The odd thing about yesterday’s European Central Bank rate cut is that just about every analyst and commentator thought it was warranted – but they also believed it wouldn’t happen, at least not yet.
Such is the success of the ECB in convincing the markets that it is an institution obsessed with chasing inflation down, from any arbitrary starting point, that nobody thought high unemployment, feeble to non-existent economic growth and near-zero inflation, would have an impact on policy.
In a week that saw the EU downgrade, again, its economic forecasts for next year, the only surprise really is that everyone is so surprised by a logical and rational response from the ECB.
Mario Draghi has just celebrated two years in charge at the ECB and is in danger of acquiring a reputation that is abhorred by most central bankers – he is becoming interesting. Within weeks of taking office, he began to reverse the reckless rate hikes imposed by his predecessor and began a series of massive liquidity injections to rescue the European banking system from a near-death experience.
That is still very much a work in progress – the next 12 months sees him embark on a series of banking stress tests that have to finish the job he started in 2011. Those liquidity injections now have to be followed up by forced capital raisings if the banks are to be properly stabilised. If the stress tests are badly handled, Mr Draghi’s promise to “do whatever it takes” to save the euro will be tested in anger: he will have to embark on quantitative easing as practiced in Britain and the US, something that will have explosive political consequences in Germany. Indeed, it is easy to argue that the state of Europe’s economy already warrants much more than just a small cut to interest rates.
If the euro zone data were the only numbers the ECB ever looked at, it would note that credit growth to households is virtually nil and is negative for non-financial businesses. Inflation is 0.7 per cent and falling quite rapidly. The zone’s budget deficit is expected to be 2.5 per cent of GDP in 2014 (which means it is in large structural surplus). Broad money growth is running at a feeble 2 per cent. We have had one quarter of marginal GDP growth following six quarters of falling output. Unemployment stands at 12.2 per cent.
Austerity fatigue
If the surprise rate cut signals that official Europe has realised that austerity fatigue is real, we may have reached a watershed.
It’s a big if, admittedly, but this could mean a very different policy regime ahead. If we look at the evidence of the last few years from Britain, the US and the euro zone, we can see the effects of two quite different policy experiments. In the US, fiscal and monetary expansion in the wake of the global financial crisis prevented a recession from turning into a depression. Mild fiscal austerity and aggressive monetary ease produced the same outcome in Britain, although the downturn was worse than in the United States.
In the euro zone, taken as a whole, aggressive fiscal austerity along with token monetary easing has led to depression, comparable to the 1930s. If policymakers wish to base their actions on the empirical evidence, I’m not sure what more needs to be said.
The temptation to compare the performance of the British economy with that of Arsenal football club is impossible to resist. One or two commentators have been quick to point out that both are now top of their respective leagues, few people thought it was remotely likely and neither has experienced much by way of a policy change. Almost out of the blue, performance has arrived when it was least expected.
But, like the ECB rate cut, it shouldn’t be all that surprising. The Bank of England has reduced the UK’s national debt by a third (that’s what quantitative easing means in practice) and London, in particular, has boomed. Owning a London flat is now the equivalent of possessing a Swiss safety deposit box that earns interest.
Britain is now the fastest growing economy in the developed world. But for the dysfunctional nature of US politics, I suspect the US would be vying for the top slot. As it is, yesterday’s news that the American economy is growing at a near 3 per cent pace puts it a very close second.
Not for the first time, Ireland can be grateful for the strong links we still maintain with the US and British economies.
