By Jurgen Stark
The European Central Bank is in the middle of a big, risky experiment. Key interest rates have remained close to zero for six years now. Financial markets are flooded with liquidity. Crisis management has resulted in major market distortions, with some segments’ performance no longer explainable by fundamental economic data. The unintended consequences of this policy are increasingly visible – and will become increasingly tangible with the US Federal Reserve’s exit from post-2008 ultra-loose monetary policy.
And yet Europe’s crisis is far from over, as the decisions by the European Central Bank’s Governing Council in June and September demonstrate. This reflects two factors: too little ambition in carrying out essential balance-sheet corrections, and slow progress – negligible in France and Italy – in restructuring Europe’s national economies.
The ECB’s decision to double down on monetary stimulus should thus be regarded as an act of desperation. Its key rate has been cut to 0.05%, the deposit rate is negative, and targeted longer-term refinancing operations are supposed to support bank lending. Moreover, the asset-backed securities market is to be revived by the purchase of ABSs. All of this is intended to flood the markets, expand the euro system’s balance sheet by €700 billion ($890 billion), and return to the balance-sheet volume recorded at the start of 2012.
The expansion of the ECB’s balance sheet and the targeted depreciation of the euro should help to bring the eurozone’s short-term inflation rate close to 2% and thus reduce deflationary risks. For the first time in its history, the ECB appears to be pursuing an exchange-rate target. As was the case for the Bank of Japan, the external value of the currency will become an important instrument in the framework of a new strategic approach.
Financial markets have applauded the ECB’s recent decisions. Moreover, having “effectively thrown off all of the Maastricht Treaty restrictions that bound the bank to the model of the Deutsche Bundesbank,” as former Fed Chair Alan Greenspan put it, the ECB is prepared to break further taboos.
But for what purpose? Particularly by guaranteeing highly indebted countries’ sovereign bonds, the ECB has actually weakened the willingness to reform, particularly in the larger European Union countries, whose decrepit economic structures are an obstacle to potential growth, and where more room must be given to private initiative.
The ECB’s willingness to buy ABSs is especially risky and creates a new element of joint liability in the eurozone, with European taxpayers on the hook in the event of a loss. The ECB lacks the democratic legitimacy to take such far-reaching decisions, with potentially substantial redistributive effects, which implies an even greater risk to monetary-policy independence.
Indeed, the ECB already has been driven onto the defensive by the International Monetary Fund, the OECD, financial-market analysts, and Anglo-Saxon economists in the wake of feverish discussion of the risk of deflation in the eurozone. But what is the appropriate eurozone inflation rate, given de facto economic stagnation? Should higher nominal (that is, inflation-driven) growth replace debt-driven growth?
Europe must aim for sustainable, non-inflationary growth and the creation of competitive jobs. The current inflation rate of 0.3% is due to the significant decline in commodity prices and the painful but unavoidable adjustment of costs and prices in the peripheral countries. Only Greece currently has a slightly negative inflation rate.
In other words, price stability reigns in the eurozone. This strengthens purchasing power and ultimately private consumption. The ECB has fulfilled its mandate for the present and the foreseeable future. There is no need for policy action in the short term.
It is, instead, the eurozone governments that must act. But any clear division of tasks and responsibilities between governments and central banks has, it seems, been jettisoned. Government action in many problem countries ultimately ends in finger pointing: “Europe,” the ECB, and Germany, with its (relatively) responsible policy, have all been scapegoats.
Against this background, the ECB has yielded to immense political pressure, particularly from France and Italy, to loosen monetary policy further and weaken the exchange rate. But indulging the old political reflex of manipulating the exchange rate to create a competitive advantage will yield a short-term fix at best. It will not eliminate the structural weaknesses of the countries in question.
The ECB is moving ever farther into uncharted territory. In view of the insufficient balance-sheet corrections in the private sector and inadequate structural reforms, macroeconomic demand-management tools will not work. Despite the ECB’s aggressive approach, monetary policy in the absence of structural economic reform risks being ineffective.
Simply put, more liquidity will not lead to more active bank lending until there is more transparency regarding the extent of non-performing loans and the relevant economies have become more flexible. The ECB’s asset quality review and bank stress tests are expected to bring some clarity to the first question. Then, more lending will occur on acceptable terms – assuming that there is corresponding demand. But the uncertainty regarding the extent and pace of economic reforms remains.
The ECB’s recent decisions, with their focus on short-term effects, indicate that monetary policy is no longer targeted at the eurozone as a whole, but at its problem members. Ad hoc decisions have replaced a feasible and principled medium-term strategy. The problems created by this approach will be compounded by the unavoidable conflicts of interest with monetary policy implied by the ECB’s assumption of its new financial-stability and banking-supervision roles. The first casualty will most likely be price stability.
Formerly published on project-syndicate.org