By the usual indicators — which define a recession as two consecutive quarters of a shrinking economy — Europe is almost there. Growth of the euro zone’s gross domestic product was a meager 0.2 percent in the third quarter. Growth for Germany, Europe’s largest economy, was only 0.1 percent. Employment growth for the euro zone, the 19 countries using the euro, was only 0.1 percent.
No one can want this. The economics are brutal: higher unemployment, lower confidence and squeezed profits. The politics are worse: greater distrust of government, more nationalism (including more suspicion of immigrants) and rising alienation.
But what can be done, if anything?
Note that the ECB is Europe’s equivalent of the Federal Reserve. The tenure of Lagarde’s predecessor, Mario Draghi, who ran the ECB from November 2011 until last month, is widely considered a success, because his policies prevented the euro from being abandoned by weaker countries (for example, Greece or Portugal). Their exit from the euro zone might have shattered the whole scheme.
This was always a plausible threat if euro-denominated debts could not be repaid. The crisis might also have been self-fulfilling. If depositors expected that, say, Spain might leave the euro, the fear might trigger a panicky outflow of money from Spanish banks.
On July 26, 2012, Draghi effectively foreclosed these possibilities by declaring that the ECB would do “whatever it takes” to avoid the euro’s collapse, adding that, “believe me, it will be enough.” In effect, Draghi pledged that the ECB would lend enough to banks and financial markets to ensure that they could meet their euro obligations.
Later, the ECB reduced short-term interest rates and embraced its version of “quantitative easing” (QE). This was an approach adopted by the Fed under Chairman Ben Bernanke. It involves having the central bank — the ECB or the Fed — buy bonds to reduce long-term interest rates.
The United States and Europe are in similar economic positions. In each, recovery is faltering. The basic problem on both sides of the Atlantic is that economies have become dependent on government-created “stimulus” policies — whether low interest rates supplied by central banks or huge budget deficits created by politicians — rather than being able to generate spontaneous internal growth.
The trouble with this approach is that the government-supplied stimulus programs are losing their punch. In both the United States and Europe, low interest rates are proving less and less effective in expanding GDP and employment. Whatever the initial effect of low interest rates and the QE programs of bond-buying, the law of diminishing returns seems to have set in. The benefits seem to be fading.
This creates a dilemma for the ECB and Lagarde. In a short report, Jean Pisani-Ferry of the Peterson Institute for International Economics notes: “Growth in the euro area has slowed since the beginning of 2018, and the risk of a recession is growing. Yet the [ECB] has barely any space left for monetary stimulus.”
What are the alternatives? The most obvious are what economists call “fiscal” policies: government spending, taxes, deficits and surpluses. Budget deficits are what matter here.
There are two problems for the ECB. The first is somewhat technical. There are self-imposed limits on the ECB’s bond purchases, about 33 percent of the qualified securities. The ECB is approaching these limits, says Jacob Funk Kirkegaard of the Peterson Institute. If the rules aren’t relaxed, the bond-buying would presumably have to stop.
Lagarde has provided some hints that she thinks some countries — Germany is the best example — could spend more and, thereby, stimulate growth. “Central banks are not the only game in town,” she has said.
Sounds simple. It isn’t. The second problem is that the countries that could spend more don’t want to, and the countries that want to are already overburdened with debt and shouldn’t.
Where does that leave us? Well, in a very delicate position from which there is no obvious easy exit. Another recession in Europe would slow the already-sluggish global economy and, quite probably, further fan the flames of nationalism and protectionism.
As David Wessel of the Hutchins Center on Fiscal and Monetary Policy notes, Lagarde has a well-deserved reputation as a skillful negotiator and conciliator. Good. She will need all the help she can get.