The ECB and its Options at the Zero Lower Bound

Following up on my last post on what easy money actually means I would like to offer some options the ECB could, and in my opinion should, pursue to achieve its mandate of getting inflation back in the vicinity of 2%. Whether doing that is enough is another topic, but it would at least be a start. In general, the consensus is that central banks have three types of tools at their disposal once the zero lower bound is reached: first, they can try to shape public expectations about future monetary policy (e.g. forward guidance), second they can expand the size of central banks balance sheets (e.g. quantitative easing) and third they can change the composition of those balance sheets (e.g. operation twist).

All of these measures have, in the vast majority of studies, shown to be able to affect the economy. The view that economic policy is ineffective at influencing the economy at the ZLB is therefore not correct – it might be less effective, and most importantly probably shows decreasing returns, but it does not become impossible. As Bernanke et al. for instance have argued, we should try to avoid such a situation in the first place, but once there we do have options. So let me offer some more concrete ideas on what the ECB might do in particular.

A major problem the Eurozone is having at the moment, which is generally a problem we find at the zero lower bound, is that banks are not willing to lend all the liquidity that central banks are trying to pour into the markets since it does not really cost them anything to hold this liquidity other than the potential opportunity costs of not lending this money out, which are likely to be small given our still depressed economy. So in essence, what needs to be done is something that eliminates this bottleneck in order to reestablish one of the standard monetary policy transmission mechanisms. As the ECB has stated many times in the past and reiterated today, it is technically ready to move the interest rate it pays on bank reserves parked at the ECB into negative territory. Theoretically, banks could always just buy up some of the massive empty housing stock sitting around in Spain and fill it with €500 bills to avoid having to park their money at the ECB and be “punished” for doing so. There is no flaw in that logic. In practice, this is very unlikely. There were roughly of €900 billion Euros in currency in circulation and a total of roughly €4,500 billion of overnight deposits at the ECB (.pdf) as of September 2013. Printing close to €3.6 trillion worth of Euro bills overnight is simply physically not possible. Thus the negative interest rates would very much have some effect on the amount of lending commercial banks engage in. And even if it doesn’t, so what? At worst we give a little boost to the safe-building industry, at best we move a great deal closer to finding a solution to the ZLB.

Further, the ECB is currently sterilizing all bond purchases it does in the southern periphery by removing the same amount of money from the economy somewhere else. This sterilization is not as complete as it would seem, as in practice the ECB does not really “remove” the money from the market but forces banks keep this money at the ECB for a certain period of time (one week at a time, to be exact). This essentially prevents it from entering into circulation during that time. In a certain way it has to do this, since its statutes explicitly prohibit it from printing money in order to finance governments. Whether this limitation has to be removed by changing the ECB statutes or can be “imagined” away on a technicality is not clear to me. After all, open market purchases are a standard tool of many central banks all around the world, and a fairly uncontroversial one at that.

In practice this of course mitigates any effects the bond purchases might have on the eurozone economy as a whole. It makes the debt burdens of southern countries more bearable as it reduces the rates at which these refinance themselves, but doesn’t do all too much in terms of directly stimulating the economy, which is what we would need. One could say the ECB is doing something akin to quantitative rebalancing, which has shown some success at least in terms of narrowing interest rate spreads, but not so much in terms of monetary easing. With enough easing rebalancing essentially takes care of itself. So stop the sterilization.

Which brings me to my last point: we need Eurobonds. Not necessarily because these would help the south refinance itself cheaper, as I am actually not sure they would, but because this would give the ECB the asset it needs to conduct monetary policy like any other central bank, both in normal times through straightforward open market purchases and in ZLB times through quantitative easing that is “eurozone neutral” and straight-forward.


6 thoughts on “The ECB and its Options at the Zero Lower Bound

  1. Florian, I like your entry, but I honestly have serious doubts regarding the statement that these forms of intervention have been shown to be effective. As the author of the speech you cite points out as well, very FEW studies have been conducted in a ZLB environment and particularly the transmission mechanism of asset purchases/ open market operations is badly understood.

