Mario Draghi, president of the European Central Bank, gave a clear indication last week that monetary easing would arrive in June. That would be welcome. It would also be vastly too late and, in all probability, too little. Mr Draghi saved the day in July 2012 when he announced that "within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough." He needs to promise to do whatever it takes yet again, to eliminate excess capacity and raise inflation to 2 per cent. If he does not, crisis might yet return.
I had doubted whether the ECB's program for Outright Monetary Transactions would work. But in the end, this conditional promise by the central bank to purchase government bonds in the secondary markets proved so effective at stopping the panic that it never had to be carried out. Together with the commitment of vulnerable countries to austerity and reform, this has unblocked sovereign debt markets. Complacent policy makers and investors imagine the crisis is over.
One indication is the decline in yields on 10-year bonds. On May 8, Irish bonds were yielding 2.7 per cent; Spanish, 2.9 per cent; Italian, 3.0 per cent; and Portuguese, 3.5 per cent. Even Greek bonds yielded only 6.2 per cent. These countries all ran current account surpluses last year, partly because domestic demand had collapsed and partly because competitiveness had improved. They no longer require net inflows of capital. Combined with the renewal of market confidence, this is reversing financing imbalances, which had left some of the eurozone's national central banks deeply indebted to others. The OECD's new Economic Outlook forecasts economic growth of 1.9 per cent in Ireland; 1.1 per cent in Portugal; 1.0 per cent in Spain; and 0.5 per cent in Italy in 2014. This is a welcome turnround.
Yet at the end of last year these economies were between 6 per cent and 9 per cent smaller than before the crisis. Unemployment is very high, especially in Spain. Greece is in still worse shape. Furthermore, credit markets are yet to recover as the Economic Outlook also shows.
Above all, according to the OECD, by 2015 Spanish gross public debt will be 109 per cent of gross domestic product; Irish, 133 per cent; Portuguese, 141 per cent; Italian, 147 per cent; and Greek, 189 per cent. Even if bond yields remain at low levels and these countries run balanced primary budgets (before interest payments) indefinitely, nominal GDP must grow at close to 3 per cent a year (in the case of Greece, far more) merely to keep the public debt ratio stable. If they want to lower it, as they should under the new fiscal compact, the budget must be tighter, growth higher, or both.
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Growth of nominal GDP depends on real rates of growth and rates of inflation. But although higher inflation would ease the burden of public debt, vulnerable countries also need to improve competitiveness with core countries, either through higher productivity growth or lower inflation. In the year to March, core consumer price inflation in Greece, Portugal and Spain was negative, while it was 0.6 per cent in Ireland and 0.9 per cent in Italy. Yet overall eurozone core inflation was only 0.7 per cent and Germany's 0.9 per cent. This makes adjustment hard.
Suppose vulnerable countries continue with zero inflation. Then their economies need to grow at a real rate of 3 per cent to stabilise public debt ratios, unless they run primary fiscal surpluses. The OECD says Greece will run a structural primary fiscal surplus of 7.5 per cent of GDP, Italy one of 4.7 per cent and Portugal one of 3.5 per cent this year. Markets are betting such austerity will continue indefinitely. If – as is easy to imagine – it does not, crisis could quickly return.
How might the ECB help? At the end of last year the eurozone's real GDP was 3 per cent lower than in the first quarter of 2008. This is a sign of excess capacity. Moreover, M3 – a broad measure of money supply – grew cumulatively by only 7 per cent between September 2008 and March 2014, while nominal GDP expanded a mere 4 per cent between first quarter 2008 and fourth quarter 2013. Amazingly, the balance sheet of the central bank is now shrinking. The ECB is clearly failing to do its job. A more expansionary monetary policy should raise output sharply and inflation slowly.
Now suppose core inflation were 2 per cent and the eurozone economy cyclically stronger. This might not raise yields on bonds of vulnerable countries by the same amount, since it should reinforce confidence in their ability to grow out of their difficulties. Furthermore, an expansionary policy should raise inflation by more in core countries than in the periphery, where spare capacity is concentrated. That would accelerate adjustments in competitiveness too.
The ECB is right to argue it cannot solve the problems of the eurozone on its own. Yet it should do far more to generate growth in demand in line with potential. It could also help to strengthen credit in the weaker countries. In brief, it needs again to show the imagination it demonstrated with OMT.
A move to negative interest rates is part of the answer. So is an asset-purchase program that would expand the ECB's balance sheet by buying collateralized private sector assets and government debt. This could also reduce the persistent fragmentation of credit markets across the eurozone.
Furthermore, the creation of markets for securitized assets, initially with an ECB backstop, must be a part of the escape from crisis. Banks play too big a role. Should the ECB's asset quality review find big holes in banks' capital, the eurozone will need a plan to fill them. If all this is done with real force, the eurozone might stop stumbling and regain its ability to run.
In brief, the recovery in confidence is encouraging and the revival of growth welcome. But the former is too fragile and the latter too feeble. The eurozone's authorities – and above all the ECB, its only effective actor – can and must do far more.
Avoiding catastrophe is still not guaranteed. That is anyway a grossly insufficient goal. The aim must be to secure a healthy recovery. It is the ECB's job to hit its inflation target and strengthen credit markets. It must do whatever it takes. It has not yet done enough.