August 17, 2014 4:44 pm
Draghi is running out of legal ways to fix the euro
The ECB has signalled that it is safe to bet against the inflation target
In an interview with the Financial Times last week, Matteo Renzi struck a defiant tone against suggestions by the European Central Bank that Italy needs to implement more structural reform.
Still, the Italian prime minister missed a trick. He should have said that he does not take advice from a central banker who is missing his own targets. If Mario Draghi, president of the ECB, had delivered his side of the bargain – an inflation rate of 2 per cent – the situation in Italy would not have been nearly as bleak as it is now.
I, too, believe Italy needs to reform. But slow progress on that score has nothing to do with Italy’s economic performance in the last quarter. After all, Germany also declined by the same percentage, while unreformed France did better, managing to avoid a contraction.
Yet each month inflation undershoots, and the ECB is apparently taken by surprise. Because it relies on inaccurate intelligence, the ECB has committed three errors over the years.
First, the ECB should have embarked on large asset purchases and cut interest rates to zero early on in the financial crisis. It did neither. This level of support was needed even more urgently in the eurozone than in the US, because fiscal policy in Europe was much tougher. This was compounded by the decision to raise interest rates briefly in 2008 and in 2011, when the ECB governing council expected a recovery that never happened.
The second mistake was Mr Draghi’s promise to buy eurozone government debt in the secondary markets, known by the official name of outright monetary transactions. This surely helped the bond market to recover, and took the heat out of the eurozone crisis. But it was at best a partial victory because it made everybody, including the ECB itself, complacent. OMT ended all crisis resolution.
The third mistake was to misjudge the dynamics of the fall in inflation rates late last year. Core inflation, which excludes volatile items such as food and energy, has been fluctuating around 0.8 per cent since November. Yet each month at his press conferences and in speeches Mr Draghi repeats the mantra that “inflation expectations are firmly anchored” at close to 2 per cent.
He reminds me of Cato the Elder, the Roman senator, who ended all of his speeches in the Senate with the remark that Carthage needed to be destroyed. The difference is that Cato was right.
Almost a year ago I argued in this column that the ECB should buy government bonds in proportion to the member states’ share in the central bank’s capital. I no longer think this would work.
Sovereign yields are converging to zero in anticipation of deflation; they cannot fall much further. This policy would have been far more potent had it been applied at a time when inflation was still close to the target. By pussyfooting around with liquidity policies instead of acting on inflation, the ECB has signalled that it is safe to bet against the inflation target. That is what German bond yields are telling us.
The ECB should start by ditching the inflation target and replacing it with a price-level target. This would signal to investors that if inflation is too low in one year, the ECB will make up for it by overshooting in the opposite direction the next.
The ECB should starting buying equities and junk bonds. It should subsidise mortgages and consumer credit. It could fund an investment programme in transport infrastructure, energy networks and scientific research, by buying debt to fund such projects at zero interest rates. All these measures would be effective. Most would be illegal.
The one thing the central bank can do without any legal problems would be to drop the silly macroeconomic model – known as the Smets-Wouters model, after its authors – on which it has been relying for too long.
My guess is that the ECB will not do any of these things. It will continue blaming eurozone governments for not implementing structural reforms. Eventually, it will adopt a programme of asset purchases that is too small, which it will abandon prematurely at the first sign of recovery.
The result is that the eurozone will end up looking like Japan, but with one difference. Countries whose policy goes off track have nowhere to go. The member states of a monetary union have alternatives. By failing to deliver on its inflation target, the ECB could give member countries a good reason to leave the eurozone: they could have a better central bank. My advice to the ECB: do not let that happen.
Copyright The Financial Times Limited 2014.
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