• The eurozone is treading water in high seas

    Ben D. Kritz

    Ben D. Kritz

    On Thursday, the European Central Bank is expected to announce the start of a quantitative easing (QE) program to help jump-start the continent’s flagging economy.

    A very good brief analysis from Agence France-Presse of the anticipated ECB move appeared yesterday in The Manila Times (“Quantitative easing, deflation explained”), and makes one disturbing point very clear:

    The European authorities have no real idea how to pull Europe’s chestnuts out of the fire created by the unwieldy experiment its single currency has turned out to be.
    What Europe is experiencing is a situation similar to the US three or four years ago; keeping interest rates near zero percent has failed to substantially expand credit. If lending is not increasing that means overall demand is not increasing, and that, in turn, leads to falling prices and a deflationary cycle. The eurozone has been gradually moving in that direction for some time and in December finally crossed over into negative territory – consumer prices dropped 0.2 percent year-on-year, the first time in five years or since the height of the global financial crisis that the eurozone has recorded deflation.

    However, European monetary authorities and analysts alike have pointed out, correctly, that one month does not a trend make, and they also point to an improving consumer confidence index in Europe as an additional indicator that “there is no sign of deflation in the region just yet.” So why is the ECB taking the next logical step – implementing a more direct way to increase money supply – if it doesn’t need to?

    The most obvious answer is that, despite public reassurances to the contrary, the ECB in fact feels it does need to act aggressively against deflation, and for good reasons. Once deflation starts, it is difficult to control; spending paradoxically drops when prices become deflated, as consumers hold off on purchases in anticipation of even lower prices in the future. The consumer confidence index cited as an indicator that deflation is not yet a problem might actually reflect this cycle: Since its most recent ‘peak’ at -7.1 in May of last year (The last time the index was actually positive was in March 2001, so do not attach too much importance to the negative number), the consumer confidence index dropped steadily to -11.4 by the end of the third quarter, and has spent the past four months floundering at that level.

    To the extent it has been used so far QE has apparently worked, but what should worry the ECB is the very real possibility that their decision to move forward has come too late. The US QE program was, in effect, for much longer than anyone thought it would be before it began to bear fruit, and it did not have to contend with the oil price rout. As we have seen here with the Philippines’ rapidly-slowing inflation, the drop in oil prices is a strong deflationary factor.

    The impact of a eurozone QE program is also likely to be diminished by compromises that need to be made; unlike the US, the eurozone is not an economic monolith. Germany has been dead-set against a eurozone-wide QE program because it would relieve risks on individual national banks and spread it out among all the members of the currency union, something the austerity-minded Germans deem unfair.

    Proceeding over opposition from Europe’s largest individual economy would ruin the credibility of the ECB so it really has no choice but to accommodate German concerns, but doing so may water down the program with conditions that reduce its effectiveness. As a consequence of all this, there is a very real possibility that the ECB will find itself creating a large amount of money (the consensus estimate for the size of the QE program is 500 billion euros) to little effect, creating asset and debt bubbles that are going to create new problems in the future.

    For the Philippines, the eurozone QE is a mixed blessing; the equity and securities markets will benefit from it, although probably not to the extent they did from the US QE program, but it will also put additional pressure on the peso. With both the ECB and the Bank of Japan preparing QE programs that will, in effect, devalue their respective currencies, the US dollar will gain; that in turn will push the peso lower.



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