Wolfgang Münchau: Why Europe needs to try unconventional policy

Last week’s dreadful data for the eurozone tell us that a long period of low economic growth and excessively low inflation lies ahead. France is falling back into recession; the signs of recovery in Italy have disappeared – again; even Germany has lost momentum.
What should the European Central Bank do now? It could, and probably should, cut interest rates again. The eurozone needs all the help it can get, but an additional cut will probably not be sufficient. We are in a situation of diminishing marginal returns. The main significance of rate cuts these days are their impact on forward rates – money market rates ranging from a duration of one week to one year. A cut in the main interest rate, together with policies to supply unlimited liquidity at those rates, would probably nudge forward rates down further. But if Mario Draghi, the ECB president, wants to make a real difference, he should contemplate quantitative easing.
There are three reasons why he should now look beyond the conventional. The first is, of course, the economic outlook, and the associated downside risk on inflation. When German commentators such as Hans-Werner Sinn criticise the ECB’s decision to cut rates they never discuss the decision in connection with the inflation target – which should be the primary benchmark. The current inflation rate of 0.7 per cent is below target, and forecasts tell us that it will remain so for at least two years.
The second reason is a lack of further policy tools after the next rate cut. The main ECB interest rate is now 0.25 per cent. The deposit rate – the one levied on commercial bank deposits at the ECB – is zero. The central bank could cut its main rate one more time and impose a small negative deposit rate. At that point, the ECB will have run out of policies. That would be an uncomfortable position.
The third set of reasons relates to Mr Draghi’s lender-of-last-resort promise – the outright monetary transactions he launched last year. The OMT has no doubt calmed down markets over the past year, but it is not a monetary policy instrument. It is an insurance policy. Its purpose is to reassure investors by reducing the likelihood of a country’s being forced from the eurozone. But it is still only a backstop. Quantitative easing, by contrast, is a monetary policy instrument. Its purpose would not be to bail out countries but to reduce medium to long-term interest rates in specific sectors of the economy.
Even though QE and OMT differ, they are both asset-purchase programmes in the end. If the OMT lost credibility you would need another asset purchase programme to take its place. That could happen if, for example, the German constitutional court were to rule against the OMT in one of its forthcoming judgments. The court is currently considering whether the OMT violates the German constitution. In a hearing in June, the chief justice left no doubt that he has fundamental problems with the programme. Even if the verdict is nuanced – as verdicts by this court usually are – any doubts about the OMT’s legality or practicality might upset investors. At that point, the ECB would be well advised to have a plan B in place. QE could meet that requirement.
Indeed, QE has the advantage that it is legally beyond reproach. With a programme of QE, the central bank would target specific types of securities without prejudice to their national origin. It is a pure monetary policy operation. Unlike the OMT, it cannot be mistaken for an illegal monetisation of sovereign debt – the use of the central bank’s balance sheet to reduce a state’s debt in real terms.
Would such a programme be feasible? QE is certainly more difficult in a monetary union with fragmented financial markets than in the US or the UK, where the central banks have used QE in part to help the housing market and the corporate sector. In the eurozone, the ECB would buy sovereign and corporate bonds – and perhaps some bonds that back loans to the property sector. Since small and medium-sized companies in the eurozone are heavily reliant on bank finance, they are beyond the direct reach of such a programme. For them, the impact on QE would be indirect. The ECB could, for example, speed up work it is already undertaking on securitised finance for small company loans, where it could become a central market maker. Or it could set up a scheme, similar to the Bank of England’s Funding for Lending programme, to assist bank lending.
Would QE work? Once you hit the zero limit on interest rates, QE is the most effective policy instrument. It is not a cure-all – we know from the US how hard it is to curtail. But the alternative is worse. Without QE, the eurozone economy threatens to get stuck in an equilibrium of low growth and ultra-low inflation, or even outright deflation. And if you are worried about the impact of QE on financial stability, you might want to consider the impact of a long depression.
The case for quantitative easing is overwhelming.

Wolfgang Münchau

Fonte: FT