Advice for the European Central Bank: Reduce Interest Rates
On December 8, at its next governing council meeting, the European Central Bank (ECB) should reduce its interest rates by one percentage point to 25 basis points. Anything less would amount to dereliction of the ECB's duty to the euro area economy.
The euro area faces the deepest economic and financial crisis since the exchange rate mechanism nearly collapsed in 1993. The future of more than six decades of European economic integration hangs in the balance. The ECB is the one European institution that can credibly act to head off a downward economic and financial spiral in Europe that threatens to plunge the global economy and financial system into a second stage of crisis and recession.
Much of the debate about ECB policy within Europe and in the rest of the world focuses on what the ECB calls its non-standard measures of enhanced credit support to the euro area financial system and its economy. On Wednesday (November 30) the ECB joined with the Federal Reserve and other central banks to make it easier for banks to borrow and lend, a welcome step that nonetheless did not address the deeper threats to the European economic outlook. Missing from the debate is the fact that the ECB has at least 100 basis points of standard, or interest rate, measures to support the euro area. Given the euro area's multi-year trajectory toward massive fiscal contraction, the case is overwhelming for employing its interest rate tool on December 8, which also happens to be the day before the next European summit meeting. The Federal Reserve's announcement on November 30 of a 50-basis-point reduction in the cost of borrowing dollar funds from the ECB strengthens the case for a 100-basis-point reduction in the cost of borrowing euro funds from the ECB. Why should the rest of the world provide assistance to the euro area if the Europeans and the ECB are unwilling to do substantially more to help themselves?
On November 3, commenting on the euro area growth outlook following the marginal 25-basis-point downward adjustment of the interest rate on its main refinancing operations, the ECB president, Mario Draghi, said: “What we are observing now is slow growth headed for a mild recession by the end of the year.” This was a remarkably frank acknowledgment of reality by a central banker. Central bankers generally do not admit to the risk of recession until one is fully upon them. Over the ensuing month, the preponderance of evidence about the outlook for the European economy has been negative. Nothing in the outlook for Europe or the global economy gives reason to believe the euro area recession will be mild.
Between March and September, the midpoint of the ECB staff forecast of 2012 real growth in the euro area declined by 0.6 percentage points to 1.3 percent. There is little doubt that the December ECB staff forecast, with its customary band of about 1.5 percentage points, will have a large component below zero. Between August and November, Consensus Economics Forecasts, which are an average and necessarily have a lot of inertia, have marked down 2012 euro area growth by 1.1 percentage point to 0.4 percent. Among individual private forecasters, the Citigroup forecast for euro area growth in 2012 has declined by 1.6 percentage points to minus 0.7 in its latest (November 25) forecasts. The Organization for Economic Cooperation and Development (OECD) projects euro area growth in 2012 at 0.2 but on the optimistic assumption that policymakers will take sufficient action to avoid disorderly sovereign defaults, a sharp credit contraction, systemic bank failures, and excessive fiscal tightening. Forecasters often are wrong, but their errors are that they tend to miss turning points and to underestimate recessions.
A resumption of euro area growth is essential if Europe is going to solve its sovereign debt problems. The solution will be greatly aided if the denominators of debt-GDP ratios grow faster than the interest rate on the numerators Lower ECB interest rates improve both the numerator, by reducing interest costs, and the denominator, by supporting nominal growth.
The risk of inflation in the euro area is negligible, contrary to the concerns of some in Europe and especially Germany. All indicators point to inflation in the euro area of less than its objective of below but close to 2 percent over the medium term. Commodity prices in euros have declined by more than 5 percent over the past 12 months. Growth rates of the broader euro monetary aggregates, M2 and M3, are at their lowest since the advent of the Euro in 1999.
Normally, the euro area might count on the rest of the world to pull it out of recession. But we are seeing the reverse. The European sovereign debt crisis has infected the global economy and ricocheted back onto Europe. Euro area export orders in September were down more than six percent, and more current indicators for the global economy point to a further contraction over the following months.
Some policymakers in the rest of the world may complain that aggressive monetary easing by the ECB would further depress the euro. That would be a small price for the rest of the world to pay if the alternative is a deep European depression and the financial chaos that would be triggered by a break-up of the euro. However, the euro could strengthen. The recent weakness of the euro has occurred in the context of rising interest rates on euro-denominated assets and appears to be associated with the inability of euro area policymakers to get their acts together, including policymakers at the ECB.
A strong case can be made for a dramatic expansion of the ECB's non-standard toolkit to address the European crisis. Innocent bystanders in the rest of the world hope that this will be a major component of the next comprehensive plan to address the European debt crisis that is expected from the next European summit on December 9. Whatever the outcome in Brussels, it would be inexcusable if the ECB did not act aggressively and proactively the day before to lower its interest rates by 100 basis points.