By Christophe Blot, Jérôme Creel, Paul Hubert, Fabien Labondance and Xavier Ragot

Rising inequality in income and wealth has become a key issue in discussions of economic policy, and the topic has inserted itself into evaluations of the impact of monetary policy in the US and Japan, the precursors of today’s massive quantitative easing programmes (QE). The question is thus posed as to whether the ECB’s QE policy has had or will have redistributive effects.

In a paper prepared for the European Parliament, Blot et al. (2015) point out that the empirical literature gives rise to two contradictory conclusions. In the US, the Fed’s base rate cuts tend to reduce inequality. Conversely, in Japan an expansionary QE type policy tends to increase inequality. So what’s the situation in Europe?

Based on macroeconomic data aggregated for the euro zone as a whole, Blot et al. (2015) show that while European monetary policy, conventional and unconventional, have indeed had an impact on the unemployment rate, the number of hours worked and the rate of inflation (see graphs), this was limited. This result suggests that the ECB’s expansionary monetary policy has tended to reduce inequality, but not by much. So when the ECB finally decides to wind up its expansionary policy, we can expect a slight increase in inequalities to follow. Because of this effect, though small, Blot et al. (2015) suggest that the ECB should be held accountable not just for price stability or economic growth, but also for the impact of its policies in terms of inequality and the mechanisms needed to take this into account.

By Christophe Blot, Jérôme Creel, Paul Hubert and  Fabien Labondance

The ECB decision to launch a quantitative easing (QE) programme was widely anticipated. Indeed, on several occasions in the second half of 2014 Mario Draghi had reiterated that the Governing Council was unanimous in its commitment to take the steps needed, in accordance with its mandate, to fight against the risk of a prolonged slowdown in inflation. Both the scale and the characteristics of the ECB plan announced on 22 January 2014 sent a strong, though perhaps belated signal of the Bank’s commitment to fight the risk of deflation, which has been spreading in the euro zone, as can be seen in particular in inflation expectations over a two-year horizon (Figure 1). In a special study entitled, “Que peut-on attendre du l’assouplissement quantitatif de la BCE?” [“What can we expect from the ECB’s quantitative easing?”], we clarify the implications of this new strategy by explaining the mechanisms for the transmission of quantitative easing, drawing on the numerous empirical studies on previous such programmes in the US, the UK and Japan.

The terms of the quantitative easing decided by the ECB are indeed similar to those adopted by other central banks, especially by the US Federal Reserve and the Bank of England, which make comparisons legitimate. It appears from the American, British and Japanese experience that the measures implemented have led to a decline in sovereign interest rates and more generally to an improvement in the financial conditions of the overall economy[1]. This has been the result of sending a signal about the present and future stance of monetary policy and a reallocation of investors’ portfolios. Some studies [2] also show that the US QE caused a depreciation of the dollar. The transmission of QE from the ECB to this variable could be critical in the case of the euro zone. An analysis using VAR models shows that the monetary policy measures taken by the ECB will have a significant impact on the euro but also on inflation and inflationary expectations. It is likely that the effects of the depreciation of the euro on European economic activity will be positive (cf.  Bruno Ducoudré and Eric Heyer), which would make it easier for Mario Draghi to bring inflation back on target. The measure would therefore have the positive effects expected; however, it might be regrettable that it was not implemented earlier, when the euro zone was mired in recession. Inflation in the euro zone has fallen constantly since late 2011, reflecting a gathering deflationary risk month after month. In fact, the implementation of QE from March 2015 will consolidate and strengthen a recovery that would undoubtedly have occurred anyway. Better late than never!

[1] The final impact on the real economy is, however, less certain, in particular because the demand for credit has remained stagnant.

[2] Gagnon, J., Raskin, M., Remache, J. and Sack, B. (2011). “The financial market effects of the Federal Reserve’s large-scale asset purchases,” International Journal of Central Banking, vol. 7(10), pp. 3-43.

Christophe Blot, Jérôme Creel, Paul Hubert and Fabien Labondance

In June 2014, the ECB announced a set of new measures (a detailed description of which is provided in a special study entitled, “How can the fragmentation of the euro zone banking system be fought?”, Revue de l’OFCE, No. 136, in French) in order to halt the lowering of inflation and sustain growth. Mario Draghi then clarified the objectives of the ECB’s monetary policy by indicating that the Bank wanted to expand its balance sheet by a trillion euros to return to a level close to that seen in the summer of 2012. Among the measures taken, much was expected from the new targeted long-term refinancing operation (TLTRO), which gives banks in the euro zone access to ECB refinancing with a maturity of 4 years in return for providing credit to the private sector (excluding mortgages). However, after the first two allocations (24 September 2014 and 11 December 2014), the picture has become rather complicated, with the amounts allocated well below expectations. This reflects the difficulty the ECB is having in fighting effectively against the risk of deflation.

