“How do we decide the mix of policies? Assume that someone has decided on the total dose, that is, the path of GNP and unemployment. What is a socially rational choice of the mix of policies to support that decision? The mix does make a difference, much more for the long run than for the short run … Demand management strategy does affect the long-run capacity of the economy to produce. The policy mix makes that connection.” (Tobin 1986)
At the root of this eBook are three basic questions:
- What resources or institutional mechanisms proved absent or ineffective during the crisis?
- What worked well?
- What lessons for the future can be highlighted?
The specific vantage point of this contribution is to revisit these questions by focusing on macroeconomic policymaking in the Eurozone (EZ), in the tradition of the far-reaching body of literature on the policy mix epitomised by the classic ‘funnel’ theory of James Tobin. The key question for Tobin and his successors was how to calibrate the overall stance of macroeconomic policy in a country or economic region, choosing the combination of fiscal and monetary elements that deliver the appropriate degree of macro stimulus or restraint. In this light, in what follows we aim at considering the recent past and the potential future of the European macroeconomy using the evolution of the EZ policy mix as the Ariadne’s thread to escape the maze of liquidity traps, low-inflationary pressures, and anaemic growth prospects.
What proved absent or ineffective during the crisis?
Let’s start with what went wrong. Facing adverse cyclical developments, the absence of meaningful fiscal risk-pooling among EZ members forced less creditworthy countries into pro-cyclical fiscal tightening. Lack of fiscal capacity also left these countries unable to provide credible backstops for troubled domestic banking systems. Such weakness proved self-reinforcing, with capital flight and deteriorating financial conditions further undermining domestic economies and banking systems.
One could be tempted to read the parabola of the European periphery as a cautionary tale about the risks of fiscal profligacy, as countries with bad fiscal fundamentals were unable to cope with the consequences of the downturn by adopting appropriate countercyclical stimulus. But there was no meaningful fiscal loosening even in countries with fiscal space, except briefly during the height of the Great Recession; indeed, policy often went in the opposite direction. In Germany, for example, the European Commission’s measure of the cyclically-adjusted primary balance tightened by 2.3 percentage points relative to GDP over 2010-13. The general thrust of policy discussion was toward structural reform and belt-tightening, measures at best ineffective in meeting a large demand shortfall.
In parallel with fiscal policy, monetary conditions were tight when the crisis hit. Estimates of the neutral (or natural) real interest rate moved quickly into dangerously low if not negative territory, reflecting a sudden deterioration in financial conditions encompassing widespread deleveraging, reduced risk appetite, and revised expectations about growth and employment prospects. These developments came on top of slow-moving structural factors depressing the natural rate, including demographic developments and globalisation trends. Closing the output gap or fighting deflationary tail risks in the face of a low neutral rate requires very low nominal policy rates and relatively high inflation expectations. Implementing this strategy is difficult enough when central bank policy runs into the constraint set by the zero (or effective) lower bound (ZLB) and resorts to unconventional policies of unknown or doubtful efficacy to meet its mandate. But it can be argued that, at first, the ECB was actually reluctant to pursue this route. Policy rates were hiked as late as July 2008, and not eased until September. Perhaps more puzzlingly, the ECB embarked on an abortive new tightening cycle in April 2011.
In the EZ this raised doubts about policymakers' commitment to the 2% target and allowed inflation expectations to ratchet downward. At the country-specific level, membership in the currency union meant that real exchange rate misalignments within the EZ could only be cured through the slow process of internal devaluation. Low inflation in the core implied deflation in the periphery.
As the bank-lending channel plays a key role in the mechanism of transmission of monetary policy in the EZ, market and policy pressures pushing banks to deleverage in the aftermath of the crisis reduced the effectiveness of monetary stimulus. Quantitative easing and associated forward guidance, when they were finally adopted in force in late 2014, proved relatively effective in flattening the yield curve, but quite ineffective in supporting inflationary expectations. Indeed, swap pricing suggests that inflation is expected to average barely 1% three to six years ahead, below when the ECB’s expanded asset purchase program was rolled out in March 2015. Disagreement among policymakers and problematic communication about the direction of policy may have worked to undermine the effectiveness of forward guidance.
What worked well?
On a more positive note, after the inception of the crisis in August 2007, the ECB proved to be quite effective in addressing the malfunctioning of the interbank markets. Like other central banks in advanced economies, the ECB progressively increased the scale and scope of its interventions in such markets, preventing their stoppage and creating the preconditions for a return to normality, at least in the secured segment. In the case of the EZ, the improvement was nonetheless complicated by the uncertainty emanating from the EZ debt crisis. Namely, worries about sovereign debt triggered significant fragmentation in money markets in the EZ. The combination of sovereign and counterparty credit risk concerns led investors to search for safe and liquid assets across national borders.
