Rebalancing and the Euro

Pushing down the euro is seen by many as a solution to stagnation and ‘lowflation’ in the euro area, but this paper argues it needs to be supported by a fiscal expansion, in particular in Germany. Unfortunately the incentives for Germany to embark on fiscal stimulus are weak. Yet without a fiscal expansion the current account surplus would widen further in response to exchange rate depreciation, thus exacerbating the current imbalances—excess saving in Germany alongside indispensable deleveraging in southern Europe. It would risk producing a protracted slump that feeds onto itself, with (core) inflation declining further and the risk of outright deflation increasing. If that risk were to materialise the ECB may have to be called to rescue the euro again, as it did in 2012 with the introduction of Outright Monetary Transactions (OMT). And it would have to do so persuasively or else Europe risks ending up in a Japanese conundrum. It is in this perspective the ECB's move towards quantitative easing should be seen.