In September the European Central Bank announced a hugely expansionary monetary policy involving rate cuts and the purchase of asset-based securities and covered bonds. It also conducted the first targeted longer-term refinancing operations, or TLTROs.
These moves go in the right direction and are in line with the ECB’s mandate. Yet their effects on the economy will prove insignificant. The private sector will continue to deleverage, wealth effects will remain weak, production will continue to fall, and the ECB will continue to drive down the euro’s exchange rate.
Acting alone, the ECB cannot solve the underlying weaknesses in the euro area. There is no fiscal or monetary stimulus capable of producing a worthwhile effect while the zone lacks ambitious structural reforms. That said, as with fiscal consolidation, the ECB needs to recognize its own role — not least because restoring inflation to the target rate would make structural reform much easier.
It is clear that the central bank is doing all it can to revive lending. As economic agents in the euro zone are still bent on deleveraging, however, this strategy is perplexing. It is important to understand that private sector debt is still at peak levels in the region and has not changed since 2008. In contrast, leverage in the U.S. has returned to its 2004 level. Euro zone households and companies must therefore continue to reduce their debts, whatever the ECB’s policy. And so even if there is decent demand from banks for ECB liquidity, it will not boost bank lending.
In this respect, the first TLTRO has not been a huge success. The program aims to encourage banks to lend more, offering them cheap loans — at a fixed annual rate of 0.15 percent for up to four years — if banks pass on low borrowing costs to their customers. Demand for the ECB’s first offering of loans, in September, was lower than market participants had been hoping for, however, and there is now speculation as to whether the ECB will consider broadening its asset purchases, to include sovereign bonds, to reach its desired balance sheet expansion.
The euro zone is not a financial market economy. Wealth effects, which work by changing expectations of spending, are very weak. This is evident by the lack of corporate investment over the past two years despite a pickup in the stock market. That in turn makes the ECB’s monetary policy ineffective: If it succeeds only in increasing banks’ liquidity, it will not change the economic equilibrium. If the ECB switches to full-blown quantitative easing, it could drive up prices of assets such as equities and real estate, but it would still be unable to count on wealth effects alone to kick-start demand. More needs to be done.
Another issue that requires addressing is the continuing deindustrialization of the euro zone. This is driven by the overvaluation of the euro, the problems of competitiveness and product sophistication in countries such as France, and the loss of industry in the peripheral countries. The euro zone no longer suffers from a liquidity shortage, but production levels are spiraling downward — as demonstrated by the fall in industrial production capacity since 2007.
October brought disillusion to the outlook for Europe’s largest economy with the news that German factory orders had fallen 5.7 percent in September. Although the weak data and falling sentiment confirmed that the German economy is losing steam, we do not expect it to fall back into recession. Given that Germany’s domestic economy is fundamentally strong, fears of a hard landing are overstated.
The ECB is dealing with a contraction in supply that is not related to bank liquidity or the level of short-term interest rates. Today’s weakness reflects underlying real-economy challenges such as flagging productivity, aging societies and a lack of federalism. A recovery can be obtained only through an improvement in profitability, regulatory reforms and other structural changes — not through monetary policy.
On a positive note, it is clear that the ECB’s easing is driving down the euro. A tightening of monetary policy in the U.S. and the U.K. means the euro is unlikely to strengthen versus the dollar and pound. This will increase the competitiveness of European exports, providing a desperately needed boost. Yet the net effect of a weaker euro on European growth will be very limited because the impact on import prices cancels out 75 percent of the positive impact on export volume.
All in all, the ECB is acting strongly, but we should not expect these measures to give rise to significant changes in economic prospects. Politically, implementing long-run fiscal consolidation or structural reforms would not be popular for euro zone governments. This means that, in all likelihood, this monumental move by the ECB will not be its last. • •
Patrick Artus is chief economist at France’s Natixis.
