanism of failure, what will tip it out of their control. Putin will be rubbing his hands at the opportunities to tease to eurocrats and play on their fears.

  4. Andrew Dundas says:

    There is widespread agreement that the principal cause of our exceptional house price inflation is that our Council planning system prevents enough new homes being built to satisfy the growing numbers of mostly small households. QE and other financial stuff simply causes short-term fluctuations in willingness to buy, and also leads to some speculative attempts by home-owners to hold excess property as a store of value.

    If we removed local controls over housing permits, our house-builders would have to earn their profits on the basis of efficiency in design & building instead of their current expertise in circumventing those building restrictions.

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