By Cyrus Sanati
FORTUNE -- Slashing interest rates won't be enough to fend off Europe's deflationary demons for very long. The surprising move by the European Central Bank Thursday to decrease refinancing and marginal lending rates in the eurozone is the economic equivalent of giving Tylenol to a patient suffering from the flu -- it might lower the fever, but it's no cure.
What Europe needs is bona fide economic growth, and that won't come until confidence returns to the political and economic institutions of the European Union, as well as to the euro itself. But with European leaders unable to agree on basically anything, things will probably get worse before it gets better.
The markets were taken aback after ECB President Mario Draghi announced a surprising 25 basis point cut to both the refinancing and marginal lending rates in the eurozone. The move brought rates down to 0.25% and 0.5%, both extremely low. Analysts had expected any cut, if at all, would have come in December after the central bank issued its latest economic forecasts.
But Draghi felt that he could no longer sit back and do nothing. His decision to lower rates was predicated on two major economic data points released in the last week. The first is very low inflation -- the eurozone experienced a 0.7% increase in prices last month, well below the central bank's target of 2%. The second is poor growth -- the European Commission lowered its 2014 economic growth forecast for the eurozone from 1.2% to 1.1%. Bear in mind that they were predicting 1.4% growth only a few months ago.
The first issue, low inflation, really scares central bankers, as this could lead to deflation. This means prices for goods and services would fall. You might think that's a good thing, right? After all, since real wage growth in Europe is negative (meaning people are taking home less money), lower prices might be a good thing as it would encourage consumption.
But economists see it differently. They worry that deflation would discourage investment as it would induce people and banks to hoard cash. With interest rates so low, they figure banks and people wouldn't risk lending or investing cash when they can see a measurable return in purchasing power by simply holding on to that cash and not spending it. This would decrease the amount of cash in circulation, causing prices to fall even further, leading to a destructive deflationary spiral.
Every central banker seems convinced that deflation is the most destructive thing that could ever happen to an economy. As such, modern monetary policy is based on the theory that inflation is healthy and necessary. If the value of money is decreasing, the theory goes that banks and people would be more inclined to lend and invest in order to protect the value of their capital.
In order to fight off deflation, a central banker needs to basically create inflation. This can be done by lowering rates, just as the ECB has done. But the ECB, like its counterpart in the U.S., the Federal Reserve, has a problem -- interest rates are already close to 0%. As the rate closes in at zero, the effectiveness of the ECB's power to fight deflation wanes, eventually pushing the central bank into a so-called liquidity trap.
Yet Draghi claims that he still has an "arsenal" of weapons by which he could fight off Europe's deflationary demons. One is to copy the Federal Reserve's "quantitative easing" program and begin buying bonds and replacing them with cash. Another arrow in his quiver would be to lower the rate at which banks can park their reserves with the ECB below the current rate of zero. By making the deposit rate a negative number, the ECB would essentially be charging banks money to park their reserves in its vault. The hope is that this would encourage them to take their money out of the ECB and lend it to businesses and consumers.
In the end there is only so much the ECB can do here. Economies can't be healed through monetary policy, they can only be maintained. Banks need to lend, and people and businesses need to invest, or else the whole system will eventually collapse in on itself.
To get things going, some economists believe there needs to be more fiscal stimulus (increased government spending on the national level), but many European countries, like Greece and Portugal, continue to cut spending, ironically at the direction of the ECB. France is bucking the trend and continuing to spend like mad.
But fiscal spending is no panacea, either. Much of the reason why business confidence in Europe is so low is because countries like France continue to run large budget deficits while also carrying massive debt loads. This increases default risk -- the true mother of economic calamities. Given this, why invest in somewhere like France, which could be sitting on an economic time bomb, when you can invest it in oil or New York City real estate?
Like it or not, Europe needs to fix its broken government at both the national and supranational levels. The eurozone's fragmented fiscal situation, where each country decides how to tax and spend, isn't going to work in the long run. The problem is Europe isn't even close to this point in its integration. It has been two years since European leaders agreed to unify the continent's banking system and create a universal deposit scheme, and it still hasn't happened. This would go a long way to inject confidence in the eurozone banking system. Beyond a banking union there is a whole host of changes necessary to get Europe back on its feet, ranging from labor reform to tax collection.
