Britain cannot escape from Europe's storm

Two years ago, it appeared as though the eurozone’s problems might tear the single currency apart, leading Mario Draghi, President of the European Central Bank (ECB), to pledge to do “whatever it takes” to save the euro. His historic words were interpreted as heralding a European programme of quantitative easing (QE)—the process by which central banks “print” money to buy financial assets, thus injecting liquidity into the economy. Draghi’s words alone had a dramatic effect in ending the crisis.

Eventually, in January this year, came the announcement of large-scale QE in the eurozone, which was designed not so much to save the euro as to get its inflation and growth rates up. The scale of the plan was enthusiastically received by financial markets.

But quantitative easing cannot be the long-term answer to the problems of the eurozone. These spring from the nature of the single currency—a currency without a government, without a fiscal union, without a single flexible labour market and with different economies with different structures and sensitivities to interest rates.

Quantitative easing may be good for financial markets. Judging by the United States and the United Kingdom, it puffs up asset prices, property, shares and bonds, and lowers interest rates.Some will regard this as good. Others will fear a bubble. But what will it do to stimulate recovery and growth? It will drive down the value of the euro, making it easier for eurozone exporters—but Europe will not recover just on the back of exports. Its problems are also internal.

To be fair to Draghi, he has always emphasised the limitations of QE, arguing that it can create the conditions for growth but not the growth itself. That depends on governments implementing pro-growth measures and reforms. It is precisely because QE may lessen the pressure to reform that Germany has opposed it. Even before Draghi’s announcement, the euro was already weakening, consumer confidence was rising and then there was the collapse in oil prices, all of which have improved the outlook for the eurozone. He may have caught the tide and QE will get the credit for something that would have happened anyway. Draghi has committed to continue with QE until September 2016 and perhaps longer if inflation hasn’t returned to 2 per cent by then. (Inflation may pick up in 12 months’ time when the oil price drops out of the consumer price index, used to measure the rate of inflation.)

But for now, deflation remains a threat—eurozone prices in the year to January fell by 0.6 per cent. In the UK, fear of deflation had caused hawks at the Bank of England to delay calls for an interest rate increase. Some economists distinguish between “good” and “bad” deflation. “Bad deflation” involves a cycle of falling prices which leads to consumers delaying spending, reducing demand, increasing unemployment and then further falls in prices. This is allegedly what led Japan into its “lost decade.”

“Good deflation” is when prices fall as a result of a one-off drop in, say, the price of oil or other commodities. This feeds straight into people’s pockets, increasing consumer spending and living standards. Britain has “good deflation.” European deflation is of a different, potentially more, serious kind.

It is concerning that Draghi’s version of QE has turned out to be something of a compromise. Most of the bonds will not be bought by the ECB but by individual national central banks. This is because of German opposition to Europe-wide risk sharing and fears that the German taxpayer would bear the cost of any losses from bond purchases. Losses are possible and investors may not be convinced that they can be confined to one central bank without affecting others or the ECB itself.

To many, this compromise programme seems much weaker than the one Draghi originally proposed. Michael Noonan, the Irish Finance Minister, has said, “If quantitative easing becomes the function of national central banks rather than primarily of the ECB, then I think it will be ineffective.” One can see why he worries. Is the Bundesbank going to buy German bonds with negative yields—bonds that it must pay to hold? Can the ECB force the Bundesbank to do this? One is bound to wonder what sort of monetary union it is that abjures risk sharing in this way. This messy compromise could ultimately undermine its credibility.

The arrival of a government like Syriza in Greece was an inevitable development and merely highlights the problems. If the euro survives, and it may well, it will be with low growth and low inflation. QE may boost the eurozone marginally but it will not address its central problems. None of this is good news for Britain: outside the eurozone but doomed to be affected by it.