Professor Barry Eichengreen : The ECB’s Bridge Too Far

Is Europe’s economic crisis mutating once again? If debt fears are now being superseded by the danger of deflation, as recent data suggest, the European Central Bank has its work cut out for it – and there is nothing to suggest that it is up to the task.

The numbers are alarming. Core inflation (the consumer price index after excluding volatile food and energy prices) in the eurozone fell to an annual rate of 0.8% in October – a 47-month low – while producer prices fell by 0.5%, suggesting that deflation is already in Europe’s economic pipeline. Annual growth of M3 money supply, meanwhile, dropped to 1.4% in October, from an already dismal 2% in September, while loans to the private sector contracted by 2.9% year on year. All of this makes it remarkable that the best the ECB could do at its December meeting was stand pat.

So what should a good central bank be doing? For starters, it should focus on maintaining appropriate monetary conditions and get out of the business of negotiating policy conditionality with governments. A central bank’s core mandate is to keep inflation at appropriate levels, not to negotiate structural reforms with countries like Greece, a task that is best left to the European Commission and the International Monetary Fund.

Similarly, the ECB’s outright monetary transactions (OMT) program, announced in the wake of President Mario Draghi’s “do whatever it takes” speech in the summer of 2012, is at best a distraction. While a central bank should ensure the smooth operation of the payments and financial system, it makes no sense for this task to be contingent on governments’ negotiation of a reform program with the European Union’s rescue fund, the European Stability Mechanism (ESM), as is the case with OMT.

The commitment to preserving the integrity of the payments system must be unconditional. If the ECB concludes that panicked investors are threatening the integrity of the payments system by selling a member state’s bonds, then it should intervene, buying up those bonds on the secondary market, ESM agreement or not.

The ESM link is designed to reassure the German public that the ECB will not intervene indiscriminately. But it also creates uncertainty and delay, and prevents the ECB from acting as a true lender of last resort.

German public opinion also prevents the ECB from cutting interest rates and expanding the supply of money and credit. There is, as always, Germans’ deep-seated fear of inflation to overcome, along with the belief that too much easy credit will weaken the pressure on southern European countries to reform. But a responsible central bank should not cater to irrational fears of inflation in what is in fact a deflationary environment, just as it is not an independent central bank’s role to tighten the thumbscrews for fiscal and structural reform.

Unfortunately, Europe’s central bank does both. Thus, we have the unseemly spectacle of the ECB hesitating to cut interest rates for fear that, having exhausted conventional policy, it would have to turn to unconventional measures like quantitative easing, which would antagonize German public opinion even more.

It is reasonable for the ECB to be concerned about its public standing. But if its leaders are worried about the impact on its reputation of embracing unconventional policy, they should pause and reflect on the much greater damage that would follow from allowing the economy to slip into a deflationary trap from which it would be difficult, if not impossible, to escape.

The more substantial argument against quantitative easing is that purchases of securities would be ineffectual, given Europe’s bank-based financial system. But this is not an argument for inaction. Rather, it is an argument for the alternative, namely a Bank of England-style funding-for-lending scheme in which the ECB provides banks with cheap financing for, say, 12 months, if they agree to increase their lending to the private sector by a corresponding amount.

The danger with funding for lending is negative side effects. Much of the money provided in the United Kingdom poured into the housing market rather than being lent to small and medium-sized businesses. The Bank of England has now corrected this by announcing that it will no longer provide funding for mortgages. The ECB could follow this example by using a funding-for-lending program to channel credit to the business sectors that need it most.

Second, there is the danger that weak European banks will extend risky loans at a time when they should be making their portfolios less risky. Here, it will be important for the ECB to work closely with national supervisors until it acquires the power next year to supervise directly the 130 largest European banks. In addition, the upcoming asset-quality review and stress tests of the banks, if sufficiently rigorous, could provide assurances that banks receiving cheap ECB funding are adequately capitalized.

This is what a responsible central bank would do. Unfortunately, the ECB has so far shown no sign that it qualifies.