Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Policy puzzles and the ECB

Pursuing a US or Japan style policy will not be easy in the euro zone

Six years after the collapse of Lehman Brothers, which triggered a full-blown global financial crisis, a large part of the world economy is still grappling with the damage it inflected. The recovery, especially in advanced economies, has been feeble and largely supported by zero-bound interest rates with a doze of unconventional monetary policy. In the US, the massive quantitative easing (QE) experiment is coming to an end, at least partially, but the prospect of policy returning to normalcy is still some distance away. Japan is pursuing QE, and possibilities of the euro zone moving in the same direction are being actively discussed. If the European Central Bank (ECB) also resorts to QE, then over 50% of the world’s gross domestic product will—directly or indirectly—depend on printing money by the central bank.

Europe has been in a difficult situation all this while with no visible sign of a turnaround. While the economic activity in the euro zone remains subdued, the region is also faced with the imminent risk of deflation. The incoming data from the region does not offer much hope. While the gross domestic product remained absolutely flat in the second quarter, inflation has slipped to 0.3%. Employment conditions remain grim as well. Even as the aggregate unemployment rate in the region is at 11.5%, conditions are a lot more trying in countries such as Greece and Spain. The unemployment rate in Spain is at 24.5% and the last reported (May 2014) number for Greece was 27.2%.

The state of the economy prompted ECB to further reduce interest rates on 4 September. In addition to cutting rates, ECB has also announced that it will buy asset-backed securities (ABSs) from the marketplace to improve credit conditions. Although markets have responded positively to the announcement, there are concerns that it may not be able to make a meaningful difference as the availability of such securities is low and the central bank’s options may be limited.

Moreover, the problem in the euro zone is deeper and is unlikely to be solved by the central bank’s intervention in the credit market. Mario Draghi, president, ECB, in his speech at the annual central bank symposium in Jackson Hole, Wyoming, highlighted the problems and also listed possible policy action. In his speech, Draghi advocated fiscal and monetary easing with structural reforms. He also argued that unlike other developed countries, fiscal policy was less effective in the euro zone as it lacked support from the central bank. Central banks have supported governments by buying sovereign debt, which allowed them to run deficit without instigating negative market reaction. “…it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints," noted Draghi.

However, pursuing a US or Japan style policy will not be easy in the euro zone. There are several problems. For one, it will be extremely difficult to build an agreement among member states. In fact, there were disagreements on the idea of buying ABSs from the marketplace that the ECB recently announced. Critics will also argue that such a policy will reduce the incentive for member states to carry out structural reforms. Furthermore, ECB will have to device a way by which it will buy sovereign paper. If it is done according to the size of the economy, it will end up accumulating bonds from Germany and France, where yields are already low. But if it decides to buy more from peripheral economics, it will upset the large economics.

Though there are a number of ifs and buts in what the ECB president has proposed, he has managed to take the QE debate forward with his Jackson Hole speech and it is being viewed positively by markets and commentators.

“As in Japan, all three arrows of Draghinomics must be launched to ensure that the euro zone gradually returns to competitiveness, growth, job creation, and medium-term debt sustainability in the private and public sectors. By the end of this year, it is to be hoped, the ECB will start to do its part by implementing quantitative and credit easing," noted Nouriel Roubini of the New York University in a recent Project Syndicate column. (See: Abenomics, European-Style, 31 August).

Adair Turner, former chairman of the UK’s Financial Services Authority, also supports the idea of a greater role for fiscal policy in the region. Turner’s column in Project Syndicate concluded: “Optimal policy may therefore require a non-transparent fudge; monetary and fiscal ‘coordination’ might mean, after the fact, permanent monetary finance, but without ever openly admitting that possibility. But, fudge or not, Draghi has moved the debate forward dramatically. Without a greater role for fiscal policy, the euro zone will face either continued slow growth or an eventual breakup." (See: Facing Reality in the Eurozone, 8 September).

The prospects of anaemic growth in the medium to long term and a risk of deflation in the euro zone will be a significant drag on the global economy. However, if the ECB actually manages to evolve an agreement where governments run higher deficits and the central bank funds them by buying bonds, the flow of easy money will continue in the global financial markets, even after the US Federal Reserve ends its easing programme. It will help the euro zone, but might create problems for others. It will create complications for policymakers in emerging market countries such as India, and lend credence to the fear of an asset price bubble. After all, it was easy money that pushed the global economy on the verge of second great depression, six years ago.

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