Credence Independent Advisors News: Eurozone Needs an Unconventional Approach to Its Economic Crisis

Mario Draghi, the head of ECB calls for more unconventional and growth friendly policies to end eurozone crisis.

Within the Eurozone, it has been a long-time since the living standards were at peak. For instance, the living standards were last at their peak in 1997 in Italy, 2000 in Cyprus and Portugal, 2001 in Greece, 2003 in Spain and Ireland and 2006 in France. Out of all the eurozone countries bailed out since eurozone debt crisis, Italy has been the only country to witness the worst performance and is now in the final stages of its two lost decades.

Last Friday, at his speech at the Jackson Hole symposium, Mario Draghi, the Italian in charge of the European Central Bank emphasized on the need for more growth-friendly policies. He further went on to make an unfavorable contrast between the eurozone and the US. For instance, during the great recession of 2008-2009, both the US and eurozone witnessed a rise of five percentage points in unemployment. However, unemployment has since fallen by four percentage points in the US, but is still more than four points higher for the eurozone. Furthermore, the US is witnessing an increase in the growth this year after being affected by weather in the winter season, whereas in the eurozone, the growth is at a standstill, along with growing deflationary pressures.

The most vulnerable threats to the eurozone currently are both economic and social.

The economic threat is that prolonged stagnation along with outright deflation or very low inflation puts pressure on the already stretched public finances. This is because inflation decreases the burden of debt, whereas deflation increases it. When it comes to countries like Italy, where the national debt is more than 100% of the annual national output, keeping interest rates high could eventually become unsustainable.

When it comes to social threat; high unemployment leads to social unrest in the society, such as the one seen in Ferguson, Missouri recently. Currently the inequality levels are not as high in Europe as in the US. However, they might become so over time. Therefore, stagnation in the economy, very high levels of unemployment and increased concentration of wealth are the main causes of social unrest and prevent achieving social harmony.

One of the reasons for the slower growth rate of eurozone compared to the US is that the US has a rising population whereas Europe doesn’t. Therefore, one option is to sort out Europe’s structural problems.

On the other hand, eurozone has a lot of laws, which prevent the full implementation of the single market and eventually act as a hurdle for growth. These include over-restrictive labour laws, too many protectionist tendencies and too much bureaucracy.

Austerity has been used by Germany as an important tool to force unwilling governments in Southern Europe to embrace structural reforms. Currently Germany would want to impose austerity on France. However, Draghi’s comments at Jackson Hole suggest that austerity is not helping structural reforms, instead Germany is becoming isolated. Furthermore, according to economist Vicky Pryce, austerity is turning Europe into a big debtor’s prison.

Even the ECB has now accepted that it would have been better to have followed the American approach to recover from the recession without worrying too much about how much money the Federal Reserve was printing or the size of budget deficit.

When we compare the economic recovery of the US and the eurozone, it is important to note that the eurozone is not lagging behind just because of the difference in the population size and growth, but because of tighter fiscal policy for too long, the ECB being slow and unwilling to try something different just like the Fed, Bank of England and Bank of Japan.

As seen previously, Europe won’t be taking a bolder approach; rather it will be taking small steps. Things such as state finances will be utilized for growth, such as for infrastructure building. Budget rules might be temporarily relaxed to allow countries to run deficits of more than 3% of the GDP (gross domestic product) without facing possibility of sanctions. When the Germans agree, the ECB will announce a modest quantitative easing programme; to buy bonds in exchange for money from the banks to help increase flows of credit around the eurozone economy.

We don’t know whether this will resolve the problem or not. However, this certainly won’t do any harm. For sure it is not the complete solution. The European banks are badly run and were even worse than their British and American counterparts, even years before the crisis. As a result they are slow to raise capital and repair their balance sheets.

As for QE, since it has not worked well, especially in the US or UK, where the banks are in a better shape. Therefore, an ECB QE will be less effective given the current status of the European banks.

Eric Lonergan (a London based hedge-fund manager) and Mark Blyth (economics professor at Brown University) have proposed an alternative of printing money and handing it straight to the people and cutting the middleman. To curb growing inequality, Lonergan and Blyth propose that the central banks should directly give a cheque to every household instead of pursuing policies that ramp up asset prices and make the financial system less stable. The benefit of this is that the people would spend rather than store, like the banks. As for the inflationary pressure, higher interest rates can be used to counter them.

It is important to note that Germany wouldn’t allow any such plan because Angela Merkel considers a reminiscent of the 1923 hyperinflation.

Draghi himself is aware of the need for a new different approach and is preparing more unconventional measures.

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