Indeed, having allotted 82.6 billion euros in September (versus anticipations of between 130 and 150 billion), the ECB granted “only” 130 billion on December 11, i.e. once again a lower amount than had been anticipated. So we are a long way from the maximum amount of 400 billion euros that had been evoked by Mario Draghi in June 2014 for these two operations. Moreover, these first two allotments were clearly insufficient to boost the ECB’s balance sheet significantly (Figure 1), and all the more so as banks are continuing to reimburse the three-year loans that they received in late 2011 and early 2012 in the very long-term refinancing operation (VLTRO) [1]. What explains the banks’ reluctance to make use of this operation, even though it allows them to refinance the loans granted at a very low rate for a 4 year term?

The first is that the banks already have very broad and very advantageous access to ECB liquidity through the monetary policy operations already implemented by the ECB[2]. These operations actually offer a lower interest rate than does the TLTRO (0.05% against 0.15%). Similarly, a TLTRO is not more attractive than some long-term market financing, especially since many banks do not have financing constraints. TLTRO is thus of marginal interest, due to the maturity of the operation, and more restrictive because it is conditioned on the distribution of credit. For the first two operations conducted in September and December 2014, the allotment could not exceed 7% of outstanding loans to the non-financial private sector in the euro zone, excluding loans for housing, as of 30 April 2014. A new series of TLTRO will be conducted between March 2015 and June 2016, on a quarterly basis. This time the maximum amount that can be allocated to the banks will depend on the growth in outstanding loans to the non-financial private sector in the euro zone, excluding loans for housing, between 30 April 2014 and the date of the operation in question.

The second explanation is that the weakness of credit in the euro zone is not simply the result of supply factors but also demand factors. Sluggish activity and private agents’ efforts to shed debt are holding back lending.

Third, beyond banks’ ability to find refinancing, it is also possible that they are trying to reduce their exposure to risk. The problem is thus related to their assets. However, non-performing loans are still at a very high level, especially in Spain and Italy (Figure 2). In addition, although the Asset Quality Review (AQR) conducted by the ECB has revealed that insolvency risks are limited in the euro zone, the report also points out that some banks are highly leveraged and that they have mainly used the available liquidity to buy government bonds in order to meet their capital requirements. They are then reducing their balance sheet risk by limiting loans to the private sector.

Finally, two uncertainties are also reducing the banks’ participation in the TLTRO. The first concerns the stigma attached to the conditionality of the TLTRO and to the fact that banks that do not meet their commitments on the distribution of credit will be required to repay the financing obtained from the ECB after two years. So banks facing uncertainty about their ability to increase their lending may very well wish to avoid the prospect of having to repay the funds sooner. The second factor concerns uncertainties about the programs for purchasing ABS and covered bonds[3]. The banks could also turn to these programs to get cash in exchange for the sale of assets that they would like to get rid of.

Has monetary policy become totally ineffective? The answer is certainly no, since by giving banks a guarantee that they can refinance their activity through various programs (TLTRO, ABS, covered bonds, etc.), the ECB is reducing the risk that credit will be rationed due to the deteriorated state of some banks’ liabilities. Monetary policy is thus helping to free up the credit channel. But its effects are nevertheless limited, as is suggested by Bech, Gambacorta and Kharroubi (2012) , who show that monetary policy is less effective in periods of recovery following a financial crisis. Can we get out of this impasse? This observation on the effectiveness of monetary policy shows that the ECB should not be viewed as the be-all and end-all. It is still essential to complement its support for activity through an expansionary fiscal policy across the euro zone. This point was also reiterated by the President of the ECB during this summer’s conference at Jackson Hole: “Demand side policies are not only justified by the significant cyclical component in unemployment. They are also relevant because, given prevailing uncertainty, they help insure against the risk that a weak economy is contributing to hysteresis effects.”

[1] See the special study in the Revue de l’OFCE no. 136, “Comment lutter contre la fragmentation du système bancaire de la zone euro?” for an examination of the various monetary policy measures taken by the ECB since the onset of the financial crisis and an estimate of their impact on the real economy.

