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The European Central Bank Is Running Out of Options

How do you address a recession, a strengthening currency, a precarious banking sector, and deflation all at the same time?
September 16, 2020
Featured Image
Christine Lagarde holds a news conference at the IMF headquarters January 17, 2013 in Washington, DC. (Photo by Chip Somodevilla/Getty Images)

One has to pity Christine Lagarde, the president of the European Central Bank (ECB). In its effort to revitalize the Eurozone economy and avoid deflation, the last thing that the ECB needs is a strong Euro. Yet the Euro has been strengthening, and there is little that the ECB can do to weaken the currency without creating another set of serious problems for itself.

It would be an understatement to say that the ECB is now facing historic economic challenges. The Eurozone is experiencing its worst economic recession in the past 90 years and is showing incipient signs of deflation. At the same time, a second wave of coronavirus could require a reversal of the recent opening up of its economy that has allowed for a partial recovery.

The combination of a weak economy and falling prices would be troubling for any central bank. It is particularly so for the ECB considering that two of the Eurozone’s largest member countries, Italy and Spain, have exceedingly high public debt levels and shaky banking systems. Slow growth and deflation would make it all the more difficult for those two countries to grow their way out of their debt and banking sector problems.

Over the past few months, largely in response to the Federal Reserve’s shift to an easier monetary policy, the Euro has appreciated by more than 10 percent against the U.S. dollar. If sustained, that would threaten to weaken the Eurozone economy by making Eurozone exports less competitive and by making imports from abroad all the more attractive. At the same time, it would intensify deflationary pressures by reducing import prices and by making the economy more sluggish.

In principle, the ECB could take action to cheapen the currency by reducing interest rates or by increasing its bond-buying program. However, it can ill afford to take such action with the explicit purpose of weakening the currency for fear of sparking a currency and trade war with the United States. This is especially the case at a time that the U.S. Treasury has already put Germany on notice for its very large trade surplus and for using the Euro as the means to gain an unfair competitive advantage with respect to the United States.

Leaving aside the risk of sparking a currency war, reducing interest rates to weaken the currency would not seem to be a viable option for the ECB. With interest rates already in negative territory, reducing them further into negative territory would run the risk of further destabilizing the Eurozone’s banking sector. Banks, including the shaky ones in Italy and Spain, would need to find a way to make up for lost income on their bond holdings, but they would find it difficult to reduce deposit rates to negative levels for fear of antagonizing their depositors.

It might seem like the ECB could avoid those complications by expanding its bond buying program, but that would risk sparking a backlash from Germany. Last May, the German Constitutional Court issued a ruling questioning whether or not the ECB had exceeded its mandate by engaging in an aggressive bond-buying program. If the ECB were to significantly expand that program now, it would risk inviting the German Court to carry through on its threat to proscribe the Bundesbank from participating in any future ECB bond-buying program. Not to mention the adverse political fallout from such action for Eurozone cohesion, without the Bundesbank, the ECB’s largest member bank, the ECB would be rendered rather ineffective.

All of this leaves Madame Lagarde with few good options to address the Euro’s recent strength. She can hope that once the U.S. economic recovery strengthens or markets begin to focus on Italy and Spain’s economic weaknesses, the Euro will revert to its previous value. Alternately, she can exhort Eurozone economic policymakers to help the ECB cope with the problems caused by a strong Euro by engaging in a more expansionary fiscal policy than has been the case to date.

That, too, would be a more attractive option if so many of the Eurozone countries were not already suffering from crushing levels of public debt.

That’s not Lagarde’s fault, but it has become her problem.

Desmond Lachman

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.