IF MARIO DRAGHI had been hoping for a quiet few months before he retires from the European Central Bank (ECB) at the end of October, he has been disappointed. He has been in charge for eight high-wire years. In 2012 he quelled panic about the break-up of the euro zone by pledging to do “whatever it takes” to save the single currency. In 2015 he introduced quantitative easing (QE, creating money to buy bonds) in the face of fierce opposition from northern member states. Now the euro zone is flirting with recession and governments are not helping by being slow to loosen fiscal policy. At the central bank’s meeting on September 12th, Mr Draghi must dust himself down one last time.
Investors’ jitters about a recession and the impact of the trade war have sent bond yields tumbling. The ECB’s hawks—such as Jens Weidmann, the head of the Bundesbank, and Klaas Knot, of the Dutch central bank—caution against overreacting with a large stimulus. But the economic data are dreadful. Output in Germany shrank in the second quarter, and some economists are pencilling in another contraction in the third. Italy is stagnating. According to a survey of purchasing managers released on September 2nd, Europe’s manufacturing decline shows no sign of abating. The deeper it is and the longer it lasts, the more likely that trouble brims over into the rest of the economy. In Germany retail sales are already slipping and firms are planning to hire fewer workers.
Inflation is dangerously low. Both the headline figure and the “core” measure—which strips away volatile food and energy prices—are stuck at around 1%, below the ECB’s target of inflation below, but close to, 2%. Investors’ medium-term expectations, as measured by swap rates, have drifted down to 1.2%, well below levels in 2014-15, when the bank prepared to launch QE. The views of professional forecasters surveyed by the ECB have fallen to their bleakest since polling began in 1999. In an attempt to bolster its credibility, the bank has tweaked its language to emphasise that it does not want to undershoot the target of 2% consistently. But without action, those words count for little.
Some economists, among them Larry Summers of Harvard University, argue that, with little ammunition left, central banks should refrain from action so as to force governments to step into the breach with fiscal policy. They are right that the root cause of the economic woe is a shortfall of demand. Sovereign borrowing costs in much of the euro area are near zero or below it. In an ideal world governments would leap at the chance to borrow so cheaply in order to invest. And it is also true that monetary policy is likely to be less effective because rates are so low. The ECB’s deposit rate is already -0.4%. At some point the benefits of further cuts will be offset by their costs, for example if customers begin to withdraw funds from banks and thus destabilise them. With financial conditions already much looser, QE will not be as effective as it was in 2015.
But for the ECB to stand back and do nothing would be irresponsible. It is legally obliged to achieve price stability. Germany’s government shows little appetite to borrow to spend, even if its entire bond yield-curve is submerged below zero. There is even less sign of co-ordinated regional fiscal stimulus in the offing. Until governments loosen the purse-strings, the ECB has no choice but to act. It is the only game in town.
Mr Draghi must therefore be bold on September 12th. Although the scope for interest-rate cuts is limited, it still exists. The important thing is to mitigate the impact on financial stability by, say, “tiering” deposit rates—giving banks a rebate on some of the interest they would otherwise have to pay to park spare cash with the central bank. This would signal that the ECB can cut rates further without blowing up the banking system.
He should also restart QE and commit the bank to buying bonds until underlying inflation shows a meaningful recovery. Mr Draghi has said before that he views asset purchases as particularly helpful in reviving inflation expectations. One constraint is the ECB’s self-imposed limit on the share of a country’s government bonds that the bank can buy. This should be lifted from a third to a half, sending a powerful signal that the ECB means business. The legality of QE is still being questioned in Germany’s constitutional court, but a ruling by the European Court of Justice last year appears to give the ECB room to raise those limits in its quest for price stability. The promise of lower borrowing costs for longer might even prompt national treasuries into issuing more debt.
Last, Mr Draghi must use the bully pulpit to urge governments to exercise their fiscal powers to fend off a recession. You might think that he should avoid taking action at the end of his tenure, so as not to bind the hands of his successor, Christine Lagarde. Not so. A determined response now will save her much work later. Mr Draghi is in a unique position. His stature with investors and governments gives him real clout. And since he departs in a few weeks he can be blunter than he has been in putting across the message that governments, not just the ECB, must act. That would cement his legacy as the man who saved the euro.■