Monetary policy is no panacea for Europe's ills

Now that fiscal stimulus has reached the bounds of feasibility in many countries, monetary policy is often seen as the “last man standing”. Having seemingly conquered inflation in the past decades, central banks are now making a substantial contribution to combating the financial, economic and sovereign debt crises, and still more is being asked of them.

To prevent the recovery stalling, demands have been directed at the Eurosystem to deliver yet lower interest rates (or at least to forego raising them), yet more liquidity and even larger purchases of assets.

However, the assumption underlying such well-intentioned advice does not hold up to closer scrutiny. Contrary to widespread belief, monetary policy is not a panacea and central banks’ “firepower” is not unlimited, especially not in the monetary union.

First, to protect their independence central banks in the eurozone face clear constraints to the risks they are allowed to take. For example, the funding of banks that are not financially sound or against inadequate collateral would shift substantial risks between national taxpayers. Such implicit transfers are therefore beyond the mandate of the eurozone’s central banks. Rescuing banks using taxpayers’ money is something that can only be decided by national parliaments.

Abiding by the rules of stability-oriented monetary policy, many of which are enshrined in the EU treaty, is not a legalistic obsession: it is key to the acceptance of monetary union by Europe’s citizens. Ignoring such constraints is not a pragmatic solution but would instead mean being carelessly oblivious to the corrosive effect such violations have on confidence in our single currency.

Second, unconditional further easing would ignore the lessons learned from the financial crisis.
This crisis is exceptional in scale and scope and extraordinary times do call for extraordinary measures. But we have to make sure that by putting out the fire now, we are not unwittingly preparing the ground for the next one. The medicine of a near- zero interest rate policy combined with large-scale intervention in financial markets does not come without side effects – which are all the more severe, the longer the drug is administered.

Research suggests that the asymmetric policy of unconditional monetary accommodation to counter a correction of financial sector excess encourages more aggressive risk-taking. Studies by the Bank for International Settlements consistently stress the need for a monetary policy to be more symmetric over the business cycle to prevent a build-up of financial imbalances that may pose a threat to price stability in the future.

In addition to lowering interest rates, the Eurosystem has enacted a number of unconventional measures to deal with the unique challenges to price stability and financial stability emanating from the crisis. These emergency measures ease the transition towards a healthier system. They must not become a convenient analgesic for prolonging an unsustainable status quo.

As a result of the measures taken, central banks now play a fundamentally different role. Before the crisis they provided scarce liquidity; now they serve as a regular source of funding that replaces or displaces private investors.

This breeds the risk of some banks becoming overly dependent on central bank funding, thus reducing incentives to reform business models. So far, progress in this regard has been very limited in several eurozone countries, even though experience of past financial crises, say in Sweden or Japan, teaches us the benefits of swift action as well as the perils of foot-dragging. Regulators need to keep up pressure on banks to proceed with the restructuring of the financial sector, particularly by unwinding unviable banks and retaining earnings to build up capital.

By the same token, relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act. Macroeconomic imbalances and unsustainable public and private debt in some member states lie at the heart of the sovereign debt crisis. It may appeal to politicians to abstain from unpopular decisions and try to solve problems through monetary accommodation. However, it is up to monetary policymakers to fend off these pressures.

It is therefore vital that there be no ambiguity about the temporary nature of unconventional measures.

To overcome the crisis, short-term measures have to be consistent with the long-term stability we all strive to achieve. Overburdening monetary policy with crisis management upsets this balancing act. Monetary policy in the eurozone is geared towards monetary union as a whole; a very expansionary stance for Germany therefore has to be dealt with by using other, national instruments. However, this also implies that concerns about the impact of a less expansionary monetary policy on the periphery must not prevent monetary policy makers from taking the necessary action once upside risks for euro-area inflation increase. Delivering on its primary goal to maintain price stability is the prerequisite for safeguarding the most precious resource a central bank can command: credibility.

In monetary policy, as in life, you will be tomorrow what you do today.

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