Wednesday, April 16, 2014
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The ECB’s Bridge Too Far

BERKELEY – Is Europe’s economic crisis mutating once again? If debt fears are now being superseded by the danger of deflation, as recent data suggest, the European Central Bank has its work cut out for it – and there is nothing to suggest that it is up to the task.

The numbers are alarming. Core inflation (the consumer price index after excluding volatile food and energy prices) in the eurozone fell to an annual rate of 0.8% in October – a 47-month low – while producer prices fell by 0.5%, suggesting that deflation is already in Europe’s economic pipeline. Annual growth of M3 money supply, meanwhile, dropped to 1.4% in October, from an already dismal 2% in September, while loans to the private sector contracted by 2.9% year on year. All of this makes it remarkable that the best the ECB could do at its December meeting was stand pat.

So what should a good central bank be doing? For starters, it should focus on maintaining appropriate monetary conditions and get out of the business of negotiating policy conditionality with governments. A central bank’s core mandate is to keep inflation at appropriate levels, not to negotiate structural reforms with countries like Greece, a task that is best left to the European Commission and the International Monetary Fund.

Similarly, the ECB’s outright monetary transactions (OMT) program, announced in the wake of President Mario Draghi’s “do whatever it takes” speech in the summer of 2012, is at best a distraction. While a central bank should ensure the smooth operation of the payments and financial system, it makes no sense for this task to be contingent on governments’ negotiation of a reform program with the European Union’s rescue fund, the European Stability Mechanism (ESM), as is the case with OMT.

The commitment to preserving the integrity of the payments system must be unconditional. If the ECB concludes that panicked investors are threatening the integrity of the payments system by selling a member state’s bonds, then it should intervene, buying up those bonds on the secondary market, ESM agreement or not.

The ESM link is designed to reassure the German public that the ECB will not intervene indiscriminately. But it also creates uncertainty and delay, and prevents the ECB from acting as a true lender of last resort.

German public opinion also prevents the ECB from cutting interest rates and expanding the supply of money and credit. There is, as always, Germans’ deep-seated fear of inflation to overcome, along with the belief that too much easy credit will weaken the pressure on southern European countries to reform. But a responsible central bank should not cater to irrational fears of inflation in what is in fact a deflationary environment, just as it is not an independent central bank’s role to tighten the thumbscrews for fiscal and structural reform.

Unfortunately, Europe’s central bank does both. Thus, we have the unseemly spectacle of the ECB hesitating to cut interest rates for fear that, having exhausted conventional policy, it would have to turn to unconventional measures like quantitative easing, which would antagonize German public opinion even more.

It is reasonable for the ECB to be concerned about its public standing. But if its leaders are worried about the impact on its reputation of embracing unconventional policy, they should pause and reflect on the much greater damage that would follow from allowing the economy to slip into a deflationary trap from which it would be difficult, if not impossible, to escape.

The more substantial argument against quantitative easing is that purchases of securities would be ineffectual, given Europe’s bank-based financial system. But this is not an argument for inaction. Rather, it is an argument for the alternative, namely a Bank of England-style funding-for-lending scheme in which the ECB provides banks with cheap financing for, say, 12 months, if they agree to increase their lending to the private sector by a corresponding amount.

The danger with funding for lending is negative side effects. Much of the money provided in the United Kingdom poured into the housing market rather than being lent to small and medium-sized businesses. The Bank of England has now corrected this by announcing that it will no longer provide funding for mortgages. The ECB could follow this example by using a funding-for-lending program to channel credit to the business sectors that need it most.

Second, there is the danger that weak European banks will extend risky loans at a time when they should be making their portfolios less risky. Here, it will be important for the ECB to work closely with national supervisors until it acquires the power next year to supervise directly the 130 largest European banks. In addition, the upcoming asset-quality review and stress tests of the banks, if sufficiently rigorous, could provide assurances that banks receiving cheap ECB funding are adequately capitalized.

This is what a responsible central bank would do. Unfortunately, the ECB has so far shown no sign that it qualifies.

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  1. Commentedzoe keller

    "The commitment to preserving the integrity of the payments system must be unconditional"
    The ECB did not put conditions to itself but only to the member states. Quite a different thing! Draghi says: you, member state, must sign a MoU, then I am free to do what I want. And if you do not sign it, I'm even more free to do what I want.

  2. Commentedhari naidu

    This a rather unfortunate end to a thoughtful think-piece...

    Imagine if Draghi had not acted, as he did during the crisis, what would you be writing about then? ECB has secured the path for stability and development and financial markets have responded, so far, positively.

    The German Karlsruhe Court decision will have no or little effect on ECB, as an independent EU institution under Lisbon Treaty.

    BTW Karlsruhe has no substantive legal authority to deal with non-German institutions, by German law. And , if it does, it'd held by ECJ to order!

  3. Commentedhari naidu

    This a rather unfortunate end to a thoughtful think-piece...

    Imagine if Draghi had not acted, as he did during the crisis, what would you be writing about then? ECB has secured the path for stability and development and financial markets have responded, so far, positively.

    The German Karlsruhe Court decision will have no or little effect on ECB, as an independent EU institution under Lisbon Treaty.

    BTW Karlsruhe has no substantive legal authority to deal with non-German institutions, by German law. And , if it does, it'd held by ECJ to order!

  4. CommentedAlex Bauboin

    A Funding-for-Lending Scheme is nothing other than centrally directed capital allocation. Especially if they try to direct even more micro by excluding mortgages, for example. It's nice in theory, but if you really think about it, it's central planning. Better to force hard capital requirements on banks, but then give (force) lots of easy money to healthy banks that will find the most appropriate allocation for it.

    Also, who says that bond buying would be ineffective? If the ECB were to buy all european government bonds in ratio of the ECB capital key, it would either increase the money supply, thereby pushing up deposits and new loan creation, or it would decrease the exchange rate if it makes those assets unpalatable for foreign investors... both of which would support inflation and demand.

    Btw, your argument against OMT is exactly why the Germans are against it and what the Bundesbank is arguing infront of the German constitutional court. Germans are not so much against monetary loosing in general, as the use of fiscal policies by the non-democratic ECB. The OMT and ESM essentially do the same thing.. but either that's fiscal or monetary policy.. it can't be both, and hence one of them is breaking their mandate.

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