The Euro Area is Already in Crisis

The euro area is already in crisis; European policymakers are just reluctant to admit that fact or to act accordingly.  That is the punchline I want to deliver.  It is a hard line to sell.  We tend to think of moments of ‘crisis’ as moments when the signs of distress are all around us.  It is a towering inferno, a crashing airliner, a listing ferry, or a hostage situation.  It is hard to see evidence of any such disaster scenario unfolding in Europe at the moment.  Neither the Greek parliamentary elections nor the Italian presidential elections would qualify; we are not in 2012 anymore, or even 2013 for that matter.  This time is different.

Nevertheless, the euro area is in a crisis right now.  To understand why (or, maybe better, what that means) it is necessary to think like a policymaker.  The goal is not to do well once disaster strikes; the goal is to avoid the onset of disaster altogether.  Hence on any given day, policymakers are working hard to design, implement, and fine-tune the rules and instruments that keep skyscrapers from catching fire (or to make sure the fires are quickly contained), to make sure that planes are well maintained, to keep ferry captains from steering too close to the rocks, and to prevent countless plots from evolving into tragedies like we have seen unfold in Paris most recently.  In other words, policymakers work hard to ensure we lead normal, disaster-free lives.  That is what good governance is all about.

The grey area is when the situation departs from normal and starts heading for disaster.  This is a situation where something bad has not yet happened but it will unless policymakers intervene to stop it.  This area is grey insofar as the normal fine-tuning in policymaking could take care of many of these circumstances.  The contrasts become sharper, however, when time for effective intervention begins to run out and the underlying dynamics risk slipping beyond the control of policymakers.  This is the moment of ‘crisis’.  According to the Compact Edition of the Oxford English Dictionary, it is: ‘a vitally important or decisive stage in the process of anything; a turning point; also a state of affairs in which a decisive change for better or worse is imminent; now applied especially in times of difficulty, insecurity, and suspense in politics or commerce.’

The point to note here is that the crisis takes place before the disaster and not after.  This distinction is important because it forces us to look at the European situation from a different perspective.  Too many people are asking whether the euro area is in deflation.  That is not the right question.  If the answer is ‘yes’ then the crisis has passed and we have already entered into the disaster area.  Hence the question is whether the euro area is headed toward deflation; more precisely, the question is whether the euro area has moved so far in the direction of a deflationary environment that the opportunities for decisive policy intervention are running out.

This is the debate that is unfolding in the governing council of the European Central Bank (ECB) at the moment.  You can see all sides of the debate on display in the three most recent ‘press contributions’ published on the ECB website.  [Ignore for the moment ECB President Mario Draghi’s opinion piece for Project Syndicate.  That is interesting for his views on economic governance but does not touch as directly on the crisis debate.]

The interview that Draghi gives to Handelsblatt on 2 January sets out one extreme in the argument.  The basic line he takes is that the euro area is not in deflation at the moment, but there are signs that it is headed in that direction and ‘we need to tackle this risk’.  This is about as far as he can go in promising action beyond the usual litany that the governing council is unanimous that something should be done if the unusually low price inflation looks like it is dragging on too long.  Draghi also makes it clear that he thinks the risk of outright ‘deflation’ in terms of medium term price expectations in the euro area is small.

What he does not explain is whether the risk is small because he believes policy action is imminent or because he believes that the euro area will avoid deflation whether or not the ECB chooses to act.  What he does say is that ‘the risks of not fulfilling our mandate of price stability are in any case higher than they were six months ago.’  This suggests that he has built some policy action into his risk estimate.  Later on in the interview he goes on to say that he remains ‘prudently optimistic’ that ‘the combination of an expansionary monetary policy with government reforms will bring back much of the confidence lost.’

The interview given by Sabine Lautenschläger to Der Spiegel and published on 10 January sets out the other side of the argument.  She admits that euro area inflation has been low ‘for quite some time now, and forecasts for the next few months predict little change.’  However, she is clear in asserting that ‘you can’t speak of deflation at the moment.’  The slowdown in price inflation is due to the fall in energy and food prices.  Moreover she see little evidence that consumers are ‘expecting steadily falling prices and thus changing their spending patterns.’  Hence she suggests that the ECB should follow a wait-and-see approach ‘until the measures that we have put into place only recently can fully take effect.’  Moreover, she remains ‘unconvinced’ that the ECB should expand its policy of accommodation to include outright purchases of sovereign debt.

The interview by Benoît Cœuré with France 24 falls somewhere in between Draghi and Lautenschläger.  Cœuré concedes that prices are falling but goes on to explain that deflation means much more than that and includes changes in patterns of consumption or investment to show that market actors were building falling prices into their behaviour over the longer term.  He then goes on to reveal the underlying complexity in deploying any unconventional monetary policy instruments — including quantitative easing — and to explain that there are good reasons for the governing council to be having a conversation about how to do more to stimulate European economic performance and equally good reasons to avoid any efforts to prejudice that conversation in one direction or another.  ‘Nothing is simple,’ he explains, ‘. . . and for that reason it is important to take the time for reflection.’

This sounds like an imminently reasonable debate — particularly when couched in other pressing considerations like the impact of low interest rates on German savers (raised in both the Draghi and Lautenschläger interviews), the importance of market structural reforms (raised in all three interviews), and upcoming elections in Greece (raised with Cœuré).  This seems less like a crisis than a tough day at the office.

Unfortunately, one of the lessons we learn from books like George Orwell’s Coming Up for Air or Christopher Clark’s The Sleepwalkers is that moments of crisis may only seem dramatic after the moment has passed and the disaster is upon us.  There is plenty of evidence that market actors have begun changing their behaviour in the markets to take into account an extended run of falling prices.  According to Eurostat data the quarter-on-quarter growth of gross fixed capital formation was negative in the euro area for the second and third quarters of 2014 after a brief reprise in 2013 and early 2014.  Moreover, the Financial Times reported on 8 January that since June 2013 more than €1.2 trillion is being parked in ‘safe haven’ assets — meaning mostly sovereign debt instruments — that are offering a negative real rates of return.  Such assets only preserve capital if you expect prices to fall.

Finally, the Financial Times noted on 9 January that market participants shifted more than €14 billion into the same pool of safe haven assets since the start off the year to avoid the volatility likely to arise around the Greek elections.  This is an interesting choice because if there is a bubble in European asset markets, it is surely in sovereign debt where yields are not only at historic lows for Germany but also for countries like Italy and Spain.  The implication is that investors think those prices are going to be more stable than the alternatives.

That confidence will last only so long as the ECB remains active — at least potentially — as a buyer of last resort.  If the governing council decides not to engage in quantitative easing, it seems reasonable to assume that investors who have parked their money in negative yielding peripheral country sovereign debt will look to safeguard their capital elsewhere.  The impact of such a portfolio reallocation is hard to assess.  What is easy to guess is that it won’t make the problem of low interest rates in Germany any simpler to manage and it won’t make the provision of lending to the private sector on the euro area periphery any more generous.

The result may not be deflation as defined by Lautenschläger or Cœuré, but it will be a near cousin and won’t make for good public policy.  The euro area is already in crisis in the sense that only some action by the ECB can avoid negative consequences in terms of market expectations and market behaviour.  These are the same metrics that all voices in the debate I outlined above agree are important.  Let’s hope that the governing council accepts the need for some kind of timely intervention before this moment of crisis evolves into something more problematic.

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