ECB Criticism of Criticism (Part 1/2)

Since the financial crisis, the ECB's policy has often provoked controversy. Its actions have moved away from the framework in which we used to conduct monetary policy. Negative rates, asset purchases, liquidity injections are things that were not imagined then. There is a legitimate debate about the desirability of these measures and their effectiveness. This debate has recently taken a turn of a rare violence, sometimes bordering the insult. Here we examine 12 criticisms against the ECB to assess whether they are fair, relevant, consistent with each other, and whether they offer superior alternatives to the current policy.

By Bruno Cavalier, Chief Economist and Fabien Bossy, Economist

12 criticisms of the ECB on the test bench

What is the point of monetary policy? How should it be conducted? These are old questions. One of the most influential schools of economic thought in the second half of the twentieth century, monetarism, took off by examining the problem in the case of the United States, with special attention to the Great Depression of the 1930s¹. For at least fifty years, these two questions have been revisited, especially during major upheavals. They were so before and after the creation of the European Monetary Union in 1999, and ten years later, during the financial crisis and the Great Recession associated with it. In other words, there is no single answer, invariant, unconditional, except if one remains at a high degree of generalities. As such, it can be said, without causing controversy, that monetary policy serves to reduce cyclical fluctuations and must be conducted in accordance with the mandate of the central bank. This is where the debate can begin.

Recently, this debate took in the eurozone an unprecedented twist by its violence. In response to the latest monetary easing measures, the ECB and its president are accused of almost all ills in very harsh, sometimes insulting terms². Critics have come from various sources in the political, journalistic, academic or financial circles, and, last but not least, in the community of central bankers themselves³. In this note we list the main criticisms of the ECB and propose our own critical review.

1. The ECB fulfills its mandate, it has no reason to do more

The mandate of the ECB, set by the Maastricht Treaty, is to ensure price stability. All central banks have the same, but sometimes add, like the Fed, other objectives of the same importance (maximum employment). In the European Treaty, the other objectives, mentioned in a secondary way, are to promote growth and full employment. When it was created, the ECB defined price stability as inflation below 2%. In 2003, this definition was revised as inflation below 2% but close to 2%. It would have been easier to say 1.9%. The widespread use around the world is to have a symmetric inflation target at 2%.

Of course, no one has ever demanded that the goal be touched every moment of time. There are often deviations from the target that the central bank is not expected to respond to, especially if they are attributable to one-off shocks, such as oil price changes. But this is not the current situation in the euro area.

Deviations are repeated. Under Draghi's mandate, inflation has almost always moved well below its target, closer to 1% than 2% on average (graph). To a lesser extent, other central banks, especially the Fed, have the same problem of low inflation.

2. Keep dry powder ahead of the next recession

After the financial crisis of 2008, monetary policy has been loosened everywhere in often unequaled proportions. No central bank has since reconstituted its room for maneuver, the ECB less than many others. It is obvious that its means to further ease the monetary conditions are limited.

Are they null? It is hazardous to say it. The intervention arsenal of central banks has expanded. The standard tool, which was the day-to-day pricing of liquidity, was supplemented by long-term refinancing operations, massive securities buying programs, and enhanced communication. These new tools that were unconventional are no longer. We can imagine many other modes of relaxation⁴. Personalities⁵, no less eminent than the authors of the Memorandum, have even proposed that, in the next crisis, central banks come to directly finance the economy ("Going direct"), at the cost of an unprecedented coordination with the budgetary authorities. In short, it will still be possible to find "powder" when it really needs it.

3. Monetary policy is inefficient, it does not support growth

This is the central point of the debate on the ECB. It is absurd, of course, to pursue a policy that has no positive effect on the activity, moreover, if it has perverse effects for the financial sector. But it is one thing to say, like a petition in principle, that monetary policy is inefficient, it is another to prove it. It is a third to say what should be done instead.

Criticism of unconventional monetary tools, especially asset purchases, has supporters in academic research. One of the most renowned economists in monetary theory, Michael Woodford, has repeatedly defended this point⁶. At Jackson Hole in 2012, he noted that long-term interest rates are only defined by agent preferences. No purchase of securities by the central bank can modify them. If QE has effects, it is only indirectly, by strengthening forward guidance. It is the credibility of the central bank expressed in the forward guidance that really changes the financial conditions, not the asset purchases. Other authors consider that the effectiveness of QE comes from improving liquidity and thereby acting as a factor of financial stability⁷.

