Potentials and limits of monetary policy to boost growth and employment in the
euro area
Elisabeth Blaha, economist, Austria
1.- ECB’s monetary policy during the crisis – an assessment
In the aftermath of the financial crisis the United States has employed modest fiscal and
extensive monetary stimulus and herewith produced – after the slump in 2009 - modest
positive growth and declining unemployment rates that were, however– to a large
extent– driven by falling participation rates.
The Eurozone experienced a double-dip recession where the second dip that started in
2011 took the form of a great recession in the core and a Great Depression in much of
the periphery. Today, roughly one-third of the eurozone population is in states with Great
Depression levels of unemployment.
The causes of the transatlantic divergencies in performance of growth and
unemployment are multifaceted: The US have engaged in fast restructuring of the
banking sector, private sector deleveraging was supported by expansionary fiscal and
monetary policies, herewith dampening the recessionary impact of reducing the debt
levels of private households and firms. Fiscal consolidation only started after the
deleveraging process of the private sector was almost completed.
In the euro area, however, the adjustment process of banks’ balance sheets in most of
the countries has been delayed. Rising shares of non-performing loans and troubled
assets that are a legacy of the financial crisis and the following recessions exert drag on
the banks’ ability to provide loans to firms and households. Fiscal consolidation started
already after 2010 pushing large parts of the euro area into a balance sheet recession.
The institutional design flaws of the euro area, such as the lack of a true fiscal and
banking union, have exposed the periphery states to the risk of liquidity runs, contagion
and self-fulfilling defaults.
Since late 2008, ECBs’ monetary policy has followed an expansionary path, but it has
been slow to act. In early 2008 policy rates in the US and the euro area were about 4%.
Over the next year, the Federal Reserve lowered the FED funds rate rapidly to 0,25%.
Over that year, the ECB brought its rate down to 2,5%, having raised it once in between.
Thereafter, the ECB’s policy rate was lowered only slowly. The ECB have increased
rates in April and July 2011 when the euro was falling into another recession. In
November 2013, the ECB has lowered its rate to 0,25% - five years after the FED has
reached that interest rate level. Also with non-conventional measures the ECB has been
less decisive. After the FED funds rate has hit the lower zero bound in December 2008
the FED started with large-scale asset purchases, including government bonds, so
called quantitative easing with substantial stimuli effects. The ECB also expanded its
balance sheets, predominantly by providing liquidity to banks (above all via long-term
refinancing operations) that were increasingly unwilling to lend to each other. To be
more precise, the banks in the stressed economies were suffering from liquidity
withdrawals while this liquidity was deposited mainly in banks of the euro area core
economies who again were depositing excess liquidity with the ECB. What the
refinancing operations of the ECB did was to reshuffle this excess liquidity to the banks
in the periphery. Hence, the monetary policy operations of the ECB were essential in
particular to prevent a meltdown of banks in the debtor economies in the periphery that
were faced with liquidity runs.
When government bonds yields of the periphery countries were reaching unsustainable
high levels the securities market program (SMP) of the ECB was introduced in May
2010. This program involved the purchase of public and private debt securities and
officially aimed at restoring an appropriate monetary policy transmission mechanism in
the stressed economies, since the low policy rates of the ECB nether have fed into the
yields of the securities markets nor into the retail interest rates of the banking systems,
that were prohibitively high. Two years after the introduction of the SMP-program, in the
same line of reasoning the ECB announced the OMT (Outright Monetary Transaction), a
program under which the central banks undertake purchases in secondary bond markets
provided the bond-issuing countries agree on strict conditionality attached to an
appropriate European Stability Mechanism program.
Until today the OMThas not been activated but its announcement has turned out to be
quite effective because it has brought down government bond spreads within the
Eurozone considerably.1However, both programs, the SMP and the OMT, are
nothttp://en.wikipedia.org/wiki/Quantitative_easing quantitative easing operations, because
they arefully sterilized. This means that the ECB is or will be reabsorbing the liquidity
pumped into the system.
1
De Grauwe, P, &Ji, Y. (2013)."Panic-driven austerity in the Eurozone and its implications" Vox EU, Paper
on voxeu.org, 21 February 2013.
To sum up, contrary to the US, the monetary policy measures taken in the euro area did
have less of a stimulating effect on the overall economy. Its primary accomplishment
was to partly restore the transmission mechanism of monetary policy in the stressed
economies and to avoid a breakup of monetary union.
2.- Disinflation and risk of deflation in the euro area
Since more than one year inflation has been declining steadily and month for month has
repeatedly turned out to be below expectations and official forecasts. According to the
recent flash estimate, in May 2014 the price level increased by 0.5% against May of last
year; in April the inflation rate came up to 0,7%. Notwithstanding the fact that disinflation
is a more general phenomenon in all euro area countries (that also extends to non-euroarea countries of the European Union), these aggregate figures hide large differences
across countries in the euro area.
