Why “Europe’s ills cannot be cured by monetary innovation alone” [EN]

27 giugno -

 

Introduction

On 24 April 2013, the Financial Times published a short article written by Yves Mersch, a member of the European Central Bank’s (ECB) Executive Board. The title of the article, “Europe’s ills cannot be healed by monetary innovation alone”, can be interpreted either as a cry for help, or as a veiled threat coming from the ECB itself. How so? One needs to look at the context first: the institutional framework of the European Union’s (EU) economic governance was under duress on several fronts at the time. The two pillars on which Economic and Monetary Union (EMU) as created with the 1992 Maastricht Treaty was based, the monetary pillar, controlled by the ECB, and the fiscal pillar, with numerical fiscal rules to ensure national budgetary discipline, were proving both unsuccessful and insufficient for crisis management. In 2012 alone, the year before the article was written, Greece agreed to a second rescue package for €130bn; Spain formally requested financial assistance for up to €100bn to rescue its banking sector and implemented a €65bn austerity package; finally, Cyprus, too, asked for assistance, due to its large exposure to the neighbouring Greek economy. It was becoming increasingly clear that countering the crisis effectively required a concerted effort. It was also understandable to think that the two pillars alone were not enough to sustain the EU’s economic architecture.

 

In other words, there was a growing belief that “Europe’s ills” could only be cured by making use of all the instruments at the disposal of the EU, if not more. Monetary innovation had to be matched by fiscal and financial innovation. Only then would the European mechanism of economic governance be well oiled enough to start running smoothly. This is also Mersch’s belief, and one that he expresses in this and numerous other articles and press conferences. But what are the ills and the monetary innovations he refers to, and why does he believe that the ECB alone cannot save the EU? In order to answer these questions, the present article will be structured as follows: a first part will describe the “ills” and will provide some data to back up Mersch’s point; a second part will lay out an overview of the ECB’s remit and the monetary tools at its disposal; a third part will analyse the monetary innovations introduced since 2010; finally, some concluding remarks will explain why this may not be enough.

 

Europe: a sick patient

In his article, Yves Mersch refers in particular to three ills that are ailing the EU: weak governments, fragile banks, and shrinking economies. Governments are weak because the states are stretched: not only were many governments that failed to properly face the crisis voted out, but also there exists a “doom-loop” between sovereigns and the banking system (i.e., the second illness), and ultimately the economy as a whole (the third illness). This vicious cycle is enabled as governments bail out failing banks; this is seen as a weakness in the eyes of the investors, and in turns affects sounder banks – which leads on the one hand to a lower credit rating for the country; and on the other to a hampered flow of credit, which translates into less investment, higher unemployment, peaking in early 2013, and by consequence, less growth. When Mersch was writing his article, the EU’s GDP growth had been stagnating for two years – it is no wonder, then, that Mersch saw the policies taken at the time as an underwhelming failure.

 

These three ills, therefore, are heavily interconnected and can form a vicious cycle if not properly addressed. These are some reasons why he claims Europe (and not merely the ECB!) needs to have the “full toolbox ready” and that was not the case in 2013. But what is the toolbox comprised of? And up to what point does and can the ECB’s remit expand?

 

The remit of the ECB: what can it do?

According to Article 127(1) of the Treaty on the Functioning of the European Union (TFEU), the primary objective of the European System of Central Banks, at the helm of which sits the ECB, is to maintain price stability. The target set out is to have it hover just below a yearly two percent threshold. It can do so by defining and implementing the EU’s monetary policy (i.e., by controlling money supply and by defining interest rates), by conducting foreign exchange operations, by holding official foreign reserves, and by promoting the smooth operation of payment systems (Article 127(2)).

 

In exercising its mandate, the ECB has to observe three principles. The instruments it adopts have to be suitable, in that they need to properly address the price stability objective; they need to be necessary, for no other option has to be found available; and they have to be proportionate stricto sensu, as in their benefits outweigh the costs. Between 2008 and 2012, the ECB pursued a marked action consisting of slashing interest rates, flooding the banking sector with liquidity, and lending widely. These “semi-conventional” measures were mostly aimed at preventing deflation, although, as should be known today, they failed in this aspect. They included a first intervention in the public and private securities markets in the euro area, launched in 2010; and a second innovation with the 2011 long-term refinancing operations, with the ECB lending to banks with maturity up to 36 months, and as an addition to the main refinancing operations, where maturity only counted up to three months. Both measures were aimed at ensuring depth and liquidity to restore an appropriate monetary policy transmission mechanism. In both cases, too, the ECB’s intention was to build a “liquidity cushion” to pursue a double goal, one that is preventive, and one that is corrective. The preventive goal was essentially to avoid interbank lending in a situation that was deemed too precarious, so as to also avoid another credit squeeze; the corrective goal was, as stated before, to ensure growth by means of restored flows of credit. This path, however, was still not proving sufficient, since the strong relationship between sovereigns and banks was perpetuating the vicious cycle of bad governance.

 

Monetary innovation: what is being done?

Following Mario Draghi’s famous speech in July 2012, according to whom the ECB would do “whatever it takes” within its mandate to save the euro, the ECB more than ever before made use of the discretion allowed by its not-so-precise remit. A month after the speech, it ventured in the riskier enterprise of outright monetary transactions (OMTs), without, however, entering the primary market – forbidden by Article 123 TFEU. Indeed, OMTs allow the ECB to make purchases in secondary, sovereign bond markets, with the main goal to eliminate risks of currency redenomination due to possible break-ups in the euro area. As such, not only were OMTs suitable, since they aimed at price stability, but they also were meant to fight redenomination risks (and were therefore necessary) and, as liquidity in the peripheral states was drying up, risks of inaction were far bigger than untested innovative policies (hence their proportionality).

