The ECB’s leap into the un­known

Financial Mirror (Cyprus) - - FRONT PAGE -

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 EUR 700 bln ($890 bln), 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 short­term 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 i mplies 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, non­in­fla­tion­ary 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 de­mand­man­age­ment 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 non­per­form­ing 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 i mplied by the ECB’s as­sump­tion of its new fi­nan­cial-sta­bil­ity and bank­ing-su­per­vi­sion roles. The first ca­su­alty will most likely be price sta­bil­ity.

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