What Recovery? The ECB and Unconventional Monetary Policy
By Ashesh Rambachan
The Economist reported last week,
“The recovery, though feeble, has nonetheless been sustained. Output rose by 0.3% (an annualised rate of 1.3%) in the second quarter of 2013, and although growth slowed to 0.1% in the third, it picked up to 0.2% in the fourth. More important, there are signs that the pace may be accelerating this year. Despite the crisis in Ukraine, euro-zone surveys of confidence and activity in the first three months of 2014 have been encouraging.”
Since when is .2% growth encouraging? How is 1.30% growth encouraging when unemployment across the Eurozone is 11.9%? (It’s much, much worse in member states such as Spain and Italy.) To make matters worse, inflation across Europe fell to 0.50% this last quarter. Newsflash: This is not a recovery and to make matters worse, there are concrete steps that can be taken to ameliorate the pain.
Economists, such as Paul Krugman, have pointed out time and time again that, given the challenges facing European nations, higher inflation, even above 2%, is good. It reduces the real value of debt. It reduces operating costs for businesses relative to the rest of the world, increasing competitiveness. It also encourages individuals to spend as it creates a real cost to sitting on cash. Even though the European Central Bank has hit the dreaded zero-lower bound (in other words, interest rates can go no lower), it can still take steps to combat deflation, boost the monetary base and hopefully generate growth.
Look at the Federal Reserve in the United States as an example. Since hitting the zero-lower bound in late 2008, the Federal Reserve has engaged in unconventional monetary policy, known as quantitative easing. While central banks conventionally target the interest rate on short-term government debt, they can also affect the interest rates on other financial instruments, such as long-term government debt, private securities or even stocks. Armed with the printing press, central banks have the power to engage in massive purchases of these unconventional assets, driving down their interest rates and shoving cash into the economy. The Federal Reserve Bank of San Francisco estimated the direct effect of these purchases in the United States. It estimated that these purchases of over $600 billion of long-term US government debt boosted GDP growth by between 0.10% to 0.50% annually. Not a lot to be sure, but 0.1%-0.5% is still significant.
Sadly, no similar action appears to be on the horizon in the Eurozone. The head of the European Central Bank, Mario Draghi, after the most recent meeting of the ECB’s executive board, announced that while the Bank is considering unconventional action, it has decided to wait and see if prolonged low inflation continued. This is a mistake. Given the inability of European governments to increase spending or slash taxes (see: debt crisis), unconventional monetary policy represents a ready tool to generate much-needed growth and inflation. The longer the ECB waits, the more damage personal damage economic stagnation will reek across the Eurozone.