Is the current ECB monetary policy enough?
The International Financial crisis of 2008 affected deeply almost all the world’s economies. The history was not forgotten because the 1929 crash and subsequent crisis in the following years led to a profound and long depression and deflation with a very high unemployment rate. Governments all over the world had to answer to this catastrophe. The two primary methods to stimulate the economy were the Fiscal Policy and the Monetary Policy. On developed countries the Monetary Policy gave a good portion of that response. That forced Central Banks all over the world to respond to this crisis. The FED and the Bank of England were quick to react with an aggressive decrease in interest rates and especially in the American case a large program of buying public debt asset titles known as quantitative easing. These measures should be able to stimulate investment (because it’s easier for companies to finance themselves at lower rates) and also the consumption. However the ECB decreased the interest rates sharply but only to 1% and in 2011 and even increased the interest rates a bit to around 1,5%, which increased even more the difficulties of the countries, also affected by the Sovereign Debt Crisis such as Greece, Portugal, Ireland and Italy. One of the reasons for a slow decrease in the interest rates by the ECB is that the objective of the ECB is to guarantee price stability unlike the FED and other central banks of developed countries. The following graph shows that path taken by the ECB interest rates:
Comparing with the path taken by the FED interest rates the difference is clear:
Realizing it’s mistake after that increase in the interest rates ECB started decreasing again the interest rates but only slowly, it only reached around 0% in the middle of 2014, the same value that the FED had for more than five years. This decrease only happened because the European economy as a hole slowed down since that period with the Eurozone GDP becoming negative and the inflation having a sharp decrease from around 2,5% in 2012 to around 0,5% in 2014 having become negative later that year, while the US had a GDP growth rate of around 2% in the same period with an inflation rate around 1,5%. The difference in the monetary policy between the two was of course an important factor to explain this. Another factor of higher interest rates is that they also cause a valuation of the currency which is bad for the exports and that’s why the Eur/Usd exchange rate was much higher than now. That is why when the ECB decreased interest rates the Eur/Usd exchange rate decreased from around 1,4 to 1,1 supporting Euro Zone exports.
Another measure that the US adopted early in its response to the crisis but that the Euro Zone took too much time to adopt was quantitative easing. The FED was forced to adopt this program because of a phenomenon known as Liquidity Trap in which the nominal interest rate already reached it’s zero low bound but the real interest rate (the rate at which the banks lend to companies) is much higher because of the lack of trust in the market and the negative perspectives for the economy. Quantitative easing consists on the purchase of financial assets as mortgage backed securities from financial institutions. It is a form of increasing money supply and it’s used as a last resource measure when low interest rates are no longer enough to stimulate the economy and increase price levels because after the crisis a deflationist cycle was a real danger (price levels decreased to around -1% in 2009 during the crisis). Both countries developed this purchase of financial assets in 2009 but the increase was much bigger in the US than in Europe except in 2011 but since then the gap has been widening strongly. A problem of the quantitative easing is that some of the financing gets stuck in the banks and never reaches the real economy.
Quantitative easing program in US and Euro Zone
As we can see in the graph above in 2015 the Quantitative Easing in US was 4,5 trillion dollars but in the Euro Zone was just 2 trillion dollars, less than half, for a more populous region. The combination of higher interest rates and a much smaller quantitative easing program contribute for a smaller economic growth in the Euro Zone than in the US and also to a lower price level.
What’s the impact of these measures for the banking sector?
After analyzing the impact of these measures for the general economy we will analyze it’s impact for a specific sector, the banks. First, of all a lower interest rate facilitates the financing for banks to be able to increase credit, after the big deleverage following the financial crisis in 2008. In many countries there was also several large-scale programs to recapitalize banks in trouble. Just in the UK the Bank rescue package announced in October 2008 by the former prime minister Gordon Brown totaled $850 billion. In Portugal the taxpayers had to spend 19,5 billion euros to help and save banks an amount equivalent to 11,3% of the country’s GDP between 2008 and 2014. This sector requires government intervention because it’s a key sector for the economy, without banks there is no credit, which would cause a tremendous decrease in investment and long duration goods consumption. We can conclude that the banking sector has been a large burden to many European Union countries so something must be done to strengthen this sector rather than just putting there more money.
A clear problem of the low interest rate more specifically of the slightly negative interest rates, that already exist in some banks, including in the Euro Zone is that with a negative deposit rate banks have to pay to lend their money to the ECB, so they have to pay to the borrower and not the other way around. A similar situation happens in Switzerland, Sweden and Denmark. Many Euribor rates, relative to the loans for the housing market are already negative. That means that banks have to pay for the loans they granted to it’s costumers rather than being the costumers paying the rates. The benefits are an increase in housing credit because costumers have cheaper loans to pay so they are more willing to buy a house, however banks may be unwilling to give that credit because they will have to pay for the loans granted which is an extra burden for many banks that are already in difficulties. Because of that some National Banks have already stated the wish for the prohibition of negative interest rates with obliging zero interest rates.
To join that the yields on some bonds are already negative as it happens in German bonds. However with the market with low return rates and many investment funds with negative performances this bonds are still a better option than stocks because is better to lose only a small amount of the total invested rather than risk to lose a much bigger amount of money with only a small probability of getting an high return.
A new proposal for strengthening European banks is the Banking Union. It consists in having a single regulation mechanism, single supervision mechanism and a single deposit guarantee mechanism. The banks are thus classified not by its nationality but by its balance sheet. The biggest advantage of this is that solid banks from indebt countries can have access to lower interest rates in their loans. In my opinion it’s a good proposal because it will help banks of countries in difficulty to finance themselves on the stock market.
To conclude Europe’s reaction against the crisis had many flaws especially in terms of fiscal policy but also with monetary price. The ECB reacted too late and too little to the Financial Crisis and subsequent Sovereign Debt Crisis. That explains why the GDP growth and price levels are lower than in the United States with the unemployment being higher. However it’s also interesting to consider that even with very low interest rates and quantitative easing programs developed economies don’t grow as it’s expect which raises the question that an active expansionist fiscal policy is needed to bring strong growth rates to the United States and specially Europe has it happen in the United States in the 1930’s decade. The crisis also had a huge impact on the European banks and the ECB also has to take into account the impact of it’s measures on the banking sector.
Pedro Diogo, Economics Student
Disclaimer: This Post reflects solely the author’s opinion and do not represent the platform as a whole
