Mareeg.com-CAMBRIDGE – The European Central Bank needs to ease monetary policy further.
Eurozone-wide inflation, at 0.8%, is below the target of “close to 2%,” and
unemployment in most countries remains high. Under current conditions, it is hard
for the periphery countries to reduce their costs to internationally competitive
levels, as they need to do. If inflation in the eurozone as a whole is below 1%, the
periphery countries are condemned to suffer painful deflation.
The question is how the ECB can ease policy, given that short-term interest rates
are already close to zero. Most of the talk in Europe concerns proposals to
undertake quantitative easing (QE), following the path taken by the US Federal
Reserve and the Bank of Japan. This would mean expanding the money supply by buying
member countries’ government bonds – a realization of ECB President Mario Draghi’s
“outright monetary transactions” scheme, announced in August 2012 in the midst of
growing uncertainty about the euro’s future (but never used since then).
But QE would present a problem for the ECB that the Fed and other central banks do
not face. The eurozone has no centrally issued and traded Eurobond that the central
bank could buy. (And the time to create such a bond has not yet come.) By purchasing
bonds of member countries, the ECB would be taking implicit positions on their
That idea is not popular with the eurozone’s creditor countries. In Germany, ECB
purchases of bonds issued by Greece and other periphery countries are widely thought
to constitute monetary financing of profligate governments, in violation of the
treaty under which the ECB was established. The German Constitutional Court believes
that the OMT scheme exceeds the ECB’s mandate, though it has temporarily tossed that
political hot potato to the European Court of Justice.
The legal obstacle is not merely an inconvenience; it also represents a valid
economic concern about the moral hazard that ECB bailouts present for members’
fiscal policies in the long term. That moral hazard – a subsidy for fiscal
irresponsibility – was among the origins of the Greek crisis in the first place.
Fortunately, interest rates on Greek and other periphery-country debt have fallen
sharply over the last two years. Since he took the helm at the ECB, Draghi has
brilliantly walked the fine line required to “do whatever it takes” to keep the
eurozone intact. (After all, there would be little point in upholding pristine
principles if doing so resulted in a breakup, and fiscal austerity alone was never
going to return the periphery countries to sustainable debt paths.) At the moment,
there is no need to support periphery-country bonds, especially if it would flirt
What, then, should the ECB buy if it is to expand the monetary base? For several
reasons, it should buy US treasury securities. In other words, it should go back to
intervening in the foreign-exchange market.
For starters, there would be no legal obstacles. Operations in the foreign-exchange
market are well within the ECB’s remit. Moreover, they do not pose moral-hazard
issues (unless one thinks of the long-term moral hazard that the “exorbitant
privilege” of printing the world’s international currency creates for US fiscal
policy). Finally, ECB purchases of dollars would help push down the euro’s exchange
rate against the dollar.
Such foreign-exchange operations among G-7 central banks have fallen into disuse in
recent years, partly owing to the theory that they do not affect exchange rates
except when they change money supplies. But in this case we are talking about an ECB
purchase of dollars that would change the euro money supply. The increase in the
supply of euros would naturally lower their price. Monetary expansion that
depreciates the currency is more effective than monetary expansion that does not,
especially when, as is the case now, there is very little scope for pushing
short-term interest rates much lower.
Depreciation of the euro would be the best medicine for restoring international
price competitiveness to the periphery countries and reviving their export sectors.
Of course, they would devalue on their own had they not given up their currencies
for the euro ten years before the crisis (and if it were not for their
euro-denominated debt). If abandoning the euro is not the answer, depreciation by
the entire eurozone is.
The euro’s exchange rate has held up remarkably during the four years of crisis.
Indeed, the currency appreciated further when the ECB declined to undertake any
monetary stimulus at its March 6 meeting. Thus, the euro could afford to weaken
substantially. Even Germans might warm up to easy money if it meant more exports.
Central banks should and do choose their monetary policies primarily to serve their
own economies’ interests. But proposals to coordinate policies internationally for
mutual benefit are fair. Raghuram Rajan, the governor of the Reserve Bank of India,
has recently called for the advanced economies’ central banks to take
emerging-market countries’ interests into account via international cooperation.
ECB foreign-exchange intervention would fare well in this regard. This year, the
emerging economies are worried about a tightening of global monetary policy, not the
policy loosening that three years ago fueled talk of “currency wars.” As the Fed
tapers its purchases of long-term assets, including US treasury securities, it is a
perfect time for the ECB to step in and buy some itself.
Jeffrey Frankel is Professor of Capital Formation and Growth at Harvard University.