Monetary policy: What's the alternative?

The news last week that the ECB will commit to keeping interest rates on hold for the remainder of this year and provide additional liquidity in the form of targeted longer-term refinancing operations (TLTROs) is an illustration of the central bank’s concern about the economic slowdown. But it also reflects the continued reliance on monetary policy to support the economy in the absence of any other options.

That the euro zone economy has lost momentum is not in doubt. But this to a large extent reflects a number of exogenous factors, such as the Chinese slowdown, which is at least partly the result of the trade dispute with the US. ECB President Draghi indicated as much in his prepared statement, telling the assembled journalists that the loss of economic momentum was primarily due to “the slowdown in external demand” and that “the risks surrounding the euro area growth outlook are still tilted to the downside, on account of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” Responding to this slowdown by committing to keep rates unchanged makes some sense. But what is less obvious to me is why, when factors beyond the control of the ECB are responsible for the loss of economic momentum, is the ECB prepared to activate monetary measures designed to target the domestic economy, particularly TLTROs which operate at one remove? Moreover, why wait until September to initiate them?

In the ECB’s words, TLTROs “provide financing to credit institutions … at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy.” And whilst it is true that in recent months the rate of loan growth to the euro zone private sector has slowed (chart), the most notable loss of momentum has been in corporate sector loans which is likely to be a consequence of global business conditions. Increasing liquidity supply is all very well, but there are serious questions as to whether demand for additional cheap credit exists. Indeed, unlike 2008-09 when the credit crunch was actively holding back economic recovery, today we are awash with liquidity. But the euro zone’s problem is magnified by the growing split between northern and southern states. For example, borrowing costs for Italian banks have risen since last summer as concerns grow regarding the government’s fiscal stance. The TLTROs are thus of more benefit to southern Europe than the north.

Draghi’s comments also repeated the long-standing message that “structural reforms in euro area countries need to be substantially stepped up to increase resilience, reduce structural unemployment and boost euro area productivity and growth potential.” This is a message which has been part of the ECB’s communications strategy since the days of Wim Duisenberg and in fairness has been heeded by the likes of Germany. But Italy’s growth performance remains by a considerable margin the worst in the G20 and recent efforts in France to broach the subject of reform were met with a wave of public protests which caused the government to back down. But the fact that the euro zone’s potential growth limit today stands at 1.5% compared to 2% at the start of monetary union does illustrate the necessity to heed Draghi’s call.

But the biggest failing across large parts of the industrialised world in recent years has been the unwillingness to use fiscal policy as a tool of economic management, which has thrown the burden of adjustment onto monetary policy. Draghi did point out that fiscal policy across EMU is mildly expansionary but “countries where government debt is high need to continue rebuilding fiscal buffers.” Whilst accepting that excessively high levels of debt have economic costs, notably the fact that they represent claims on future resources, Italy has consistently run a primary surplus over the last 20 years of around 1.5% of GDP. Requiring additional fiscal tightening in Italy is only going to prove counterproductive. The extent of fiscal tightening across many European countries is captured by the decline in cyclically-adjusted government spending (here, see Table 6A) which in Germany has fallen by 10 percentage points of potential GDP since the mid-1990s whilst in Ireland it is down by 15 percentage points (and nearly 40 points since mid-2010).

A lax monetary policy cannot offset a fiscal tightening of that magnitude. For one thing, monetary policy operates in an indirect route in which the benefits may get lost in the transmission process (e.g. if there is limited demand for credit). Moreover, a long period of low interest rates is likely to have adverse side effects. Our future incomes as represented by pension savings require us being able to generate a decent rate of return on the income we set aside to provide for tomorrow. The ECB’s policy of holding the short end of the yield curve deep in negative territory, whilst buying up to one-third of the euro zone debt stock, has resulted in German maturities up to nine years falling into negative territory. Following last week’s announcement by the ECB, even the nine-year segment fell below the line whilst the benchmark 10-year Bund yield at one point hit just 0.05%.

That is not going to help our future incomes. Nor does it help banks, which rely on a positively sloped yield curve in positive territory to generate income. With the ECB deposit rate at -0.4%, banks have no incentive to hold excess liquidity at the central bank. Even the BIS has pointed out that profitability is a crucial area of banking resilience since this determines the extent to which they can recover from losses resulting from economic shocks. Although much progress has been made to weather-proof bank balance sheets thanks to legislation implemented in the last decade, profitability – particularly in Europe – remains well below pre-2008 levels. With European bank price-to-book ratios still well below unity, this indicates that investors are not very optimistic with regard to a recovery in profits.

It is hard to avoid the conclusion that central banks, particularly the ECB, continue to operate a lax monetary policy because there are no other policy options. But the longer we operate policy consistent with economic conditions prevailing in 2009, the greater will be the potential adverse long-term consequences. Whilst this is all part of Draghi’s “doing whatever it takes” strategy outlined in 2012 to hold the euro zone together, we are now at the point where the ECB needs help from governments to get the economy back on its feet.