Same ECB Medicine, Higher Dosage – Good But More Needed

The ECB has announced a further expansionary shift by beefing up a range of existing policy instruments. Barring unexpected positive shocks this will not be enough to break out of a deflationary environment and convincingly underpin growth and a rapid reduction in unemployment. For that to happen fiscal policy must turn expansionary and/or the ECB must cast caution to the winds and adopt new tools. At the press conference following the policy announcement ECB President Draghi gave a tantalizing glimpse that new tools may indeed be on the way: we may yet see monetary financing of fiscal policy, or helicopter money as it is popularly known.

The ECB announced three sets of measures:

• Cuts in all three base rates, including, finally, a zero rate for the in normal times most important repo rate, and a further push into negative territory for the deposit rate (the rate paid by banks on the excess reserves with the central bank), from -0.3 to -0.4%.
• An expansion of the quantitative easing (QE) programme, raising the volume of monthly purchases from €60 to €80 billion and extending coverage to include high-quality non-bank corporate bonds.
• And a renewed “funding for lending” scheme (known as TLTRO, targeted long-term repurchasing operations) that is even more generous, offering the banks negative interest rates on central bank loans that are lent on to the real economy.

All of these measures will have an expansionary effect, putting upward pressure on inflation and real output (and thus on nominal growth rates). The slightly higher negative rate on reserves increases the incentive on banks to find alternatives to holding reserves with the central bank. It may lead to higher lending to the real economy (although it is a common misperception that reserves can be directly lent or are a constraint on bank lending). They may simply hold more currency, though; bigger vaults, installing stronger locks and some extra security personnel will not noticeably add to demand.

An extra €20bn of assets will be bought with “printed” money every month. It was virtually inevitable that this would be accompanied by a broadening of the assets under consideration if ECB purchases are not to distort sovereign bond markets. Such purchases push up asset prices, creating wealth effects and improving private sector balance sheets. Yields (market interest rates) are pushed down, cheapening finance for governments and, now, issuers of investment-grade corporate bonds. And there are knock-on effects of a similar nature in other markets as financial investors are pushed into riskier assets. Together the above effects tend to depress the currency, stimulating demand and pushing up prices.

Lastly, the TLTRO Mark II is effectively saying to the banks that the central bank will pay you to lend to the private sector. This measure also aimed to offset the squeeze on bank profitability implied by the negative deposit rate.

So all is well then? No.

Reasons to be sceptical

The immediate market reaction was substantial and positive, in marked contrast to the disappointment registered by markets after the weaker-than-expected measures announced last December. The euro fell by about 2% against the dollar while equity markets rose by a similar order of magnitude, bank shares – recently heavily depressed – by substantially more. The euphoria was short-lived, however. The euro reversed course and appreciated on the day substantially, on realization that the deposit-rate cut was small and, as Draghi explained in the ECB press conference, was probably the end of the road for this measure in view of the problems it creates for (and the consequent political opposition from) the banks. The major share indices ended the day down, although those in the euro area periphery still registered gains.

Yet the reasons for giving a welcoming, but very restrained response to the ECB’s decisions are much more fundamental than the verdict made by the famously fickle “Mr. Market”. A terse but accurate characterization of the package is that the central bank will try more of the same, just a bit harder. But barring unexpected tailwinds this will not be enough. And if there are headwinds the disinflationary, demand-sapping spiral will resume, and the question will return: what will you do now Mr. Draghi?

Views on the impact of the unconventional monetary policy measures implemented to date vary widely; for earlier assessments see here p. 5ff. and here p 79ff. Some predicted an inflationary tidal wave. (We should be so lucky, one is tempted to remark.) For others they have done nothing useful but rather have blown up asset bubbles, creating dangers down the road. (In fact the bubbles, such as they were, have largely evaporated.) Indeed there is a debate whether the negative deposit rates have actually been contractionary because they squeeze banks profits. (In fact experience suggests the effects have been minor, there are ways to reduce the cost to banks while maintaining incentives to banks to reduce excess reserves and fund investments with a positive return.)

Taking as given the inappropriate fiscal stance – the unwillingness or inability of governments to finance public investment or other expansionary measures at a time of extremely low, often indeed negative interest rates – the unconventional monetary measures have been, on the one hand, absolutely indispensable. Without them deflation would in all probability have taken hold and the real economy would have been much weaker, the modest reductions in unemployment would most likely not have materialised. Some form of disorderly break-up of the common currency would have very probably been the result. On the other they have been clearly insufficient. The positive impacts – on the exchange rate, on inflationary expectations – came at the start of QE or in anticipation of it. More recently the exchange rate has stabilised, offering no additional stimulus. In any case the euro area current account has risen substantially and already reached around 4% of GDP; the scope for further increases in net exports is tightly circumscribed. Inflationary expectations have been declining, equity markets have fallen back substantially. Meanwhile the global economic environment has deteriorated and confidence and leading indicators have headed south.