So Mario Draghi can cuts rates to zero, he can even cut them below zero, and it won't do a lick of good to cure this sick patient. Europe needs major reform and that ultimately needs to come from Brussels, not Frankfurt.
As bad as things are -- especially for the poor, the young, the unemployed, and other vulnerable segments of the economy -- things need to get worse to overcome the enormous active inertia that is now embedded in the political systems and institutions.
By Mohamed El-Erian
FORTUNE -- In Happy Feet, one of my 9-year-old daughter's favorite movies a few years ago, a young penguin (Mumble) takes on the colony's wise MOREMay 13, 2013 9:04 AM ET
The European Central Bank's move to lower interest rates won't be enough to help the small and medium-sized businesses that drive the economy in many regions.
FORTUNE -- The European Central Bank eased investor worries last week when it cut its benchmark interest rates for the first time in almost a year. Stocks around the globe soared, but the central bank stopped short of doing one thing that could really turn MORENin-Hai Tseng, Writer - May 6, 2013 11:36 AM ET
Cyprus is more than the sad story of a small economy which allowed its banks to grow irresponsibly. It is also points to shifts in the determinants of European stability.
By Mohamed A. El-Erian
FORTUNE -- Many are hoping that, after dominating the headlines for almost two weeks now, the tiny island of Cyprus will soon return to virtual obscurity in the global financial media. For this to happen, the latest MOREMar 27, 2013 1:38 PM ET
Despite an eleventh-hour deal, the fallout from the Cypriot crisis is far from over.
By Cyrus Sanati
FORTUNE -- The banking crisis in Cyprus is far from resolved and will almost certainly morph into a far more serious sovereign debt crisis in the near future, threatening investors around the globe. The revised bailout agreement hatched over the weekend will still leave the island nation's banking-centric economy in ruin, thus limiting the government's ability MOREMar 26, 2013 9:27 AM ET
If the latest economic projections from the European Commission are to be believed, expect greater socio-political fragility in 2013.
By Mohamed El-Erian
FORTUNE -- The European Commission (EC) published its winter projections Friday. They point to further economic contraction and worsening debt dynamics this year giving way to recovery and financial stabilization in 2014 (and presumably beyond). But will they?
Let us start with the official numbers, focusing on five items:
After contracting MOREFeb 22, 2013 1:46 PM ET
If the EU's leading nations aren't willing to forgive the debt of their troubled bretheren, then maybe they need to start printing more euros.
By John Cassidy, contributor
FORTUNE – From the U.S., the European debt crisis can seem like a black comedy populated by regional stereotypes: iron-fisted Anglo-Saxons, feckless Mediterraneans, and haughty Brussels bureaucrats. Closer to the action, it isn't funny at all. In the words of Mervyn King, governor MOREMay 30, 2012 5:00 AM ET
The Greek bailout could keep investors from making additional sovereign debt purchases, further exacerbating the crisis. This will make the governments even more dependent on the ECB for funding -- something it may not always be able to provide.
By Cyrus Sanati, contributor
FORTUNE -- The latest Greek bailout has done little to convince Wall Street that Europe has gotten a grip on its debt woes. If anything, the deal has cemented the view that private MOREFeb 22, 2012 12:37 PM ET
A fragile recovery in the U.S. could get derailed by a European meltdown. ECB chairman Mario Draghi can keep things on track.
By John Cassidy, contributor
FORTUNE -- Who will be the most important person in economics in 2012? President Obama? Mitt Romney? Ben Bernanke? My candidate is Mario Draghi (a.k.a. "Super Mario"), who took over as chairman of the European Central Bank. Though virtually unknown to Americans, the dapper Italian technocrat could MOREJan 24, 2012 5:00 AM ET
The currency remained resilient through most of Europe's turmoil last year, but investors are finally beginning to see the euro for what it is: Weak.
FORTUNE -- Investors have been unnerved for more than a year now about the future of the embattled euro zone. Bond yields for the zone's troubled peripheral countries soared, as investors lost faith that Greece and others would be able to pay back its huge debts. And MORENin-Hai Tseng, Writer - Jan 10, 2012 12:06 PM ET
|Boost for trade as global deal struck|
|Someone bought a $100,000 Tesla with Bitcoins|
|2 million Facebook, Gmail and Twitter passwords stolen in massive hack|
|Where should you put your money now?|
|Ron Paul: Bitcoin could 'destroy the dollar'|