May 28

Mario Draghi can’t get no respect. The head of the European Central Bank is routinely criticized for being too timid in stimulating Europe’s weak economy. The ECB — Europe’s equivalent of America’s Federal Reserve — is widely expected to cut interest rates and loosen credit once again at its next meeting June 5. But already, some commentary is critical. “Too little too late,” predicts economist Desmond Lachman of the American Enterprise Institute.

In some ways, pessimism seems wrong. Europe is in a better place today than a few years ago, when it grappled with recession and a full-blown “sovereign debt crisis.” Starting with Greece and spreading to Ireland, Portugal and Spain, countries needed giant rescue packages because their governments couldn’t borrow freely on open markets.

Now the economy is growing again, and the debt crisis has eased. All the major debtor countries are borrowing on the market. Interest rates have also dropped sharply. From a year ago, rates on 10-year government bonds fell from 4.3 percent to 2.9 percent for Spain, from 4 percent to 3 percent for Italy and from 3.5 percent to 2.7 percent for Ireland. The Irish rate is close to the rate on 10-year U.S. Treasury bonds, about 2.5 percent.

That’s the good news. Unfortunately, it isn’t very good.

Growth is feeble. In the first quarter of 2014, gross domestic product (GDP) in the euro zone (the 18 countries using the euro) expanded at a meager annual rate of 0.8 percent. This was about half what was expected and isn’t strong enough to make a big dent in unemployment. It’s 11.8 percent for the entire euro zone and higher in some countries: 25 percent in Spain, 15 percent in Portugal and almost 13 percent in Italy.

What has really spooked economists is the specter of deflation — a general fall in prices. It’s the opposite of inflation, which is a general rise in prices. On paper, deflation can benefit consumers. Falling prices boost their purchasing power. But deflation can have adverse effects. Consumers may delay purchases — especially of big-ticket items — if they expect lower prices. Deflation also increases the debt burden on borrowers; as prices fall, it’s harder to earn the incomes needed to repay loans made when prices were higher.

History seems to emphasize the bad effects. Since Japan began experiencing mild deflation in the mid-1990s, its economy has struggled. In the Great Depression, deflation was rampant; wholesale prices plunged 33 percent from 1929 to 1933. The fear is that European deflation would renew both the recession and the sovereign debt crisis, which would feed on each other.

The fear isn’t abstract. Inflation has drifted down. In April, euro-zone consumer prices were only 0.7 percent higher than a year earlier. That’s less than half the ECB’s inflation target of just below 2 percent. At some point, low inflation could become deflation. Indeed, seven small countries including Greece and Portugal already show slight deflation. High unemployment and unused industrial capacity keep downward pressure on prices.

By loosening credit, the argument goes, the ECB can preempt deflation. It might also ease upward pressure on the euro’s exchange rate. A high euro lowers the price of imports (risking deflation) and raises the price of exports (worsening unemployment).

But what can the ECB do? Its main lending rate to banks is already a paltry 0.25 percent. This might be cut to 0.15 percent or zero. Would that spur new lending? The ECB could also charge banks an interest rate for holding deposits at the ECB, prompting banks to lend the money instead. But these deposits are tiny; any effect is also likely to be tiny.

Jeffrey Anderson of the Institute of International Finance (IIF), an industry think tank, suggests that the ECB should funnel credit toward small and medium-size firms. A study of six European countries by the IIF and Bain & Co., a management consulting firm, found that this lending had dropped by roughly 50 percent since 2008. But Anderson concedes that the technical problems of encouraging this lending would limit its impact.

Because interest rates on government bonds have already dropped sharply, the ECB won’t emulate the Federal Reserve’s policy of massive bond purchases (known as “quantitative easing”), argues Jacob Kirkegaard of the Peterson Institute. Mostly, he says, any ECB package will protect Europe against any adverse foreign “shock”: say, a China slump.

Draghi’s dilemma is: Expectations are high; practical possibilities are low. But he has been here before. In 2012, it was feared that some euro-zone countries might default on their debts. Draghi quashed those fears by promising that the ECB would stand behind debtor countries. Thus reassured, investors were more willing to hold government bonds; that’s one reason interest rates dropped. Now as then, Draghi’s task is to improve psychology. Maybe he can do it again.

Read more from Robert Samuelson’s archive.