ECB readies itself for extraordinary monetary measures defying Germany

European Parliament. Committee on Economic and Monetary Affairs (ECON) meeting: Hearing of Mario Draghi as ECB president here photographed with Sharon Bowles (ALDE, UK) ECON Chair (EP Audiovisual Services).

In direct antithesis with the German Federal Minister of Finance Wolfgang Schauble, Mario Draghi, the President of the European Central Bank, raised yesterday the issue of the deflation risk  (negative inflation, most prices fall) which could possibly engulf Eurozone. Draghi, after receiving the ‘Schumpeter Preis’ in a ceremony for the Schumpeter Award, at the Oesterreichische Nationalbank in Vienna, delivered a speech entitled, “Bank restructuring and the economic recovery”.

The theme of his speech was the ongoing deleveraging in the financial system. Draghi stressed that, “What we want to achieve, is a ‘good’ form of bank deleveraging, where equity is built up, where deposits rise and where balance sheet reduction takes the form of swift asset clean-up…”. Of course, ECB’s monetary policy is closely related to this deleveraging process and understandably the central bank is helping it. But let’s take one thing at a time.

Naturally, interest rates and inflation are two parameters with a pivotal role, not only in bank deleveraging but for the entire monetary policy as it is planned and applied by the ECB. In more detail, inflation is a crucial parameter determining not only real interest rates, but the state of the economy as a whole. As such, the rate of change of consumer prices constitutes a guide for all real economy agents and plays the prime role while the ECB’s decides its monetary policies.

Strong criticism from IMF and US

Currently, many international economic organisations like the International Monetary Fund have warned Eurozone’s decision makers, that deflation presents a real threat for euro area. This assessment is usually accompanied by criticism that Eurozone, and mainly Germany, apply austere economic policies, which firstly harm all the European countries and secondly the entire world economy.The US is deeply hurt as the major trade partner of the EU.

By the same token, the ECB is criticized that it applies a monetary policy mix which is not at all helpful for the real economy due to the influence of the German central bank, the Bundesbank. This is a ‘package criticism’ against Europe strongly voiced by the US and other major countries. The main argument the Americans and the IMF use is that Eurozone’s economic policies fight the not existent danger of inflation, while the contrary is true, because as they argue, deflation is the real danger for Europe.

Yes, there is a deflation risk

In this scenery, ECB’s analysis about inflation is at the moment a very crucial and closely monitored affair. On 6 March, after the regular monthly meeting of ECB’s Governing Council which left the basic interest rate unchanged at 0.25%, Draghi indirectly raised the issue of the rising foreign value of the euro. He estimated that the devaluation of currencies of major developing countries threatens Eurozone’s exports and consequently presents a risk for the euro area’s anemic growth. In this way, the rise of the euro may send Eurozone again back to recession, this time accompanied by deflation. However, Draghi has being denying for quite some time that Eurozone runs a threat of deflation, partly siding with Berlin. Not anymore.

Yesterday, Draghi changed this certainty. The difference from what he had said on 6 February is very eloquent. On that occasion, he had very decisively stated that “First of all, we have to dispense once more with the question: is there deflation? And the answer is no. There is certainly going to be subdued inflation, low inflation for an extended, protracted period of time, but no deflation”.

On Thursday in Vienna though he accepted that, “The risk of deflation, which would make deleveraging harder, is quite limited. But the longer inflation remains low, the higher the probability of such risks emerging. That is why the ECB has been preparing additional non-standard monetary policy measures to guard against such a contingency and why it stands ready to take further decisive action if needed”.

ECB could print money

This last narrative is in line with his analysis of 6 March. On 7 March the European Sting stated “In short, what Draghi said yesterday is tantamount to ECB’s being now ready “to take decisive action if required”. Seemingly, the ECB has now monitored a transmission of the developing countries foreign exchange volatilities (devaluation) to their interest rates (rising), which will affect economic activities there, with negative repercussions on Eurozone’s exports from those huge economies”.

It is obvious then, that Draghi now sees a real danger of deflation in Eurozone. He must have already undertaken painstaking efforts to convince Germany and the Bundesbank for a change in the monetary policy mix. Of course this is not an easy job. On Tuesday, Schauble stated very loudly that Eurozone doesn’t run any deflation danger, and that there is no need for the ECB to introduce extraordinary monetary measures. It’s the archaic Teutonic idealistic conviction that monetary policy cannot create growth and only hard labour in metallurgy can create wealth.

In any case, Draghi would rather not wait for the Germans to change their stance over the reality of the deflation danger. He can try to put together a majority in the Governing Council and pass the new extraordinary monetary measures, as he did with the reduction of interest rates last November. The two Germans of the Council had then voted negatively.