[2] This includes standard monetary policy operations as well as the VLTRO operation through which the ECB provided liquidity for an exceptional term of 3 years in December 2011 and February 2012.

[3] This involves programs for the purchase of securities in the market and not cash distributed directly to the banks. The covered bonds and ABS are securities pledged on assets whose remuneration depends on that of the underlying asset, which is by necessity a mortgage in the case of covered bonds and which in the case of ABS may include other types of loans (credit cards, cash loans to businesses, etc.).

By Christophe Blot

This text draws on the article “Le piège de la déflation: perspectives 2014-2015 pour l’économie mondiale” [The deflation trap: the 2014-2015 outlook for the world economy],  written by Céline Antonin, Christophe Blot, Amel Falah, Sabine Le Bayon, Hervé Péléraux, Christine Rifflart and Xavier Timbeau.

According to a Eurostat press release published on 14 November 2014, euro zone GDP grew by 0.2% in the third quarter of 2014, and inflation stabilized in October at the very low level of 0.4%. Although the prospects of a new recession have receded for now, the IMF evaluates the likelihood of a recession in the euro zone at between 35% and 40%. This dismal prospect reflects the absence of a recovery in the euro zone, which is preventing a rapid reduction in unemployment. What lessons can be drawn?

In the short term, this sluggishness is due to three factors that have held back growth. First, fiscal consolidation, although less extensive than in 2013, has been continued in 2014 in a context where the multipliers remain high. Second, despite the reduction in long-term public interest rates due to the easing of pressure on sovereign debt, financing conditions for households and businesses in the euro zone have worsened, as the banks have not consistently passed on the reduction in long-term rates and lower inflation is leading to a tightening of real monetary conditions. Finally, the euro appreciated by more than 10% between July 2012 and early 2014. Even though the currency’s rise reflects the winding down of pressure on euro zone bond markets, this has hurt exports. In addition to these short-term factors, recent data could herald the beginnings of a long phase of moderate growth and low inflation or even deflation in the euro zone.

Indeed, after a period of sharply increasing debt (see Figures), the financial situation of households and firms in the euro zone has deteriorated since 2008 due to a series of crises – financial, fiscal, banking and economic. This deterioration in the financial health of the non-financial sector has weakened its thirst for credit. Furthermore, households may be forced to cut down on their spending on consumption, and firms investment and their need for employment in order to reduce their debt. Adding to this is the fragility of certain banks, which need to absorb a high amount of bad debt; this is leading them to restrict the supply of credit, as is evidenced by the latest SAFE survey  conducted by the ECB on SMEs. In a context like this where private agents prefer deleveraging, fiscal policy should play a crucial role. But this is not happening in the euro zone due to the desire to consolidate the trajectory of public finances at the expense of the goal of growth[1]. Furthermore, while many countries could get out of the excessive deficit procedure in 2015 [2], fiscal consolidation is expected to continue because of the rules in the Treaty on Stability, Coordination and Governance

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(TSCG) requiring Member countries to make fiscal adjustments to bring public debt down to the 60% threshold within 20 years[3].

These conditions could push a recovery further down the road, and the euro zone could wind up locked in the trap of deflation. A lack of growth and high unemployment are creating downward pressure on prices and wages, pressure that is being exacerbated by internal devaluations, which are the only solutions being adopted to improve competitiveness and regain market share. This reduction in inflation is making the deleveraging process even more protracted and difficult, thus undercutting demand and strengthening the deflationary process. The Japanese experience of the 1990s shows that it is not easy to pull out of this kind of situation.

[1] The costs of this strategy were evaluated in the two preceding iAGS reports (see here).

[2]  France and Spain would, however, constitute two major exceptions, with budget deficits of, respectively, 4% and 4.2% in 2015.

[3] See the post by Raul Sampognaro for more on the specific case of Italy.

By Christophe Blot and Jérôme Creel

The debate on economic policy in Europe was re-ignited this summer by Mario Draghi during the now traditional symposium at Jackson Hole, which brings together the world’s main central bankers. Despite this, it seems that both the one side (Wolfgang Schaüble, Germany’s finance minister) and the other (Christine Lagarde, head of the IMF) are holding to their positions: fiscal discipline plus structural reforms, or demand stimulus plus structural reforms. Although the difference can seem tenuous, the way is now open for what Ms. Lagarde called “fiscal manoeuvring room to support a European recovery”. She is targeting Germany in particular, but is she really right?

