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Europeans are taking radical steps to save their economy. Here's why it’s not working.

European Central Bank To Announce Bond-Buying Program
ECB President Mario Draghi.
Hannelore Foerster/Getty Images

The economic situation in Europe is looking grim. On Thursday, the European Central Bank lowered its projections for inflation and economic growth, predicting that the European economy would grow a paltry 1.4 percent in 2016. Inflation is now projected at 0.1 percent — far below the ECB's 2 percent target.

To combat this projected slowdown, the ECB announced a series of extraordinary measures to try to boost the economy. The central bank already has negative interest rates — meaning it charges banks to store their money — but it pushed them down from -0.3 percent to -0.4 percent.

The ECB is also increasing the amount of government bonds it's buying. And in a remarkable move, the ECB is going to start buying bonds from private companies — effectively lending money directly to the private sector, something that central banks don't traditionally do.

Yet all of these measures don't seem to have done the trick. After an initial rally, European stock markets fell when ECB President Mario Draghi signaled that he didn't expect further rate cuts. Put simply, despite the many unorthodox measures the ECB has taken to boost the economy, markets don't believe the central bank is truly committed to getting the economy going again.

The ECB needs a strategy that focuses more on long-term economic growth than short-term tactics. A strategy called level targeting, which I explain in more detail below, could finally make the central bank's promises credible, giving businesses the confidence they need to invest.

Europe is facing a danger of Japanese-style stagnation

In the 1990s, Japan faced an economic predicament much like the one Europe faces today. After peaking in 1989, the stock market entered a decade-long bear market. Economic growth slowed.

Japan's central bank cut interest rates to 0 percent, a measure that would ordinarily spur economic growth. But it wasn't enough to get Japan out of its economic slump. The economy remained sluggish, and Japan has been forced to keep interest rates near zero ever since.

As Japan's growth prospects became more and more dire, Japan's central bank became mired in a no-win situation. Businesses knew that with interest rates already near zero, the central bank was unlikely to do more to support the economy. That made them reluctant to spend and invest, which in turn pushed down the inflation rate. But falling inflation meant that inflation-adjusted interest rates — which are what matter for monetary policy — were actually going up, further strangling the economy.

A quarter-century after Japan's stock market crashed, policymakers there are still facing this dilemma. The longer the economy remains stuck in the zero-interest-rate doldrums, the more pessimistic businesses become about the economy's growth prospects and the more reluctant they become to invest in growth.

The eurozone is at risk of falling into the same trap. The region's core inflation rate — excluding volatile food and energy costs — has been below 2 percent since 2008, and it has been falling over the last two years. Counting energy costs, the inflation rate has been stuck at 0 percent for the past year. And falling inflation means that the ECB's 0 percent interest rate policy is becoming less and less effective.

On Thursday, the ECB announced a new set of measures designed to deal with this situation. By assessing a 0.4 percent penalty for money banks deposit with the ECB, the central bank hopes to spur banks to lend money out.

The ECB is also buying a wide variety of other assets. It's expanding a program called quantitative easing, in which it buys billions of euros' worth of government bonds every month. Most remarkable of all, the ECB is going to start buying some bonds from private companies — effectively lending money directly to non-bank companies in the private sector. That's something central banks don't normally do, but Draghi believes the serious threat of a deflationary recession justifies taking extraordinary measures.

The ECB is doing a bad job of setting expectations

The point of easy money is to make it more attractive for businesses to borrow, spend, and invest. But if businesses foresee a future of Japanese-style economic stagnation, they're going to be reluctant to invest no matter how low interest rates get. So what the market expects the ECB to do in the future matters as much as what the ECB does now.

This is why the ECB's Thursday announcement included a promise to keep interest rates low even after its asset-purchase programs expire. (Fed Chair Ben Bernanke made a similar promise back in 2010.) The central bank wants to convince businesses that it plans to continue supporting the European economy for a long time, generating spending growth that will allow today's business investments to pay off.

The problem is that this kind of promise isn't very credible. The experience of the past decade — not only in Europe but also in the United States — suggests that central banks are itching to raise interest rates as soon as economic catastrophe has been averted. Here in the US, the Fed raised interest rates in December despite the fact that inflation was still below its 2 percent target and economic growth was anemic.

The ECB wants markets to believe that this time is different — that it won't start raising rates as soon as the economy starts to recover. But there's good reason for markets to be skeptical. And that skepticism itself makes a central bank's efforts to stimulate the economy less effective.

Indeed, the markets provided a nice illustration of this point today. When the ECB initially announced its easing, the market value of the euro fell about 1 percent. That was a good sign, because it meant that European exports would be more competitive on world markets.

But then, during a press conference following the announcement, Draghi expressed ambivalence about whether the ECB was prepared to cut rates further. The value of the euro soared, essentially undoing the effects of the ECB's original announcement.

Evidently, markets don't believe the ECB when it says it's committed to its 2 percent inflation target. So businesses are expecting sluggish growth, which means that investments made today are unlikely to produce big profits.

A better strategy is known as level targeting. Right now, the ECB has an official inflation target of 2 percent, but if it undershoots that target — as it's done for most of the past eight years — it just shrugs it off. So people don't take the target seriously and tend to shrug off ECB stimulus efforts like the one announced today.

Under a level-targeting regime, the central bank would compensate for low inflation in one year with higher inflation the next — if inflation came in at 1 percent in 2015, the central bank might shoot for 3 percent inflation in 2016. If inflation again comes in at 1 percent in 2016, the ECB might shoot for 4 percent inflation in 2017.

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