Helping the ECB Cross the Rubicon

PARIS – Eurozone monetary officials are expected to make history when they gather for the European Central Bank’s next policy-setting meeting on January 22. Observers anticipate that ECB President Mario Draghi and his colleagues will finally cross the Rubicon and announce the launch of a large-scale program of quantitative easing (QE) – in other words, high-volume purchases of government bonds. Though the ECB has resisted QE for more than five years, even as other major central banks embraced it, Executive Board member Benoît Coeuré has already called it the “baseline option.”

On the face of it, the ECB has many reasons to launch QE. For two years, inflation has consistently failed to reach the 2% target. In November, the annual price growth was just 0.3%, while the recent collapse in oil prices will generate further downward pressure in the coming months. Even more important, inflation expectations have started to de-anchor: forecasters and investors expect the undershooting of the target to persist over the medium term.

Low inflation is already a serious obstacle to economic recovery and rebalancing within the eurozone. Outright deflation would be an even more dangerous threat.

Moreover, financial markets consider QE so likely that the largest part of its bond-rate and exchange-rate consequences have already been priced in. Should the ECB disappoint expectations, bond and foreign-exchange markets would confront an abrupt and damaging unwinding of positions: long-term interest rates would rise, stock markets would sink, and the exchange rate would appreciate. That is not what Europe needs as it struggles to achieve in a year the growth that the United States has already recorded in a single quarter.

Yet hesitations are palpable. Jens Weidmann, the president of the German Bundesbank, remains openly skeptical. Though Weidmann does not deny the risk of deflation, he argues that the consequences of recent price data may be less serious than believed, while those of full-fledged QE could be more serious than assumed. Several of his colleagues share his reservations.

It is important to understand why there is still no agreement in Frankfurt on the best possible course of action. At a time when the US data seem to validate the Federal Reserve’s strategy, why is the ECB hesitating?

Contrary to conventional wisdom, the issue is not one of pure doctrine. Yes, the Bundesbank fiercely opposed the ECB’s conditional support of debt-distressed eurozone members and backed legal challenges to Draghi’s innovation, the outright monetary transactions (OMT) scheme. But German officials do not dispute the legitimacy of wholesale bond purchases for monetary-policy purposes, and that there can be circumstances that require QE.

Orthodoxy rules out providing ECB support to a particular country, because this would violate the separation between monetary and fiscal policy: The authority to commit public resources to the benefit of a particular country belongs exclusively to parliaments, not the central bank. But a wholesale purchase of government bonds does not raise similar concerns.

Unlike in 2012, when the OMT was announced, the objective of QE is not to help governments keep market access. In principle, QE has nothing to do with sovereign solvency. It is a monetary instrument that the central bank must rely on when its policy interest rate has hit the zero lower bound and thus cannot be pushed lower. The debt level of the government is irrelevant to the decision to use it.

But, by lowering long-term interest rates, central-bank purchases of government debt can help contain government debt service. In this way, QE can keep solvent a government that otherwise would be insolvent – a nightmare scenario for a central bank.

Japan is a case in point. The Bank of Japan already holds government securities worth 40% of GDP, and it is committed to annual purchases worth 16% of GDP within the framework of Prime Minister Shinzo Abe’s economic revitalization agenda. The mammoth size of the BOJ program implies that it has taken full control of the market for government paper. With annual purchases amounting to twice the deficit, it has become hard to speak of a “market” for government debt. In fact, the BOJ sets the price.

Such a situation can make the central bank hostage to the government’s behavior. The BOJ’s action is predicated on Abe’s commitment to restoring the sustainability of public finances once deflation has been defeated and the economy has returned to growth. Should Abe fail to deliver, the BOJ would be trapped. If it stopped buying government debt, it could trigger a sovereign crisis and reduce the value of its own portfolio (especially if it started selling the bonds on its balance sheet). But continuing its purchases would tighten the government’s grip.

Trust in the government is therefore vital for any central bank that embarks on QE. This trust is missing in Europe. Despite an accumulation of legal texts and procedures, the EU fiscal framework lacks credibility and does not give the ECB confidence that governments will continue to pursue sustainability after its bond purchases shelter them from market pressure even further.

Moreover, unlike its counterparts, the ECB does not face a single interlocutor, and none of the governments that hold it accountable is or feels in charge of the eurozone as a whole. This is a deeply unfavorable situation, which explains why the ECB, once obsessed with the risk that governments would coalesce to assail its independence, has turned into the staunchest advocate of fiscal-policy coordination.

Concern is therefore understandable. But it does not diminish the need for bold unconventional action against deflation, and it should not prevent the ECB from launching QE. The parallel with Japan highlights the need for governments to behave responsibly, individually and collectively. Europe’s elected national leaders have a large role to play, and they must not eschew their duties. The more confidence they give to the ECB, the more effective QE will be.

Jean Pisani-Ferry is a professor at the Hertie School of Governance in Berlin, and currently serves as the French government’s Commissioner-General for Policy Planning.

Copyright: Project Syndicate, 2014.
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