ECB faces tough choices as European economy grinds to a halt

Posted on 08-19-2014 09:08
Summary: Europe's foundering economy sprung new leaks Thursday, turning up the heat on the European Central Bank to deliver a quantitative-easing lifeline.

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Europe's foundering economy sprung new leaks Thursday, turning up the heat on the European Central Bank to deliver a quantitative-easing lifeline.

New data released Thursday showed that the 18-nation euro zone's economy stalled utterly in the second quarter, with gross domestic product unchanged from the first quarter - short of even the puny 0.1per-cent quarter-over-quarter gain that economists had anticipated.

On a year-over-year basis, euro zone growth is now a tepid 0.7 per cent.

Most worrisome was that Germany, the economic powerhouse of the region that has been a critical source of strength, saw its GDP shrink by 0.2 per cent in the quarter, its first contraction in five quarters.

France, the currency group's second-biggest economy, was flat.

At the same time, the euro zone's inflation has now slumped to financial-crisis levels.

The July inflation rate came in at 0.4 per cent, the lowest since October, 2009.

The numbers point to a couple of unpleasant conclusions: That Europe's economic struggles are broadening from the long-standing weakness of its periphery to increasingly infect its core, and that despite the ECB's efforts to date, the deflation threat looms larger than ever.

"The European Central Bank has its work cut out as it attempts to rekindle growth and get rid of the threat of deflation," said National Bank of Canada senior economist Krishen Rangasamy in a research note.

"Poor fiscal policy (e.g. austerity at a time of deficient private sector demand, and the lack of meaningful structural reforms) and ineffective monetary policy (largely due to an impaired transmission mechanism) continue to act as speed bumps on the road to recovery. Geopolitical uncertainty isn't helping."

Certainly, the Russian trade sanctions over Ukraine have dropped an anvil on the euro zone's best-laid recovery plans.

Russia is the European Union's third-biggest trading partner, and Germany - the EU's biggest economy and a massive exporter - has particularly close trade ties to Russia.

Since the recession, Russia has been one of the EU's fastestgrowing markets, with an average export growth of better than 16 per cent a year.

In short, Russia had been an important source for growth as the euro zone struggled to get its economic head above water; now, Russia may be the thing to dunk it back under again.

Europe has been a massive laggard in the postrecession recovery. And with conditions now showing further erosion, the threat of the euro zone slipping into a deflationary spiral is inching closer - an event that would have serious ramifications for not just European but global economic and financial stability.

The ECB acted last June to try to stimulate the euro zone economy and reverse the inflation's slide into dangerously low territory - cutting interest rates to the bone and making cheap loans available to banks.

At the time, ECB boss Mario Draghi indicated that the bank was prepared to pull out more ammunition if necessary. While Mr. Draghi may be tempted to give his June actions more time to take hold and create the desired spark, it's hard to overlook the fact that since he implemented them, things have gotten worse.

Just last week, the ECB stood pat on its monetary policy, but Mr. Draghi and his colleagues will be under intense pressure ahead of next month's meeting to haul out the big guns to halt the deterioration. That means, finally, pulling the trigger on quantitative easing - asset purchases by the bank aimed at directly injecting monetary stimulus into the market.

Mr. Draghi has so far resisted this extraordinary action - which, while similar to what the U.S. Federal Reserve has been doing for years now, would be unprecedented for the euro zone, and it's not altogether clear how it could be implemented under the laws governing the 18-country monetary partnership.

However, the ECB earlier this year opened the door to using QE if necessary. There had been some hope that the mere talk of QE would shift market sentiment enough to give Europe the desired lift (through a lower euro and more attractive lending rates), but it clearly hasn't been enough.

Mr. Draghi may have little choice now than to introduce QE.

DAVID PARKINSON

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