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Friday, May 25, 2012

The Need for More Monetary Expansion in the Eurozone

In the previous posts, we’ve talked about the costs and benefits of a Greek exit. This post will argue that if the eurozone is to continue, more aggressive policies by the the European Central Bank (ECB) are desperately needed.

Germanys Recession and Recovery in the Early 2000s 

Even if Greece exits the euro and the ensuing financial contagion is limited, the euro area still faces a lot of tricky problems. For the eurozone to survive, the ECB needs to stop its obsession with inflation and focus more on growth. Monetary expansion is needed to counteract the contractionary impact of fiscal austerity, though Germany seems unwilling to accept this fact.

As Paul Krugman argues, when Germany was in a recession in the early 2000s, its recovery was aided by a current account surplus against the peripheral countries that are in deep financial trouble now. In the early 2000s, Greece, Ireland and Spain enjoyed strong economic growth. The low interest rates set by the ECB were optimal for Germany but too low for these 3 countries.

On one hand, the low interest rates helped Germany recover. On the other hand, the low interest rates led to high inflation and even higher growth (to the point of overheating) in the PIIGS. In economic boom, the PIIGS bought more exports from Germany, adding an extra boost to Germany’s recovery. 

Expansionary Policies to Pull the PIIGS out of Recession 

Now the monetary policy is again optimal for Germany, but not expansionary enough for the PIIGS countries. Last time the PIIGS helped Germany return to growth, and now is the time for the reverse to happen. 

Under monetary expansion, Germany and the Netherlands will experience relatively high inflation. While this may be unpleasant internally, wages and prices in the South will be cheaper in relative terms as a result. This is exactly what Europe needs to solve its key problem – the large productivity gap between Germany and the troubled economies in the South. With cheaper, more attractive exports, the PIIGS can sell more to Germany and the rest of the world, getting out of recession.

Though deflation and wage cuts in the South can narrow the gap too, deflation is contractionary while wages are sticky in the short run. Hence, it’s much better to have inflation in the North instead of deflation in the South.

Indeed, the ECB should help narrow the productivity gap with more aggressive policies. Easing measures can restore cost competitiveness of the PIIGS, which is the first step to less unemployment and economic recovery. In turn, recovery will help governments control the public debt and achieve balanced budgets.

Liquidity Injection to Support Banks

Signs show that the ECB is moving in the right direction. The long-term refinancing operations (LTRO) in December and February injected liquidity in the markets by offering banks unlimited short-term loans at interest rates as low as 1%. Many commentators think of the LTRO as the European version of quantitative easing.

In addition to boosting the economy, injecting liquidity is also a measure to strengthen the firewall and prevent contagion. The ECB can inject liquidity by, for example, guaranteeing to buy unlimited amounts of sovereign bonds in the event of a Greek exit.

In this way, the ECB can ensure that banks won’t collapse because of sour sovereign debt. This is important because credit freezes if banks fail, which will result in a further economic slump in Europe and probably the rest of the world.

The real question is who should take the responsibility to bail out troubled banks, and the answer is the ECB is in a better position to do so than the euro countries. Government bailouts will add to the public debt and risk increasing borrowing costs for the state. Obviously, this isn’t helpful and will only aggravate the sovereign debt crisis.

(Entry 3 of 4 in the Update on the Euro Debt Crisis series) 

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