 

The ECB continued down this road in the following years. While banking union was being negotiated upon and then implemented (see below), the ECB also made use of a tool typically employed by the US Fed: quantitative easing (QE), more technically referred to as public sector purchase programme (PSPP). With the PSPP, the ECB will buy, until September 2016, sovereign bonds and securities from European institutions and national agencies. Much like OMTs, the PSPP, too, follows the criteria of suitability (it eases the financing conditions of the private sector and expands the monetary base); of necessity, as interest rates are already very low, but also insufficient in scope; and proportionality, since any risk that the PSPP entails is offset by its credit quality requirements (although this choice has been criticised by some, notably LSE economist Paul De Grauwe).

 

Finally, one last monetary innovation to cure Europe’s ills is represented by banking union. Its main goal is to create a safer and sounder financial sector for the Single Market by improving prudential requirement for banks – now subject to a hard-coded Single Rulebook and monitored by the first pillar of banking union, the Single Supervisory Mechanism – as well as depositor protection, both of which are guaranteed by the Single Resolution Mechanism and the soon-to-be European Deposit Insurance Scheme (EDIS). Banking union, by far the most radical innovation enacted so far, is part of a bigger picture, put forth in 2015 by the so-called Five Presidents’ Report, sponsored by European Commission President Jean-Claude Juncker, and supported by the presidents of the ECB, Parliament, European Council and Eurogroup. The Report aims to complete four different unions within the EU: economic union, fiscal union, financial union, and ultimately political union. Indeed, the usefulness of political union lies in its ability to automatically transfer shocks, thus finally making full effective use of the toolbox at the disposal of the EU, managed under the other three unions. Only then, and bar disintegrative thrusts, could Europe’s ills be cured.

 

Concluding remarks: is monetary innovation alone enough to save the Eurozone?

The context and innovations described so far raise two questions, which will be answered in this last part of the article. Firstly, why is Mersch making this remark, or in other words, why does he believe that monetary innovation alone is not enough to overcome the crisis? And secondly, how does monetary innovation relate to Europe’s ailments – that is to say, has it been effective in combating the three issues he describes?

 

As for Yves Mersch’s remark, it has to be read in relation to three aspects: in relation to the job he holds as member of the ECB’s Executive Board; to the overall position of the ECB in the current predicament; and to the political economy of regional integration. With regard to the first aspect, Mersch is assumed, as is any high-ranking officer within the ECB, to have a strong pro-integrationist stance. This can be seen in particular in the recent clash between Draghi and the German finance minister, Schäuble, with the former defending the independence of the ECB in the interest of the whole of the Union.

 

The position of the ECB is also becoming ever more centre-stage in crisis management. Mersch writes that “calls are becoming louder for the ECB to introduce new tools, swallow ever more risk and start economic fine-tuning.” When financial stability is at stake, it becomes difficult for the ECB to refuse to respond to the pressure for playing a quasi-fiscal role, but the ECB can only do so much and its main goal is to “buy time for the political authorities to fix the governance framework and implement reforms.” Therefore, for all the innovation the ECB can bring, there still needs to be a collaborative environment between all institutions.

 

Finally, with EMU and the EU covering different territories, the Union risks becoming an entrenched “club of clubs” in which demand and supply for integration will have an increasingly hard time meeting, and where the action of the ECB cannot have overarching effects.

 

The second question, instead, concerns the effectiveness of monetary innovation to cure Europe’s ills. The graphs below show that, while the situation is far from optimal, one of the ailments, the shrinking economies, is slowly disappearing. To be sure, inflation has turned into deflation, and this has negative consequences on markets’ expectations (Graph 1), but the overall unemployment is steadily declining (Graph 2), signalling a slow, yet steadfast recovery in European GDP growth.

 

Graph 1: Euro area annual inflation and its main components (%), January 2006 – April 2016 (Source: Eurostat)

 

 

 

Graph 2: Unemployment rates EU-28, EA-19, US and Japan, seasonally adjusted, January 2000 – March 2016 (%) (Source: Eurostat)

 

 

 

These lukewarm adjustments are far from enough to call it a day and relent the grips on economic governance. The ECB has been playing its part – sometimes well, sometimes less so – but it cannot be the sole actor. As Brancaccio and Fazi, taking a post-Keynesian perspective, wrote in a recent blog post on Il Sole 24 Ore, it is illusory to think that the ECB alone can counter deflation, as inflation targets tend to be unrealistic; what the ECB can do, instead, is influence capital insolvency, which is still asymmetric throughout the Eurozone, and that is what it should focus on. Banking union, for its part, will certainly help a great deal, but its implementation, including EDIS running at full steam, is still far ahead in time and it remains to be seen how it will pan out.

 

One final note seems fitting. It is remarkable how, almost eighty years before Mersch, John Maynard Keynes expressed very similar concerns. In The General Theory, he wrote: “There is…no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment…any more than for the belief that an open-market monetary policy is capable, unaided, of achieving this result.” It is true that Keynes referred to government policy, rather than a central bank’s, but the post-1929 ailments were very similar to the post-2008 ones: weak governments that paved the way for the rise of right-wing extremism; a fragile banking sector, as the credit crunch massively lowered demand; and soaring unemployment due to shrinking economies. Whether Mersch’s words were a cry for help or a veiled threat, one thing is certain: throughout the history of modern economics, not once has monetary innovation alone cured a country’s ills, nor is there any reason to believe that it will be so for the European Union.