During an Aug. 22 speech at the U.S. Federal Reserve's annual conference in Jackson Hole, Wyo., Draghi laid out the framework of a new plan to raise inflation and promote sustainable growth in Europe. He also implied that the austerity measures imposed during the European crisis have been ineffective. The idea behind austerity, which Germany strongly supported, was that tight restrictions on fiscal policy would reduce debt, and that low debt would in turn facilitate growth. His speech seemed to align with an alternative view from Southern Europe, which sees economic malaise as a byproduct of a lack of demand, not a preponderance of debt.
The departure may not be as radical as it first appears. For the past two years, the European Central Bank has been forced to take more unorthodox measures to counter dangerously low inflation rates — rates that are actually nearing deflation, which wrecks countries with high levels of debt. The prospect of even looser fiscal policies in the eurozone, such as higher taxes and spending, will worry Germany, which has a longstanding mistrust of eurozone largesse. However, Berlin would be even more hesitant to accept the other major option for stimulating demand: quantitative easing.
The problems the European Central Bank faces differ from those of other central banks. It presides over a collection of nations with competing interests, so it cannot undertake the same initiatives that the Bank of England or the U.S. Federal Reserve can, particularly in the case of quantitative easing.
The German-dominated core of the eurozone has a strong aversion to moving money from the center to the periphery via the purchase of sovereign bonds. This is particularly true regarding peripheral countries — France and Italy, for example — that have failed to adequately implement economic reform. If they did not reform before the adoption of quantitative easing, they may be even less inclined to do so after money is injected into their economies.
In Germany, the debate over quantitative easing is also a political matter. The anti-euro Alternative for Germany party gains support whenever the specter of quantitative easing looms largest. In fact, Euroskepticism is growing in Germany due to a wariness among German voters of using German money to pay other countries' debts. This could destabilize German Chancellor Angela Merkel's fragile coalition.
There are also legal considerations. The German Constitutional Court ruled that the mechanism that would facilitate quantitative easing is illegal. Though the ruling is in legal purgatory in the European Court of Justice, the threat of legal action will hang over any future purchase of sovereign bonds.
Notably, even if quantitative easing was adopted, the purchase of sovereign bonds would not affect the part of the economy that needs to be stimulated — namely, the small and medium-sized companies that many hope will drive growth in the eurozone. In fact, measures introduced by Draghi on Sept. 4 were designed to get at those hard-to-reach areas, but it is still unclear whether they will make an appreciable difference. (The policies involved purchasing asset-backed securities, which constitute only a small market in Europe.)
Another reason inflation is such a problem involves the relationships among eurozone members. The eurozone inflation rate has been dropping steadily ever since the euro crisis of 2012. Heavily indebted peripheral economies (France, Ireland, Italy and Spain) have a strong incentive to keep their inflation levels as high as possible, since high rates alleviate some of the pain of debt repayments.
Meanwhile, competitiveness relative to Germany has complicated the situation. Before the eurozone was created, countries became more competitive by devaluing their currency. But that became no longer possible once those countries entered a monetary union. Their only recourse is to keep inflation lower than that of the strongest country in the union: Germany, which keeps its unit costs extremely low largely through reforms undertaken at the beginning of the last decade. So as eurozone inflation fell, eurozone economies had a hard time remaining competitive without slipping into deflation. Now, very low inflation levels benefit no one, least of all the fragile economies that are trying to grow while managing their debt.
A suitable solution that pleases everyone may prove elusive, but two approaches are being discussed. The first is increased investment. Incoming EU Commission President Jean-Claude Juncker has spoken of a program to re-industrialize Europe by investing some 300 billion euros ($387 billion) in its energy, broadband, transport and industry. Reports from Sept. 8 indicated that the French and German finance ministers are seeking joint investment opportunities in Europe. The same day, Italy's top EU affairs official asked for more leeway to increase public spending. The request followed the Italian economy minister's suggestion of a growth compact to replace the current EU fiscal compact, clearly marking a shift in thinking from austerity to growth.
However, German-dominated EU institutions probably will not allow France and Italy to renege on their commitments and embark on a spending spree under the pretext of stimulating growth. More likely, the European Central Bank and some eurozone members will directly or indirectly encourage Germany to loosen its fiscal policy to spend more heavily on investment within its borders and raise wages. After a surprisingly sluggish second quarter, a record trade surplus announced Sept. 8 suggests the economy will recover in the third quarter. With sovereign bond yields at record lows, Germany has room to loosen its policies domestically.
If German inflation rises, it would bring the eurozone average higher and free up space for the peripheral countries to run higher inflation rates while remaining competitive with the core. Along with Juncker's more generalized investment throughout the eurozone, this could save Europe from its inflation free fall and buy time to implement necessary reforms. It will also allow time for the implementation of the targeted long-term refinancing operation, Draghi's other policy for placing money into the hands of small and medium-sized enterprises, is providing banks with a loan facility that is attached to various conditions. That policy will take effect Sept. 18.
But rarely do things work out so easily. Germany has a longstanding phobia of high inflation rates, a fear born of a dangerous bout with them in the 1920s. But while raising inflation rates so that other countries can mend their economies will be politically unpopular, there are some reasons for optimism. Berlin may decide that it is a better option than the capital relocation plan, since it does not involve money leaving Germany. Moreover, it could benefit the German economy. German investment currently stands at 17 percent, well below the 21 percent average for industrialized countries. The investment gap is at 3 percent of gross domestic product, according to the German Chambers of Commerce and Industry.
In addition, Germans have long had to live frugally as wages have failed to keep up with those of other industrialized nations, and higher wages could lead to an increased quality of life for citizens. (Anti-establishment political parties may also end up losing support as a result.) Increased German consumption would probably lead to increased imports from the rest of the eurozone. France and Italy have called for a looser fiscal policy, with particular reference to the budget requirements of the fiscal compact, which neither country can meet. Leeway from Brussels on that issue should make both countries more open-minded when it comes to structural reforms.
Until the Jackson Hole conference, the differences within the European monetary union appeared to be irreconcilable. With inflation dropping, quantitative easing seemed to be the only solution, albeit one that did not benefit small and medium-sized enterprises enough and ran counter to German ideology, politics and jurisprudence. That policy would have pitted Germany against Italy and France, potentially rupturing the European project.
But stimulating demand through increased investment, as France and Italy implement key structural reforms, allows Europe to forestall that confrontation. Of course, progress will not be immediate — German Finance Minister Wolfgang Schaeuble spoke out against budgetary laxity Sept. 8 — but these are the first steps of Draghi's plan to save the eurozone. His plan will not mean the end of austerity; the past decade of fiscal laxity will not be allowed to return to the eurozone anytime soon. But it would likely benefit Germany, a country that may soon get to spend some of the money it has been saving for so long.