Wishful thinking at the European Central Bank

Albert Einstein famously observed that a sure sign of insanity was one who repeated the same experiment on numerous occasions but expected different results. In refraining from quantitative easing and relying instead on individual countries to improve their labor markets and to engage in sustainable fiscal reforms to promote economic growth, one has to wonder whether the European Central Bank (ECB) is not basically repeating the same policy experiment that it has tried these past few years and from which it is now expecting a different and better result.

A surprising aspect of last week’s ECB policy decision is the seeming disconnect between the ECB’s understanding of the parlous state of the European economic recovery and its decision to persevere with very much the same policy approach of “too little too late” that it has pursued to date. In his post-meeting press conference, ECB President Mario Draghi himself acknowledged that the European economic recovery now appears to have run out of steam, inflation has drifted to a dangerously low level, and European inflation expectations now appear to be becoming unstuck. Yet the ECB still remained reluctant to change its basic game plan of the past few years.

{mosads}Cognizant of the fragile state of the European economy, and being mindful of the European economic periphery’s dangerously high public- and private-sector debt levels, one might have expected that the ECB would have taken a leaf out of former Federal Reserve Chairman Ben Bernanke’s playbook and engage in full scale quantitative easing to avert the risk of deflation from taking hold in Europe. Instead, the ECB stuck to its game plan of making small reductions in its policy interest rates and to holding out the prospect of limited ECB transactions in asset-backed securities and in covered bonds beginning in October. Mario Draghi also stuck to his Jackson Hole mantra that monetary policy alone cannot get the European economic recovery moving, but rather that monetary policy needed to be fully supported by improvements in individual countries’ labor markets, sustainable fiscal reforms and shifting public spending towards growth boosting investments.

One has to fear that, in sticking to its game plan, the ECB is engaging in wishful thinking on several fronts. First, by suggesting that European inflation will pick up in the absence of a new monetary policy approach, the ECB seems to be underestimating the risk of Europe drifting toward outright deflation. This is all the more surprising considering that Europe’s very large output and labor market gaps have contributed importantly to the marked deceleration in European inflation over the past two years. It is also surprising considering that Europe’s large labor and product market gaps are very unlikely to close in the period immediately ahead in the context of at best an anemic European economic recovery. If large output and labor market gaps caused core inflation to decelerate in the past, it would seem reasonable to expect that they will continue to do so in the immediate future, which could very well push Europe into outright deflation.

A second area in which the ECB appears to be engaging in wishful thinking regards the prospect of individual European countries implementing painful structural economic reforms with renewed vigor to get the European economy moving again. One would have thought that today’s political climate in France and across the European economic periphery is very much less receptive to the sort of structural economic reforms that would supposedly jumpstart the European economic recovery than they were over the past few years. If those reforms were not adopted in the past, it would seem fanciful for the ECB today to expect those reforms to be adopted in a more hostile political environment.

A third area of wishful thinking on the ECB’s part relates to the risk of a deflationary debt trap in the European economic periphery. For not only does the ECB seem to be minimizing the adverse impact that low inflation and faltering economic growth would have on the European economic periphery’s already dangerously high public- and private-sector debt ratios — it also seems to be minimizing the risk of an early start to the normalization of U.S. interest rates that would result in a more challenging global liquidity environment and that would highly complicate the ability of Europe’s highly indebted periphery to finance itself.

By suggesting that monetary policy alone cannot get Europe moving again, the ECB is positioning itself well for avoiding blame in the eventuality that debilitating deflation might indeed take hold in Europe. However, by eschewing quantitative easing, the ECB would not seem to be playing its role in minimizing the chances of that eventuality.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.