September 2, 2015    6 minute read

The Right Way to Economic Recovery

   September 2, 2015    6 minute read

The Right Way to Economic Recovery

The global economic scenario these days seems to be in need as never before of a shake to boost economic growth and facilitate recovery. The doubt “to intervene or not to intervene” has now been replaced by questions about how and in what measure intervene to stabilise the economic situation. The picture, itself complicated due to the legacy of previous problems such as the tail of the financial crisis of the latest years and the Greek situation, has worsened due to the Chinese events. The three subsequent devaluations of the yuan created panic on the global markets. The whole thing found its peak during the so-called “Black Monday”, characterised by a drastic fall in all markets around the world with Shanghai closing at -8.5%, Milan at -5.96% and Wall Street at -3.9%.

In just one day, European stock exchanges lost 411 billion euros and in we consider the global picture more than 1.5 trillion dollars were lost. Significative effects were also the fall of the price of raw materials below historical minimums, the revaluation of the euro with respect to the dollar at 1.17 and the enormous increase in volatility, with the VIX index reaching more than 50 base points. As the effects spread from the emerging socialist economy to the whole world, global has to be the solution to this moment of crisis. The latest Chinese events and its repercussions pointed out a call for a greater awareness and cooperation among countries. In a world where all economies are interdependent cooperation between various nations is the key to recovery and to save economies form a new 1929.

Numerous voices from the chorus seem to agree in promoting quantitative easing as a valid answer to today’s issues. It consists of an expansionary open market operations with the aim of increasing the liquidity level of an economy through a central bank’s purchase of financial assets, in particular government bonds. The role of the central bank is fundamental in creating and then injecting currency in the economic and financial system. The increase in the supply of money would boost aggregate demand leading to an increase in bonds’ prices and thus to a fall in their interest rate. The effects of this kind of operation could be also felt in the devaluation of the currency with a consequent rise in exports.

Meanwhile, it is actually the incremented liquidity which is at the base of the rise of the general price level, and, in facts, maintaining a targeted inflation level is among the main objectives of Central Banks worldwide. At the same time it is worth considering the beneficial effect on credit of this open market operation due to facilitated access, and lower costs. On the other hand the inverse process is at the top of a vicious cycle which passes through lower investment and spending, ending up in economic stagnation.

First among all, the European Central Bank that in January 2015 announced the beginning, starting from the 9th March 2015 and lasting at least up to September 2016, of a programme of quantitative easing. Mario Draghi, president of the European Central Bank, stated that the ECB would purchase government bonds for the amount of 60 billion euros per month in order to bring up inflation, which has fallen to 1.6%, below the targeted level of 2%. The intention is that of acting of investors’ expectations spurring them to invest and to be more confident by letting them understand that interest rates would stand still.

These non-standard measures not only have successfully improved the credit and financial conditions of the Eurozone but have also contributed to sustain the normalisation of price stability, and economic recovery. This, however, has not been done without critiques; three German public law experts believe that the purchase plan of government bonds goes beyond the tasks of the ECB and the former Treasury secretary, Lawrence Summers, clarified his expectations regarding European QE to be not so impactful in Europe.

A different situation is now present in the United States where the Federal Reserve Bank manifested its intention to push up interest rates for the first time after the financial crisis. Lawrence Summers, ex Treasury secretary, and Ray Dalio, head of Bridgewater fund group, disagreed with this move and supported the restarting of quantitative easing. Nevertheless, the hypothesis of a fourth round of quantitative easing similar to those in 2008, 2010 and 2012 is far from being accomplished. At the same time after the recent market ructions economists and investors have drastically scaled back their forecasts for when and how quickly US interest rates will rise in the coming months. While more quantitative easing is clearly a minority view at the moment, according to Lawrence Summers:

“It is far from clear that the next Fed move will be a tightening”

On the other side of the globe, only the critical Black Monday convinced the PBoC of the need to intervene in the economy. The Central Bank eventually decided to implement a series of expansive measures kicking off Chinese quantitative easing. 150 billion yuan have been injected in the system through open market operations, bank reserve ratios has been cut of 50 base points and one year interest rates of 25 base points.

By the way, it is not always gold what sparks; the main central banks all over the world have already planned open market operations or are moving towards quantitative easing but the way to reach an ideal size for them and to find the policy mix needed to restabilise equilibrium in the global economy is still long and full of difficulties. Everything done so far would probably not be enough. Many retain that the quantitative easing implemented up until now is not sufficient both from a quality and quantity point of view.

The International Monetary Fund feels that the Eurozone still has to face hard economic perspectives due to pre-existent problems regarding the Greek situation, elevated unemployment rates and a financial sector still signed by the crisis. International cooperation is needed to implement structural reforms and raise even more the liquidity level. In spite of the last years’ talking about the need of being independent, the European model, export-centred, is extremely dependent on others’ growth and instability.

The Chinese crisis and the European depression have thus pointed out the weaknesses and the fragility of the European political and economical model. In spite of the fact that the blame for the latest events has to be put on China, the repercussions on the Eurozone and the subsequent problems derive from the incapacity of these countries to assume a strong and active personality in economic policy; reason why Europe is destined to pay even when someone else is doing wrong.

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