Playing With Fire

The only thing worse than an economy headed for a recession is an economy headed for recession with rising interest rates. That appears to be Europe’s fate, and it’s a fate that increasingly looks like a self-inflicted wound. The stakes could hardly be higher. The blowback from Europe threaten the feeble growth in the U.S., which in turn carries dire implications for the global economy, starting with China. But, hey, the political “leadership” in Germany, which in many ways is directing this horror show, doesn’t see any reason to change its plans.

Chancellor Angela Merkel yesterday reminded the world that her rigid embrace of Austerity Now remains intact. She continues to reject a bigger role for the European Central Bank as a tool for lowering the Continent’s rising interest rates. Centuries of precedent in central banking during financial panics are effectively dismissed in favor of what Ambrose Evans-Pritchard correctly labels as “reactionary policies being imposed on two thirds of the eurozone by Germany’s Wolfgang Schauble and the northern neo-Calvinists – with input from 1930s liquidationists at the ECB.” Indeed, the newly installed head of the ECB, Mario Draghi, is embracing this ill-fated plan, insuring a united front in short-circuiting any hope for monetary relief.
Germany’s position is all about insuring that the spendthrift countries suffering high debts and low growth should be forced onto the straight and narrow path to fiscal rectitude. This is a solution in the long run, but it’s a disaster in the short run. Unless and until the central bank steps in to lower bond rates, the potential for crushing economic pain looks inevitable. Those who disagree argue that ramping up the ECB’s lender-of-last-resort role risks unleashing higher inflation. That’s a concern, but it’s a risk that’s surely several years away as the European economy slows, with negative consequences for China, which relies on the European Union for roughly one-fifth of its exports.
“The damaging effects of the eurozone’s ongoing debt crisis are likely to push the region’s economy back into a deep and protracted recession,” warns Jonathan Loynes of Capital Economics. The high odds for this negative shock far outweigh the potential for inflation at the moment.
Until the ECB recognizes this risk and acts accordingly, economic conditions in Europe look set to deteriorate for the foreseeable future. The immediate cause: the slow strangulation that accompanies higher rates in a time of slowing growth. Indeed, Italy is “forced to pay record rates” at its latest bond auction. It’s the same narrative in Spain, Greece, and throughout Europe. Even Germany may no longer be immune to higher rates.
Granted, the lender-of-last resort solution is no free lunch and so it should be used with eyes wide open. This is a game of choosing the least-worst option from a set of awful choices. Like every decision in macroeconomics this one comes with tradeoffs. That includes the recognition that it’s easier to minimize macro risk vs. engineering economic growth. But even that policy decision is being artificially dismissed. That doesn’t change the fact that we’re at a point where the debt-deflation risk dominates. Germany will bend to reality eventually. There may no longer be a euro to save at that point, but economic pressures can’t be denied indefinitely. History is quite clear on the end game. Only the timing and costs are debatable. Meantime, there will be blood.