by Andreas Hoffmann and Nicolás Cachanosky
The Federal Reserve’s (Fed) and European Central Bank’s (ECB) policy responses to the recent financial disasters offer two tales of unintended consequences. Our previous post outlined undesired effects of the Fed’s policies. In this post, we suggest that the ECB’s stabilization policy did not only fail to achieve its goals. Monetary policy has also hampered the structural adjustment of the European economy and prolonged the crisis.
When the crisis hit
Like the Fed, the ECB cut policy interest rates to historically low levels when the financial crisis hit Europe to accommodate financing needs of banks. To tame markets the Eurosystem provided liquidity to (illiquid) financial institutions via Emergency Liquidity Assistance (ELA-credit). From 2011 to 2012, the ECB’s Long-Term Refinancing Operations (LTRO) were supposed to help match liquidity needs of market participants and stimulate bank lending. The ECB has provided liquidity against dubious collateral ever since.[i] Neither the Fed nor the ECB has followed Bagehot’s principles.
When pressure on governments in the periphery of the euro area grew, the ECB started to purchase government bonds in secondary markets to lower bond yields. The ECB bought, for example, government securities via its Security Markets Program (SMP) until 2012. Because fear in markets depressed bond values and rendered bonds (of the periphery countries of the euro area) issued with low yields untradeable, undermining monetary and financial stability, the ECB famously announced an unlimited government bond-purchasing scheme – the Outright Monetary Transactions (OMT) program in July 2012. In 2015, the ECB started its “expanded asset purchase program” (APP), or quantitative easing (QE), to raise inflation expectations and stimulate the economy. The ECB will continue to buy bonds of all sorts until at least the end of 2017.
When policy ideas meet reality
ECB programs were supposed to stabilize markets, stimulate bank lending and boost growth. But the programs did not increase bank lending or growth sufficiently. Instead, in the post-2008 economic environment, well-intended ECB policies seem to have inhibited the structural adjustment in the euro area and encouraged a process of zombification. Ailing banks continue to put financial stability at risk. The ECB’s interventions in the bond market have allowed governments to borrow at lower costs. However, contrary to noble presuppositions of central bankers, governments have not used the leeway to implement the reforms needed for a sustainable take-off of the economy. Instead, progress with structural reforms slowed down.
a) Asset mispricing
On the upside, monetary policy effectively reduced government borrowing costs, mitigating the debt crisis. At the height of the debt crisis in late 2011 and early 2012, ten-year Greek government bonds traded about 3500 basis points above German Bunds. When ECB President Mario Draghi made clear, he would do “whatever it takes” to save the euro area in 2012, bond yields in the euro area started to converge again.
Today, following several rounds of policy interventions, Greek bond yields are at approximately the same level as before the crisis. German Bund yields are currently at about 50 basis points. Thus, ten-year Greek bonds trade at a spread of some 500 basis points above German Bunds. That is remarkable considering the haircuts Greek bondholders had to take and the uncertainty concerning Greek finances that still depend on EU assistance. Given that U.S. bonds yield 230 basis points, it is highly unlikely that European bond prices reflect anything close to market fundamentals. Yields are low because the ECB stands ready to buy bonds whenever yields rise.
b) Financial stability issues
During the height of the debt crisis, banks were betting on the survival of the euro area when spreads between the German Bund and the periphery bonds widened. Additional bond purchases added to the problem of the interdependence of sovereign and bank risk in Europe. Bailouts became more likely as the costs of defaults rose. The ECB stood ready to buy bonds.
Policymakers understand that the link between the health of banks and public finances, which is often referred to as the sovereign-bank nexus, contributed to the financial crisis in Europe’s periphery. The IMF’s recent Global Financial Stability Report (April 2017) clarifies that the linkages between banks and government finances continue to threaten global financial stability.
But there is empirical evidence that, for example, following the ECB’s announcement of its 3-Year Long Term Refinancing Operations (the Big Bertha) in December 2011 banks increased the holding of domestic short-term government debt which could be used as collateral in refinancing operations. Programs that were supposed to stabilize markets incentivized banks to purchase riskier bonds, undermining financial stability.
c) Bank lending
The ECB programs have also fallen short of expectations in encouraging bank lending. Various ECB bank lending surveys indicate that the impact of the fall in interest rates and QE on loan growth was limited until 2016. Although the low-interest rate policy lowered the bank loan rates, it also compressed the bank spread (lending rate minus deposit rate). The smaller spread has made traditional banking less attractive. Even worse, although the announcement of an OMT program improved bank balance sheets as bond prices rallied up, the announcement had unintended real effects. Contrary to the intentions of the ECB, (undercapitalized) euro area banks did not use the leeway to extend loans to sound businesses. Banks mainly started to roll over loans to prevent losses and limit loan write-downs.
Rather than promoting bank lending and stimulating aggregate demand, as standard models would imply, in the present environment monetary policy has inhibited the market correction. Resources that were misallocated during the boom remain stuck in low productivity firms and sectors. Consequently, productivity growth has remained below trend. Like in Japan (since the 1990s), “zombification” may become a drag on growth in Europe and complicate the exit from low-interest rate policies.
d) Structural reforms
Many economists argue, of course, that monetary policy alone cannot do the job! They call for reforms in the euro area crisis countries to promote entrepreneurship, investment, and growth. Mario Draghi is one of them. He has often argued that overall policy success required governments and ECB to work in tandem. According to Draghi, the accommodative policy could help stabilize markets and provide governments with some time to implement reforms identified as necessary for a sustainable take-off of the economy. Following this logic, Draghi and the ECB must have assumed that governments would use the “window of opportunity” opened up by monetary policy to implement reforms.
These presuppositions of Sonnemannstraße have been proven wrong time and again.[ii] Indeed, Draghi has found it necessary to repeatedly address national governments and push for additional reforms. He has emphasized in speeches that the ECB was doing its job but governments were not doing theirs. That is not super surprising! The ECB’s bond purchases have dampened the adjustment pressure for euro area governments. Having to sell bonds in financial markets at market prices typically helps discipline governments. Since 2012, government bond yields have hardly reflected market fundamentals because the ECB has been standing ready to buy bonds and bring down yields if necessary. Absent market pressure, economists, including Draghi, seem to be talking to a wall. Contrary to Draghi’s assumptions, monetary policy has discouraged governments (facing an electorate) from implementing far-reaching reforms. In a 2016 report, the OECD (p. 16) noted that progress of structural reforms has indeed slowed down since 2012. Draghi’s policy seems to have backfired.
Draghi pushing his luck?
Despite numerous unintended consequences, Draghi continues to apply the very same policies. Some say that this is evidence that Draghi’s real objective is to make it possible for governments to borrow at very low costs. If there is no hidden agenda, he is for sure a hell of a gambler.
This commentary is cross-posted at ThinkMarkets and Sound Money Project.
[i] For example, Portugal’s bonds merely reach investment grade but may be used as collateral. One rating agency (DBRS) only rated bonds triple B.
[ii] The ECB (main building) is located in Sonnemannstraße 20, Frankfurt 60314.