It was one of those days when Mario Draghi just couldn't seem to please anyone. When a journalist accused the president of the European Central Bank of having duped financial markets, he flashed his trademark ironic smile. With his head tilted and his mouth turned up at the corner, it looked as if he was laughing at the complexity of the situation.
Last Thursday, Draghi once again announced a decision that could end up in the history books. The main refinancing rate, the central bank's most important tool, was cut to a new record low. Banks now only have to pay 0.25 percent for money they borrow from Draghi. That's less than ever before.
The rate cut followed heated debate in the ECB's Governing Council which includes the heads of the euro zone's national banks. The decision boosted share prices and caused the euro to depreciate sharply.
Draghi said it made no sense to comment on such market reactions. "It is usually quite useless because they do what they want, no matter what," he quipped. The former investment banker, whom critics accuse of being too focused on pleasing the markets, meant it as a joke.
But it also summed up the powerlessness of the euro's supreme guardian. A statistic announced last week sent alarm bells ringing not just inside the Frankfurt-based ECB headquarters but in national capitals as well. That figure is 0.7 percent, and it refers to the euro zone year-on-year rate of inflation for October, the lowest rate since November 2009. A rate of two percent is regarded as healthy for the economy. What's worse is that the 0.7 seems to contradict all conventional monetary policy wisdom.
In his battle against the euro crisis, Draghi has pumped more money into the financial system than any other ECB president before him. He didn't just embark on a high-speed reduction in interest rates to almost zero; he also launched all kinds of special loan programs for banks. Hundreds of billions of euros poured into the monetary system in that way.
Loose Money Has Helped Japan and US -- So Far
Conservative colleagues, among them Jens Weidmann, the head of the Germany's central bank, the Bundesbank, warned that this could lead in the long term to a repeat of Germany's historic nightmare: massive inflation leading to the impoverishment of large parts of the population.
But now, suddenly, the euro zone is showing the first symptoms of a quite different disease: deflation, meaning a broad decline in prices which deters people from spending money. That phenomenon paralyzed Japan's economy for almost two decades and turned the former economic paragon into a problem case. It's a nightmare scenario for the euro zone.
That is why Draghi argued forcefully in favor of an interest rate cut last week while around half a dozen members of the Governing Council warned that such an abrupt response to a single monthly figure was too hasty. Critics see the move as yet another sign that Draghi is increasingly following the example set by his central bank colleagues elsewhere around the world.
Outside the euro zone, central banks have shown far less restraint in intervening in their respective economies -- and their efforts appear to have met with considerable success.
Draghi's Japanese counterpart Haruhiko Kuroda has been particularly aggressive. The Bank of Japan's governor purchases some €55 billion ($73.6 billion) worth of securities and government bonds from banks each month, thereby reinforcing a massive stimulus program launched by Shinzo Abe, the new Prime Minister. Abe wants to put a stop to his country's economic stagnation by massively depreciating the yen and investing in gigantic infrastructure projects. As a result, Japan's debt has soared to the unimaginable sum of some €7.8 trillion -- but the economy has finally awoken from its chronic slumber to show marked growth. Between April and June, Japan's GDP grew 3.8 percent, a bigger growth rate than any other industrial nation. Companies like carmaker Toyota, boosted by the cheaper yen, are finally performing better after years of woe.
Ben Bernanke, the head of the US Federal Reserve, is spending $85 billion per month on mortgage-backed securities and government paper. The key interest rate in the world's biggest economy has long been at a historic low of 0.25 percent. In the US, too, the economy is picking up after the traumatic financial and economic crisis of recent years. Unemployment is slowly declining, the housing market is recovering and industrial production is rising. Despite these gigantic stimulus programs there is no sign of inflation in the US either -- the figure hasn't risen above two percent in any month this year.
Risk of Inflation Persists
The phenomenon confronting Bernanke and Draghi is easy to explain. They can't inject their money straight into the economy and have to go via the banks instead. But if those banks hoard the cheap money instead of lending it to businesses, the system doesn't work.
