How Europe could escape deflation
ECB and EIB should reflate Europe’s economy
by Harald Benink and Wim Boonstra
Fri 19 Dec 2014
Mario Draghi, president of the European Central Bank, says policy-makers ‘without delay’ should bring euro area inflation, now 0.3%, back to the target of below but close to 2%. We agree. However we think that Draghi has not yet embraced the most optimal solution.
The ECB should not start buying existing government bonds as part of a classical quantitative easing programme which may lead to financial bubbles without creating substantially higher economic growth. Instead, it should buy new bonds to be issued by the European Investment Bank to finance infrastructure projects of up to €1tn.
Europe is on the brink of deflation. Euro area growth is insufficient to bring about substantially lower unemployment in the periphery. Inflation is dangerously low, and inflation expectations are declining. Most international institutions, including the IMF, recommend a substantial increase in investment in Europe’s infrastructure, including bridges, roads, sustainable energy, electricity power grids, and research and education. However, given the deplorable state of government finances, there is little room for extra fiscal spending. Germany could do more but seems reluctant to do so.
The plan by Jean-Claude Juncker, president of the European Commission, to create a €21bn fund under the aegis of the EIB is an important first step. By using public money as a capital base, the plan could finance a total of €315bn of infrastructure projects. Yet this is too modest to reverse the deflation risk. For this, a substantially larger impulse is required, organised by the EIB, to be financed by ECB monetary expansion.
In our proposal, €21bn of European taxpayers’ money could be made available as a capital base to mitigate the risk to the ECB of its investments in the infrastructure fund. There are three clear benefits from our proposal.
First, an investment impulse of up to €1tn would stimulate demand and reduce unemployment. The announcement itself would have a positive impact on confidence. Second, higher investment in infrastructure would strengthen the supply side of the economy, enhancing Europe’s competitiveness and longer-term growth potential. Third, the announcement of such a substantial monetary expansion, raising the ECB’s balance sheet from €2tn to €3tn, would have a significant upward effect on long-term inflation expectations, anchoring them at higher levels and reducing the risk of deflation.
This is not a call for monetary financing of government spending. But it takes account of the ECB’s track record of going to the limits of its mandate to rescue the euro. Concerns are sometimes voiced about the potential inflationary nature of monetary expansion. However, these voices pay insufficient attention to euro countries’ experience of moving perilously close to deflation. Although the situation in southern European countries is gradually improving, the prospects for many of Europe’s unemployed remain dismal. There is only one remedy: a strong growth impetus.
Our proposal is designed as part of a ‘grand deal’ where countries like France and Italy commit to detailed structural reforms, especially in labour and services markets and pension systems. Without such a commitment, the EIB should not be willing to make infrastructure investments in these countries. At the same time the EIB’s willingness to make substantial investments in France and Italy should help their politicians to convince electorates to endorse economic reforms. Without such a deal the euro area may face a long period of stagnation.
Harald Benink is professor of banking and finance at Tilburg University and a member of the OMFIF Advisory Board. Wim Boonstra is chief economist of Rabobank Nederland and professor of economic policy at VU University Amsterdam.
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