Tag Archives: financial crises

The ECB’s Daunting Task

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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.

Capital Liberalization and Inequality

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Inequality, which has drawn a great deal of comment and analysis following the publication of Thomas Piketty’s Capital in the Twenty-First Century, has sometimes been seen as a byproduct to increased international trade. But now other international economic linkages are being investigated. The International Monetary Fund’s Managing Director, Christine Lagarde, has acknowledged the need to take distributional consequences into consideration when designing IMF policy programs. Moreover, Fund economists have contributed to the research on the linkages between financial globalization and inequality.

Davide Furceri and Prakash Loungani of the IMF have investigated the effect of capital account liberalization on inequality. They looked at 58 episodes of capital account reform in 17 advanced economies, and found that the Gini coefficient (a measure of inequality) increased by about 1% a year after liberalization and by 2% after five years. One channel of transmission from the capital account to inequality could be the Increased borrowing by domestic firms that allows them to hire skilled workers, who pull ahead of the less-skilled workers.

A similar impact was found by Florence Jaumotte, Subir Lall and Chris Papageorgiou, also of the IMF. They analyzed the effect of financial globalization and trade as well as technology on income inequality in 51 countries over the period of 1981 to 2003. They reported that technology played a larger role in increasing inequality than globalization. But while trade actually reduced inequality through increased exports of agricultural goods from developing countries, foreign direct investment played a different role. Inward FDI (like technology) favored workers with relatively higher skills and education, while outward FDI reduced employment in lower skill sectors. Consequently, the authors concluded, while financial deepening has been associated with higher growth, a disproportionate share of the gains may go to those who already have higher incomes.

Jayati Ghosh of Jawaharlal Nehru University of New Delhi has examined the role of capital inflows in developing countries. She maintains that the inflows appreciate the real exchange rate and encourage investment in non-tradable sectors and domestic asset markets. The resulting rise in asset prices pulls funds away from the financing of agriculture and small firms, hurting farmers and workers in traditional sectors. Eventually, the asset bubbles break, and the poor are usually those most vulnerable to the ensuing crisis.

After the Asian crisis of 2007-08, Barry Eichengreen of UC-Berkeley analyzed some of the other linkages that could tie inequality to capital account liberalization. He dismissed claims that capital mobility hinders the ability of governments to maintain social safety nets or to use macroeconomic policy to stabilize output. He agreed that developing countries were more likely to suffer the negative effects of capital mobility. But the problem lay in the combination of an open capital account and inadequate institutions and regulations.

The global financial crisis demonstrated that weak regulation and volatility in financial flows are not unique to emerging markets and developing countries. Moreover, while the U.S. economy now shows signs of increased growth, the long-term unemployed are not sharing in the recovery.  The U.S. Senate has passed a bill that would extend benefits to this group of workers, but it faces opposition in the House of Representatives. On the other hand, those households that own substantial financial assets have benefited greatly from the increase in their value since 2009, which is due in large part to monetary policy. Similar patterns can be found in Europe.

Those most hurt by the outcome of financial instability should be the first to benefit from government policies intended to mitigate its impact. But we know that politicians are much more responsive to their more affluent constituents, who hold financial assets. The uneven recoveries that follow financial crises injure those least capable of dealing with misfortune, thus exacerbating the disparity between those at the top of the income distribution and those at the bottom.