In an interview with the newspaper Les Echos, Christine Lagarde said that Germany “very likely has the fiscal manoeuvring room necessary to support a recovery in Europe”. It is clear that the euro zone continues to need growth (in second quarter 2014, GDP was still 2.4% below its pre-crisis level in first quarter 2008). Despite the interest rate cuts decided by the ECB and its ongoing programme of exceptional measures, a lack of short-term demand is still holding back the engine of European growth, mainly due to the generally tight fiscal policy being pursued across the euro zone. In today’s context, support for growth through more expansionary fiscal policy is being constrained by tight budgets and by a political determination to continue to cut deficits. Fiscal constraints may be real for countries that are heavily in debt and have lost market access, such as Greece, but they are more of an institutional nature for countries able to issue government debt at historically very low levels, such as France. For Ms. Lagarde, Germany has the manoeuvring room that makes it the only potential economic engine for powering a European recovery. A more detailed analysis of the effects of its fiscal policy – both internally and spillovers to European partners – nevertheless calls for tempering this optimism.

The mechanisms that underlie the hypothesis of Germany driving growth are fairly simple. An expansionary fiscal policy in Germany would boost the country’s domestic demand, which would increase imports and create additional opportunities for companies in other countries in the euro zone. In return, however, the impact could be tempered by a slightly less expansionary monetary policy: as Martin Wolf argues, didn’t Mario Draghi ensure that the ECB would do everything in its power to ensure price stability over the medium term?

In a recent OFCE working document, we have tried to capture these various commercial and monetary policy effects in a dynamic model of the euro zone. The result is that a positive fiscal impulse of 1 GDP point in Germany for three consecutive years (a plan involving 27.5 billion euros per year [1]) would boost growth in the euro zone by 0.2 point in the first year. This impact is certainly not negligible. However, this is due solely to the stimulation that would benefit German growth and not to spillovers to Germany’s European partners. Indeed, and as an example, the increase in Spain’s growth would be insignificant (0.03 point of growth in the first year). The weakness of the spillover effects can be explained simply by the moderate value of Germany’s fiscal multiplier [2]. Indeed, the recent literature on multipliers suggests that they rise as the economy goes deeper into a slump. But based on the estimates of the output gap retained in our model, Germany is not in this situation, and indeed the multiplier has dropped to 0.5 according to the calibration of the multiplier effects selected for our simulations. For an increase in German growth of 0.5 percentage points, the effect of the stimulation on the rest of the euro zone is therefore low, and depends on Germany’s share of exports to Spain and the weight of Spanish exports in Spanish GDP. Ultimately, a German recovery would undoubtedly be good news for Germany, but the other euro zone countries may be disappointed, just as they undoubtedly will be from the implementation of the minimum wage, at least in the short term, as is suggested by Odile Chagny and Sabine Le Bayon in a recent post. We can also assume that in the longer term the German recovery would help to raise prices in Germany, thereby degrading competitiveness and providing an additional channel through which other countries in the euro zone could benefit from stronger growth.

And what would happen if the same level of fiscal stimulus were applied not in Germany, but rather in Spain, where the output gap is more substantial? In fact, the simulation of an equivalent fiscal shock (27.5 billion euros a year for three years, or 2.6 points of Spanish GDP) in Spain would be much more beneficial for Spain but also for the euro zone. While in the case of a German stimulus, growth in the euro zone would increase by 0.2 percentage points over the first three years, it would increase by an average of 0.5 points per year for three years in the event of a stimulus implemented in Spain. These simulations suggest that if we are to boost growth in the euro zone, it would be best to do this in the countries with the largest output gap. It is more effective to spend public funds in Spain than in Germany.

In the absence of any relaxation of the fiscal constraints on Spain, a stimulus plan funded by a European loan, whose main beneficiaries would be the countries most heavily affected by the crisis, would undoubtedly be the best solution for finally putting the euro zone on a path towards a dynamic and sustainable recovery. The French and German discussions of an investment initiative are therefore welcome. Hopefully, they will lead to the adoption of an ambitious plan to boost growth in Europe.

[1] The measure is then compensated in a strictly equivalent way so that the shock amounts to a transient fiscal shock.

[2] Recall that the fiscal multiplier reflects the impact of fiscal policy on economic activity. Thus, for one GDP point of fiscal stimulus (or respectively, tightening), the level of activity increases (respectively, decreases) by k points.

