European Central Bank (ECB) President Mario Draghi pledged over two years ago to do “whatever it takes” to preserve the continent’s common currency. That speech was an articulation of Draghi’s view that the union is irreversible and has been a turning point for the performance of the currency, reflected in immediately lower borrowing costs for the member states. Most significantly, in the year after his promise, financially stressed nations like Spain and Italy were able to borrow more cheaply than the potentially unsustainable peaks of over 6% in 2011.
However, despite that tough talk, Draghi has been accused along with other European leaders for inactivity in terms of actual economic stimulus in recent years. Most of the reason that conditions have improved has been because of investor confidence based on his statements rather than his actual activity impacting markets. While American, English, and Japanese central bankers have triggered aggressive bond-buying programs worth hundreds of billions of dollars, Draghi has been far more conservative. His strategy has been to keep rates low to spur lending. Last week, he lowered the main European interest rate to 0.05%, the lowest he is willing to go.
Starting in October, the ECB will join their major economy counterparts in the world of quantitative easing. This is a monetary strategy in which a nation’s central bank, for all intents and purposes, prints money to buy assets from banks, therefore injecting them with cash to spur lending and economic growth. The full details of the program have yet to be released, but analysts expect there to be incentives within the program for banks to lend to the more credit-starved nations within the currency bloc, such as Greece. The ECB will also begin extending cheap, emergency loans to banks in a few weeks as part of a program announced earlier this summer.
According to the Belgian think tank Bruegel, the ECB would need to spend 1% of the bloc’s GDP in order to boost inflation by 0.2%. With inflation currently at 0.3%, hundreds of billions of euros would have to be spent in order to bring Europe in line with the ECB’s stated 2% inflation target. This would be a comparable amount to what the United States, United Kingdom, and Japan have been spending.
Early iterations of quantitative easing in the United States during the downturn were stopped short by some apprehension among some of the Fed governors. One school of thought is that the practice induces too much inflation by flooding the economy with too much currency. This looks like a possible obstacle in Europe as well. The German ECB Governors remain hawkish, and the ECB noted that there was significant dissent in the meeting about Draghi’s measures. Being the largest member of the Eurozone, Germany has the most influence of any nation over monetary policy. For the policy to work, it is important that the ECB makes it very clear that it intends to continue the program until it has successfully recapitalized banks’ lending arsenals. Otherwise, it will not have a significant enough impact on investor confidence.
Mario Draghi is entering perilous, uncharted territory for the Eurozone. The outcome of monetary policy is affected by numerous inputs, including not just the virtue of the policy itself, but its subsequent implementation and communication. For the rest of his tenure as ECB President, his greatest challenge is to ensure that the German delegation maintains support for the stimulus measures. They have a history of checkered support for stimulus during the recovery and outsized power. When struggling countries needed emergency loans from Germany, Chancellor Angela Merkel’s government tied the assistance to austerity programs that some economists believe harmed the recovery. It would not be out of character for Germany to use its influence to derail the program and its potential benefits in troubled European economies.
If Germany continues to use its perch to as the most influential member of the Eurozone, struggling economies without much power like Greece will sink further into depression and the continent will experience a double dip recession. Greece’s unemployment rate, six years after Lehman Brothers declared bankruptcy, stands tall at a Herbert Hoover-like 27%. If Draghi is unable to stave off the fiscal and monetary hawks in Germany, nations like Greece, Ireland, and Spain should think long and hard about leaving the currency. If that happens, Draghi will break his promise to do “whatever it takes”.