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3 more Q&As on why ECB is no Saviour

So, where were we. At the issue of:

1) Does  lowering rates by the ECB through expansionary monetary policy provide relief to the economy by boosting credit growth?

Not necessarily and in this phase of the cycle not likely. Imagine banks did not want to lend to firms before the injection of liquidity by the ECB to firms since these were not trusted to be good borrowers (a likely event in a recession). Then banks will not increase by much their credit to the economy but will concentrate again in looking at preserving their equity through a series of deleveraging operations.

Imagine instead, an apparently positive scenario, that banks are willing to lend more and lower rates on loans to attract more credit demand. How much can this increase caused by the ECB
monetary policy last? Well, until short-term rates go down. How much down can they go? At zero level, we know that. Once they touch the zero barrier, Draghi is stuck, he has done what he could.

2)     Do economic conditions favor the ECB policy in such an environment?

No. News are arriving that are not easy to bear. The Italian bond linked to inflation is yielding more than the straight bullet fixed income bond. This signifies only one thing. That investors are growing wary that deflation (negative inflation with the general price level declining) is now expected in the future to dominate. Many attribute this to a scenario driven by a deep recession in the euro area. Fair enough, the OECD has just confirmed that. Terrible news for us and for Mr. Draghi, the ECB Governor. Why? Because his zero-rate policy will imply that real rates of interest (how much creditors expect to reimburse in purchasing power at maturity) will grow (borrowers would receive 1 euro today from the bank and will be asked to give up 1 euro tomorrow, but that euro will imply a greater and greater number of goods to be reimbursed as prices increasingly go down). If real rates go up while nominal rates stay at the zero minimum level, credit demand will dry up, it will not increase and thus the economy will suffer another restrictive blow, even, that is, with the ECB acting as a lender of last resort.

Allow just a brief note on this issue. Two quotes I downloaded from the newspapers.

Quote # 1: “this terrible recession is not incompatible with the survival of the euro, especially if such survival will come from an austerity plan engineered ” to save the euro itself. I agree with this quote when it underlines that markets are now expecting a deflation because they expect fiscal austerity. Right.
But, no, this, unfortunately, is not compatible with the survival of the euro: restrictive monetary policy (due to deflation and zero rates) and restrictive fiscal policies will make the euro collapse.

Quote # 2: “the collapse of the euro would lead inevitably in a deep recession in all countries and, with it, a deflation. It would be like 1929 or 1933.” We beg to differ: recession and deflation are  already here, and they will be the causes and not the effect, of the collapse in the euro. Unless  ….

3)      Unless what?

Unless we do as Keynes suggested many  decades ago: use the fiscal policy tool to
eliminate deflation: raise public spending!

So, let us recap: in our 2 posts on monetary policy we have argued that there are hardly any “monetary solutions” out of this crisis.  Draghi (and ECB as a lender of last resort) can’t work, and maybe it is not even necessary that he acts. What we need is a more courageous stance on fiscal policy and public spending. Increase spending! That is, if we want to save the euro.

But who will implement and how will such an action be implemented? Next post, tomorrow  opefully.


  1. Antonella Bucci

    30/11/2011 @ 10:45

    Il ragionamento sulla deflazione non fa una piega. Ma osservando la realtà quotidiana a me pare che lo scenario sia diverso. Oggi abbiamo questo: PIL fermo e previsto in diminuzione e inflazione. Nell’area euro oltre il 2%, in Italia le stime annuali sono del 3,4%. Potere d’acquisto in calo già da qualche anno e non di poco, prezzi del petrolio alle stelle con tutte le conseguenze classiche sulle bollette energetiche. Perché si parla di deflazione quindi?


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