By Christophe Blot, Jérôme Creel, Paul Hubert and Fabien Labondance

The financial crisis has sparked debate about the role of the central banks and monetary policy before, during and after the economic crisis. The prevailing consensus on the role of the central banks is eroding. Having price stability as the sole objective is giving way to the conception of a triple mandate that includes inflation, growth and financial stability. This is de facto the orientation that is being set for the ECB. We delve into this situation in one of the articles of the OFCE issue entitled Reforming Europe [1], in which we discuss the implementation of these three objectives.

The exclusive pursuit of the goal of price stability is now insufficient to ensure macroeconomic and financial stability. [2] A new paradigm is emerging in which the central banks need to simultaneously ensure price stability, growth and financial stability. This has been the orientation of recent institutional changes in the ECB, including its new responsibility for micro-prudential supervision. [3] Furthermore, the conduct of the euro zone’s monetary policy shows that the ECB has also remained attentive to trends in growth[4]. But if the ECB is indeed pursuing a triple mandate, what then is the proper relationship between these missions?

The crucial need for coordination between the different actors in charge of monetary policy, financial regulation and fiscal policy is lacking in the current architecture. Furthermore, certain practices need to be clarified. The ECB has played the role of lender of last resort (with banks and to a lesser extent States) even though it has not specifically been assigned this role. Finally, in a new framework in which the ECB plays a greater role in determining the euro zone’s macroeconomic and financial balance, we believe it is necessary to strengthen the democratic accountability of the Bank. The definition of its objectives in the Maastricht Treaty in fact gives it strong autonomy in interpretation (see in particular the discussion by Christophe Blot, here). Moreover, while the ECB regularly reports on its work to the European Parliament, the latter does not have any way to direct this [5].

Based on these observations, we discuss several proposals for coordinating the ECB’s three objectives more effectively henceforth:

1 – Even without modifying the treaties in force, it is important that the heads of the ECB be more explicit about the different objectives being pursued [6]. The declared priority of price stability no longer corresponds to the practice of monetary policy: growth seems to be an essential objective, as is financial stability. More transparency would make monetary policy more credible and certainly more effective in preventing another financial and banking crisis in particular. The use of exchange rate policy [7] should not be overlooked, as it can play a role in reducing macroeconomic imbalances within the euro zone.

2 – In the absence of such clarification, the ECB’s extensive independence needs to be challenged so that it comes up to international standards in this area. Central banks rarely have independence in deciding their objectives: for example, the US Federal Reserve pursues an explicit dual mandate, while the Bank of England’s actions target institutionalized inflation. An explicit triple mandate could be imposed on the ECB by the governments, with the heads of the ECB then needing to make effective tradeoffs between these objectives.

3 – The increase in the number of objectives pursued has made it more difficult to deal with tradeoffs between them. This is particularly so given that the ECB has de facto embarked on a policy of managing the public debt, which now exposes it to the problem of the sustainability of Europe’s public finances. The ECB’s mandate should therefore explicitly spell out its role as lender of last resort, a normal task of central banks, which would clarify the need for closer coordination between governments and the ECB.

4 – Rather than calling the ECB’s independence completely into question, which would never win unanimity among the Member States, we call for the creation ex nihilo of a body to supervise the ECB. This could emanate from the European Parliament, which is responsible for discussing and analyzing the relevance of the monetary policy established with respect to the ECB’s expanded objectives: price stability, growth, financial stability and the sustainability of the public finances. The ECB would then not only be invited to report on its policy – as it is already doing to Parliament and through public debate – but it could also see its objectives occasionally redefined. This “supervisory body” could for example propose quantified inflation targets or unemployment targets.

[1] Reforming Europe, edited by Christophe Blot, Olivier Rozenberg, Francesco Saraceno and Imola Streho, Revue de l’OFCE, no. 134, May 2014. This issue is available in French and English and has been the subject of a post on the OFCE blog.

[2] This link is examined in “Assessing the Link between Price and Financial Stability“ (2014),  Christophe Blot, Jérôme Creel, Paul Hubert, Fabien Labondance and Francesco Saraceno, Document de travail de l’OFCE, 2014-2.

[3] The implementation of the banking union gives the ECB a role in financial regulation (Decision of the Council of the European Union of 15 October 2013). It is henceforth in charge of banking supervision (particularly credit institutions considered “significant”) in the Single supervisory mechanism (SSM). As of autumn 2014, the ECB will be responsible for micro-prudential policy, in close cooperation with national organizations and institutions. See the article by Jean-Paul Pollin, “Beyond the banking union”, in Revue de l’OFCE, Reforming Europe .

