Why The ECB Might Be Confusing The Symptoms With The Illness

The ECB is widely expected to cut key lending rates today. The most compelling argument for the central bank and many investors stems from the persistence of low inflation and the threat of deflation.

This seems intuitively obvious. Persistent low inflation may encourage consumers to defer purchases. Falling prices are disincentives for business investment. Arguably, even more undesirable, low inflation and/or deflation makes debt servicing (and de-leveraging) more difficult.

The effort to combat low inflation and the risk of deflation is understandable. It makes perfect sense. However, what is more problematic is that the ECB may be confusing the symptom with the illness. What is the cause of the low inflation in the euro area?

Is it that interest rates are too high? Probably not. The refi rate is at 25 bp, and the ECB provides as much liquidity as its banks want and have the collateral to back. Germany can borrow up to 3 years at less than the refi rate. Spanish and Italian bond yields are near record lows. Spain's 5-Year bond yield is below the U.S. 5-Year rate (which makes one wonder about the still occasional references to de Gaulle's claim of an exorbitant privilege of the US).

Part of the low inflation in the euro area is, in fact, desirable. Peripheral European countries have essentially two ways to boost their competitiveness. The first way, which was advocated and expected by many of the bright lights in the field, was for the peripheral countries like Greece to drop out of the monetary union and devalue.

The alternative is what we had anticipated. Stay in the euro area and accept an internal devaluation, which means accepting a decline in the general domestic price level. This includes wages. The key here is that to restore competitiveness peripheral countries do not need outright deflation. Instead, they need to have inflation sustained below German levels. Because Germany has very low inflation (less than 1% year-over-year in May), it forces the periphery, if it is going to boost competitiveness, to have even lower inflation.

This shifts the focus from the cause of low inflation in the euro area to the cause of low inflation in Germany. There is an answer, and it is not that nominal or real rates are too high in Germany. It is the lack of aggregate demand. Private consumption has averaged 0.25% per quarter in 2013 and 0.1% in 2012. German interest rates, of course, are the lowest in the euro area.

The G7 and the G20 have called for a reduction of global imbalances. The US and China might not be "obeying" such calls, but the US trade deficit has fallen and the Chinese trade surplus has been reduced. The one notable imbalance that has not been reduced is Europe's and that is driven by Germany. It is true that the demand compression, and the internal devaluation, has helped reduce the deficits in the periphery and this only compounds the imbalance.

Few economists appear to be linking the large external surplus to the strength of the euro and to the low inflation. If the linkage is correct, it means the ECB is barking up the wrong tree if it thinks that its challenges can be addressed with a 10-15 bp rate cut. This in turn implies that what ails the euro area may not be adequately addressed by monetary policy. It is fiscal policy and pro-growth structural reforms that are required. This will sound sacrilegious to the ordo-liberals at the ECB and the Bundesbank (and our monetarist friends), but it helps explain a priori that the rate cuts that will likely be delivered on June 5 are unlikely to cure the patient's illness.