Thursday, November 3, 2011

Few good options for Europe’s central bank

 
 

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via Wonkblog by Brad Plumer on 11/3/11

When Mario Draghi took the helm of the European Central Bank this week, he faced a lot of skepticism over whether he'd be sufficiently tough on inflation. "For Italians," sneered one German tabloid, "inflation is a way of life, like tomato sauce with spaghetti." Indeed, most euro-watchers expected Draghi to spend his early months establishing his hawk credentials. So the fact that the ECB's very first move under Draghi was, instead, to cut interest rates a quarter point (even as inflation is well above target) suggests that the bank's really, really concerned about the fact that Europe could soon enter into another recession.

Most observers don't expect the ECB's rate cut to boost Europe's economy all that much. "You've got fiscal tightening, a credit crunch, economies going into recession — a quarter percent isn't going to do much," says Desmond Lachman, a former IMF official now with the American Enterprise Institute. But it is a signal that the ECB under Draghi will be far more aggressive about trying to stave off weak growth than it was under Jean-Claude Trichet. "It shows that the ECB's now at battle stations for a recession," says another bank observer.

Yet the ECB's announcement today also highlighted the trap that Europe finds itself in. The continent's raging debt crisis is being exacerbated by slow growth. But those same debt problems — as well as many of the proposed solutions — are also making it extremely difficult for Europe to grow in the first place.

Richard Baldwin, a professor of international economics at the Graduate Institute in Geneva, explains Europe's bind. The rescue package that the European Union recently put together could, in theory, defuse the Greek debt crisis for a little while. But the package will also force Europe's banks to shrink their balance sheets in order to raise their capital ratios — further worsening Europe's credit crunch. What's more, the renewed commitment to austerity will only further hurt economic growth. That could easily spur a recession, which will make it even harder for countries to reduce their debt loads. Even if the latest rescue package holds together — and that's a big if, given the chaos in Greece — "the real danger is that we'll be back in this situation in a few months," Baldwin told me.

Meanwhile, an economic slowdown in Europe has the potential to pinch the United States hard. For one, Europe is one of our biggest trading partners — and export growth has been one of the few bright spots in the U.S. economy lately. Worse, as Lachman pointed out in his testimony to Congress on Tuesday, the U.S. financial system is hugely exposed to Europe. U.S. banks have some $1.2 trillion in exposure to the German and French economies. "We're already watching share prices get beat up on any bank even remotely connected with Europe," says Lachman. It's why many commentators are noting that Obama's biggest obstacle in his re-election campaign is likely to be Europe, not the GOP.

And, at least for now, there's only so much Draghi and the ECB can do to boost growth. Lachman notes that the really crucial task for the ECB right now is to try to prevent the debt crisis from spreading to Italy and Spain by buying up bonds. So far, though, the ECB's efforts are struggling — Italian interest rates are still far higher than the bank is aiming for — in part because Germany won't let the ECB do whatever it takes to buy up Italian bonds and contain the crisis.

"Germans correctly view that as converting the EU to a transfer union through the back door," says Lachman. "If the ECB's German representatives and the Bundesbank are reluctant to go full throttle, I don't see how the ECB can defy them." Not exactly a fun week for Draghi to start work.




 
 

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