In April, Greece (-1.6%), Cyprus (-0.4%), Slovakia (-0.2%) and Portugal (-0.1%)
experienced deflation; Austria (1.6%), Finland (1,3%) Germany (1,1%) were exhibiting
the highest inflation rates in the euro area, but even these are still much below the
ECB’s target of below, but close to 2% over the medium term. As a consequence, the
stressed economies have much higher real interest rates. Hence, countries in the euro
periphery that needed to get the most stimulus are getting the least. These are also the
countries that were forced to private and public deleveraging and so-called ‘internal
devaluation’. In mainstream economics and in most of the international organizations,
declining wages and prices are seen as natural and even beneficial adjustment process
towards a new competitive equilibrium for countries having lived ‘beyond their means’.
This strategy of ‘internal devaluation’ has increased risk of deflation and was selfdefeating by undermining debt sustainability via declining growth.
The inflation differentials tend to be naturally amplified. High real interest rates in the
periphery will cause even more downward pressure on prices via lower demand
herewith amplifying a deflationary spiral. This dynamic is particularly severe in
economies that are still experiencing high debt levels. Deflation increases the risk of
falling into a long period of a so-called liquidity trap, a situation with a zero policy rate,
deflation, and expectations of low inflation or even deflation, as observed in Japan for
almost two decades. Then, in spite of a zero policy rate, the real interest rate is too high,
with continued deflation and high unemployment as a result.
With deflation there are two reinforcing mechanisms at play.
First, by creating expectations that prices will be lower next year it gives consumers
incentives to postpone purchases and firms will delay investments since profits are
expected to drop with declining prices. As a result, aggregate demand declines putting
further downward pressure on prices.
Second, since private and public debts are fixed nominally, declining prices increase the
real burden of the debt. Put differently, as prices decline government and private
revenues decline while the service of the debt remains unchanged. This forces the
private and public sectors to spend an increasing proportion of revenues to service the
debt, forcing them to cut back their spending on goods and services. This in turn
increases the intensity of the deflationary process. Thus, households’ and firms’ debt
burden increases, especially compared with if inflation had been 2 percent. Inflation has
fallen far below inflation expectations and this means that the price level has become
considerably lower than anticipated. This in turn means that real debt has become
considerably larger than borrowers had anticipated and planned for. This debt-deflation
dynamic is probably the more important negative effect of deflation in comparison to the
consumption-postponement effect, in particular in countries where debt levels are still
high.
Given the threat of deflation the ECB has talked for some months of doing quantitative
easing hoping that as soon as the economic upswing becomes more broadly based the
disinflation trend will be reversed without monetary policy action. Arguments against
monetary policy actions under the lower zero bound (when interest rates are close to
zero) are widespread and are formulated against different ideological backgrounds.
Different versions of monetarism point towards excess liquidity, the risk of high and
hyperinflation and misallocation of capital. The argument of fiscal profligacy (‘moral
hazard’) if the ECB purchases government bonds on the secondary market is very
popular among the opponents of doing quantitative easing, either. Quite recently the
moral hazard argument was extended to banks. In this line of reasoning, purchasing
bank bonds would undermine risk awareness of bank mangers because the
corresponding declining refinancing costs would spur excessive risk behavior. But there
are also more serious concerns articulated by progressive economists, such as negative
implications on wealth distribution, if quantitative easing or expansionary monetary
policy more generally and related carry trade-effects trigger a speculative asset price
bubble benefiting the wealthy owners of securities and shares. Another argument
stresses the ineffectiveness of monetary policy in countering deflationary threats as
deflation may not be a monetary phenomenon. It is, so the argument goes, rather the
effect of austerity and asymmetrical adjustment in the euro area that resulted in the
build-up of large imbalances between savings and investment and slack in the
economies. Further, the whole burden of adjustment in the course of the crisis was
imposed on the debtor countries, while the core economies of the euro area are still
exhibiting large current account surpluses. Rather than using monetary policy tools
growth enhancing measures should focus on expansionary fiscal policies, rise in wages
and, more generally, on any policy that reduces the imbalance between savings and
investment, in particular through more equal income and wealth distribution.
A more general concern with non-standard measures of monetary policy is that the ECB
takes huge risks on their balance sheets when it purchases assets of firms, banks and
governments that may default or when taking risky securities as collateral for loans given
to banks in the course of long-term refinancing operations.
In the following we discuss potentials and limits of monetary policies to boost growth and
employment in the euro area by looking in detail at the transmission mechanism of the
monetary policy instruments at stake.
