Mario Draghi

Europe likely to get worse before it gets better

November 8, 2013: 10:23 AM ET

The European Central Bank's latest interest rate cut won't solve the region's problems. It needs bona fide economic growth.

By Cyrus Sanati

130307073809-ecb-building-620xaFORTUNE -- 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.

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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.

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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.

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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.

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