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Dysfunction at the Heart of Europe

As a result of high unemployment, below optimal inflation, and dismal output growth, the European Union is facing a severely protracted economic downturn. Since 2008, European policymakers have tried to reignite growth to little avail. Unemployment still hovers at 10.1%, and last year the European Union witnessed a meager .1% growth in GDP. As recently reported in Bloomberg, the euro-area “is on the brink of a third recession in six years.” Europe’s situation is not getting better and if a consensus-based approach among the European powers is not found soon, the future political and economic unity of the continent may be seriously threatened.

The head of the ECB, Mario Draghi, contemplates Europe’s future. To ease or not to ease?
The head of the ECB, Mario Draghi, contemplates Europe’s future. To ease or not to ease?

To save itself, the European Union must come together under firm leadership with a clear plan for economic recovery, yet the center of European policymaking is currently dominated by bitter ideological and personal disputes. The main conflict within the European economic realm is between the European Central Bank (ECB) and the German government over the issue of extensive quantitative easing (QE). Recently, on November 6, the ECB declared it was ready to move forward with QE, despite Germany’s stance, and prepared to pump €1trillion into the Eurozone. Under this policy, the ECB would attempt to stimulate economic growth by injecting money into the euro-area through the purchase of government bonds—i.e. debt. This move has sparked hope amongst investors, but also instigated broader controversy along two main lines: QE’s somewhat uncertain economic impact and the legality of this action.

From an economic policymaking perspective, the ECB has largely exhausted its traditional options. Mario Draghi, the head of the ECB, has tried to stimulate growth by cutting short-term interest rates in the euro-area to historic lows in an attempt to encourage banks to lend money. However, these policies have proved insufficient and have failed to stimulate growth or raise inflationary levels. In fact, inflation still resides at about .5%, well below the ECB’s inflationary target of just under 2%. At this low level of inflation, Europe faces the risk of deflation, a downward trend in prices that threatens to substantially decrease investment in the economy. Consequently, Draghi has looked to more unconventional options, like quantitative easing, to help right Europe’s economy. Through this policy, the ECB would conduct large-scale purchases of government securities in an attempt to spur investment and avoid deflation.

Empirical evidence suggests quantitative easing could be effective. Britain and America have both implemented QE programs in recent years, which have subsequently been linked to higher rates of economic growth. A report by the Federal Reserve Bank of San Francisco suggests that quantitative easing by the Federal Reserve has lowered America’s unemployment rate by 1.5%. Additionally, a report by the Bank of England states that its £200 billion quantitative easing expansion may have raised inflation by 1.5% and increased real GDP by 2%. The success of quantitative easing programs in these countries provides strong economic backing for Mario Draghi’s strategy of QE.

Germany, however, is unconvinced. Economically, German officials are much less concerned about Europe’s low inflation (and the possibility of deflation) than the ECB is and fears quantitative easing could lead to runaway inflation, known as hyperinflation. Neil Irwin, senior economics correspondent for the New York Times, writes that German officials view “any effort to print money to buy government bonds as the pathway to hyperinflation perdition.” Some of this fear may stem from Germany’s experience with hyperinflation after World War I, where at one point, a loaf of bread cost 200,000,000,000 German marks. While there is certainly merit in trying to avoid hyperinflation, Europe’s dangerously low level of inflation coupled with evidence from Britain and America suggest that Germany’s fears may be overblown.

Rather than emphasizing active monetary policy to right the Eurozone, Germany stresses that fiscal responsibility and austerity on the part of European nations will be crucial to Europe’s recovery and long-term growth. This stems from Germany’s belief that a large part of Europe’s current economic crisis was caused by fiscal irresponsibility on the part of other governments, such as Portugal and Greece, which led to the accumulation of massive amounts of public debt. This foreign debt is viewed as especially egregious in Berlin because Germany has had to commit a significant amount of money to bail out these nations since the crisis began. Germany thus fears that quantitative easing, which would be used to further underwrite other European governments’ debt, would decrease the pressure on these nations to fix their budgetary problem and become more efficient. Without reform, Germany worries other European countries will continue to accumulate debt that Germany may once again have to help pay off in the future.

Germany has also critiqued the ECB’s proposal on political grounds. The EU treaty that created the ECB does not allow the bank to directly finance national governments. German officials thus view quantitative easing, the large scale purchasing of government bonds, as a violation of the EU treaty because it is tantamount to the financing of national governments. Such an action by the ECB would overstep the mandate set for them by the sovereign states of Europe. Germany’s insistence that the ECB not expand its power, therefore, may reflect Germany’s deeper desire for a less centralized system of European governance.

Worsening the matter, Germany and the ECB’s ideological differences has created hostility between key officials in both groups. Reuters states that the relationship between Mario Draghi and Jens Weidmann, the head of Germany’s central bank and one of the main intermediaries between the two financial institutions, has broken down. The New York Times describes the two as “barely on speaking terms.” Further exacerbating this rift is Draghi’s exclusionary leadership style.  According to Jean-Claude Trichet, the former head of the ECB, Draghi “operates with a small group of confidants” from a few European nations rather than “sounding out a broad range of views on the ECB Council.” This approach has irritated Germany and many other nations that feel excluded from the policy making process.

Moving forward, given Europe’s stagnant economy, some policy change must occur in order to stimulate growth. Germany’s advocacy for fiscal responsibility, which would lead to less government spending and higher taxes, will arguably decrease overall investment and spending in Europe. Conversely, it is hard to ignore the empirical success quantitative easing has had in Britain and the United States where output has increased without causing overly high rates of inflation. The primary risk for Draghi’s strategy, however, lies in the political realm. If implemented, Germany will likely instigate more legal challenges to the ECB and may even threaten to leave the Eurozone and return to the mark. Thus, if Draghi does decide to push ahead with full-scale quantitative easing, he should show resolve for the policy, yet be diplomatic enough to keep Germany in the Euro by opening up the ECB’s decision making process and forging a better working relationship with German officials.

If significant action is not taken and Europe’s economy remains unchanged or if it falls into an even worse recession, a generation of Europeans could live with higher unemployment levels and lower living standards. The future of European economic and political integration may hinge on decisions made during this economic crisis. This is not a time for European leaders to refuse to work and communicate with each other on a daily basis. Rather, policymakers must face the reality of the situation and act together with strength. Quantitative easing could be the best economic policy for Europe to pursue, but if it is implemented half-heartedly or without wholehearted support throughout Europe, it will have little impact.

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