The ECB is much too stodgy

The euro fuelled a leveraged bet that went bad. The ECB is best positioned to orchestrate the painful sharing of losses. If the ECB does not reinvent

Publishing date
13 February 2014
Ashoka Mody

See also blog posts by Guntram Wolff 'The ECB should be more aggressive on monetary policy' and 'OMT ruling: Karlsruhe says no, refers to ECJ and suggests ECB should always be preferred creditor', by Marcel Fratzscher, Michael Hüther, Guntram B. Wolff 'Taking the mandate of the ECB seriously'.

This piece was published by BreakingViews on January 29th 2014.

The euro area's incomplete monetary union arose from a political compromise in which the member states ceded monetary authority to a supranational agency while retaining their fiscal sovereignty. Because a banking union is ultimately a fiscal union, the latest "banking union" predictably comes without a meaningful centralised pot of money. Once again, the decision to "muddle ahead" has produced a muddle: costly delays and half measures, with cumbersome governance structures.

Unfortunately, the European Central Bank has also chosen to stay behind the curve. Disregarding its unique credibility, mandate, and means to heal and protect, the ECB has too often invoked worn euro area prejudices while exhorting the national authorities to act. It is past time for the central bank to be proactive on monetary policy, banks and sovereign debt.

The ECB's tight monetary policy explains why the weakest of the advanced economies has the strongest currency and faces the greatest threat of deflation. The widespread surprise at its Nov. 7 decision to belatedly lower the policy rate is a testament to the ECB's stodginess.

The other major central banks have had near-zero policy interest rates for much longer. Moreover, through early and aggressive quantitative easing (QE) - buying assets to lower long-term interest rates - the United States has achieved an effective policy rate of about -2.0 percent. In turn, the QE has served to weaken the dollar relative to other currencies. The Japanese yen bore the brunt of this pressure early on, until the Japanese engineered their own QE, which promptly caused the yen to depreciate. The consequence is a strong euro.

With its single-minded commitment to maintain annual price inflation below 2 percent, the ECB has felt no urgency in responding to euro-area economic weakness or to countering other central bank actions. With market expectations of inflation at about 1 percent a year over the next two years, the ECB's insistence on waiting for more evidence of deflation is a dangerous gamble.

The ECB must push conventional and unconventional policy buttons to help a more robust euro-area recovery. Today, when the distressed periphery faces a painful and extended "internal devaluation" - more plainly, a large real wage reduction - a weaker euro is their best hope for a jump start.

The shrill German commentators who criticised the ECB's Nov. 7 decision ignore that an aggressive monetary policy - and a weaker euro - offer Germany the least-cost option for restoring the euro's economic and political viability. Unwilling to make large fiscal transfers for fear of being sucked into an open-ended commitment, Germany also has no simple way to engineer domestic inflation, even if its traditional anxieties could be set aside.

Stressed banks remain the euro area's Achilles heel. Without centralised funds for recapitalising banks, the creditors will need to bear significant losses, ideally through debt-to-equity swaps. The ECB's hesitations - allegedly due to the contagion bugbear - risk diluting and prolonging the process.

We are long past the moment when several banks should have closed down. Zombie banks weigh on the economy. The ECB could expeditiously force losses on bondholders of insolvent banks, since it is well-positioned to deal with contagion risk by providing liquidity to solvent institutions.

The taboos are greatest with regard to sovereign debt. The ECB has insisted that it will not engage in monetary financing - that is, it will not buy sovereign bonds on an open-ended basis; instead, sovereigns must preserve their bonds as risk-free assets. By making its support conditional on promises of good behaviour, the Outright Monetary Transactions (OMT) programme conflates solvency and liquidity.

The euro area needs unconditional ECB bond purchases alongside selective sovereign default. With default risk rendered more believable through, for example, sovereign "CoCos" (contracts that specify debt restructuring at pre-agreed levels of distress), the ECB should stand as a lender of last resort to solvent sovereigns. This is not monetary financing: it is maintaining financial stability.

The ECB's political independence and technocratic goals have accorded it deference on controversial and fast-moving matters. Despite its flaws, the OMT was endorsed by German Chancellor Angela Merkel, over the fierce opposition of Jens Weidmann, the Bundesbank president and ECB governing council member.

Five years into the crisis, with the worst seemingly over, the temptation is to declare victory and improvise when new challenges emerge. That would be a mistake. The ECB must harness the deference it enjoys.

The euro fuelled a leveraged bet that went bad. The ECB is best positioned to orchestrate the painful sharing of losses. If the ECB does not reinvent itself for the times, it will be hobbled by its obsolescence and by increasingly acrimonious politics. And the flawed euro project will be further damaged.

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