We Don’t Give Up

Mario Draghi reassured the markets at the 21 January press conference of the European Central Bank (ECB) by making it clear that the Governing Council is unanimous in its desire to reassess economic conditions at the upcoming March meetings and to reconsider its policy stance if necessary. He stressed that there is no limit to the action that the ECB can undertake to achieve its mandate. And he reiterated that whatever the actual policy decision in March, the ECB is already working to resolve any technical issues that might prevent it from using the full range of instruments at its disposal. The response in the markets was immediate. Bonds and equities rallied while the euro moved lower against the dollar – all good things from the ECB’s perspective. ECB watchers were cautiously optimistic. A few voices noted that the ECB had promised in October of last year only to under-deliver in December; this time actions should speak louder than words. So should results. Draghi has reiterated his July 2012 promise to do ‘whatever it takes’. What he did not say is that ‘it will be enough’. Instead, he insisted: ‘We don’t give up.’

The ECB cannot commit to results because it is caught in a double conundrum. The first problem is that the unconventional monetary policies adopted by the Governing Council are slow to have effect and the distortions that the policies create accumulate increasingly over time. The ECB can celebrate the success of its policy by pointing to the gradual growth of lending to households and firms. Yet it also has to admit that private sector borrowers have a long-way to go in repairing their balance sheets and that banks will need time to handle non-performing loans. In the meantime, the policies of the ECB are pushing up the prices of any instrument eligible for inclusion in the Asset Purchasing Program and so pushing down the yields of those assets for other investors. Alas, this has not resulted in forcing investors to take on more risk as proponents of the policy intended.

The ‘portfolio channel’ has not worked well beyond the slow improvements in bank financing to firms and households. There are many reasons why this is so. The important point is that pensions and insurance companies are suffering as a consequence and the mismatch between the performance of their assets and the liabilities they have to cover in the future is growing increasingly. That is at least part of the reason why Draghi admitted that ‘our monetary policies . . . could become a source of instability’. His point was not that it is within the ECB’s ‘mandate to protect a bank’s profitability, or for this matter insurance companies’ profitability.’ Rather it was that the ECB needs to make sure that ‘the overall economy returns to growth . . . with price stability’.

This is where the second conundrum emerges. As Draghi would freely admit, European economic performance is largely outside of the control of the ECB. Monetary policy can only do so much. Alas, there are two ways to interpret that statement. One is to imagine outside forces that work against the ECB’s policy goals. Commodity prices are falling and that is holding down expectations of inflation. Effective exchange rates are rising and that is cutting into the competitiveness of European exports. Markets are volatile and that is damaging confidence in the financial industry. These are things the ECB cannot manage directly. All the Governing Council can do is redouble its efforts to offset the effects that these outside forces are having on price stability and overall economic performance. This is the view you find both in Draghi’s opening statement and in the questions and answers that follow.

Another way to interpret the ECB’s powerlessness is through the lens of interdependence. The problem is that the ECB’s actions – and the actions of other European policymakers – are having effects in the outside world that are rebounding against Europe. In this telling of the story, the problem with commodity prices is that the ECB was too late in supporting European economic activity. There are sound political reasons why it took the Governing Council longer than other monetary authorities to engage in quantitative easing. Nevertheless the result has been to hold down European economic performance during a period when investments in resource extraction and commodity production were coming to fruition. Now we face a surplus of supply in energy resources and other commodities for which there is relatively low demand. This means that commodity producers have to adapt quickly to diminished earnings. The European economy is not there to support emerging markets and so emerging markets have few resources to buy exports from Europe.

This is where the Governing Council’s relatively late introduction of quantitative easing becomes more directly relevant. While the ECB is engaging in large scale asset purchases, the Bank of England is keeping its position neutral and the U.S. Federal Reserve is looking to exit. This divergence has put considerable downward pressure on the euro relative to the dollar or upward pressure on the dollar relative the euro depending upon your perspective. For Europeans, the downward pressure on the euro is the ‘exchange rate channel’ that has been the main source of economic stimulus from the asset purchasing program. For those emerging market countries that tie their exchange rates to the dollar or that use dollar markets for corporate borrowing, the upward pressure on the dollar has been a constraint on economic performance and a threat to financial solvency. The only recourse for these countries is to loosen their links to the dollar and, where possible, to repay their dollar-denominated debts. As they do so, however, their currencies will weaken relative to the euro as well – and so close off the positive effects of the ‘exchange rate channel’ for the ECB’s policy.

The market volatility that Europe is experiencing is largely a result of commodity price movements, currency realignments and cross-border capital flows. Of course some of this would have happened if the ECB had not existed or did nothing. The logic of interdependence can be exaggerated. Nevertheless the ECB has been a protagonist in these developments as well and this latest hint that it will reconsider its monetary stance is all part of that interactive process. The implication is that any change in ECB policy will be muted by the actions and reactions of policymakers and market participants in countries both inside and outside Europe. Draghi is probably right that the ECB retains a raft of policy options and instruments. But each of these is going to create its own distortions and reactions. So it is hard to imagine this situation will resolve itself quickly. And the longer it drags on the more pressing will be the first conundrum about the potential for ECB policy to become a source of instability.

A final concern is that some factor truly outside the influence of the ECB will spark a European recession before the Governing Council has had the chance to reset its portfolio of policy instruments. This is the concern that German Chancellor Angela Merkel raised with Draghi before the latest ECB press conference. It is also a concern that the word’s other major central banks are facing. Monetary authorities are now in an unenviable situation. They cannot exit from their current policy stances without potentially triggering a market correction; they cannot continue as things are without suffering from ever greater distortions; and they cannot anticipate how long they have to escape from this unconventional monetary policy cul-de-sac before another major crisis demands their attention. When Draghi says they won’t give up he is making a realistic commitment. Whether the ECB’s efforts will be enough is probably too much to ask.

This piece was originally published on E!Sharp. For the edited version, go here.