The Target2 system worked very smoothly, ensuring that the massive withdrawal of funds from the periphery by the banks in the lending countries, capital flight, and loss of bank reserves, did not produce any ‘balance of payments crisis’ within the EZ. With the growth of the balance sheet of the ECB, stepping in and substituting for trade in the interbank system, the operations that involved cross-border banks amounted to credits extended to the periphery countries in excess of any historical IMF program (in percentage of GDP).
The ECB proved proactive in ‘credit easing,’ to address strains on national banking systems, authorising national central banks (NCBs) to accept a broader range of collateral and to lend at full allotment in refinancing operations with local commercial banks. This strengthened the ability of NCBs to inject liquidity into local banking systems, and kept periphery countries from seeing the sharp shrinkage in domestic credit that normally accompanies large-scale capital flight. The exchange rate relative to the EZ’s main trading partners acted as an important and effective transmission tool for monetary policy, including unconventional policy tools. As a more general point, the biggest and most consequential surprise of the crisis period and its aftermath was that populations in the periphery proved willing to suffer significant deprivations in order to remain in the EZ.
Last but not least, the launch of the Outright Monetary Transactions (OMT) program proved to be an effective measure to reign in the variable and large risk premia on government debt that, after 2010, had driven the interest differentials across member states to levels not seen since the first half of the 1990s. Just as there was no mechanism for restraining growing imbalances in the current account during the run-up to the crisis, after its outburst there was virtually no mechanism to contain the risk of destabilising capital flow reversals, feeding high and variable risk premia, possibly disconnected from fundamentals. The OMT program created the possibility for the ECB to intervene in the debt market with the explicit goal to address issues in self-fulfilling expectations of debt default and/or break-up of the EZ. Its launch, in conjunction with the famous ‘whatever it takes’ speech by Draghi in July 2012, had a strong calming effect on financial markets. Interest rates remained higher in countries with relatively weak public finances and macroeconomic & banking conditions, but their dynamics turned out to be better anchored to developments in domestic fundamentals.
What are the lessons for policy design going forward?
In the short term, some of the headwinds from the past crisis are likely to linger on. And given the demographic and productivity trends, measures of the real neutral interest rate are expected to remain subdued over the medium term. If secular stagnation theories prove correct for the EZ, low real equilibrium rates may be with us for the foreseeable future. In light of this, the EZ needs to prepare for the possibility of hitting the ZLB again and again going forward, not because the risks to the outlook are persistently tilted on the downside, but because real rates consistent with a neutral monetary stance are likely to be lower than historical averages.
If this is the case, EZ monetary policymakers may want to consider the benefits of temporarily overshooting the 2% inflation objective. Moving away from the notion of 2% as an inflation ceiling – as currently envisioned in the EZ monetary framework – toward a symmetric inflation objective is unlikely to be an easy task. Even in the US – where an objective for inflation has been long recognised as an integral component of the ‘dual mandate’ – it took until January 2016 (in the newly revised Consensus Statement) to make it explicit that such an objective is symmetric, and that FOMC participants are equally concerned with inflation deviations below and above mandate-consistent levels. But moving toward a symmetric objective in the EZ may come with even stronger benefits, by expanding the expected policy space to escape current and future liquidity traps and re-anchoring longer-term expectations around the desired level. In a region facing risks of persistent headwinds (if not secular stagnation), a longer-term posture of ‘opportunistic re-inflation’ might go a long way in stabilising expectations. A move toward a symmetric objective raises non-trivial communication challenges, but may well be considerably less onerous than the adoption of a higher numerical inflation target – which would raise concerns about long-term social costs and undermine public confidence in the determination of the central bank to pursue price stability – or a more radical switch to regimes of targeting the price-level path or nominal income.
Facing these prospects, a number of ‘unconventional’ strategies of monetary policy adopted in the recent past may get promoted to the ‘conventional’ range, and join the permanent toolkit of the ECB, ready to support the appropriate degree of monetary stimulus in response to obdurately adverse circumstances. That is, monetary policymakers may need to rely on asset purchases and allow the policy rate to fall into negative territory more often than originally planned by the EZ architects. Negative rates may have a better chance of getting upgraded to permanent instruments of demand management in the EZ, in contrast with the experience of the US, where negative rates have not emerged as an unconventional tool. Large-scale asset purchases seem to have done visible good both in the US and the EZ; in the EZ in particular, borrowing rates for corporates are significantly lower than they were two or three years ago. As already noted, however, inflationary expectations haven’t responded in a meaningful way to programs of quantitative easing and periods of prolonged balance sheet expansions. Tools more directly related to affecting currency valuations are much less likely to be considered in the design of the future policy mix, even though the exchange rate channel is certainly a powerful element of the transmission mechanism.
