Governments must follow the ECB's rate cut with policy action

The Eurozone is still at risk of falling into deflation. Euro area core inflation rates, i.e. inflation rates excluding volatile energy and food prices, have been falling since late 2011. Inflation expectations two years ahead are hardly above one percent and even at a 5 year outlook, market-determined inflation forecast is at 1.44%. So clearly, the euro area is currently confronted with an inflation rate well below the target. This has consequences: The reduction of the inflation rates in the last 2 years was unexpected. As is well known, lower-than-expected inflation re-distributes wealth from debtors to creditors, and increases the burden of the debtors. Thus, the disinflation of the euro area undermines private and public debt sustainability, in particular in the periphery where the debt overhang is largest. It is therefore a real risk for the euro area as a whole. Prior to the crisis, inflation rates in the periphery had been well above 2%, while the German inflation rate had been below 2%. With the end of the bubble-driven growth in the periphery, inflation rates had to fall in order to regain competitiveness relative to the euro area core. But in this process, the ECB failed to achieve its mandate, the stabilization of euro area inflation rates at close but below 2%, and instead accepted lower inflation rates. The German inflation rate did not move above the 2% threshold even though this would have been an arithmetic necessity of the lower inflation rates of the periphery.

Many in Germany now worry that the lowering of the interest rate would lead to an increase of the German inflation rate which supposedly would devalue German savings. But in a monetary union, the value of money by definition has to be defined at the union level. German savings may be valued less in terms of euros spent in Germany but they become more valuable when spent in the periphery. As long as the area-wide inflation rate is below but close to 2%, one can therefore not speak of devaluing savings. Monetary policy decisions often have distributional consequences, the independent monetary authorities should therefore focus strictly on their mandate which, in the euro area, is defined by an inflation goal of the euro area. The ECB had to act to fulfil its mandate and restore inflation to close to 2%.

But will the ECB’s action be enough to prevent a further disinflation of the euro area? Is it sufficient to prevent deflation? The ECB’s rate reduction will mostly support the banks in the euro area periphery as funding costs for banks are already close to zero in the core of the euro area. But as long as balance sheets of the periphery are still weak, relatively little new lending will reach corporations and households. The move will therefore need to be complemented by significant restructuring of banks’ balance sheets and their restoration to health. The asset quality review of the ECB could force some of the necessary debt restructuring in the corporate sector to happen more quickly. The balance sheet of banks liberated of the debt overhang would allow new lending to new business activity. Growth would resume and deflation would be prevented.

Besides bank restructuring in the periphery in particular, the right conditions for more growth in Germany and France need to be put in place. The rate cut will hardly lower funding costs for core euro area banks and it is unlikely to trigger much additional lending. More important for growth in the core of the euro area will be deep structural reforms, better conditions for investment, less state intervention and adequate public investment. The ECB alone cannot prevent deflation in the euro area. The last rate cut helps but government’s need to step up their efforts to solve the more fundamental structural problems the euro area is confronted with. Monetary policy cannot be a substitute for bank restructuring and pro-growth structural reforms.