The Challenge for the European Central Bank
The European Central Bank may disappoint once again at Thursday’s meeting. Given deteriorating conditions in the euro area, the failure to embark on a quantitative easing program, as other major central banks have already done, becomes tough to defend.
It has been five years since the epicenter of the global financial crisis moved from the United States across the Atlantic. Since then, while the U.S. economy has enjoyed recovery with steady growth, the euro area economy has languished, going through a double dip slump and currently at risk of falling back to an unprecedented triple dip recession. Another downturn in Europe would be a major drag for the global economy. As a result, ECB policy decisions, and their effect on the euro area economy, demand global attention.
The crisis has exposed the deeply flawed political construction of the euro area which has led to woefully inefficient crisis management in the past five years. Member-state politics have dominated decision making over sound economic reasoning and the ECB has been caught in the crosshairs of this dysfunctional political environment. Under such circumstances, maintaining a steady course independent of politics can become impossible.
In theory, the ECB is the most independent central bank in the world. Compared to the Fed, the ECB is more independent and less accountable. The ECB’s primary mandate is to maintain price stability and subject to that contribute to the achievement of the objectives of the European Union which include balanced economic growth and full employment. In pursuing its mandate, the ECB adopted a numerical definition of price stability, to maintain inflation rates close to but below 2%, over the medium term, and a two-pillar strategy that provides a prominent role for money and credit as a cross check to monetary policy decisions.
Judging from money and credit growth, the ECB has pursued consistently exceptionally tight monetary policy over the past few years, bringing into question whether the ECB has abandoned the two-pillar strategy. Faster money and credit growth would have contributed to higher employment and faster economic growth and stability.
Moreover, over the past 2-3 years, the ECB has guided the euro area to an unhealthy disinflation, bringing headline inflation down to merely 0.3-0.4 percent, significantly below the ECB’s definition of price stability. For the past 6 months, core inflation has been registering readings under one percent, the first time such low core inflation readings have been recorded so persistently.
What are the causes of the ECB’s deflationary bias? One possibility is a miscalibration of policy at the zero lower bound, perhaps resulting from the misleading notion that policy is already “as easy as can be” once short-term nominal interest rates are close to zero. Such confusion, often associated with the notion of the so called “liquidity trap,” has been noted in earlier historical episodes, for example at the Fed during the Great Depression and at the Bank of Japan in the late 1990s and 2000s.
The simplest way to calibrate the proper stance of monetary accommodation at the zero lower bound is by adjusting the size of the balance sheet of the central bank through the accumulation of government debt. Lessons can be drawn from the past, such as the Fed experience from the 1930s and the Bank of Japan experience in the 1990s. Economists such as John Maynard Keynes, Milton Friedman and Allan Meltzer called for quantitative easing in those episodes. Unfortunately, their warnings were not heeded in the 1930s and 1990s.
The expansion of the Fed’s balance sheet since the beginning of the crisis suggests that in the current episode the Fed did not repeat these mistakes.
Sadly, in the case of the ECB, the data point to a different conclusion. In the summer of 2012, the Fed and ECB balance sheets were comparable, at $3 trillion and 3 trillion euro respectively. Since then, the Fed expanded its balance sheet to about $4.5 trillion, but the ECB massively tightened policy by reducing its balance sheet to about 2 trillion euro.
Why has the ECB pursued such overly tight monetary policy since the summer of 2012? The ECB is an independent central bank for the euro area but has had to worry about the very existence of the euro area as a result of the mismanagement of the crisis by euro area governments. Perhaps the politics involved in managing the crisis unduly influence monetary policy decisions.
Whatever the explanation, it is difficult to escape the conclusion that the ECB has not been operating in a manner that promotes the fulfilment of its mandate. To fulfill its mandate, the ECB should have been pursuing considerably more expansionary monetary policy. This would have contributed to growth and greater stability in the euro area as a whole, while also delivering rates of inflation closer to the ECB’s definition of price stability.
What should the ECB do? The most straightforward and time-tested course of action is for the ECB to announce and start the implementation of a quantitative easing program with no further delay. Purchases of euro area sovereign debt should be apportioned according to the ECB’s capital key, to account for the relative sizes of the member states whose sovereign debt would be purchased in the secondary market.
How large the purchases should be to restore growth and stability in the euro area, and in full respect of the ECB’s primary mandate, cannot the determined in advance. Judging from the experience of the Fed, the ECB could announce an initial plan of purchases aiming to double its balance sheet in coming quarters, with a target of reaching at least 4 trillion euro. One could further hope that the ECB will return to its pre-crisis roots and refocus on its two-pillar strategy ensuring that money and credit growth in the euro area economy is commensurate with sustainable growth and price stability, in accordance with its mandate.
Further timidity and inaction should be worrisome. Europe is not out of the woods and a severe deterioration of the crisis cannot be ruled out, especially in light of continuing political fragility and dysfunction. Implementation of the warranted monetary policy for the euro area by the ECB would provide a welcome boost to the euro area economy and notably contribute to the stability of the global economy.
Athanasios Orphanides is a member of the Shadow Open Market Committee and Professor of the Practice of Global Economics and Management at the MIT Sloan School of Management. He is a former member of the ECB Governing Council.
Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.