All of the above notwithstanding, at the ZLB, monetary policy by itself will not be sufficient to achieve stabilisation objectives. There need to be stronger mechanisms for fiscal burden-sharing and risk-pooling. The EZ will remain a semi-functional monetary union so long as such mechanisms are lacking. In this direction, one could consider creating room for fiscal policy to achieve the correct macroeconomic stance at EZ level, while preserving fiscal sustainability at the national level.
Alternative institutional developments may be functional to this goal, entailing different degrees of transfer of national sovereignty to common institutions and decision-making bodies. But it should be clear by now that a successful institutional development in this direction cannot occur without any transfer of sovereignty.
In particular, the management of a common macroeconomic stance may be particularly difficult without addressing two open issues. The first is the creation of a safe asset for the EZ as a whole - a bond which is effectively considered free of default risk in nominal terms. The second is the definition of institutions and procedures for an orderly management of debt restructuring at the national level, in case the legacy debt - whose growth has not been unrelated to the effects of the crisis - turns out to be unsustainable.
We sketch hereafter the directions that reforms could take. The literature has discussed several variants of instituting a fund with the ability to buy national public debt (from countries satisfying specific fiscal criteria) and issue a safe asset, in the form of Eurobonds, with an explicit ECB backstop. Since the onset of the crisis, concerns about keeping default risk premia on national debt as low as possible have clearly acted as a drag on reasonable use of fiscal space at the national level for procyclical expansions. The OMTs have in part addressed this issue, by shielding countries from disruptive, self-fulfilling debt selloffs. They have not, however, eliminated the contractionary bias for the EZ level. With the fund issuing safe common bonds, the EZ as a whole could respond to large shocks with sufficient fiscal determination while containing vulnerability to sovereign crises.
This fund could naturally be given the responsibility to coordinate fiscal policy in response to Euro-wide shocks. In normal times, its main function would not interfere with national fiscal policymaking. In the presence of large recessionary shocks, it would take charge of setting the required degree of fiscal accommodation at union-level, which may possibly require short-run deviations from deficit criteria in some countries.
The Fund, together with the ECB, would guarantee the face value of its bonds, not of national public debt. Access to the fund would only be conditional on clear fiscal criteria, ensuring fiscal discipline at the national level, and would be denied to countries violating these criteria.
For this reason, the viability of the scheme requires the creation of a framework for managing restructuring in an orderly way. This framework should be designed with the explicit goal of preventing credit events from feeding (self-validating) expectations of exit and thus ruling out breakup risk. To set the right incentives to restore fiscal viability, the Fund would stand ready to resume debt purchases after restructuring, conditional on the government complying again with the fiscal criteria.
These criteria should, of course, be set to minimise possible opportunistic behaviour. But it is worth noticing that exposure to risk of default per se would to some extent foster discipline.
One could argue that, in part, an appropriate policy mix could already be achieved in the present circumstances, with the ECB keeping its monetary stance appropriately accommodative and issuing reserves in order to purchase national public debt – as implemented in the more recent Public Sector Purchase Program. Member states could move further from fiscal consolidation to limited fiscal accommodation. But while this shift may be a sensible option in the near future, if the global outlook deteriorates, there is no reason to be confident that the macroeconomic stance would become sufficiently expansionary, implying a concrete risk of overburdening monetary policy. It is difficult to think of the future of the EZ without a convincing answer to the issue of creating fiscal risk sharing in Europe.
A key lesson from the global crisis and the Great Recession focuses on the disruptive effects of financial risk, endogenously magnified by various types of market distortions and coordination problems. The economic regions that were most successful in reigning in this risk were the most effective in containing the economic costs of the crisis. In the case of the EZ, an incomplete institutional development has long delayed this process, often feeding, rather than containing, endogenous risk. The difficulties so far experienced in sustaining economic activity can and should be overcome, however, by recognising that macroeconomic stabilisation needs instruments and policies that square at the EZ level.
Disclaimer: The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of New York, the Federal Reserve System, or any other institutions the authors are affiliated with.
Tobin, J (1986) “The monetary and fiscal policy mix”, Federal Reserve Bank of Atlanta Economic Review, 71(7): 4-16.