This column was first published in the Journal For A Progressive Economy.
The unemployment rate in the Euro area has increased by more than 50% since 2007, starting from an already unacceptably high level. The financial crisis that hit the world in 2007-8 is of historical proportions and explains some of this increase, of course. Figure 1 shows that the decline has been much worse in the Eurozone than in other developed countries that suffered from the financial shock. It is not surprising, therefore, that citizens are asking who is responsible for this unmitigated disaster? The disaster can be measured in the number of job losses; any amount will conceal the distress experienced by individuals and families which will inevitably have deep and long-lasting political consequences. Moreover, the impact of the financial crisis can be captured by lost revenues which will most likely never be recovered. Essentially we are witnessing a massive theft that dwarfs the biggest criminal operations.
Figure 1. Rates of unemployment in 2007 and 2013
The answer involves two separate questions. First, why did the crisis happen? Second, why were its effects so deep and long lasting? The list of potential culprits includes economists, governments and central bankers. My answer to both questions is that governments have failed their people, nowhere as badly as in the Eurozone.
Economists can be blamed for a poor understanding of economic mechanisms. I have no doubt that, one century from now, future economists will look with scorn at our current level of knowledge, but this is how progress works. Still, we have enough knowledge to understand the crisis and some (including the latest Nobel Prize recipient Robert Shiller) actually described it quite precisely before it occurred. This does exonerate the profession at large, which collectively failed to issue strong warning signals. At least, once the crisis erupted, the profession did suggest policy responses, but disagreements were – and remain – present and made for confusion.
Governments were in charge of banking regulation and supervision. They failed. They were in charge of policy responses and they equally failed, to varying degrees. The situation has been worse in the Euro Area where the financial crisis morphed into a debt crisis, which remains poorly managed. Central banks were also in charge of policy responses. The rest of the paper offers an evaluation of their actions, focusing on the ECB.
Central banks during the crisis
As is well known, central banks have taken extraordinary measures during the crisis. They rapidly reduced their interest rate policies down to the zero lower bound, in an effort to alleviate the contractionary impact of the bank crisis. They also provided ample liquidity to banks in an effort to restart the interbank market, which is where banks borrow from each other to be able to grant loans to households and firms. When this proved insufficient, the central banks lent directly to individual banks; the ECB even committed to provide any amount to banks at a preannounced and very low interest rate. The amounts injected in the economy have been enormous, beyond anything previously done. Figure 2 shows the “size” of the ECB and of the Federal Reserve (the size of their balance sheets) and draws attention to these extraordinary actions.
Figure 2 also shows some important differences between the ECB and the Federal Reserve. While the sizes of liquidity injections are broadly of the same order of magnitude, the timing has been different. The Federal Reserve moved faster and more decisively in September 2008 as Lehman Brothers collapsed. The fact that the crisis originated in Wall Street probably explains the difference. Afterwards, however, the Federal Reserve continued to expand liquidity – a process that it dubbed Quantitative Easing or QE – while the ECB compensated any support to banks by an equal amount of liquidity withdrawal. The ECB explicitly rejected any QE-type policy, even though the economic recovery in the Eurozone lagged behind the US recovery. The onset of the sovereign debt crisis did not elicit a change in the ECB policy, even though the Euro area went into a second recession. It is only when the crisis reached alarming proportions in the second half of 2011 that the ECB started again to expand its liquidity provision programme.
In the US, QE was explicitly designed to support the economic recovery and to bring unemployment back down. The ECB, on the other hand, has always considered that its policy stance was expansionary enough. Its liquidity provision operations were explicitly designed to support banks in 2008 and to alleviate pressure on public debts in 2011-12. This is why the ECB has always asserted that its actions were not of the QE type. This means that the ECB was, officially at least, not concerned, or much less concerned about rising unemployment than the Federal Reserve.
