Europe’s Emerging Bubbles

Hans-Werner Sinn

Project Syndicate, 28.03.2016

The European Central Bank’s latest policy moves have shocked many observers. While the goal – to prevent deflation and spur growth – is clear, the policies themselves are setting the stage for severe instability.

The policies in question include setting the interest rate on the ECB’s main refinancing operations to zero; raising monthly asset purchases by €20 billion ($22.3 billion) to €80 billion; and pushing the interest rate on money that banks deposit with the ECB further into negative territory – to -0.40%. Moreover, the ECB has launched a new series of four targeted longer-term refinancing operations, which also carry negative interest rates. Banks receive up to 0.4% interest on ECB credit that they take themselves, provided they lend it out to private businesses.

These policies are, in essence, the latest in a string of attempts by the ECB to address the fallout of the collapse of the massive bubble that formed in southern Europe in the early years of the euro. It all began with the announcement of the euro’s introduction at the 1995 EU Summit in Madrid, which caused interest rates to tumble.

The inflationary credit bubble spurred in southern European countries by the persistence of lower interest rates undermined their competitiveness and drove asset and property prices to unsustainably high levels. When the bubble burst, the ECB tried to prevent the excessive prices from returning to their equilibrium levels by using its printing press and promising unlimited coverage to investors. The latest ECB measures are just more of the same.

Of course, when the financial crisis erupted in full force in 2008, following the collapse of the US investment bank Lehman Brothers, the ECB’s interventions were justified. But after the global economy started to recover during the latter part of the following year, the ECB’s moves became increasingly problematic, because they enabled countries to evade structural reform and hindered the necessary disinflation in the southern eurozone countries – or even halted it altogether, as in Portugal and Italy.

Southern Europe had succumbed to the drug of cheap credit. But when private credit stalled and the symptoms of withdrawal began to appear, the ECB provided replacement drugs. Instead of treating the addiction, it created junkie economies that were unable to function without a fix.

Japan made a similar mistake when its property bubble burst in 1990. For over two decades, the Bank of Japan flooded the economy with money at near-zero interest rates. The Japanese government, for its part, has followed such a relentless policy of deficit spending that public debt jumped from 67% of GDP to 246% of GDP today, with the latest upward push provided by the dubious “Abenomics” economic strategy being pursued by Prime Minister Shinzo Abe’s government.

None of this has helped, because neither monetary nor fiscal policy can substitute for structural reform. On the contrary, the more Keynesian and monetarist drugs are administered, the feebler the self-healing power of the markets and the weaker the willingness of policymakers to impose painful detoxification treatments on the economy and populace.

But the worst effects of the ECB policy may be yet to come, if the eurozone’s still-sound economies also become credit junkies. There are already some worrying signs of this. Property markets in Austria, Germany, and Luxembourg have practically exploded throughout the crisis, as a result of banks chasing borrowers with offers of loans at near-zero interest rates, regardless of their creditworthiness. In Austria, property prices have risen by nearly half since the Lehman collapse; in Luxembourg, they have risen by almost one-third.

Even Germany, Europe’s largest economy, has been experiencing a massive property boom since 2010, with average urban property prices having risen by more than one-third – and by nearly half in large cities. The country is undergoing a construction boom not seen since reunification. Real estate agents have only leftovers on offer.

The German property boom could be reined in with an appropriate jump in interest rates. But, given the ECB’s apparent determination to head in the opposite direction, the bubble will only grow. If it bursts, the effects could be dire for the euro; the new Euro-skeptic Alternative for Germany party, which made astonishing headway in the country’s recent state elections, would make sure of that.

Read more

Also published in