[4] Castro (2011), “Can central banks’ monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?”, Journal of Financial Stability vol.7(4), p. 228-246. This paper uses an estimation of Taylor rules between 1991:1 and 2007:12 to show that the ECB reacted significantly to inflation and to the output gap.

[5] In the United States, the mandate of the Federal Reserve is set by Congress, which then has a right of supervision and can therefore amend the Fed’s articles and mandate.

[6] Beyond clarifying objectives in terms of inflation and growth, the central bank’s fundamental objective is to ensure confidence in the currency.

[7] This issue is considered in part in a recent OFCE post.

Christophe Blot and Fabien Labondance

As expected, on 5 June 2014 the European Central Bank (ECB) unleashed an arsenal of new unconventional measures. The aim is to curb deflationary tendencies in the euro zone. Among the measures announced, the ECB decided in particular to apply a negative interest rate to deposit facilities. This unprecedented step deserves an explanation.

Note that since July 2012, the rate on deposit facilities has been 0%. It now falls to -0.10%, meaning that a bank depositing cash at the ECB will have its deposit reduced by that rate. Before considering the repercussions of this measure, it is worth clarifying the role of deposit facilities. The ECB’s activity is baed on loans to credit institutions in the euro zone through the channel of main refinancing operations (MRO) or long-term refinancing operations (LTRO). Prior to the crisis, these operations were conducted at variable rates based on an auction mechanism, but since October 2008 they have been conducted at fixed rates. The refinancing operation rates must allow the ECB to influence the rate charged by credit institutions for interbank loans (Euro OverNight Index Average rates, or Eonia) and, through this channel, the entire range of bank rates and market rates. To ensure the Eonia is not too volatile, the ECB provides the banks with two facilities: credit facilities, enabling them to borrow from the ECB for a period of 24 hours, and deposit facilities, enabling them to make cash deposits with the ECB for a period of 24 hours. In case of a liquidity crisis, the banks thus have a guarantee of being able to lend or borrow via the ECB, at a higher for credit facilities or a lower rate for deposit facilities. These rates can then be used to regulate fluctuations in the Eonia, as shown in Figure 1.

In practice, until the collapse of Lehman Brothers in September 2008, banks made little use of deposit facilities, indicating that the interbank market was functioning normally. The situation has radically changed since then, and the amount of deposits left with the ECB has fluctuated to a greater or lesser extent, depending on concerns over the sovereign bond crisis (Figure 2). The height of the crisis in spring 2012 coincided with a peak in the amounts deposited by the banks, which had excess liquidity. Over a period of three months, around 800 billion euros (equivalent to just under 10% of euro zone GDP), paid at 0.25%, were deposited by Europe’s banks. In the context of fear of a euro zone collapse and uncertainty about the financial situation of financial and non-financial agents, the banks have been depositing poorly compensated sums with the ECB. They chose to do this rather than to exchange the excess liquidity in the money market or support activity by lending to companies or buying shares. It was not until Mario Draghi’s statement in July 2012 that the ECB would do “whatever it takes” to support the euro zone that confidence returned and these sums fell. It was also then that the rate went down to 0%, further reducing the incentive to use the deposit facilities. The level of deposits fell by half, from 795.2 billion euros to 386.8 billion. Since then, they have declined gradually, but are still high, especially given that they receive no interest. In the last week of May 2014, there were still 40 billion euros in deposits (Figure 2).

This situation prompted the ECB to set a negative rate in order to encourage commercial banks to reallocate this money. We can be sure that once the negative rate applies, the level of deposits will quickly drop to zero. Even so, this will mean an impulse of only 40 billion euros, and further action will be needed to support the real economy. On its own, this step by the ECB has certainly not convinced the markets that it has dealt with the situation.

The ECB has thus once again demonstrated its proactive approach to curbing the risks facing the euro area. Its reaction can be compared to the response of Europe’s other institutions, which have struggled to fully take on board the depth of the crisis. Looking outside the euro zone, it is noteworthy that the US Federal Reserve and the Bank of England moved with greater speed, even though the risk of deflation was lower in the United States and the United Kingdom. This active approach is perhaps no stranger to the renewed growth seen in these countries. The ECB’s action is therefore welcome. Now we need to hope that it will stave off the risk of deflation hanging over the euro zone, a risk that could have been avoided if the euro zone’s governments had not generally adopted austerity policies, and if the ECB had taken less of a wait-and-see attitude.