    I find it striking that asset prices are back at their pre-crisis level, while the CBs seem to be unable to stimulate the real economy and get core inflation to pick up. I agree with you that this is a problem, but I think monetary policy is unable to solve it. (Which is, where we disagree, because I do think that they’ve tried)

    Ben Bernanke, for example, explicitely said in 2012 that their strategy is to raise asset prices (houses, bonds, equity, …) so people feel wealthier and spend more.
    You can follow the link in this article:

    Firstly, I don’t really think that works, because after the house price/ mortgage drama I’m not sure how many people can be deceived into believing that they are rich just because their houses are worth a lot. Secondly, I think it creates ENORMOUS amounts of distorted incentives (buying “unproductive” assets instead of conducting profitable investments. Finally, some have argued that this is a trickle down monetary policy: we push asset prices up, which mainly makes the rich richer and hope that they spend enough money so some of it trickles down into the economy.

    Anyway, I guess what I’m trying to say is that even after reading some of the references in your blog entry I have trouble seeing how these “alternative” tools are going to help us to lift core inflation.

    • I’m not sure if I’m missing something, but what I find in the article is that only FEW studies were undertaken on effectiveness of forward guidance policies at the ZLB, not on unconventional monetary policy in general. From the list of the studies on the effects of LSAP, most of those seem to involve ZLB episodes. That we don’t know the exact transmission mechanisms at work is certainly true.

      Bernanke mentions many different possible channels in the text quoted. Why, in that particular statement, he focuses on the wealth effect is unclear to me. As you are correct in pointing out, that does not seem to be an all too important channel at the moment.

      As on distorted incentives, by far the biggest source of these is that our nominal interest rates are too high. As the theory of the second best tells us, in a situation where one market failure cannot be eliminated, it might be better to move other variables away from their “would-be” equilibrium as well. Whether we are doing this in the correct way is another question, but it seems like the most straight-forward alternative. In a sense you might even argue that the FED buying up “enormous amounts of unproductive investments”, particularly with regard to MBS, takes these unproductive assets out of the economy and thus in theory allows private players to buy something more useful. The argument on trickle-down monetary policy, however, is definitely a valid one.

      • Sorry, I didn’t read the part about the particular studies very carefully.

        Our nominal interest rates are too high? Could you explain that please? Because I’m currently trying to find a suitable savings deposit option and a 0,5% interest rate doesn’t strike me as very high.

        That’s not what I meant with distorted incentives: I think by implicitely or explicitely bidding up asset prices and keeping the interest rates on savings and treasury yields (=save investments) low, it creates incentives for people to speculate on rising asset prices and not focus on productivity enhancing investments.

      • Of course our nominal interest rates are too high. That’s what I tried to explain with my “what does easy money even mean” post. If nominal interests weren’t too high, why would the ZLB even be a problem? It is a problem precisely because we would want central banks to be able to set them lower than 0. The real interest rate in our economy (of which there of course is not “just one”, as in our models) is too high to restore output back to its potential and, given inflation remains constant, this also means that nominal interest rates are too high. That’s also the whole reason why we want more inflation in the first place – given constant nominal interest rates, a higher level of inflation means lower real interest rates, meaning more stimulus.

        I’ll try to comment on the rest and your post as soon as I get to it, unfortunately I’m not sure when that will exactly be. As a quick note, different assets are of course valued in very different ways. Anyone speculating on bond prices rising is throwing money out of the window, as bond prices behave inversely to interest rates, and interest rates can’t really fall much further.

  2. So yes, the ECB would have some options left even if ordinary monetary policy (fiddling with short term interest rates) is no longer possible. But in effect all these options require Mr Draghi to promise higher inflation in the future. This is anathema to the hawks (=Germans) in the ECB governing council as well as to most EU politicians (not only but mostly Germans). So at the moment I see zero chance for an effective monetary stimulus from the ECB. I also can’t see a chance for a significant fiscal stimulus because one half of the euro zone can’t do deficit spending and the other half won’t because… well I don’t know. So my best guess is that we’ll have a japan-style lost decade with low euro zone inflation and mass unemployment and possibly serial default in the GIPS. Awsome!

  3. Pingback: The ECB Isn’t Allowed To Directly Finance EU Governments – Who Said It Needs To? | Graz Economics Blog

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