Comparing ECB’s and FED’s management of the 2007–2012 crisis
This article is written in the scope of very subjective and specific economic theories and in no way claims to be definitively correct in the analysis of the FED and ECB as well as their mistakes. The financial crises of 2007–2012 sent a wave of economic destruction throughout the globe. Unpredicted events occurring, coupled with globalization caused a sudden spread of disaster. While economists have received a lot of backlash for not foreseeing the crises (Kenny and Morgan), it proved to be more than the simple economic cycle of boom and bust. The crises was due to a multitude of both economic and sociological factors. The European Central Bank(ECB) and the Federal Reserve(FED) in the United States both tackled the crises in powerful and creative waves. Both the European and United States economies have improved since the crises. Different markets require different implementation, this paper seeks to discuss the tools and methods used in both the ECB and FED, and compare the effects from both. It is important to remember that the European Union had a unique additive to the crises in 2010–2012, and so it is important to separate comparison to before and after this second crises.
The financial crises of 2007–2012 primarily began in the U.S. due to a sub-prime debt crises and later on developed into a Euro Area sovereign debt crises. The spread, caused by increased globalization of financial sectors, started off a chain events of economic methods to help dig the economy out of a recession. The FED and and the ECB both have similar roles in their economies: They are responsible for the monetary policy of their respective economies including responsibilities such as maintaining the national currency, controlling subsidized loans interest rates, and providing liquidity for banks by producing money through bond trade or other means (Elbert). For the purpose of proper analysis, this paper will compare the FED and ECB during the global 2007–2009 crises, and further on in the more euro centered crises in 2010–2012. The financial crisis of 2007–2009 is commonly seen as the worst financial crises since the Great Depression of 1929–1933. The crises of the Great Depression involved trips on banks by depositors, while the crisis of 2007–2009 showed distrust in real estate markets that left banks unable to roll over short-term debt. (Wheelock) On the other hand, the 2010–2012 crises was a European sovereign debt crises. Multiple European member states, especially Greece, were unable to repay or refinance their public debt, or bail out their over-indebted banks. In this essay, I shall discuss in more details both these crises, their causes, and go into specific details on actions and effects.
II. 2007–2009 Background.
To begin our understanding of how the FED and ECB were acting before the crises was discovered, we shall look at the Taylor rule. The Taylor Rule is basically a forecasting tool used to determine what interest rates will or should, be in different times of the economy. Taylor’s rule usually concludes that interest rates should be raised when inflation is high or when employment exceeds maximum levels. This is also inversely true. The Taylor rule takes into consideration 3 factors: expected vs real inflation levels, full employment vs actual employment, and the optimum short term interest rate for full employment. (Twomey) How does this relate? The Taylor rule helps provide imperial data to help show the dangers of loose monetary policy. In 2007, the inventor of the Taylor rule himself, John Taylor, ran his own rule over that of the FED.
If the FED had been following his rule, rates should have been going up, and not down, since 2002, and should have not hit an all time low of 1% at the time. This happened due to fear of deflation and desire to stimulate the economy. (The Economist) Ben Bernanke, the at the time chairman of the FED, mentions in his speech to the American Economic Association that interest rates were calculated using the Taylor rule however with forecasted interest rates and not actual. (Taylor, The Fed and the Crisis: A Reply to Ben Bernanke) This caused a problem since as Taylor mentions, “the appropriate response to an increase in actual inflation would be different from the appropriate response to an increase in forecast inflation.” Furthermore, Bernanke claims in the same speech of the lack of proof that the low interest rates caused housing booms. However, in a study made by the OECD in 2008, they come to the conclusion of “The available evidence suggests that periods when short-term interest rates have been persistently and significantly below what Taylor rules would prescribe are correlated with increases in asset prices, especially as regards housing.” (Ahrend, Cournede and Price) To provide evidence, Taylor used regression techniques to calculate the relationship between interest rate and housing, and then simulated what would have occurred in the case that the FED had used the Taylor rule with actual interest rates. (Taylor, The Financial Crises and Policy Responses: An empirical analysis of what went wrong.)
Low interest drove excessive risk taking as banks sought to gain higher yields. There is still the entire usual argument of rating agency’s mislabeling mortgages, and them being bundled into Collateral Debt Obligations (CDO’s) to produce higher yield. Real interest was at 0% to even negative at some points up to 2005. (Amadeo) However, the main argument is that had the FED acted differently, the housing boom would not have been as sharp, meaning that the bust would not have been as severe. Furthermore, higher interest might have demotivated the high risk use of faulty CDO’s. Now that the nominal interest rates have been shown as important, the EU had a more difficult issue to deal with. While they were also subject to false confidence lowering interest rates, they had the problem of a singular interest rate. The one interest rate policy led to all countries having having non-optimal levels (some more than others.) The interest rate was low for strong core countries with low inflation, but extremely low and stimulating for periphery countries that had very high inflation.