Several studies have identified that QE has effectively reduced interest rates. In the case of the ECB, various studies show that, without the measures put in place since 2014, GDP growth would have been 0.7-0.8pt lower and inflation 0.4pt than it was in 2017- 2018⁸. For those who think this is pro-domo (biased), we refer to the most comprehensive assessment of the unconventional policies recently published under the auspices of the BIS, which is usually rather located on the side of monetary orthodoxy⁹. These studies recognize, on the one hand, the stimulating effects of unconventional policies and, on the other, the efforts of central banks to mitigate their undesirable consequences.

4. The ECB creates asset bubbles, sows the seeds of an upcoming crash

If the discount rate is zero, any asset displaying a cash flow positive should see its price tend towards infinity. This is true in theory provided that the zero rate is a permanent regime. In practice, asset prices have not seen an explosive trajectory when interest rates have fallen to zero or below zero. Still, falling rates push up market valuations. It is even one of the channels of transmission from monetary policy to the real economy.

Remembrance of the 2008 crisis tends to make any price increase take the form of the beginning of a bubble, but this term is only appropriate if the price deviates from its fundamental valuation, in other words when investors expect to be smarter than neighbor and exit in time from an overvalued market ("Greater fool theory"). Finally, a reminder: in history, many bubbles developed while monetary policy was in the process of tightening. The most famous case is the Fed in 1928. It is not obvious that the monetary policy of the ECB creates a risk of financial destabilization. In fact, if it reduces the probability of recession or deflation, it reduces that risk.

What about the reality of overvalued asset prices? Consider three cases, stocks, bonds, real estate. Some stock markets look expensive in terms of cycle averages, but nothing that looks like a generalized bubble trajectory. Regarding government bonds, the very term bubble is in itself hazardous. Returns, as atypical as they may be, can be explained by rational factors, which in addition to monetary policy, include conditions of activity and inflation, global savings-investment balances, and even regulation. There remains the case of real estate. According to Eurostat, the average rise in house prices has been 4% per annum in the euro area for four years, and 6.3% per year in Germany over the same period. In relation to changes in household disposable income, the rise in real estate prices is not uncontrolled (graph).

5. The ECB increases inequalities, even sowing the seeds of a social crisis

Monetary policy creates transfers between categories of agents, for example between savers and borrowers. This has always been the case, but in the past these redistributive effects were not very visible. The zero rate bar unquestionably represents a strong psychological limit, which highlights "winners" and "losers". The winners would be the holders of real assets (real estate, equities) whose value rises, and the borrowers who can finance their expenses on credit. The losers would be the small savers whose wealth, laboriously accumulated, was in deposit with the bank – these same deposits that the "Count Draghila" sucked by billions. We hardly exaggerate! In short, in this criticism, we are not far from presenting the ECB as a factor of increasing social inequalities. From there, one easily overflows onto the political terrain. Wolfgang Schauble, former German finance minister, once said that the ECB's policy was driving the populist party AfD, which has criticized the ECB for the expropriation of the saver.

The fundamental question is whether savings and investment decisions are dictated by the single level of interest rates – and, moreover, nominal rates (which would be the sign of a monetary illusion) – or by conditions of the real economy. Again, we must turn to numbers. In the last five years the ECB has pursued a negative interest rate policy, it is not observed that German households have reduced their spending to save more. Over this period, their volume consumption grew by 1.6% per year. In the five years preceding the 2008 crisis, the pace was half that. It is true that the conditions of employment between these two periods are radically different.

No one disputes, not even the ECB, that the policy of negative rates is an abnormal situation. (The purpose of this note is to clarify it is not to justify the negative rates) But no one has ever claimed that monetary policy, beyond its short-term effects, could structurally change the return. of capital. This return depends on a multitude of factors unrelated to the ECB's action, demographics, education, infrastructure, technology, etc.

6. The ECB zombies the economy, thereby reducing the growth potential

The argument is that the low level of interest rates keeps non-profitable companies afloat, which otherwise would have gone bankrupt. This survival would prevent other firms from flourishing, which would affect productivity and potential future growth. It is customary to cite the case of Japan. It would be better to "liquidate" lame ducks to give way to innovative companies¹¹.

What is the extent of the phenomenon of zombification? The BIS has devoted a lot of work to this issue. It notes an increase in the share of zombie companies (defined as not being able to cover their interest charges in the medium term from their profits alone) in developed countries since the end of the 1980s. The phenomenon is therefore not radically new. The BIS explains it by lower financial pressure and makes the link, with caution, with the decline in interest rates. In these estimates¹², the BIS estimated that this share of zombie companies in 2015 was about 10% in the euro zone … and 17% in the United States, which has never practiced negative rates, which growth much higher than that of the euro zone and a much lower unemployment rate!

Footnotes