Wednesday, 4 June 2014

Tomorrow the ECB must answer

Before the answer, the question:

In a monetary union like the Euro that is not underpinned by a common fiscal policy, should monetary policy carry a greater role to protect or restore  the necessary equilibrium in the union or can it simply accept that it is only responsible for achieving the inflation targets and the rest ( unemployment, economic stagnation, balance of payments problems) is not its problem?

Dominated as it is (through its culture, statute restrictions and location) to strict monetarism doctrine of Deutsche Bundesbank (BUBA), the European Central Bank (ECB) has generally tended to argue for the latter rather than the former.   At least under Trichet the ECB used to argue that it had only one compass for the control of inflation and for the rest it was up to the politicians to take care of through fiscal and other economic policies.

The depth of the Euro area recession, the great disparities between the economic fortunes of member countries in the Euro area with Germany and Greece at different extremes but sharing the same currency and monetary policy, and the arrival of Mario Draghi as President of the ECB, has changed that.

But most of the change has been verbal rather than through practical policy measures.   Draghi's 'whatever it takes' to save the Euro pledge in July 2012 was sufficient to restore order to a market that was spiralling out of control,  threatening the sustainability of the Euro area banking system and of the Euro itself.   The introduction of the OMT ( Outright Monetary Transactions),  which remained unused to date, was sufficient to persuade the markets that the ECB was serious in giving substance to the 'whatever it takes' pledge even though the Bundesbank is still trying to have the German and European courts declare that the OMT is ultra vires the ECB mandate.

Now we are at a stage where words are no longer enough, for three reasons:

1. Inflation in the Euro area is coming in consistently far below the ECB's 2% target and the latest May 2014 reading at 0.5% means that some Euro area countries are in outright deflationary territory.

2. The risk of deflation causes terror to monetary authorities, far more than the risk of inflation.

3. In the MEP elections voters have clearly revolted against German inspired austerity polices and they demanded sustainable economic growth to which the ECB can contribute  by a more imaginative monetary policy.

So tomorrow the ECB has to take measures that it has never taken before, as extreme situations demand extreme solutions,  Their menu is:

a. reduction in official interest rates - but these are already every low and a shave of 0.15% is symbolic but hardly effective

b. charging banks negative interest rates for excess reserves parked that the ECB rather than used to lend to private sector to promote investment and consumption.

c. offering banks generous long term repo facilities to give them cheap funds  to lend longer term to industry and private economic operators.

d. consider some sort of asset purchases ( through quantitative easing) especially if directed to lift assets from bank's balance sheet - through securitisation of their loan book - to allow space for new lending without demanding fresh capital.

There are other things the ECB should do, but they are still considered a bridge too far to keep the Germans on board.   The ECB should license the ESM as a credit institution and fund the ESM to recapitalise periphery Euro area banks that need capital to repair their balance sheet and start acting as reliable channels to deliver the monetary policy instrument to places where it is most required.

A bridge too far may become feasibly near if the threat of deflation persists.

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