This week, the Organization for Economic Cooperation and Development (OECD) revised down their forecast for global economic growth. What was more telling, however, is the effect that the European Union will have on the rest of the developed world. Inclusive of the 34 member nations, growth is expected to be two tenths of a percent less this year than the year prior. And what is revealing about that estimate is that it accounts for more robust growth out of the US and Japan, thus Europe will once again not only be the scar on the developed economies, but also the rest of the world.
Where some analysts try to tell a story of rising consumer confidence or gains in productivity, the OECD doesn’t pull any punches. It is quite clear to them, as their report states, that “monetary policy will continue to bear most [of the] responsibility for supporting [economic] activity, including through unconventional measures.” As bond prices sold off this week at the continued thought of the Federal Reserve tapering their asset buying program, the OECD believes that these unconventional measures are what will continue to pull the US along. Any tapering or restricting of the Fed’s stimulus will be done so in a fashion not to disrupt or alter the markets.
That really is no secret though. To the academics and policy wonks quantitative easing in the US is going as planned, and efforts from the Bank of Japan are productive despite then being a little late to the party. That’s not necessarily the case for the Eurozone where the situation is dire. The policy suggestions for a deteriorating currency bloc continue to look more and more desperate.
One of the OECD’s suggestions for the European Central Bank is to cut their key interest rate to negative territory in order to discourage banks from parking their funds overnight. The idea is to promote banks to lend out their cash reserves; the uncertainty is whether or not they will do it. Coincidentally, it is a similar situation as with the US during QEI and QEII. It was a crisis of liquidity. Like in Europe, the challenge stems from the transmission of a central bank providing emergency level interest rates so that small and medium size businesses are able to actively participate in credit markets. The risk premium, however, that is priced into borrowing rates for SMB’s remains undistorted (unlike perhaps sovereign bond markets) by this record stimulus.
It is this leg of the cycle that is yet to be fixed in Europe, and that threatens the fate of the Euro. We hear from policy makers about the importance of a banking union and an EU regulator, but that just adds more complexities to an already diverse problem. Where the EU is struggling in their recovery, akin to the US in 2009/2010, is that cash is sitting idle. Credit needs to be transmitted through their financial system to the businesses that will look to provide jobs and create opportunity for economic expansion.
As we learnt from the US, providing confidence to an economy isn’t as easy as providing liquidity. The US Fed had to more than triple their balance sheet and the stock market had to rally for four years before people bought into the idea of another bull market for equities. But as Reinhart and Rogoff point out in their historical masterpiece, “This Time is Different,” economies can take 5 to 7 years to bounce back from currency crises. Maybe in hindsight a negative interest rate or a tax on savings for banks will be the right incentive to make financial institutions lend, but in present time it really comes off more as desperate.