Debate has spread throughout the media in recent weeks over whether the European Central Bank, or ECB, may be about to take more aggressive measures to stimulate the eurozone economy. The specific question is whether the bank might start extensively buying government bonds and private assets — moves it has to this point avoided.
The ECB has played a fundamental role in helping contain the financial damage wrought by the European crisis and preventing a breakup of the currency union. In contrast to the lengthy decision-making processes that characterize eurozone member states' negotiations over bailouts and aid to banks, the ECB has been able to rapidly make and act on decisions necessary to preserve the currency union.
However, the bank manages a currency union of 18 countries. It is more constrained than other leading central banks in the measures it can take, and it is facing greater challenges to the conduct of its monetary policy as economic stagnation in Europe persists. As the crisis drags on, revising the ECB's role in stabilizing the European economy will become a more pressing issue of political debate, particularly in Germany.
The ECB has helped stabilize the eurozone and bring down borrowing costs for troubled states during the crisis years through small purchases of the sovereign debt of countries such as Greece, Spain and Italy. It has also granted banks easier access to liquidity and has managed the expectations of financial markets by announcing that it will do everything to preserve the eurozone. While these actions were necessary to calm financial markets, the ECB has been less successful in helping Europe overcome its economic crisis.
The Bank's Role
The ECB's sole legal mandate is to control inflation. Other central banks — the U.S. Federal Reserve, for example — have an additional mandate to ensure low unemployment. The ECB's role is a constant source of debate in the eurozone. France and the southern countries, which are willing to tolerate higher inflation in exchange for lower unemployment, argue that the bank should be more proactive in aiding European economies through its monetary policy (for example, by ensuring a weaker euro to help exporters and expand credit). Northern eurozone members, especially Germany, would rather the ECB stick to its inflation mandate. These countries fear that an overly interventionist central bank would limit countries' efforts to improve their competitiveness through structural reforms, such as ensuring more flexible labor markets.
Also constraining the ECB are the widely diverging economic structures of the 18 countries for which the bank has to implement monetary policy. In southern Europe, consumers and companies, particularly small and medium-sized businesses, struggle to access bank lending, despite ECB measures that have made it less costly for banks to borrow from it. Banks in struggling countries are cautious to extend lending as the proportion of non-performing loans expands and economic activity remains weak. This limits the ECB's ability to transmit its monetary policy to the real economy.
Options and Constraints
The ECB has kept interest rates at a record low of 0.25 percent, but the continued economic stagnation (the International Monetary Fund expects the eurozone to grow at 1.2 percent in 2014) and low eurozone-wide inflation of around 0.5 percent are prompting the bank to take additional steps. The option to exercise quantitative easing — the purchase of government and private debt by the ECB — is one of the steps under consideration but would probably be used only after other measures have failed to bring about the desired effect.
Quantitative easing — something the U.S. Federal Reserve, the Bank of England and the Bank of Japan have long carried out — involves a central bank purchasing government and private sector debt, such as mortgage-backed securities or corporate debt, thus expanding the monetary base. This in theory should inflate the supply of money relative to demand and help keep interest rates throughout the economy low. There are several obstacles to the ECB implementing such a policy. First among them, the bank is not allowed to finance the creation of government debt (so-called monetary financing) by purchasing that debt.
If the ECB started buying government debt through a quantitative easing program, the bank would likely face legal battles in several countries, the most important of which would be Germany, where groups have already challenged ECB policies before the German Constitutional Court. If the legal limitations are overcome, the ECB would then have to decide which government's debt to purchase. Countries that contribute the most capital to the ECB, such as Germany and France, would want the bank to purchase their debt, which is the most liquid and considered safer than the debt issued by the struggling economies that are most in need of ECB aid.
Before the ECB would start buying government debt, it would probably stop the sterilization of the government debt purchased from struggling countries between 2010 and 2012. To sterilize government debt, the ECB makes sure that banks deposit an amount back into the ECB that is equivalent to the value of the sovereign debt that the bank purchased between 2010 and 2012. In this way, the bank ensures that the money used to buy sovereign debt does not reach the financial system as added liquidity.
