An Abenomics for Europe
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The Eurozone needs to embark on monetary and fiscal expansion as well as institutional reform. But for both, it needs Germany to cooperate.
November has not been an easy month for the European Central Bank (ECB). It started with worrisome data on eurozone inflation (that dropped below 1 per cent, well beyond the 2 per cent target) and increasing unemployment — 12.5 per cent. Then, the European Commission and independent forecasters seemed to agree that, while the recession may be over, growth is projected to remain very weak and jobless for two years. The latest bad news is the publication on November 28 of data on bank lending to firms and households that decreased by 2.1 per cent in October, reaching an all-time low.
While the eurozone flirts with deflation and sluggish growth, the transmission mechanism of monetary policy is malfunctioning. The European economy is in a liquidity trap, with massive liquidity injections from the ECB that hardly reach the real sector. Deflation would be catastrophic, as falling prices would increase the burden of debt for governments and the private sector alike. The more deflation there is, the more agents will hoard money, the more the economy will be stuck in a liquidity trap. This may come as a surprise in an emerging economy with positive inflation, but is unfortunately familiar for the Japanese public.
Standard textbook analysis dictates that when facing deflationary threats in a liquidity trap, monetary policy has little or no traction; the burden for sustaining aggregate demand therefore falls on fiscal policy. But there is little to be expected on that front, as European countries, under pressure from the German government and European institutions (including, somewhat paradoxically, the ECB), are all engaged in austerity programmes that further depress growth.
If November was not an easy month, the next ones may be even more difficult. With the end of quantitative easing programmes in the US (the "tapering"), world financial markets are likely to enter a period of turbulence and higher interest rates, and emerging economies are also experiencing some difficulties.