A complacency about the euro zone seems to have settled on markets and pundits both.  It is misplaced.  The fact is that the euro zone and the European Union (EU) have become much more fragile in recent months. On the economic and financial side, very low inflation and the threat of deflation have exacerbated the continent’s ongoing crisis and made the European Central Bank’s (ECB) job considerably more difficult than it already was.  On the political side, Europe seems to be losing its former determination to hold things together and see the euro succeed as a common currency.  The betting at the moment still favors union and the euro’s survival, but matters are much less secure than they were only a few months ago.            

To be sure, the ECB seems to be full of resolve.  Confronted with a slowing of zone-wide inflation to a rate of only 0.5 percent a year, far below its 2.0 percent target, and news that several member countries are reporting outright bouts of deflation, the bank has moved swiftly and dramatically. It has brought down its main policy interest rate from 0.25 percent to 0.15 percent and cut the rate it charges on direct lending to banks from 0.75 percent to 0.40 percent.  For the first time ever, it has brought its deposit rate, what it pays banks on the reserves they keep with the ECB, into negative territory.  It now charges a fee of 0.10 percent a year on such reserves.  It has reaffirmed its commitment to buy government bonds issued by Europe’s troubled periphery.  To provide additional market support, it has decided to cease its efforts to neutralize (sterilize in central bank jargon) the flows of liquidity that otherwise occur from such purchases.  It has made plans to initiate a quantitative easing program that would make outright purchases of privately-issued securities, and it has initiated policies to encourage Europe’s banks to lend more freely by offering them cut-rate credit on up to 7 percent of their outstanding loans for a period of four years. 

Two objects stand behind all this. First, the bank trusts that a free flow of liquidity into financial markets will allow debtor nations to borrow more readily and at lower rates, easing the budget pressure on them while they presumably pursue more fundamental economic and fiscal reforms.  The second ECB purpose is to stimulate economic activity in the euro zone by making credit cheaper and more readily available to businesses and individuals.  The problem is that the slowdown in inflation, and much more the threat of deflation, has weakened the effectiveness of these policies, even after these most recent, dramatic actions.

The ECB’s problem lies in how inflation affects real borrowing costs.  A simple comparison with 2012 illustrates.  Back then, the ECB had set short-term interest rates at 1.5 percent, far above today’s 0.15 percent. But the comparison does not end here.  In 2012, zone-wide inflation was much higher than today, averaging 2.5 percent and offering debtors considerable implicit relief by allowing them to pay on their loans with euros that each year became less valuable in real terms.  Though the interest rate of 1.5 percent imposed a nominal borrowing charge, this inflation-linked break more than offset it, so that the real cost of borrowing amounted to a negative 1.0 percent (the interest charge of 1.5 percent minus the 2.5 percent inflation break).  The ECB rate cuts since, though substantial, have failed to keep up with the slowing in inflation.  Inflation now at 0.5 percent offers a much smaller real break on borrowing costs that the older, higher inflation imparted two years ago.  The net effect even though rates have fallen to a mere 0.15 percent, has actually been an increase in the real cost of credit.  It remains negative, but stands at only -0.35 percent (the nominal interest charge of 0.15 percent less the inflation break of only 0.5 percent)--not nearly what is was.

Even the headline-grabbing negative deposit rate has failed to keep up with changing conditions.  To encourage lending to businesses and individuals, the ECB decided to charge a fee on any bank reserves left idle on deposit with it.  Two years ago, the central bank neither offered a return on these deposits nor did it impose a charge on them.  But still the monies left idle at the ECB lost purchasing power at the rate of inflation, at the time 2.5 percent a year.  In itself that was a pretty powerful incentive to put the money to work.   Though the ECB now imposes a nominal charge of 0.10 percent on those idle funds, the slowdown in inflation has made the combined incentive to use the funds much less significant than it was.  Instead of the 2.5 percent annual loss in purchasing power that prevailed two years ago, the present loss in purchasing power, and hence the push to use the funds, amounts to only 0.6 percent (the 0.5 percent loss to inflation plus the 0.1 percent charge.)    