Stopping the sterilization process would be the first step toward quantitative easing, since additional liquidity of around 170 billion euros ($236 billion) would now stay in the financial system. The head of the German central bank has signaled that he supports a temporary halt to sterilization and has suggested that there is little opposition within the ECB to the measure. Nevertheless, the move's legality would likely be challenged in court.
In the United States and the United Kingdom, quantitative easing programs also involve the purchase of private sector debt. Central banks purchase financial products that bundle the loans commercial banks issue to households or companies. Purchasing private sector debt would help the ECB avoid accusations of engaging in monetary financing since government debt creation would not be encouraged, as it is with the purchase of state debt. The problem is that the market in Europe for such products is small, limiting the ECB's ability to buy private sector debt.
It is unclear how effective the ECB's efforts to add liquidity to the financial system would be in fueling activity in the real economy, which is struggling to get access to bank lending. This problem afflicts several of the monetary policy tools that remain at the bank's disposal.
Cutting interest rates to zero and providing more cheap loans to banks are the least controversial options that the ECB has. However, measures already taken have not helped as much as the bank would have hoped. Cutting the interest rate at which banks can borrow from the ECB and providing more liquidity (for example, through a new round of long-term lending that added around one trillion euros to the financial system in late 2011 and early 2012) has done little to increase lending to consumers and companies in struggling countries. Introducing a negative deposit rate could incentivize banks to lend. The deposit rate, or the interest that banks earn when they deposit money at the ECB, currently stands at zero but the ECB is considering negative deposit rates to encourage banks to lend in the private sector instead of parking cash at the central bank. Whether lending to the private sector would in fact pick up, however, is questionable. The banks may continue to avoid lending to peripheral countries, even in the presence of a negative ECB deposit rate. Banks could use their reserves to repay their loans, rather than increase lending. They could also increase loan rates, especially in the periphery, which would further harm small companies and consumers.
The ECB could also take measures to make it easier for commercial banks to use their holdings of private debt as collateral for additional ECB funding. Again, the trouble is that it is difficult to target a specific troubled country or sector. Banks would likely direct any increased lending to northern Europe, where companies are still relatively sound financially, overlooking family-run businesses in troubled states like Spain or Greece.
Beyond technical hurdles, the ECB is probably reluctant to push banks too hard to lend to struggling sectors. ECB officials often point out that the bank cannot correct inefficiencies or a lack of competitiveness in eurozone economies. The central bank cannot take over the role of the banking system in assessing which customers are worthy of credit, so there is great concern that forcing banks to lend more would gradually destabilize the very banking system that the ECB is already trying to clean up.
Communication is the First Step
The fear of deflation is adding urgency to the bank's attempts to give the real economy a jolt through monetary policy. The inflation rate in the eurozone is well below the ECB target of 2 percent, currently standing at around 0.5 percent. Communicating its commitment to do something is the first step toward influencing financial markets. The July 2012 promise to do everything to preserve the eurozone calmed financial markets without the ECB having to take concrete steps. Recent comments by ECB board members, and leaks about preparations supposedly being made for a quantitative easing intervention, are meant to have a similar effect.
The ECB knows that quantitative easing is a controversial move, and though it is floating the idea to assess the strength of support and criticism by financial markets and politicians, it is probably not yet ready to use it.
If it is to stymie potential legal challenges while engaging in controversial policies, the ECB will need wide political backing, particularly from the eurozone's two largest economies, France and Germany. When the eurozone was created, France accepted the demand to have an ECB that solely targets low inflation, like the German Bundesbank. However, in light of the European crisis, the mandate of the ECB is once more up for debate.
The economic crisis has reached France, and Paris is feeling increasingly uncomfortable with the ECB's limited role. France is more likely than it has been in the past to be able to convince Berlin that the bank should have more leeway to fuel economic growth, instead of just focusing on inflation. For Germany, preserving the eurozone is a strategic interest, but it will be a challenge to convince the German population of its importance and keep institutions such as the Constitutional Court aligned with this goal.