The medicine, in other words, initially stabilized a patient whose health was declining precipitously. But the effects appear to be wearing off. The prospects of a lasting cure are receding and the patient is too weak to withstand any additional shock. Dr. Draghi has therefore increased the dosage of the existing drugs. This is, in a certain way, a logical step and, of itself, sensible and welcome. As to those critics rejecting this upping of the dosage, pointing to side-effects such as an (alleged) “expropriation” of savers or plundering the banks, one suspects that they secretly want the patient, the common currency, to perish. At the very least they are dangerously complacent about that risk – unless that is they simultaneously propose alternative measures to stimulate aggregate demand and nominal GDP growth.

And brings us to the crucial question: whether other more effective medicines need to be prescribed in addition or complementary to the existing treatment.

The euro area needs a new drug

What is desperately needed is simple: higher levels of spending in the real economy, raising incomes and prices, facilitating deleveraging, stabilising expectations and encouraging investment. Unconventional monetary policy has had limited success achieving this indirectly. Macroeconomically the obvious answer is expansionary fiscal policy: direct higher spending by the public in the private sector (relative to given tax levels). The fiscal stance is currently broadly neutral, at best very slightly expansionary. This is macroeconomic madness when the central bank is pulling out all the unconventional stops, governments can borrow at virtually zero nominal (never mind real) interest rates and private-sector investors are crying out for safe assets. In a nutshell the barriers are political. The insistence of countries with fiscal space to achieve a “black zero” on the government balance, the legal constraints on countries willing to run more expansionary policies, and the lack of serious European-level alternatives, including the Juncker Plan. (The situation is little changed from the analysis here, p. 6ff.)

A decisive shift to coordinated fiscal expansion would be highly desirable, but there seems little sign of it being forthcoming. The ECB President regrettably, if perhaps understandably, failed to call explicitly on Member State governments to support the central bank’s efforts by loosening the fiscal belt (see both his opening statement and response to a question at the press conference). If that is the case, the ball will remain in the ECB’s court, as it has for much of the crisis. This is economically wrong and unnecessary. But one cannot just wring one’s hands about that regrettable fact. One needs to consider what the central bank should do if no substantial support is forthcoming from fiscal policy. It would surely not be credible to merely offer a yet higher dosage in four or five months’ time.

Two steps, in particular, can and need to be considered. The first is to better anchor expectations by explicitly committing to create additional inflation to offset the extended period in which inflation has been substantially below target. A simple way to do this is to announce a target for the desired trajectory for the level of nominal GDP (an accessible, nuanced discussion is here). This is a fairly modest step that amounts, in the lingo, to rendering more credible the central bank’s forward guidance regarding its policy intentions and priorities.

The second would be for the ECB to directly support fiscal policy measures, in other words monetary financing of fiscal policy or so-called helicopter money. I have argued for some time that the ECB needs to have monetary financing in its toolbox and should explore ways of financing public investment, for instance in tandem with the European Investment Bank. Others favour transfers to households (e.g. here). A useful summary of positions in the debate is here. President Draghi was asked about helicopter money at the press conference and gave an intriguing answer, that is worth quoting:

“We < i.e. the ECB Governing Council – AW> haven’t really thought or talked about helicopter money. It’s a very interesting concept that is now being discussed by academic economists and in various environments. But we haven’t really studied yet the concept. Prima facie, it clearly involves complexities, both accounting-wise and legal-wise, for our view, but of course by this term “helicopter money” one may mean many different things, and so we have to see that.”

Not having really discussed the concept yet implies that at least informal discussions probably have taken place at some level; indeed given the prominence of monetary financing concepts in recent debates it would be surprising if this had not been the case. More importantly, Mario Draghi did not rule out more formal investigations in the future, addressing the – undeniably – complex legal and accounting issues involved.

I would certainly recommend that the ECB do so, with great urgency. Looking forward the number of plausible scenarios is very limited. A combination of (unexpected) economic tailwinds and (unexpected) forcefulness of the higher-dosage existing measures turns the euro area economy around. Or the economy continues to struggle, with little or no progress being made is reaching the price stability target. Negative external shocks squeeze the little life there is in the European economy. In that case the Member States (particularly Germany) and the European Commission will need to relent on the fiscal stance, permitting an appreciable fiscal expansion.

If this is not forthcoming it would be completely incredible for the ECB to repeat its most recent policy decisions at even higher dosage. By then the ECB Governing Council had better have a viable monetary financing plan to put forward. It will be helicopters over the euro tower, either that or vultures.

This post was first published on Andrew Watt’s Blog