Monthly Archives: June 2014

The ECB’s Daunting Task

Mario Draghi, head of the European Central Bank, and the members of the ECB’s Governing Council are receiving praise for the initiatives they announced last week to avoid deflation (see here and here). The immediate impact of the announcement was a rise in European stock prices. But the approval of the financial sector does not mean that the ECB will be successful in its mission to rejuvenate the Eurozone’s economy.

The ECB is taking several expansionary steps. First, it has cut the rate paid on the deposits of banks at the ECB to a negative 0.1%, thus penalizing the banks for not using their reserves to make loans. Second, it is setting up a new lending program, called “Targeted Longer-Term Refinancing Operations (TLTROs),” to provide financing to banks that make loans to households and firms. Third, it will no longer offset the monetary impact of its purchases of government bonds, i.e., no “sterilization.” Moreover, Draghi’s announcement included a pledge that the ECB will consider further steps, including the use of “…unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation.”

Draghi’s promise to take further steps are reminiscent of his announcement in 2012 that the ECB was “…ready to do whatever it takes to preserve the euro.” That promise was successful in calming concerns about massive defaults and a break-up of the Eurozone. Consequently, the returns that sovereign borrowers in the Eurozone had to pay on their bonds began a decline that has continued to the present day.

But the challenges now facing the ECB are in many aspects more daunting. The current Eurozone inflation rate of 0.5% is an indicator of the anemic state of European economies.  Achieving the target inflation target of the ECB of 2% will require a significant increase in spending. The latest forecast for 2014’s GDP Eurozone growth from The Economist is 1.1%, which would be a pick-up from the 0.7% in the latest quarter, with an anticipated inflation rate for the year of 0.8%. Unemployment for the area is 11.7%, and this includes rates of 25.1% in Spain, 26.5% in Greece, and 12.6% in Italy.

More bank lending would encourage economic activity, but it is not clear that European banks are willing to make private-sector loans. Many banks are still dealing with past loans that will never be repaid as they seek to pass bank stress tests. And Draghi’s success in calming fears about sovereign default has (perhaps paradoxically) resulted in banks holding onto government bonds, which are now seen as relatively safe compared to private loans.

There is one other aspect of the European situation that can derail the ECB’s efforts: the distribution of financial wealth. The recent publication of House of Debt by Atif Mian and Amir Sufi has led to discussions of the deterioration of household balance sheets during the global financial crisis, and the economic consequences of the massive decline in household wealth. Larry Summers has praised the authors’ contribution to our understanding of the impact of the crisis on economic welfare by focusing on this channel of transmission.

Mian and Sufi have claimed that income distribution has a role in the response of households to policies that seek to boost spending. Low-income households, they point out, will spend a higher fraction of fiscal stimulus income checks than high-income households. They would most likely also spend a higher proportion of a rise in their financial worth. A concentration of such wealth in the hands of a small proportion of European households, therefore, limits the increase in spending due to higher asset prices.

The ECB, therefore, may find that the plaudits they have earned do not translate to a better policy outcome. The situation they face is not unique, and resembles in many ways the challenges that the Bank of Japan in has faced. Draghi and the ECB may have to follow their lead in devising new measures if European spending and inflation do not pick up.

The Challenges of Achieving Financial Stability

The end of the bubble in 2000 led to a debate over whether central banks should take financial stability into account when formulating policy, in addition to the usual indicators of economic stability such as inflation and unemployment. The response from many central bankers was that they did not feel confident that they could identify price bubbles before they collapsed, but that they could always deal with the byproducts of a bout of speculation. The global financial crisis undercut that response and has led to the development of macroprudential tools to address systemic vulnerabilities. But regulators and other policymakers who seek to achieve financial stability face several challenges.

First, they have to distinguish between the signals given by financial and economic indicators, and weigh the impact of any measures they consider on anemic economic recoveries. The yields in Europe on sovereign debt for borrowers such as Spain, Portugal and Ireland are at their lowest levels since before the crisis. Foreign investors are scooping up properties in Spain, where housing prices have fallen by over 30% since their 2007 highs. But economic growth in the Eurozone for the first quarter was 0.2% and in the European Union 0.3%. Stock prices in the U.S. reached record levels while Federal Reserve Chair Janet Yellen voiced concerns about a weak labor market and inflation below the Federal Reserve’s 2% target. When asked about the stock market, Yellen admitted that investors may be taking on extra risk because of low interest rates, but said that equity market valuations were within their “historical norms.” Meanwhile, Chinese officials seek to contain the impact of a deflating housing bubble on their financial system while minimizing any economic consequences.

Second, regulators need to consider the international dimensions of financial vulnerability. Capital flows can increase financial fragility, and the rapid transmission of financial volatility across borders has been recognized since the 1990s. Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh analyzed the factors that led to what they called “fast and furious” contagion. Such contagion occurred, they found, when there had been previous surges of capital inflows and when the crisis was unanticipated. The presence of common creditors, such as international banks, was a third factor. U.S. banks had been involved in Latin America before the debt crisis of the 1980s, while European and Japanese banks had lent to Asia in the 1990s before the East Asian crisis.

The global financial crisis revealed that financial integration across borders exacerbated the downturn.  The rise of international financial networks that transmit risk across frontiers was the subject of a recent IMF conference. Joseph Stiglitz of Columbia University gave the opening talk on interconnectedness and financial stability, and claimed that banks can be not only too big to fail, and can also be “too interconnected, too central, and too correlated to fail.” But dealing with interconnected financial networks is difficult for policymakers whose authority ends at their national borders.

Finally, officials have to overcome the opposition of those who are profiting from the current environment. IMF Managing Director Christine Lagarde has attributed insufficient progress on banking reform to “fierce industry pushback” from that sector. Similarly, Bank of England head Mark Carney has told bankers that they must develop a sense of their responsibilities to society. Adam J. Levitin, in a Harvard Law Review essay that summarizes the contents of several recent books on the financial crisis, writes that “regulatory capture” by financial institutions has undercut financial regulation that was supposed to restrain them, and requires a political response. James Kwak has emphasized the role of ideology in slowing financial reform.

Markets for financial and other assets exhibit little sign of stress. The Chicago Board Options Exchange Volatility index (VIX), which measures expectations of U.S. stock price swings, fell to a 14-month low that matched pre-crisis levels. Such placidity, however, can mask the buildup of systemic stresses in financial systems. Regulators and other policy officials who seek to forestall another crisis by acting peremptorily will need to possess political courage as well as economic insight.