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.