This doesn't just pose the question how much of the recovery is really down to the Fed's policy. It also suggests that the risk of medium-term inflation hasn't been averted just because the current figures are headed in a different direction. "The dynamic can change very quickly," says John Silvia, chief economist for Wells Fargo. Once the masses of money have squeezed through the bottleneck, deflation can quickly turn into high inflation.
The dangerous monetary policy medicine can have further side effects: a dramatic depreciation in the value of the currency, and so-called financial repression, whereby inflation exceeds the interest rates paid on secure investments and eats into the assets of small savers, among others. Even many Americans who don't share the German trauma of hyperinflation are worried about the Fed's experiment. The president of the Federal Reserve Bank of Kansas, Esther George, has warned about the risks of aggressively putting money in the economy and said there was no historical experience the US central bankers could rely on.
In Germany, the debate is being led by economists like Michael Heise who have the country's angst of uncontrollable inflation in their DNA. Heise, the chief economist of insurer Allianz, doesn't tend to paint extreme scenarios, but the debate over deflation and inflation gets him rattled. "An interest rate cut is the wrong message; it could really get deflationary expectations going," he says. If the ECB sees the necessity to make such a cut, the argument goes, the risk of deflation must be greater than hitherto thought. If that view takes hold in people's minds, it could turn into a self-fulfilling prophecy, because people will stop buying goods and firms will have to lower their prices.
Euro-Zone Countries Need Different Medicines
But Draghi's biggest problem is his currency zone. "Whether Tokyo or Osaka, the whole of Japan has the same problem and needs the same medicine," explains Thomas Mayer, the former chief economist of Deutsche Bank. "But in the 17 countries of the euro zone conditions differ widely." The countries all have the same currency but they're not equally competitive. "That's why prices have to fall in the Latin European states from Greece to France or they have to rise in Germany and other states."
So the euro zone needs inflation and deflation at the same time -- depending on what country you're looking at. It's no wonder that Germany is worried about rising prices while Southern Europe fears declining ones.
But what price direction is more dangerous for Europe? The euro crisis managers want downward pressure on prices in Greece or Spain, where governments, private households and companies are cutting back on expenditure and wages have fallen. That makes those countries more competitive, but it causes a decline in price levels and lower inflation rates in those countries.
"The problem is that if deflation lasts for any length of time the debt mountain will get even bigger and be harder to reduce," says Mayer. And if investors start worrying again that the government may default on its debts, the countries could quickly sink into the same mess they were in last year.
That's why ever more European economists believe the ECB has no option but to follow the examples of Japan and the US. "The states on the periphery are clearly heading in the direction of deflation," warns Guntram Wolff of the Brussels-based think tank Bruegel. He believes the rate cut was the right move, but didn't go far enough. "The banking system has to be restructured to ensure that the cheap money gets to the economy."
No Alternative to Cheap Money?
The ECB and the European Commission, the EU's executive, share that view, which is why they want to conduct thorough reviews of the banks' financial health, and to get them in shape over the next 12 months. Until that has been achieved, the ECB, it seems, wants to keep buoying euro-zone sentiment with cheap money. It's also under pressure because the Fed and the Bank of Japan are proceeding so aggressively. "The strong euro is a result of this policy," says Guntram Wolff. The more expensive the euro, the cheaper the imports into the euro zone, which in turn increases the risk of deflation.
As a result, some European economists regard rising inflation in Germany as the lesser evil. "The fear of inflation in Germany is exaggerated, " says Wolff.
Even German economists concede that there's little sign of inflation in Germany at present. "But I don't think that the laws of economics have been suspended," says Heise of Allianz. According to his reading, loose monetary policy must at some point lead to higher inflation. When the economy starts picking up and confidence in banks and companies returns, "inflation will rise," he says. Then the ECB will have to respond with countermeasures, he adds.
The question is: Will it still be able to?