It is little wonder the ECB is promising more policy action.  And should actual deflation develop, the bank would find itself still further behind.  Deflation obviously would further exacerbate these real cost comparisons, forcing the ECB to go to still greater extremes to maintain its desired policy effect. More than that, deflation would also raise the real value of the outstanding debt, causing it to demand an ever larger portion of each country’s real wealth over time and compounding Europe’s already severe debt woes accordingly.  Deflation also threatens in a third way.  All are aware of Japan’s more than two decades of economic stagnation and of the role played by that country’s problem with deflation.  Though Japan has faced other problems, making the parallel far from perfect, the comparison nonetheless is unsettling.

While the ECB faces an increasingly difficult policy environment, it may find itself in danger of losing the resolve in the rest of Europe that has so supported efforts to contain this crisis throughout these troubled times.  This is no small matter.  Because every action demanded by circumstances has forced one or another member to sacrifice its narrow interest for a larger European goal, a strong commitment to hold things together and keep the euro intact has played an essential role.  It required such a commitment for euro zone’s richer nations to put taxpayer monies at risk to support the various bailouts and other efforts to stave off default in the periphery.  A strong commitment has been essential to the ECB’s low-interest rate policies, for these have penalized people in the zone’s more prosperous, high-saving economies, such as the Netherlands and Germany.  In the periphery, countries required a similar will to accept austerity and other requirements to sustain the common currency and resist the temptation to withdraw from the euro, return to a devalued national currency, and default. 

Much of this attitude no doubt remains, but of late unmistakable signs of a weakening have surfaced.  The most obvious of these lie in the recent vote for the European parliament. There, euro-skeptic parties have made significant gains.  To be sure, the same center-left and center-right groups that have dominated for years have retained their pluralities, capturing between them 53.7 percent of the 751 seats up for grabs.  The liberals and the greens, also perennials, got respectively 8.8 percent and 6.9 percent of the seats.  Though the euro-skeptic parties, the UK’s Independence Party and the Europe of Freedom and Democracy Group prominent among them, remain a small minority, the 8.0 percent they captured as a group is well up from the less than 5.0 percent these parties held formerly.  Surely political leaders of every stripe in the member countries have taken note of the change in sentiment these gains reflect and are already trimming their positions accordingly. 

Signs of just such a change are clearly emerging in Germany, if not in the election results themselves than to the same forces that created those results.  Even before the vote, the German population was beginning to chafe at the burdens the situation had placed on them.  Some months ago a German banking association, Sparbasse, complained to the ECB about how its low interest rate policy penalized German savers.  More recently no less a personage than German Finance Minister Wolfgang Schauble has warned how the low rates promoted by the ECB, no matter how helpful to the periphery, were inappropriate for Germany and could easily lead to a bubble in that country’s property market.  If such protests and warnings exhibit a resistance that was not there before, more significant change lies in the growing challenge within Germany to the power of its pro-euro Chancellor Angela Merkel.

Here the biggest push back has come from the left.  It draws strength less from direct sympathy with the euro-skeptic parties than from the fact that their gains weaken Chancellor Merkel’s particular center-right approach to the union.  Accordingly, the discipline she hitherto imposed on her coalition has loosened.  Her vice chancellor, Sigmar Gabriel, also the head of her center-left coalition partner, the Social Democratic Party, has begun to openly challenge her insistence on budget austerity.  In the process, he has, in the words of one German journalist, made her look like a “miserly bookkeeper.”  He has gathered allies from elsewhere in Europe to push his agenda, recently rallying a Paris meeting of center-left politicians to demand an alteration in the Stability and Growth Pact by which the zone administers aid to its troubled members.  The group wants the pact to do more to “support growth” through a more liberal approach to budget policy.  He has banked on allies in Berlin, too, actually setting up a working group within Merkel’s own Economics Ministry to rethink Germany’s current approach to the crisis and develop a strategy that better reflects “Social Democratic values.”  No doubt this erosion in Merkel’s position at home has emboldened her counterparts elsewhere in Europe to take her on.  Both Holland’s Finance Minister Jeroen Dijsselbloem and new Italian Premier Matteo Renzi have also called for an easing of the strictures written into the pact.