3.- Potentials of expansionary monetary policies under the lower zero bound
When the nominal interest rate of the central bank has fallen to zero and the economy
still suffers from a recession it can in principle engage in quantitative easing and/or in
credit easing.
With quantitative easing, the central banks purchases a broad portfolio of public assets
(on the secondary market)2 and private assets (on the primary and secondary market)
financed by the creation of central bank reserves. There are numerous channels through
which these measures may finally trickle down to employment and growth. First,
purchasing assets will drive up the price and lower the yield of the respective assets, as
prices and yields are inversely related (given fixed nominal principal of the asset). This
lowers borrowing costs of the assets purchased. For instance, by lowering the borrowing
costs for governments, this lowers the pressure on governments to implement selfdefeating consolidation measures.
Second, this should – under certain conditions – generate a spillover effect on other
asset prices as well. Consequently, overall higher asset prices should increase the value
of firms and real estate and thus, lead to increased spending and inflation by reducing
overall funding costs and inflation expectations. Third, the signaling or expectations
effect may be important too, i.e. by giving indications about the stance of monetary
policy and thereby increasing inflation expectations. Fourth, quantitative easing will most
likely lead to a depreciation of the euro exchange rate by making the euro less attractive
to investors via lower long-term interest rates. This is usually considered to be the
strongest channel through which quantitative easing can spur growth and it will
particularly felt by Southern Europe whose exports have suffered from the strong euro.
In the euro area the other channels are probably less effective than in the Anglo-Saxon
world, given the fact that capital markets – where the impact of quantitative easing is felt
most – are less important for financing investment in comparison to banks.
While quantitative easing is considered to counteract deflation or inflation being ‘too low
for too long’, more targeted credit easing instruments can be used to directly revive
credit flows in the economy and herewith improving the working of the transmission
mechanism of monetary policy. Whereas the risk of deflation has gained momentum in
recent months which lends to the call for a large-scale quantitative easing program, the
start of the tightening of credit standards dates back to 2008 and deteriorated further in
countries suffering from the vicious cycle of capital flight, balance-sheet recession,
corresponding poor bank balance sheets, rising interest rates, disinflation or deflation.
Throughout the recent years there were continuous calls for particular credit reviving
programs, because the ECB has been less effective to repair the transmission
mechanisms of its monetary policy through non-standard measures (e.g. Long-term
refinancing operations with banks). The 3-year long term refinancing operations the ECB
2
has carried out at the end of 2011 and beginning of 2012 that involved liquidity injections
to the banks at large scale was successful in alleviating deleveraging pressure for some
troubled banks. But some other banks have used this cheap liquidity for purchasing
bonds and other assets (‘carry trade’3), while the direct impact on lending to firms and
households has been weak or even non-significant. However, together with the OMT it
helped to reduce yields on government bonds of periphery states, because their banks
predominantly purchased sovereign bonds of their respective countries.
Credit easing instruments should be working, if the impairment of the credit channel is
considered to be the major problem. With credit easing the central banks purchase only
one type of asset (and herewith reduce yields of those assets and refinancing costs) or
make liquidity provision to the banks contingent on an increase in net credit flows to
households and firms. In particular the periphery states suffer from lack of credit
availability for small and medium sized firms and for households (see Graph 2). While
there is lack of credit demand -given austerity and wage declines - falling credit is also
driven by the unwillingness of banks to give credit under reasonable conditions.
According to surveys conducted among small and medium sized enterprises, they
reported reluctance of banks to provide credit, in particular in Greece, Italy, Spain and
Portugal.4 Credit easing instruments should support credit flowing to firms and
households given that the functioning of the credit market in these countries is seriously
impaired. Examples of credit easing instruments can be found in United Kingdom and in
Hungary. They are rather complicated in their technical details but the intuition is simple:
Banks are incentivized to lend to the real economy, by providing funding to banks for an
extended period, with both the price and quantity of funding provided linked to their
lending performance. The effectiveness of these programs is contingent on design and
volume and the fact that evaluation studies on the experience of the funding for lending
(Bank of England) and the funding for growth program (Central Bank of Hungary) are not
that convincing is no reason for rejecting credit easing altogether.
3
A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in
an asset that is likely to provide a higher return.
4
ECB (2014), Survey on the Access toFinanceof Small and Medium-Sized Enterprises in the Euro Area,
April 2014.
