Policy errors in Europe

In many ways the problems of the euro-area are the opposite of those in the US. Why?

Subdued growth

The business cycle expansion is only stutteringly under way.

There has been a major setback in manufacturing over the past eighteen months, and in several regions of the euro-area unemployment is still too high.

Inadequate balance sheet repair

Private sector balance sheets in the eurozone have not deleveraged adequately - especially in the financial sector - and the balance sheet adjustment or repair process has unfortunately been made more difficult by the decisions of successive eurozone authorities to reduce government debt and deficits first.

The correct policy is to repair private sector balance sheets first, ensuring a healthy recovery of growth in the private sector, and then to repair government finances once tax revenues have returned to normal.

Low inflation

Inflation remains too low, well below the 2% target.

While this reflects chronically weak demand (spending) in the eurozone as a result of inadequate monetary growth, on the positive side it means there is no need for the European Central Bank (ECB) to tighten credit or monetary conditions.

However, under present policies there is little prospect of reaching a growth rate of domestic nominal spending that will enable employment and interest rates to return to a normal level.

Meantime the combination of the ECB’s negative interest rate policy and sluggish growth should continue to damage the long-term savings industry - savings deposits, life insurance contracts and pension funds - across the continent.

Policy errors

Most of these phenomena are the result of the ECB and the euro-area central banks mistakenly relying on interest rates as their measure of the stance of monetary policy.

Almost one hundred years ago the American economist Irving Fisher showed that interest rates follow inflation; they do not lead inflation.

Inflation, in turn, is driven by monetary growth.

Yet the ECB acts as if interest rates are the driver; this explains why it has pushed rates down into negative territory in the belief that if rates fall low enough, at some stage banks will start to lend and spending will return to normal.

But banks in the euro-area remain risk-averse, lending is still anaemic, and the regulators are requiring banks to raise more capital (which will further slow lending and money growth).

Sadly, in starting their analysis with interest rates the ECB policymakers are looking through the wrong end of the telescope.