Mario Draghi surprised markets last week with a further cut in interest rates and a QE plan to start purchases of assets to expand the ECB balance sheet. These two actions were welcome as well as the change in the content and tone of his comments that are finally making clear the need for strong policy actions in Europe.
Unfortunately, the fear is that this is coming too late and might not be enough. While the ECB plan to buy assets could expand its balance sheet over the coming months, the reality is that this move might just take its size to where it was several months ago. It is true that purchases of certain assets could have a stronger impact than the previous rounds of bank lending, but this might not be enough.
And when it comes to interest rates, while the ECB has finally reached zero, it took so long that in the last months the Euro area has seen a dangerous move towards very low inflation. And as inflation went down, real interest rates went up. Below is a chart that compares real interest rates in the Euro area and the US (real interest rates are calculated as the central bank interest rate minus the one-year inflation over the previous year).
The first thing we noticed is that since the the summer of 2012 real interest rates have increased in Europe while they have remained broadly stable in the US. In the last two years, while real interest rates have increased by more than 1% in Europe, they have gone down by about 1% in the US. And this is all the result of the difference in behavior in inflation, which is possibly the result of the differences in policies we see during 2011 with much higher interest rates in the Euro area than in the US.
If the recent ECB actions are not enough, what else is to be done? Maybe European governments start listening to Mario Draghi and we see a reversal of fiscal policy, possibly in a coordinated fashion across Euro members. In the absence of this, the ECB has very few tools left at its disposal. It could try to increase inflation expectations, hoping that this would translate into increases in wages and prices. But raising inflation expectations would require very strong communications possibly making explicit that a temporary deviation of inflation above 2% would be welcome. Or even better, an explicit increase in the inflation target of the ECB (which could be temporary, for X years).
The only other alternative is "helicopter money", which implies a permanent increase in the monetary base/supply via either permanent purchases of assets or direct transfers to the governments or households (read Simon Wren-Lewis explain the difference between QE and helicopter money or Willem Buiter discuss why helicopter money always works). There has been some recent talk among central bankers about this idea but it has always been ruled out because of legal or practical constraints, which are likely to be more binding in the case of the ECB.
The discussion around helicopter money in the US led to the expression "helicopter Ben" to refer to the former chairman of the federal reserve, Ben Bernanke. Maybe it is time to see "helicopter Mario" do whatever it takes to save the Euro area. And finding a picture to illustrate what this would look like is so much easier with Mario Draghi...