The European Central Bank (ECB) beefed up Europe’s supply of credit, or as the markets put it, loosened its monetary policy, on March 10. European policymakers telegraphed this change well in advance and so just about everyone trading in the markets expected this to happen.
In January, ECB President Mario Draghi promised that the ECB’s Governing Council would take a long, hard look at whether it is doing enough to stimulate the European economy. Draghi testified before the European Parliament in February, dropping hints of a bold move in March.
Draghi’s January remarks didn’t really wow the global equity or bond markets. Investors remained dubious about Europe’s recovery — because the last time he signaled a policy change, he did not deliver as much as the markets expected. And so this time around, everyone was waiting to see if the ECB would make that bold move. How did it do?
Why is the ECB loosening monetary policy?
You have to start with the ECB’s mandate. The ECB wants to keep prices stable. That’s its primary (and really only) responsibility. The target inflation rate is close to 2 percent, but actual inflation numbers are well below that for the 19 member countries that use the euro. So what’s the big deal?
Europe’s economy is growing very slowly and the European unemployment rate is very high. Worse, the ECB fears that falling prices are going to make matters worse, as firms put off investments and households tighten their belts until the situation somehow magically gets better. The ECB can try to blame forces operating outside of Europe for putting downward pressure on prices, like the sagging commodity prices or wider slowdown in the global economy.
But the ECB’s Governing Council has to know that Europeans will eventually get used to permanently low levels of inflation — and lower economic expectations, which itself would slow economic activity even further. Europe would be poorer as well as cheaper as a result. And nobody wants to see that.
What instruments does the ECB have available?
Draghi tapped into his very limited box of unconventional tools. The ECB will charge banks more for parking money that they could be lending to boost production, and new jobs. It will purchase more government bonds, mortgage bonds and asset-backed securities, to push more money into the banking system. And it will buy up more corporate bonds (except for those issued by banks).
Alas, the ECB has been using these instruments since June 2014 — but the overall volume of lending has stayed flat.
Why are these tools not working?
Well, the ECB miscalculated.
Charging banks to deposit money at central banks was supposed to boost lending and grow the economy. It didn’t happen. Although not an explicit target, the ECB hoped its efforts would push down the euro/dollar exchange rate. Once the ECB started down this unconventional policy track, the euro dropped sharply against the dollar, making European exports cheaper and hence more “competitive” — especially when the ECB started charging banks to safeguard their money (which is called a “negative deposit rate” because it is really more like a tax on savings).
The ECB’s “large-scale asset purchases” – known as “quantitative easing” elsewhere — didn’t help push the euro down further, though. Worse, as time passed, many countries in the world pegged their currencies to the dollar, allowing those currencies to lose value against the dollar as well.
As a result, the euro actually gained value against those other currencies. In turn, this strengthening of the euro against other global currencies made European exports relatively more expensive again. So the ECB can no longer boost the European economy by focusing on the exchange rate.
What’s left in the toolbox?
Not a lot. Draghi kicked off “long-term refinancing operations” in 2011, offering extremely low-cost loans to banks. The ECB re-launched these concessionary loans in 2014, this time targeting loans to non-financial corporations.
Four years later, some banks now have to repay those initial loans. But repaying those loans to the ECB would mean pulling money out of the rest of the European economy. The ECB could not allow that to happen because pulling money out of the economy would only slow things down – and they were already slow to begin with.
Hence, the Governing Council decided to renew the long-term lending scheme for four more years. This time, however, it will pay the banks to lend the money on to non-financial corporations to use for investment by charging a negative interest rate. In other words, the ECB is offering to pay European banks to lend. And the more they lend, they more they will get paid.
The catch is that firms are not all that eager to borrow – at any interest rate. They lack confidence that Europe’s economy will recover quickly. That lack of confidence is precisely what the ECB is fighting against. To win, the ECB has to convince market participants that its new policy is powerful enough to make a difference.
Thumbs up or down?
Global stock markets rallied after the ECB announcement, but the fling was brief. In Southern European and other euro zone countries with little money to lend — and where banks struggle to make profits — the ECB’s latest promises may boost lending.
That all depends on whether firms are willing to take on new debt. But it’s just not so in Germany and other countries where credit is readily available and the firms are clearly reluctant to borrow more money.
Meanwhile, the ECB’s move is bad news for Europe’s pension savings and insurance companies, in particular. Low interest rates make it tough to net reasonable returns over a longer time period.
That is why the Germans are screaming about the ECB’s new policy – which they view as nothing more than a giant tax on their pensions and savings. The Germans have made it clear that they oppose this whole raft of policy measures. They also have made it clear that they do not want the ECB to go further.
Draghi promised that the ECB will not cut rates in the near future. If this latest policy change is not enough to boost market confidence and restart inflation, Europe will have to wait before the ECB makes another effort.
What’s next — and what does this mean for the U.S.?
For now, the euro is pushing up against the dollar rather than falling. That means European exports are becoming even more expensive and not less.
This is probably not a sign that the currency will strengthen to pre-crisis levels but it is a sign that the ECB cannot expect the exchange rate to make things better. To kick Europe’s economy back into gear, the ECB will have to rely on its efforts to encourage European banks to lend (and to create the confidence for European firms to borrow).
U.S. policymakers have reason to be concerned about Europe’s unimpressive credit growth. Nobody wants to see Europe trail the global economic recovery — and certainly not the United States, which needs European markets for its exports.
Worse, if Draghi has used all his tools, the ECB might not have much gas left to keep driving the European recovery. Then the United States — and the rest of the world — would be left to rely on Europe’s national politicians to lead Europe’s economic recovery.
So far Europe’s national politicians have failed to provide strong economic leadership. There is little sign that the next round will be any different.
Erik Jones (@Erik_Jones_SAIS) is professor of European studies and international political economy at Johns Hopkins School of Advanced International Studies and senior research fellow at Nuffield College, Oxford.