Time for a German fiscal stimulus

In assessing last week’s European Central Bank (ECB) monetary policy U-turn in response to a weakening European economy, two basic questions should be asked. Is there reason to expect that the ECB’s policy measures will do very much to arrest the European economic slowdown? Might the ECB’s move not have the unwelcome effect of weakening the Euro and of thereby increasing trade tensions with the United States?

The most likely answers to those two questions would suggest that a far more appropriate economic policy response to the European economic slowdown than ECB loosening would have been a fiscal policy stimulus from those European countries, like Germany, that have the fiscal space to loosen their budgets.

In response to the marked downgrade of its Eurozone economic growth forecast to around 1 percent in 2019, the ECB announced a monetary policy loosening.

It did so by indicating that interest rates would not be raised until 2020 and that the ECB would not begin reducing the size of its balance sheet this year. The ECB also announced a new targeted long-term refinancing arrangement for the banks in an effort to induce them to increase their lending.

Sadly, the ECB’s own recent experience with easy money would give reason to think that the latest monetary policy package will not do much to turn the European economy around. This would especially seem to be the case at a time that the European economy is already slowing down markedly and at a time that it could soon be hit by a Brexit or a US automobile import tariff shock.

Over the past few years, in response to the Eurozone debt crisis, the ECB resorted to a highly unorthodox monetary policy that included more than EUR 2 trillion in quantitative easing, negative deposit rates, and multiple bank subsidies. Yet despite all of that monetary policy stimulus, the European economic recovery proved to be both lackluster and short-lived. This being the case, why should one now expect that a very much more limited set of ECB policy loosening measures would have much positive economic effect?

One thing that the ECB’s move to an easier monetary policy stance must be expected to do is to further weaken the Euro. This risks opening up Europe to further charges by the Trump administration that the ECB is manipulating its currency with a view to gaining an unfair European competitive advantage.

That would hardly be helpful in improving US-European trade relations at a time when the Trump administration is already expressing displeasure with a strong dollar and when it is considering the desirability of imposing import tariffs on European automobiles.

In contrast to the ECB’s policy loosening, one would think that a well targeted fiscal policy stimulus by those European countries with the fiscal space to do so would have a salutary and meaningful effect on the European economic outlook. At the same time, unlike ECB policy loosening, a German fiscal stimulus is likely to boost the Euro by creating the conditions for European monetary policy to be less out of sync with that of the United States.

A German fiscal stimulus would also help improve US-European trade relations by holding out the prospect of reducing the German current account surplus, which at almost 8 percent of GDP substantially exceeds that of China. It would do so by reducing German’s large savings-investment imbalance that underlies its very large external current account surplus.

All of this is not to say that the ECB loosening is not to be welcomed at a time that the Italian economy is already in recession and that the German economy is on the cusp of a recession. Rather, it is to suggest that the more appropriate policy response to the European economic slowdown would have been a German fiscal stimulus. This is especially the case considering that such a stimulus might have helped reduce the large German external current account surplus that underlies the present poor state of US-European trade relations.

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.