By Christophe Blot and Francesco Saraceno

The European elections were marked by low turnouts and increasing support for Eurosceptic parties. These two elements reflect a wave of mistrust vis-à-vis European institutions, which can also be seen in confidence surveys and in the increasingly loud debate about a return to national currencies. The controversy over a country leaving the euro zone or even the breakup of the monetary union itself started with the Greek crisis in 2010. It then grew more strident as the euro zone sank into crisis. The issue of leaving the euro is no longer taboo. If the creation of the euro was unprecedented in monetary history, its collapse would be none the less so. Indeed, an analysis of historical precedents in this field shows that they cannot serve as a point of comparison for the euro zone.

Although there seem to be a number of cases where monetary unions split apart, few are comparable to the European Monetary Union. Between 1865 and 1927, the Latin Monetary Union laid the foundations for closer monetary cooperation among its member states. This monetary arrangement involved a gold standard regime that established a principle of monetary uniformity with a guarantee that the currencies set up by each member state could move freely within the area. Given the absence of a single currency created ex nihilo as is the case today with the euro, the dissolution of the Union that occurred in 1927 holds little interest for the current debate. In fact, experts in monetary unions instead characterise this type of experience as “areas of common standards”. A study in 2007 by Andrew Rose (see here) assesses 69 cases of exits from a currency union since the Second World War, which would indicate that there is nothing unique about the break-up of the euro zone. However, this sample of countries that have left a currency union cannot really be used to draw meaningful lessons. A large number of these cases involve countries that gained their political independence in the process of decolonization. These were also small developing economies whose macroeconomic and financial situations are very different from those of France or Greece in 2014. The most recent experience was the break-up of the rouble zone, following the collapse of the USSR, and of Yugoslavia, both of which involved economies that were not very open commercially or financially to the rest of the world. In these circumstances, the impact on a country’s competitiveness or financial stability of a return to the national currency and any subsequent exchange rate adjustments are not commensurate with what would happen in the case of a return to the franc, the peseta or the lira. The relatively untroubled separation of the Czech Republic and Slovakia in 1993 also involved economies that were not very open. Finally, the experience most like that of the EMU undoubtedly involves the Austro-Hungarian Union, which lasted from 1867 to 1918. It had a common central bank in charge of monetary control but no fiscal union [1], with each State enjoying full budgetary prerogatives except with regard to expenditure on defence and foreign policy. It should be added that this Union as such could not go into debt, as the common budget had to be balanced. While the Union established trade and financial relations with many other countries, it is important to note that its break-up occurred in the very specific context of the First World War. It was thus on the ruins of the Austro-Hungarian Empire that new nations and new currencies were formed.

It must therefore be concluded that monetary history does not tell us much about what happens at the end of a monetary union. Given this, attempts to evaluate a scenario involving an exit from the euro are subject to a level of uncertainty that we would call “radical”. While it might be possible to identify certain positive or negative results of exiting the euro, going beyond this to give specific calculations of the costs and benefits of a break-up comes closer to writing fiction than to robust scientific analysis. As for the positive side, it can always be argued that the effects on competitiveness of a devaluation can be quantified. Eric Heyer and Bruno Ducoudré have performed such an exercise for a possible fall in the euro. But who can say how much the franc would depreciate in the case of an exit from the euro zone? How would other countries react if France left the euro zone? Would Spain leave too? In which case, how much would the peseta fall in value​​? The number of these variables and their potential interactions lead to such a multiplicity of scenarios that no economist can foresee the result in good faith, let alone calculate it. The exchange rates between the new European currencies would once again be determined by the markets. This could result in a panic comparable to the currency crisis experienced by the countries in the European Monetary System (EMS) in 1992.

