Currency and Financial Markets Europe Monetary Policy

The ECB’s dilemma

by Marcel Fratzscher, Michael Hüther and Guntram B. Wolff.
This text was also published on
BerlinOeconomicus (German), in Le Monde  and in El País.

As the ECB is likely to announce a government bond purchase programme on January 22, the opposition in Germany is growing. The potential election of a government in Greece with its intention to restructure debt towards its official creditors puts the upcoming ECB’s decision under even greater scrutiny. The fact that the ECB has been exempt from sharing losses in the previous debt restructuring in Greece highlights the problem of sovereign QE. However, a sovereign QE excluding any potential fiscal implications is not feasible or will be ineffective: the design of the programme is therefore crucial. The ECB falls far short of fulfilling its mandate of inflation below but close to 2%, with the inflation rate at 0.3% and an increasing de-anchoring of inflation expectations. Many German economists and politicians downplay this failure by trying to re-define price stability as inflation rate above zero. This is wrong for a number of reasons. Already now about a third of the sectors in the euro area, and also in Germany, are in deflation. Low inflation is harmful because it makes price adjustments both between sectors as well as between countries harder, undermines investment by increasing real interest rates, and renders debt service more difficult.

It would be wrong to assume that monetary policy alone could fix all the problems of low growth and low inflation in the euro area. The evidence suggests that significant structural reforms and higher demand via investment will pay off rather quickly. A strong commitment to such reforms is essential for exiting the crisis. Yet, the ECB should not hide behind slow progress by governments but instead fulfil its mandate.

The opposition in Germany to a sovereign QE programme is becoming stronger. The reason is the fear that it could result in an illicit monetary financing of governments. Indeed, a QE programme would have to be combined with an implicit understanding that the ECB buys at pari passu, i.e. to potentially accept losses as the private creditors do. Otherwise, the purchase of low-rated government debt would be largely ineffective and could even lead to an increase in sovereign yields.

The ECB has four options. The first is to wait and hope for the best. This is the preferred strategy by many Germans. But this would be a dangerous and irresponsible strategy. The stronger and longer inflation expectations are unanchored, the harder it becomes for the ECB to regain credibility and achieve price stability, and the higher the real economic costs for the euro area and for Germany.

The second option consists of allocating the potential losses from purchases to the individual national central banks in the euro area. While this may sound like an attractive option, it could be counter-productive by increasing sovereign spreads and worsening financial fragmentation within the euro area. And it would send a devastating signal that the single monetary policy would be single in name only.

The third option is to focus government bond purchases on highly rated debt only to limit the balance sheet risks of the ECB. This strategy can be successful but the ECB may have to buy large amounts of already low-yielding, “safer” euro area sovereign debt and hope that private investors subsequently rebalance their portfolios towards riskier euro area countries.

The fourth option is – while accepting that the founding fathers of the euro may not have foreseen that monetary policy can have fiscal effects – for the ECB to purchase sovereign debt according to the capital key of individual euro area countries, with adjustments for those without sufficient amounts of privately held sovereign debt. The Treaty does not prohibit such purchases in secondary bond markets. The ECB’s governing council has expressed its intention of expanding the balance sheet by 1 trillion euro. As this will hardly be possible with private sector assets only, the ECB could buy a portfolio of government debt combined with a portfolio of private debt.

The ECB needs to urgently show its uncompromising determination to fulfil its mandate and repair the monetary transmission in the euro area. Accepting some fiscal risks is reasonable and unavoidable. The fourth option is the most promising strategy for the ECB to succeed and bring up inflation expectations credibly and durably, avoid stagnation and help end the debt crisis. It is a strategy with risk. The other strategies are riskier.

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