European policy U-Turn deserves kudos

Earlier this month, the European Central Bank (ECB) followed the Federal Reserve in making a major monetary policy U-turn. This move should be welcomed in light of Europe’s rapidly deteriorating economic outlook.

However, it is questionable whether the ECB’s policy measures will be nearly enough to prevent the European economy from again succumbing to an economic recession.

This would seem to be especially the case at a time that Germany cleaves to a budget austerity policy and at a time that the Trump administration undermines European investor confidence by threatening to impose punitive import tariffs on European automobiles.

In 2008, on the eve of the global economic and financial crisis, the ECB, under Jean Claude Trichet’s leadership, made the egregious mistake of raising interest rates. Fortunately, as storm clouds now gather over the European economy, Mario Draghi’s ECB does not appear about to repeat the same mistake.

Rather, recognizing that the European economy is slowing and faces a challenging global economic environment, the ECB has now slashed its European economic forecast and taken steps to provide the economy with some support. 

Those measures have included taking any interest rate increase for next year off the table as well as indicating that the ECB stands ready to revisit its decision to reduce the size of its balance sheet.

Welcome as the ECB policy U-turn might be, refraining from interest rate hikes and freezing the size of the ECB’s balance sheet alone would not appear nearly sufficient to right the ailing European economy.

This would especially seem to be the case at a time that all of Europe’s major economies are being challenged simultaneously by a variety of meaningful economic and political hurdles.

For a start, Germany, Europe’s largest and most dynamic economy, is now on the cusp of a recession as it’s highly export-dependent economy is being hard hit by the marked Chinese slowdown.

Further weighing on the German economy has been President Trump seriously considering labeling European automobiles as a national security threat, which could be a prelude to punitive U.S. tariffs on European automobile imports.

Sadly, the German government appears unlikely to aid the ECB in coping with a slowing German economy. On the contrary, the German government appears to remain inclined to aggravate any German economic slowdown by cutting public spending to honor its commitment to a balanced government budget.

At a time that the German economy is stuttering, political problems are clouding economic prospects in the United Kingdom and France, Europe’s second- and third-largest economies, respectively.

Heightened investor uncertainty about the U.K.’s post-Brexit relationship with Europe has already moved the U.K. economy from being the Group of Seven’s fastest-growing economy to its slowest.

Sadly, that uncertainty is likely to persist even should Prime Minister Theresa May get parliamentary approval for her Brexit deal since such a deal would only be the prelude to protracted negotiations over the U.K.’s future economic relationship with Europe.

Meanwhile, in France, social unrest associated with the “yellow jacket movement” is seriously denting investor confidence in that country’s economy.

More troubling yet for the European economic outlook are the economic and political troubles besetting Italy, Europe’s fourth-largest economy and its second-most highly indebted economy.

Being around 10 times the size of the Greek economy and with a public debt totaling over $2.5 trillion, an Italian debt crisis would have the real potential to roil the global financial system. It would all too likely do so in a very much more serious manner than did the earlier Greek debt crisis.

During the second half of last year, the Italian economy succumbed yet again to an economic recession. The last thing that it now needs is the simultaneous economic slowing of the German, United Kingdom and French economies.

Stuck within a euro straitjacket and saddled with a market-unfriendly populist government, it is difficult to see how Italy could grow its way out of its debt problem in those circumstances. This makes the Italian economy particularly vulnerable to any further loss of risk appetite in the global financial market.

Starting from low interest rates and a bloated balance sheet, it is doubtful that the ECB alone can save the European economy from another recession.

Rather, if a recession is to be avoided, one must hope that those European countries, most notably Germany, with the fiscal space to do so, will use that fiscal space to provide the European economy with a much need budget stimulus.

It would also help matters if the Trump administration were to back off any notion of imposing automobile import tariffs on an already troubled European economy.

In framing economic policy, global policymakers would do well to recall that the European economy is larger than that of China. As such, a setback in that economy must be expected to have large spillover effects for the rest of the global economy that would all too likely reach our shores. 

Desmond 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.