Europe’s sinister fairytale: it may sound like something from the Brothers Grimm

When all the little economists are being tucked into their beds at night, to ward off bad dreams, their elders tell them a fairytale. When economies experience downturns, so the tale goes, governments have two magic spells to make the bad downturn go away.

The first spell is fiscal policy, using taxes and borrowed money to buy more stuff, build more stuff and encourage the economy into motion again.

The second spell is monetary policy, increasing credit being pumped into the system by reducing the interest rate, or buying up dodgy stuff to increase asset valuations, shove liquidity into the system, and improve banks’ balance sheets.

Many of the governments of the eurozone can’t use the first spell any more. They either have too much debt to spend massively, or are constrained by Europe’s fiscal rules.

The second spell looks very much like it has run out of magic as well. A big question which 2016 will answer for us is what the true limits of the powers of a central bank are.

While not dire, the situation is not good for the eurozone. Things are stagnating.

Growth in the eurozone’s service sector has hit a 13-month low. Unemployment in the eurozone is 10.3 per cent. Deflation is a problem across most of the eurozone, with consumer prices falling by 0.2 per cent and industrial producer prices down by 1 per cent. The future looks even worse: the rate of inflation expected for a period of five years, five years in the future, is just 1.4 per cent. The target the ECB must try to hit by law is 2 per cent.

This is the eurozone that implemented quantitative easing more than a year ago, and now we can see long-term interest rates, yield-spreads on sovereign bonds, and the euro exchange rate are all higher than they were last year. Not good.

Low or near-zero interest rates have lots of benefits for households who borrow, and households and businesses in debt find repayments easier. Very low interest rates help reduce unemployment and almost certainly help increase wages at the lower end of the income distribution.

Negative rates, however, penalise savers of all kinds. Why would you give a bank €1,000 and get back €998, and think you’d done well? Surely we’ll see a huge increase in investments of all kinds as a result?

A paradox

We haven’t seen any marked increase, which is a paradox. Faced with more liquid cash than has ever existed in the history of humanity, households, firms and banks have chosen to leave this cash sitting there. Savings rates are much higher than they need be, while investment, particularly large-scale infrastructural investment, is miniscule.

Now should be the moment for redeveloping airports, building new train systems and changing the way our energy is produced and delivered. But we’re seeing none of this activity at the scale that the savings rates across the eurozone would warrant.

One nice thing about time is that it reveals all. The critics of quantitative easing worried it would lead to spikes in inflation, and to say the least, this has not happened.

When it briefly looked like the quantitative easing tap might switch off, the more or less instant appreciation of the euro, combined with wobbles in stock markets everywhere, had Europe’s central bankers out onto the airwaves faster than a pop star flogging a top 20 single to reassure everyone that they had it all in hand and, no, the buying of stuff would not stop any time soon.

A possible answer to the paradox I have described is the banking system, or more accurately, the financial intermediation system, which is much, much more complex than the banking network. Financial intermediaries find it very hard to make money when interest rates are near zero or negative. In fact, as the ECB’s Benoit Coeuré observed recently while out calming everyone down, since the crisis started, eurozone banks’ average return on equity has been below their cost of equity.

So what can we expect from the ECB this week? We can be sure the asset-buying programmes will continue unabated, perhaps even expanded to include many more asset types. We might well see the ECB hoovering up not just corporate bonds, but any old crap on banks’ balance sheets, just to get them lending more.

We can also be sure that if the ECB decided on this course of action, Ireland would be a big beneficiary, because our banks and the shadow banks we house in the IFSC have more crap on their balance sheets than a week-long dirty protest.

Deflationary bias

Of course, the ECB isn’t thinking about little Ireland in any of this. Its remit is the eurozone. It is now clear that the euro, as a currency, has an in-built deflationary bias, which is harming countries like Portugal, but also stronger countries like Finland and the Netherlands. Some very influential people have started calling for an exit mechanism to be built into the single currency, including Mervyn King, former governor of the Bank of England. We’re a long way from that in practical terms, but it does seem like we are at or near the extreme of monetary policy usefulness.

The magic within fiscal policy and monetary policy clearly have their limits. Japan is the most obvious case, but the eurozone is not that far behind. Fiscal policy still has quite some way to go. Is it perhaps time to see what the eurozone’s fiscal space looks like?