This interpretation is confirmed by the fact that, after June 2012, the ECB has reduced its size, meaning it has reabsorbed about €500 billion. This is the month when the President of the ECB announced the Open Market Transactions (OMT) program, whereby the central bank indicated that it would do “whatever it takes” to limit the interest rates faced by the member countries in crisis. The OMT program is a commitment to backstop public debts with unlimited purchases. It has reduced massively the fears that had dominated the financial markets since early 2010 when the Greek crisis started. Markets reacted immediately. This mere announcement, so far not backed by any action, has proved sufficient to remove the edge of the crisis, at least up to the time of writing. Even though unemployment has continued to rise after June 2012, the ECB has withdrawn some of its liquidity support.
Figure 2. Size of the central banks (Total assets in billions of respective currencies)
Sources: ECB and Federal Reserve Bank
The Mandate of the ECB
How to explain this difference in policy actions between the ECB and the Federal Reserve? The usual interpretation refers to the different mandates of the two central banks. The Federal Reserve’s mandate, set by the US Congress, is dual: the central bank is formally required to help achieve “maximum employment” and “stable prices”. The ECB’s mandate, spelled out in the Maastricht Treaty, is different. It sets price stability as the main objective while “supporting the economic policies of the union” is a secondary aim, which can only be considered when price stability is not jeopardised. In that sense, the ECB does not have to act against unemployment if it considers that inflation is a threat.
This interpretation is not fully convincing, however. Early studies, e.g. Ullrich (2003), which have examined the actual behaviour of both central banks before the crisis suggest that they did not act very differently. The ECB was found to react to both inflation and the level of activity. A more recent study that encompasses the financial crisis period (Belke and Klose, 2010) confirms the similarity of behaviour before the crisis but a divergence once the crisis started. The Federal Reserve is found to have become more reactive to the level of activity while the ECB seems to have grown more concerned about inflation. Importantly, the ECB is found to be concerned about credit, which is related to the size of its balance sheet.
These are just initial results, which may not be confirmed by further studies. Yet, they refer to what the ECB calls its monetary policy “two-pillar” strategy. From the start, the ECB has inherited the Bundesbank tradition of concern with inflation, the first pillar, and with the money stock, the second pillar. This strategy, which has been highly controversial (Wyplosz, 2000), can explain Figure 2: the ECB has expanded liquidity as a matter of necessity to contain the crisis, but it is uncomfortable with it. The role of liquidity has been the subject of acute doctrinal debates and the ECB is unique in retaining this pillar.
The rise in Eurozone unemployment is first and foremost driven by the austere fiscal policies adopted since 2010, but the ECB’s rejection of QE can be seen as a limitation to its actions toward activity and employment stabilisation. In a way, this is consistent with its mandate, but its pre-crisis behaviour suggests that the ECB has acted de facto like many other central banks, in effect caring about employment. Its actions during the crisis could well be better explained by its stated two-pillar strategy.
This distinction matters greatly. It is most unlikely that the formal mandate of the ECB can be changed, since it would require a new treaty. On the other hand, the two-pillar strategy is purely an internal matter within the ECB and it can be modified without further challenges. This strategy has been heavily criticised and can be seen as reflecting the ancient tradition of the Bundesbank, which has itself increasingly paid less attention to the second pillar. The main obstacle to the adoption of a more up-to-date strategy is that it would explicitly repudiate the intellectual inheritance from the Bundesbank.
Yet the crisis has shown that another pillar, long disregarded by the ECB, is essential. Central banks can no longer underplay their responsibility for financial stability. In fact, the ECB is now in charge of the Single Supervision Mechanism. This calls for a redefinition by the ECB of its monetary policy strategy. It offers a unique opportunity to remove what may have been an internal obstacle to QE and a policy stance more favourable to employment. Experience around the world has shown that this does not have to come at the expense of price stability.
Belke, Ansgar and Jens Klose (2010) “(How) Do the ECB and the Fed React to Financial Market Uncertainty? The Taylor Rule in Times of Crisis”, Discussion Paper 972, DIW, Berlin.
Ullrich, Katrin (2003) “A Comparison Between the Fed and the ECB: Taylor Rules” Discussion Paper No. 03-19, ZEW, Mannheim.
Wyplosz, Charles (2000) “Briefing Paper for the Committee of Economic and Monetary Affairs”, European Parliament.