OPINION 

Europe in denial

Chris Dillow

Chris Dillow

Last week's moves by the European Central Bank (ECB) aroused much excitement, almost all of it misplaced. In fact, the measures will have little effect upon the economy.

The ECB made two main announcements. One was the introduction of targeted longer-term refinancing operations - essentially, cheap loans to banks to encourage them to lend more to companies. These are the ECB's equivalent to the UK's funding for lending scheme (FLS).

And therein lies a clue. The FLS has not prevented lending to non-financial companies from continuing to fall - although it's possible that it would have fallen more without the FLS. This warns us that bank lending is constrained not (just) by banks' lack of easy cash but by companies' lack of investment opportunities. With the eurozone economy probably having more spare capacity than the UK, and with economic optimism weaker, it's hard to see why things should be different in the eurozone than in the UK.

The second measures are cuts in official interest rates of 0.1 percentage points. These, though, will have only small stimulative effects upon output. Economists disagree upon the precise size of the impact of interest rates on GDP - which is only to be expected given that we have only 14 years of noisy data. One estimate from Bundesbank economists is that a one percentage point cut in rates raises GDP at its maximum by around 0.9 per cent. Another estimate by economists at the Free University of Brussels puts the impact at three percentage points.

Even if we take the latter estimate, this implies that last week's cuts will only raise GDP by around 0.3 per cent after 18 months. This, says Michala Marcussen at Societe Generale, is "modest".

But better than nothing, you might think. However, monetary policy isn't the only game in town. There's also fiscal policy. And this will depress output. The OECD estimates that the cyclically adjusted general government financial deficit in the eurozone as a whole will fall by 0.9 percentage points of GDP between 2013 and 2015 - from 1.4 per cent of GDP to 0.5 per cent. If we assume a fiscal multiplier of around one, this will wipe 0.9 per cent off GDP.

In other words, fiscal policy will depress output by around three times as much as last week's rate cuts will raise it.

Of course, we know from theory and recent UK experience that fiscal tightening is consistent with a recovery in GDP, as long as the private sector gets its mojo back. But few expect this to happen in the eurozone: ECB economists predict GDP growth of 1 per cent this year and 1.7 per cent next, similar to many private sector forecasters.

Instead, policy makers are hoping that 'structural reforms' - many of which are euphemisms for curbing workers' rights - will raise growth by increasing competitiveness and businesses' confidence and willingness to hire. However, as a recent paper by Fabien Tripier and colleagues at France's CEPII think-tank point out, such reforms aren't sufficient to offset tighter fiscal policy.

What we're seeing here is what Oxford University's Simon Wren-Lewis calls zero bound denialism. There is, he says, a consensus among macroeconomists that when interest rates are around zero fiscal policy can have powerful effects while monetary policy is weak and uncertain - especially if the central bank shies away from full-blown money printing. Most people, though, seem to ignore this consensus. And while they do, the region stagnates.

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