A fault in the single monetary union was exposed.
III. Dealing with market crash and creation of Debt crises.
To begin our comparison, we shall talk about short term interest rates including the zero lower bound, as well as non conventional methods including Quantitative Easing (QE) and Long Term Refinancing Operations (LTRO). Adjusting the short term nominal interest rate is the usual weapon of choice for central banks. However, when the Zero Lower Bound(ZLB) is reached, which is when the Central Banks reach the lower limit of the interest rate, non conventional tools are needed.
Both the US and EU aggressively lowered their interest rates (The U.S. slightly quicker.) However, this was not enough in both cases to stimulate the economy, and so non-conventional measures were utilized in order to liquidate the market. In the case of the FED, it was the method of large scale asset purchases, or Quantitative Easing. (Mountis) These included longer term securities issued by the U.S., as well as securities issued by government sponsored agencies. The FED implemented many programs to inject liquidity into the market including: The Term Auction Facility (TAF), the Money Market Investor Funding Facility (MMIFF), the Term Asset-Backed Securities Loan Facility (TALF) and the Primary Dealer Credit Facility (PDCF). The immensity of money injected can be viewed by seeing the balance of assets owned by the FED. (Wheelock) The purchases were large and quick.
In regards to the ECB, it had a different tactic in mind. LTRO’s was the ECB lending out money to the commercial banks at low interest rates but with a qualified collateral. The ECB did not set strict guidelines for collateral and so the banks could indirectly control the amount of money they had as there was no real given limit. The banks received liquidity quickly. However, the ECB refused to directly buy large amounts of sovereign debt. This was due to the moral hazard for government. Fiscal dominance is when the central bank of an economy is ready to buy any amount of public debt, this will cause the fiscal authority to not keep strict tract of it’s financing seeing as it will just be taken care of. The ECB took the other approach, the monetary dominance approach. In this case the central bank is committed to not buying public debt. However, that did not last for long. While both the US and EU economy started looking up after each of their individual economies, the EU hit a second crises in 2010. The initial banking recession guided Europe into a sovereign debt crisis. Although the ECB’s interest was low, many peripheral countries still had high interest in bank to business loans. The monetary union did not move in harmonization. In countries like Greece, the government had racked up debt so high (almost double), and could not deal with helping their banks liquidate, while repaying or refinancing their debt. The combination of a currency union without fiscal union attributed to this since the EU economy was not on the same page, and countries had much higher interest rates before the crises that racked up the debt. It did not matter before the crises as much since the economy was in a bubble.
The fixed-rate, full-allotment (FRFA) provision and the Covered Bonds Purchase Program (CBPP) were both short term refinancing operations, while the Securities Market Program(SMP) was a short term attempt at buying straight sovereign debt from Greece. The LTRO (3-year tenure against collateral) had one of the strongest effect. (Cukierman) The Outright Monetary Transactions(OMT) also aided in great effect and replaced the SMP (European Central Bank). It allowed other member states to apply for debt relief so long as they met certain criteria. Not pictured here is the ECB’s greatest fall on it’s usual method with the establishment of the Public Sector Purchase Program (PSPP) which ensured 60 billion euros of sovereign debt bought per month. SMP, PSPP and OMT have had large and great effects, and are QE techniques that have shown the progress of the European Union.
IV. Conclusion and Decision
The initial crises that led to the European debt crises was due to the over fear of deflation, underuse of the Taylor rule, and over risky return schemes in a low real interest economy. The ECB the FED both dealt with financial crises, with the ECB dealing with more. There are three major differences between the European Union and the United States handling of the crises. The first was the slow recovery of the EU’s banking sector as interest stagnated, and QE was not implemented quickly. The U.S. was quick and aggressive with it’s liquidity policies. The second is the separated fiscal policies that caused the sovereign debt crises which is also an issue, with harmonization needed. Interest rates were far too different for one solution to be a perfect fit for all Member States. The final difference is the major differences in economic sturdiness between different member states, in the sense that many interest rates in Member States did not react to the ECB’s 0% tax rate. (Mersch) The EU zone is a work in progress, and while the sluggish recovery was due to many policy and structural hindrance, the EU has learned and changed to better react to a similar issue. It has strengthened fiscal harmonization, and has even raised the amount of month debt pay offs for PSPP. The U.S. showed its quick reaction to the crises, and its instant liquidation, although raising risk for another bubble, ultimately ended the recession and so ultimately handled the financial crises better. The sovereign debt crises is arguably not over, however the European Union is strengthening.
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