(Updates with inflation data in 13th paragraph.)
Aug. 29 (Bloomberg) -- Mario Draghi has made European political leaders an offer: You scratch my back and I’ll scratch yours.
In turning up the rhetoric on his readiness to start quantitative easing, the European Central Bank president is also asking governments to open their own wallets. His message to European leaders preparing to gather in Brussels for a summit tomorrow is that it’s high time they boost domestic demand by using the “flexibility” built into their budget pact.
With the recovery in the 18-nation euro area stalling and deflation risks mounting, Draghi called last week for a three- pronged approach of monetary and fiscal easing with structural reforms. French President Francois Hollande’s purge of an anti- austerity coup attempt this week and comments by German Finance Minister Wolfgang Schaeuble yesterday underscored how hard that will be, as Germany leads pressure to keep cutting deficits.
“This is always about packages and deals, and certainly the notion that you have to combine supply-side measures with demand side measures is the right one,” said Guntram Wolff, director of the Bruegel institute in Brussels. “The question of whether France and Italy are going to be able to deliver or not is a bit more complicated.”
A gauge of government bonds around the world approached a record high and European stocks rallied this week after Draghi’s speech in Jackson Hole, Wyoming, appeared to signal that the ECB is closer to a broad-based asset-purchase program.
Investors focused on two paragraphs citing a slump in inflation expectations as a sign that QE is at hand. Yet the ECB president spent much longer arguing the region’s governments should be prepared to spend more to spur their economies.
“It would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy,” he said. “I believe there is scope for this.”
While European Union leaders in theory agree -- stating at a summit in June that the bloc should “make best use of the flexibility that is built into the existing Stability and Growth Pact” -- there is still little consensus over what that means.
When France’s economy and industry minister Arnaud Montebourg slammed the government this month for its adherence to “absurd” austerity policies, he was fired. Prime Minister Manuel Valls said France must cut its deficit because it has “been living beyond its means for 40 years.”
Asked in a Bloomberg Television interview near Paris yesterday whether France would lower its budget shortfall, Schaeuble said he’s confident that “my French colleagues will do what’s needed in line with the rules that have been agreed again and again.”
Under the Stability and Growth Pact, EU countries face heightened scrutiny, including the risk of fines, when their budget deficit exceeds 3 percent of gross domestic product. While the euro area as a whole had a deficit of 2.9 percent in the first quarter, France’s gap was 4.3 percent and Spain’s was 7 percent. Germany had a 0.4 percent surplus.
Countries exceeding the limit trigger the Excessive Deficit Procedure, under which the EU sets deadlines for returning to below the 3 percent ceiling. Even so, governments can receive some leeway if they can show exceptional economic circumstances.
That’s a scenario the euro area may be facing. Inflation data today showed prices rose just 0.3 percent in August from a year ago, the slowest pace since 2009 and a fraction of the ECB’s medium-term goal of just under 2 percent. GDP stagnated last quarter for the first time since the region’s longest-ever recession ended a year previously.
France, the second-largest economy, has seen no growth in the past two quarters and the government has already torn up its plans to rein in the deficit this year. Italy, where Prime Minister Matteo Renzi is battling to reform the political system and remodel the region’s third-biggest economy, has slipped into its third recession since 2008.
“Nobody has the intention of pushing a country that is in an economic downturn into an even deeper abyss,” ECB Governing Council member Ewald Nowotny said late yesterday in Alpbach, Austria. “It’s about a growth-conscious application” of the rules, he said.
Draghi suggested the need for a large public investment program. Jean-Claude Juncker, President-Designate of the commission, has said he’ll propose a three-year public and private investment package worth 300 billion euros ($395 billion).
“Something has to be done on all fronts at the same time, on the fiscal side, on the monetary side, and that’s hard,” said Philippe Weil, an economist at the Universite Libre in Brussels. “The European Commission has got to stop saying that recovery is just around the corner, because it’s not.”
German Chancellor Angela Merkel is also seeking ways to boost infrastructure spending, including through partnerships with the private sector, for her country. At the same time, she said this week there’s a need to recognize that “higher spending doesn’t create growth.”
“Maybe the European Commission will again relax the budgetary targets for some countries which are in the Excessive Deficit Procedure,” said Martin Van Vliet, senior economist at ING Groep NV in Amsterdam. “But that’s not going to make a significant difference to the growth outlook.”
Draghi has had some success getting politicians to co- operate in the past. In the weeks before his now-famous “whatever it takes” speech in July 2012, euro-area leaders clinched a deal on a banking union. That paved the way for his crisis-busting OMT bond-purchase pledge in September that year.
His insistence on longer-term economic reforms such as unlocking rigid labor markets could be part of a similar strategy. Schaeuble said he agrees “100 percent” with Draghi’s call to complement monetary policy with structural reforms and with the need for more investment.
“Monetary policy can only buy time,” he said. “What we urgently need is investments, regaining confidence by investors, by markets, by consumers.”
If governments, including France’s, stick to their reform commitments, then the ECB and Germany should see that as enough to ease back in the shorter term, according to Jacob Funk Kirkegaard, senior fellow at the Peterson Institute for International Economics in Washington.
“Draghi and Chancellor Angela Merkel may conclude that the risks of political moral hazard are manageable,” he said in an article on the institute’s website. “And that France deserves a quid pro quo.”
--With assistance from Boris Groendahl and Alexander Weber in Alpbach and Caroline Connan, Brian Parkin and Mark Deen in Paris.