For the Eurozone, secular stagnation is a live threat

At the annual meetings of the International Monetary Fund and the World Bank in October 2013, the Eurozone crisis was officially declared over. A year on we know that this optimism proved illusory: we have entered year seven of a depression that refuses to end.

The timeline shows obvious parallels with the Great Depression in the US. It was declared over in 1936 when pre-crisis levels of economic activity were reached. Fiscal and monetary tightening led to a renewed recession in 1937 and 1938. In reality, these were not two consecutive recessions, just as there was no double-dip recession in the Eurozone recently, or a trip-dip in the case of Italy.

They were all long single depressions with interruptions. The Eurozone depression started in 2008. What the world celebrated last year was the false dawn of one of these interruptions.

On many levels, our depression is worse than the one 80 years ago. It is not just a giant yo-yo. It leaves us permanently below the pre-crisis trajectory of economic output. Returning to that trajectory would require growth rates higher than those we enjoyed in the previous decade.

The good news is that democracy is not in danger. Political stability, however, nurtures complacency. Without a clear policy response, the depression is in danger of turning into a secular stagnation — measured in generations, not years.

What ended the Great Depression was the fiscal expansion to finance preparations for Word War II — hardly a model to follow. As a monetary union happy to live without a central budget or transfer mechanism, the Eurozone has no fiscal capacity of its own. Germany has some, but does not want to use it; France and Italy have none, but do want to use it. The sum total of this absurdity is a number fairly close to zero, accompanied by lots of noise.

Any heavy lifting will have to come from monetary policy. This was also the message of the formidable Geneva report, compiled by a group of academics who see a real danger of a secular stagnation. Their recommendation is further monetary expansion, including quantitative easing, combined with a credible commitment to keep interest rates down for a very long time.

Monetary policy works through numerous channels. I do not believe the exchange rate is the most important one. A euro devaluation would have to be quite extreme to have a big impact on, say, Italian exporters. It is only the exports outside the Eurozone that would benefit.

Over the past three months, the euro’s trade-weighted exchange rate fell by less than 4 per cent — and that shift already includes market expectations of future QE. Like the US, the Eurozone is a large, relatively closed economy. The exchange rate is not completely irrelevant but not that important either.

The main route through which QE could work is the so-called portfolio balance channel: when the ECB buys five-year sovereign bonds, the sellers will try to replace those bonds with securities of similar characteristics — say five-year corporate debt. If that happens, the price of the bonds would rise, the interest rates on them would fall, and companies will find it easier to raise money.

There is more the Eurozone can do. How about a programme of investments or tax credits, funded by the ECB?

And while they are at it, they should also suspend the fiscal compact. There is no way that Italy or France will meet its stringent fiscal targets in the foreseeable future. Unfortunately, the discussion is going in the opposite direction. The big fear in Brussels is that the new European Commission may not be sufficiently strict in applying the deficit rules of the Maastricht treaty.

It is depressing to see that the incoming commissioners offered no new ideas about how to make the euro sustainable during their confirmation hearings.

The best chance, as ever, could come through pressure from abroad. I would advise global finance officials to question the eurozone’s strategy in some detail — if they can find one.

— Financial Times