The ECB should rethink the way its monetary policy works

European Central Bank in Frankfurt, Germany (Wikimedia Commons, M. Minderhoud)

European Central Bank in Frankfurt, Germany (Wikimedia Commons, M. Minderhoud)

So far, the European Central Bank has succeeded in preserving the existence of the euro; however, its monetary policy did not have the same efficiency to spur growth. This article will argue that the ECB should circumvent States and also the many Eurozone’s ailing banks to finance the real economy. 

Before starting, please note that this article is not “objective”. I am intellectually closer to the so-called “hawks” about inflation, i.e., I believe that the primary job of central banks is to limit inflation risks and that they should be very careful when flooding markets across the world with newly created liquidity. That being said, the latest statistics in Europe show that inflation is not an immediate threat: rather, with core inflation in the Eurozone at only 0.7%, fears of deflation are arising. Deflation would badly hurt European economies, because it creates a vicious circle: when people expect prices to decrease, they do not buy immediately goods/services, so consumption and growth fall even more, and so do the prices, and so on.

After explaining the current dysfunctions of the ECB’s monetary policy, we will try to suggest unconventional measures that the ECB could use.

I/ The ECB’s monetary policy does not work at the moment

First, let us note that there is a structural problem: “normal tools” at the disposition of a central bank (i.e., mainly the definition of key interest rates) cannot work properly because inflation figures significantly vary in the Eurozone: in 2013, Greece is expected to face deflation (-0.5%) while Austria should have an inflation rate of 2.1%; for the whole Eurozone, it is expected to be 1.4%, quite below the target of 2%. So, looking at these numbers, it looks like the European monetary policy is nearly perfect for the Austrian economy but totally inappropriate for the Greek one. To spur inflation in Greece, the ECB would have to provide the markets with more liquidity, to encourage credit and spending. A further cut in its interest rates would help to depreciate the euro (which would increase the price-competitiveness of Greek products and therefore, in principle, Greek exports), but the rates are already near 0, so the effect would be marginal.

This leads me to a first claim: a further reduction in the interest rates is useless to spur growth in the Eurozone. Indeed, ordinary people are not reactive to such a move because of the economic crisis. So, contrary to the economic theory, a lower interest rate does not lead to lower savings and more consumption. And because banks do not lend much at the moment (i.e., a lack on the offer side), it does not lead to higher borrowing (and consumption) either. Cutting interest rates may even have perverse effects. First, people receive a lower income (interests) on saving modes that are perceived as “safe” and are therefore privileged by most ordinary citizens, and this may result in a lower future spending power. Secondly, it may incentivise people to look for more risky placements, which offer higher returns: stock markets are currently rallying at record highs in Europe, despite the economic gloom, so that equity prices are disproportionate relative to the intrinsic value of listed businesses. In other words, cutting interest rates and spreading liquidity on the markets may well create a new asset bubble without even helping the real economy.

A second observation is that the two rounds of LTRO (Long-Term Refinancing Operations), which have seen the ECB lend for 3 years a total of over €1 trillion to Eurozone banks, have failed to spur credit growth and thus failed to stimulate the real economy. The reason for this is that many Eurozone banks have huge holes in their balance sheets and used the money to compensate losses on subprime and other bad loans rather than for new loans to the real economy (businesses and individuals). The result is that these mega-stimulus had nearly no impact on growth and employment. Further rounds of LTRO would mean injecting ever more money in banks, with no guarantee of positive results on growth and with growing risks of future inflation. The Eurozone’s core inflation fell quite quickly and there is no reason why it could not pick up as suddenly in the future, once the economy finds its way back to a more robust growth.

So, the ECB needs to innovate and find new “unconventional” measures which could better convey its policy choices to the real economy.

II/ Which unconventional measures for the ECB?

Every now and then, there are calls for the ECB to have the right to directly finance Member States. My opinion is that the ECB must remain independent and should continue not to finance Member States. Indeed, the idea of providing Member States with freshly printed money relies on the idea that recovery should happen via public spending. But this is illusory, considering the current state of Member States’ finances. I believe that the ECB should have the right to directly buy sovereign bonds only when there is speculation against a Member State because this unfairly distorts its borrowing costs.

Another increasingly popular idea is to drop the inflation target of 2% to adopt another of 3% or 4%, or even to fully replace it by an unemployment rate target. Higher inflation could help indebted economic actors to suffer less because it would reduce the cost of borrowing (provided of course that the costs of such debts are not linked to inflation). But inflation does not create wealth: inflation merely redistributes resources from creditors to debtors. Moreover, setting an unemployment target would mean that the ECB’s missions must be reformed to include a new objective: economic growth/lower unemployment. Some also wish a potential unemployment target to be set at a quite low rate (about the Fed, The Economist mentions a research paper suggesting that a 5.5% unemployment target would have great effects on the credibility of the Fed’s forward guidance), but the lower the rate, the bigger the risk that structural unemployment prevents such a target from being met and thus the monetary policy from ever being tightened again. This would destroy the central bank’s credibility in matters of fighting inflation.

So, the ECB needs to find a way to fund the real economy. This requires circumventing States (and their politicians, who are rarely good investment advisers) and ailing banks, since the latter repeatedly failed to play their role in the past years. A possibility would be that the ECB directly buys private assets. Peter Praet, chief economist of the ECB, hinted that the ECB may use such an unconventional instrument: the ECB would buy banks’ assets. This could be a solution, if such buying is linked to the requirement that banks exclusively use the money to make new loans.

The ECB could also directly lend money to businesses, though this is unlikely to happen. Under such a scheme, the ECB would need to open national agencies responsible for assessing loan requests of businesses above a certain value (to be determined) and lending directly to economic operators. This would ensure that central bank’s money flows into the real economy rather than being stuck in banks’ balance sheets. Moreover, the value threshold could have a positive consequence: bigger, i.e., riskier loans would be made by the ECB and banks would be able to focus on less risky, smaller loans. For reasons of simplicity, this argument does not take into account the differences of risk profile between borrowers: it may be argued that small borrowers like SMEs are particularly risky as well. But on the other hand, at least, the lost sum would represent a fairly small amount. Of course, this would require additional staff at the ECB, but it would surely cost less than hundreds of billions of euros in LTROs.


The ECB’s monetary policy is not working as intended because of structural problems in the Eurozone and the problems faced by the European banking industry. The solution surely also includes cleaning up Eurozone banks’ balance sheets and being honest about their capital shortcomings. I won’t enter into the details here; the reform of the European banking system would require several articles.

In any case, the ECB needs to acknowledge this situation and to rethink how to improve the impact of its monetary policy decisions on the real economy.

Pierre-Antoine KLETHI

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