Europe's Divided Central Bank

by: Desmond Lachman

Abraham Lincoln famously observed that a house divided cannot stand. One wonders whether the same might not be said of today's European Central Bank (ECB) as sharp divisions have emerged between the ECB's northern and southern member countries. These divisions were on full view last week when the German, Dutch and Austrian members of the ECB's Board all voted against the ECB's surprise decision to cut its policy rate to 0.25%.

The dissent within the ECB comes at an awkward moment for that institution. Since it would seem that the Eurozone is now facing a very real deflation threat that could tip the European economic periphery into a deflationary spiral, this is of all the more concern given the unusually high level of private and public debt in countries like Greece, Ireland, Portugal and Spain. Falling prices in those countries would only increase those countries' debt burdens which would make it very difficult for them to extricate themselves from a deflation trap.

Over the past year, Eurozone consumer price inflation decelerated from 2.6% to 0.7% in response to the very large labor and output market gaps characterizing the Eurozone economy. Meanwhile, several countries in the European periphery, where output and labor market gaps are considerably above the Eurozone average, now find themselves on the cusp of deflation. Sadly, with the very weak Eurozone economic recovery in prospect, one must expect that the persistence of those gaps will exert significant additional downward pressure on wages and prices. This would seem to heighten the urgency for the ECB to take a more proactive stance toward averting the deflation risk.

With its policy rate now at close to the lower band, one would think that the ECB has to consider unorthodox monetary policy measures that might support a more vigorous European economic recovery. In particular, one would think that the ECB has to find a way to get credit flowing again to the European economic periphery. One would also think that it has to find a way to effectively cheapen the value of the Euro. This might be done through a further liberalization of the ECB's long-term repurchase operations or by some form of long-term asset buying program.

The trouble with a divided ECB is that individual member countries pursue their own narrow interests without considering the overall effect on the European economy. By so doing they highly constrain Mario Draghi's room for policy maneuver. This makes it all too likely that the ECB will not be able to take a more proactive policy stance for fear of provoking a political backlash in Northern Europe. It also makes it all too likely that Europe will succumb to a Japanese style period of prolonged deflation.