The ESADE Economic Report warns of an evident risk of deflation in the eurozone

According to the latest ESADE Economic Report, the recent steps taken by the European Central Bank (ECB) are positive but "insufficient" and "additional measures may be needed in the coming months". These unconventional monetary-policy measures (quantitative easing) – which could include purchasing eurozone public debt in bulk in order to stimulate growth, as has already been done in the United States by the Federal Reserve – would help to distance Spain and other European countries from the "evident risk of deflation", according to Josep Comajuncosa, co-author of the ESADE Economic Report.

"We believe that the ECB is moving in this direction," declared Prof. Comajuncosa. In the short term, after the summer holidays, the European banks will undergo important stress tests. "If some banks, including those of the core European countries, fail to pass the stress tests with good scores, they would need to be recapitalised or, hypothetically, receive public aid," explained Prof. Comajuncosa. "This would prompt the ECB to take unconventional monetary-policy measures, such as buying massive amounts of debt."

According to the report, "In order for economic policy to be successful in the medium term, and for the single European currency to survive and thrive, it is important that the peripheral countries maintain the reform programmes that they have introduced in order to increase productivity." In places where growth remains weak – such as Spain, which is expected to grow by around 1% in 2014 – the grave threat posed by the "evident risk of deflation" looms large.

If this threat were to materialise, the ESADE report warns, the economy would fall back into a recession and the real debt load would increase in certain economies that are already highly indebted, such as Europe and, in particular, Spain. The new report discusses the recent monetary measures taken by the European Central Bank. The report’s authors consider that the most important measure taken by the ECB, besides slashing the interest rate to 0.15%, is "making €400 billion available to financial institutions in the eurozone". According to the report, this move signals a change in the ECB’s strategy and a shift towards monetary measures more similar to those already implemented by the US Federal Reserve. However, due to the weakness of economic growth, these measures may be "insufficient" and "additional measures may be needed in the coming months", according to the report.

Unconventional measures

What measures will be needed, exactly? According to the authors of the new ESADE report, these measures could include unconventional tactics such as liquidity injections tied to credit availability and even generalised liquidity injections like those used by the US Federal Reserve. According to the report, "The ECB could purchase public bonds from all eurozone countries in amounts proportional to each country’s GDP, or proportional to each country’s participation in the ECB’s capital, such that the bank would not be granting privileged financing to the public sector of any eurozone country." Such an approach would improve the flow of credit and help the peripheral countries, where "the scarcity of credit is hindering economic recovery".

The authors of the report are highly concerned about the risk of deflation, which they describe as an "evident" threat to Spain and the eurozone countries in general: "In economies that are in recession and have large amounts of debt, deflation would lead to a vicious cycle, and this outcome must be avoided at all costs." Deflation is known to increase the real cost of financing as well as the real debt load. According to the ESADE report, "The debt-reduction process is more difficult in an economy characterised by deflation, which drags down spending on consumption and investment."

Banking union and tax reform

The report also addresses, in no uncertain terms, the status of the European banking union: "The European banking union is essential in order to overcome the current fragmentation of the eurozone’s financial markets. Without it, it will be impossible to end the eurozone crisis." However, the report’s authors insist that, because of the threat of deflation, in addition to finalising the banking union, the ECB must "use unconventional monetary-policy instruments such as cash injections for banks and even the generalised purchase of public debt over a lengthy period of time".