A medical report on the Eurozone patient
One of my former macroeconomics professors used to say, “Nature has given us two eyes: one for demand, the other one for supply.” You can expand this metaphor further. Nature has given us legs - the supply side. And it has given us arms - the demand side. Even before the 2007-2008 financial crisis, the Eurozone’s legs were quite fragile. That accident broke them. And the euro crisis that followed shattered them further.
The patient is now lying motionless in his hospital bed. The Eurozone’s real GDP in 2Q14 was 2% below its 2Q08 level. In comparison, the US’s real GDP expanded by 7.4%. The Eurozone’s problems are structural. Hence, to fix the broken legs’ supply-side measures, long-term reforms are needed to boost competitiveness and reduce fiscal profligacy.
However, while the US at least hobbles along on crutches (using its arms, i.e. demand tools), the Eurozone has preferred to stay immobile, waiting for the legs to heal. It has neither used its left arm (monetary policy) nor its right arm (fiscal policy). Since the healing of the legs could take some time, the Eurozone is at risk of muscular atrophy like what Japan developed in the 1990s and from which it never recuperated.
In fact, despite interest rates already being near zero before last week’s announcement by the European Central Bank (ECB), monetary policy in the Eurozone over the last two years has been neutral at best. While the average growth rate of M3 monetary aggregate between 2000 and 2007 stood at 7.5%, it has only averaged 2.7% since 2008. Worse still, the M3 growth rate has been falling steadily since mid-2012, reflecting the decline in the ECB’s balance sheet by 1,000 billion euros. The ECB’s last announcement suggests it is now trying to reverse this trend.
But lowering interest rates alone might not necessarily do the trick. One can think of three transmission channels through which lower rates could boost the economy. First and foremost by rendering borrowing costs cheaper, second by impacting inflation expectations and finally by weakening the currency. Regarding lower interest rates, we notice the paradoxical fact that even before the ECB’s announcement, they were already at all-time lows not only for Germany and France but also for Italy and Spain, without having materially contributed to turning around credit activity in the Eurozone.
Loans to the private sector were still declining in July 2014 by 1.6% from a year ago. As long as this indicator doesn’t find its way back into positive territory, it is difficult to become positive about the Eurozone outlook, in my view.
Moreover, lower nominal interest rates alone won’t impact the economy positively unless real interest rates also come down. This means that inflation expectations have to rise or at least stay where they are. It is too early to say whether the latest ECB announcement has shifted expectations.
Finally, the euro lost another 2% against the US dollar after the announcement and is now down over 7% compared with early May. This can indeed help European exporters. But then again, as we have argued numerous times, the Eurozone already has a rather large trade surplus. Moreover, looking for rescue from abroad means that abroad should be in good shape, which is not a given.
This analysis shows that despite more goodwill from the ECB, monetary policy alone cannot do the heavy lifting. The left arm is numb. In technical terms, we could be experiencing a “Keynesian liquidity trap,” where lowering interest rates further won’t help. Usually, such an environment is conducive for using the right arm, fiscal policy, to boost the economy.
But then again, this would contradict the fiscal consolidation in Europe and could delay the healing of the legs. Patient Eurozone is in a rather difficult quandary. Moreover, there are risks of contracting a secondary infection from geopolitics. Therefore, despite the potential liquidity boost from the ECB, the decision taken last month to close our overweight in European equities was a good one.