Given deflationary forces that are a direct impact of having deliberately produced a
slump in aggregate demand and high unemployment via fiscal austerity and lowering
wages in large parts of the euro area, what is required is a mixture of credit easing
programs together with a large-scale quantitative easing program. The ECB could
purchase sovereign banking and corporate bonds. The counter-argument that the
nominal rates of these assets are historically low anyway is not convincing as the more
relevant real rates are high, particularly in the periphery – given deflation and
disinflation. Moreover, quantitative easing is most likely to depreciate the euro exchange
rate. The euro has appreciated vis à vis its trading partners since mid-2012 which is the
direct result of the rising current account surplus - savings exceeds investment by a wide
margin -together with substantial portfolio investment inflows. The strong and overvalued
euro adds to disinvestment and deflationary forces. The argument that quantitative
easing will even increase the current account surplus further by depreciating the euro is
misplaced if quantitative easing is supported by a policy strategy that increases
aggregate domestic demand and makes adjustment more symmetric, i.e. by increasing
wages also in the core (surplus) countries of the euro area.
Alongside with sovereign, corporate and bank bonds, the ECB may also purchase bonds
of the European Investment Bank(EIB) and the European Investment Fund (EIF) at a
large scale on the secondary market and herewith help to support a large new
investment program to reverse the recession, strengthen European integration and
social cohesion. This will support investment directly into euro area’s real economy.5
See Varoufakis, Y., Holland, S. and J.K. Galbraith, A ModestProposalforResolvingthe Eurozone Crisis –
Version 4.0. http://yanisvaroufakis.eu/euro-crisis/modest-proposal/
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4.- Limits of expansionary monetary policies at the current juncture
Monetary policy measures discussed above may only be effective in alleviating
deflationary pressures, reviving lending to firms and households and boosting growth
and employment if it supplemented by a completely different strategy to coordinate
economic policies across the euro area. The design flaws of European Monetary Union
have not been fixed effectively. The core countries are still exhibiting large current
account surpluses (given fiscal consolidation and wage moderation) – the adjustment so
far has been asymmetric where the working class in the periphery has borne the burden
of adjustment – together with the low income groups of the core countries. Repeatedly,
the mixing up roots and symptoms of the crisis – for instance the narrative of the
sovereign debt crisis – has obscured the view on one simple fact: the build-up of large
imbalances between savings and investment before and in particular during the crisis. A
combination of policies that are capable of reducing these imbalances are warranted,
above all a redistribution of income and wealth from those who save (the wealthy) to
those who dissave and/or borrow, public investment programs, fiscal expansion in
general financed by progressive wealth and corporate taxes while reducing the tax
burden of low income workers, strong unions as well as lower or negative real interest
rates. Concerning the latter monetary policy can be rather powerful when innovative
measures are implemented together with policies strengthening aggregate demand.
Given the large excess savings the real interest rate that is capable of balancing savings
and investments is negative and the exact number probably far from zero.
5.- Resume
Non-action of the ECB and other areas of economic policies bear the rising risk of
pushing the euro area into a deflationary spiral.Since early 2013 the ECB is constantly
undershooting its inflation target of below, but close to 2%.
Non-conventional monetary policy measures are needed but may only be effective, if
complemented with other economic policies that help reducing excess savings. Further,
the ECB needs to significantly change its approach to monetary policy. The ECB’s
inflation target of below, but close to 2% is too low, given measurement errors in
calculating inflation figures. These are constantly overestimating inflation, a topic that
was widely discussed during the changeover to European monetary union but has
disappeared from the public debate. In addition, a higher inflation target may spread the
burden of adjustment more equally across individuals and countries. Higher inflation
would be easier to reduce the debt burdens of firms, household and governments and it
would redistribute wealth from creditors to debtors. But even if the ECB does not adjust
its target upwards, this implies that over the next months the ECB has to temporarily
overshoot its target to fulfil its mandate. The ECB-Council decided many years ago that
the “below, and close to 2%” must be achieved in the medium term.
From the viewpoint of democratic legitimacy the objectives of a central bank should be
set by the general public and not by the central bank. The fact that the ECB sets the
inflation target is a practice incompatible with standards of our representative
democracies. Further, the mandate, stipulated in the Treaty of the European Union,
clearly states that inflation is the primary objective of monetary policy. However, in doing
so, the ECB has to account for other economic policy goals as well, such as economic
growth. But giving growth and employment objectives an equal weight to inflation in the
ECB’s objective function, similar to the mandate of the FED, is, however, not backed by
the Treaty.6
But the crucial point is that since early 2013 the ECB evens fails to fulfil its already
hawkish mandate. The 19 million unemployed in the euro area certainly deserve that the
ECB makes every attempt at stimulating a recovery worthy of the name.
The Maastricht Treaty assigns to the ECB a strict inflation mandate, and that only “Without prejudice to
the objective of price stability, it shall support the general economic policies in the Community” (art. 2). In
the United States, instead, the Full Employment and Balanced Act of 1978 (the Humphrey-Hawkins Act)
amended the Federal Reserve Act in establishing a dual objective of price stability and full employment for
monetary policy.
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