The European Central Bank’s decision last week to guard against deflation by cutting rates was in the collective interests of the euro area. That includes Germany, whose board members opposed the move and where the news media has excoriated ECB President Mario Draghi for it.
Deflation should be thought of as the economic equivalent of cancer: In both cases the effects can be extreme and an ounce of prevention is worth a pound of cure. Just ask the Japanese. Markets were surprised by the Nov. 7 move only because they didn’t expect the ECB to act before it published its next inflation projections, in December.
The bank, however, didn’t need to wait. The Governing Council’s members already knew the numbers would be bad; the October reading for euro-area inflation was a shocker at 0.7 percent, well below the ECB’s target inflation rate of 2 percent or just below. Even after the rate cut, it looks as though Europe is in for a prolonged period of low inflation.
Some in Germany, such as the prominent conservative economist Hans Werner-Sinn, accused Draghi of cutting the bank’s main refinancing rate to 0.25 percent from 0.5 percent purely to benefit savers in southern nations, including Italy, his home country. That charge is unfair, damaging to the ECB as the supranational institution that holds together a fragile currency, and demonstrably wrong.
It is true that, so far, the main indicator of deflation -- inflationary expectations -- remains well anchored in the euro area at 2 percent. That’s good news, and the ECB Governing Council action is intended to keep it that way. You don’t accuse a surgeon of panicking by removing a tumor that risks turning malign.
For some months now, Draghi has been holding off the Governing Council’s doves, who were a majority and wanted a cut, but were reluctant to force the issue in deference to Draghi’s desire for consensus. He offered them a new forward guidance policy as an alternative. On more than one occasion, the ECB president sided with the hawks to thwart a rate cut. If his objective was to win a rate cut for the Italians, why didn’t he act earlier? He had the votes.
There were even grumblings within the council at the time that the bank’s Italian president was acting too much like a German. Now he is being attacked by some Germans for being too Italian, but with far less grounds: The ECB cut is clearly in the interest of the euro area as a whole.
This is the second time the Bundesbank has been on the wrong side of a major ECB decision since Jens Weidmann became its chief in 2011. The first concerned the start of the ECB’s bond-buying program, Outright Market Transactions, an insurance program that most commentators consider to have been a huge success.
Now, together with executive board member Joerg Asmussen and the central bank governors of Austria and the Netherlands, Weidmann has opposed an ordinary rate decision that clearly made sense for the euro area as a whole, but in his view not for Germany. By encouraging the false notion that there is a North-South split (Finland and Belgium supported the cut), Weidmann isn’t helping the ECB, the euro or German influence in the Governing Council.
It isn’t even clear that Germany would be well-served by keeping the ECB’s policy rate higher, because if deflation took hold in Europe, Germans would suffer, too.
The major gripe against the interest rate cut is that it will hurt savers. ECB board member Benoit Coeure has explained why this isn’t the case. In addition, falling inflation in Germany (to 1.2 percent in October from almost 2 percent in July) that preceded and motivated the ECB rate cut has benefited savers: They gain from disinflation, because it increases the real interest rate that is paid on their deposits. So if anything, the ECB’s action last week took back a windfall gain that Germany’s savers received as a result of the drop in the inflation rate.
The rate cut should also reduce the flow of “safe money” into Germany by taking the heat off the periphery. Savers have paid a heavy price for Germany’s status as a haven during the crisis, because the flood of outside funds drove down the interest rate that banks were willing to offer German savers. The ECB’s cut should reduce these inflows, offsetting any effects from the ECB’s reduced refinancing rate.
German taxpayers also stand to benefit from the ECB move. Any policy that helps the finances of debtor countries means there will be less pressure on Germany to rescue the south. By increasing the real burden of interest payments, disinflation has choked the debtor countries and made a rate cut necessary.
The euro area’s North and South are interconnected. It is in Europe’s overall interest that deflation is averted and the effects of falling inflation on debt liabilities is softened. That is the explanation for the actions of Draghi and most of his colleagues on the ECB’s Governing Council last week. They were right and Europe should feel safer for it.
(Melvyn Krauss is an emeritus professor of economics at New York University and senior fellow at the Hoover Institution, Stanford University.)
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