The ECB has no solutions

Market reactions to the decision by the European Central Bank to reduce interest rates and introduce additional unconventional monetary measures can be broadly divided into two: those who welcomed the moves and those who welcomed them but said they were insufficient. Both sides misconstrue the nature of the eurozone’s economic problems and so cannot offer any viable solutions.

Indeed despite the disagreements over the scope of the ECB’s measures both sides share much in common. They make the common mistake of assuming that the crisis is largely one of insufficient liquidity and falling prices. From this flawed premise they conclude incorrectly that central banks can play a key role in reversing the process.

 For the sensible people who do not follow the shenanigans of central banks obsessively the ECB took two sets of measures. First, it reduced the interest rates it sets to historical lows including moving one key rate into negative territory. In effect commercial banks will have to pay for the privilege of depositing cash with the central bank. Second, it announced a raft of unconventional measures to bolster liquidity although it stopped short of talking about quantitative easing.

It should be clear by now that, despite all the talk of recovery, the developed economies are facing at least one lost decade in economic terms. Symptoms of the crisis were already becoming apparent in 2007 with house prices falling in America and the run on Northern Rock bank in Britain. Although the eurozone had already suffered as part of the global crisis it was readily apparent by 2010 that it was, in addition, facing its own particular challenges.

Looking forward it seems clear that it will take at least several years before anything resembling normality reemerges. For one thing western central banks are still pumping huge amounts of liquidity into their economies to keep them ticking over. The main thing that differentiates the ECB is that it is reluctant to acknowledge that its measures are a form of QE.

The fundamental problem western economies face is not deflation – that is merely a symptom of a sluggish economy – but economic stagnation. Economic restructuring is necessary if there is to be a new round of dynamic growth. Yet, as a recent study by the European Commission showed, corporate investment within the European Union is still well down on its 2008 level.

Extending easy credit, essentially what central banks are doing, can only act as a short-term palliative. It the long term it only makes matters worse.

In addition, the eurozone still retains its structural flaws. Binding fundamentally different economies into a currency union tends to create imbalances. The credit bubble that emerged in the peripheral eurozone countries in the run-up to 2010 had its origins in this arrangement.

Central bankers cannot resolve either the underlying economic challenges facing western economies or the particular structural weaknesses of the eurozone. These are matters which politicians need to play a leading role in solving. Unfortunately they would rather shirk their responsibilities and hide behind central bankers.

This blog post was first published today on Fundweb.