And what about the debt of the private and public agents of the country (or countries) pulling out? The legal experts are divided about what share would be converted by force of law into the new currency (or currencies) and what would remain denominated in euros, which would add to agents’ debt burden. So it is likely that an exit would be followed by a proliferation of litigation, with unpredictable outcomes. After the Mexican crisis in 1994, and again during the Asian crisis in 1998, both of which were followed by devaluations, there was an increase in agents’ debt, including government debt. Devaluation could therefore increase the problems facing the public finances while also creating difficulties for the banking system, as a significant share of the debt of private agents is held abroad (see Anne-Laure Delatte). The risk of numerous private defaults could therefore be added to the risk of default on the public debt. How would one measure the magnitude of such impacts? Or the increase in the default rate? What about the risk that all or part of the banking system might collapse? How would depositors respond to a bank panic? What if they seek to prop up the value of their assets by keeping deposits in euros and opening accounts in countries that they consider safer? A wave of runs on deposits would follow, threatening the very stability of the banking system. It might be argued that, upon regaining autonomy for our monetary policy, the central bank would implement an ultra-expansionary policy, the State would gain some financial leeway, put an end to austerity and protect the banking system and French industry, and capital controls would be re-established in order to avoid a bank run … But once again, predicting how such a complex process would unfold amounts to astrology … And if the example of Argentina [2] in late 2001 is cited to argue that it is possible to recover from a currency crisis, the context in which the end of the “currency board” took place there should not be forgotten[3]: a deep financial, social and political crisis that does not really have a point of comparison, except perhaps Greece.

In these circumstances, we believe that attempting to assess the cost and benefits of leaving the euro leads to a sterile debate. The only question worth asking concerns the political and economic European project. The creation of the euro was a political choice – as would be its end. We must break with a sclerotic vision of a European debate that opposes proponents of leaving the euro to those who endlessly tout the success of European integration. There are many avenues open for reform, as has been demonstrated by some recent initiatives (Manifesto for a euro political union) as well as by the contributions collected in issue 134 of the Revue de l’OFCE entitled “Réformer l’Europe”. It is urgent that all European institutions (the new European Commission, the European Council, the European Parliament, but also the Eurogroup) take up these questions and rekindle the debate about the European project.

[1] For a more detailed analysis of comparisons that can be drawn between the European Monetary Union and Austro-Hungary, see Christophe Blot and Fabien Labondance (2013): “Réformer la zone euro: un retour d’expériences”, Revue du Marché Commun et de l’Union européenne, no. 566.

[2] Note that Argentina was not in a monetary union but rather under what was called a “currency board”. See here for a classification and description of various exchange rate regimes.

[3] See Jérôme Sgard (2002): “L’Argentine un an après: de la crise monétaire à la crise financière”, Lettre du Cepii, no. 218.

by Christophe Blot [1], Olivier Rozenberg [2], Francesco Saraceno [3] et Imola Streho [4]

From May 22 to May 25 Europeans will vote to elect the 751 Members of the European Parliament. These elections will take place in a context of strong mistrust for European institutions. While the crisis of confidence is not specifically European, in the Old Continent it is coupled with the hardest crisis since the Great Depression, and with a political crisis that shows the incapacity of European institutions to reach decisions. The issues at stake in the next European elections, therefore, have multiple dimensions that require a multidisciplinary approach. The latest issue of the Debates and Policies Revue de l’OFCE series (published in French and in English), gathers European affairs specialists – economists, law scholars, political scientists – who starting from the debate within their own discipline, share their vision on the reforms that are needed to give new life to the European project. Our goal is to feed the public debate through short policy briefs containing specific policy recommendations. Our target are obviously the candidates to the European elections, but also unions, entrepreneurs, civil society at large and, above all, citizens interested by European issues.

In the context of the current crisis, the debate leading to the next European elections seems to be hostage of two opposing views. On one side a sort of self-complacency that borders denial about the crisis that is still choking the Eurozone and Europe at large. According to this view, the survival of the euro should be reason enough to be satisfied with the policies followed so far, and the European institutions evolved in the right direction in order to better face future challenges.

At the opposite, the eurosceptic view puts forward the fundamental flaws of the single currency, arguing that the only way out of the crisis would be a return to national currencies. The different contributions of this volume aim at going beyond these polar views. The crisis highlighted the shortcomings of EU institutions, and the inadequacy of economic policies centered on fiscal discipline alone. True, some reforms have been implemented; but they are not enough, when they do not go in the wrong direction altogether. We refuse nevertheless to conclude that no meaningful reform can be implemented, and that the European project has no future.

The debate on Europe’s future and on a better and more democratic Union needs to be revived. We need to discuss ways to implement more efficient governance, and public policies adapted to the challenges we face. The reader nevertheless will not find, in this volume, a coherent project; rather, we offer eclectic and sometimes even contradictory views on the direction Europe should take. This diversity witnesses the necessity of a public debate that we wish to go beyond academic circles and involves policy makers and citizens. Our ambition is to provide keys to interpret the current stakes of the European debate, and to form an opinion on the direction that our common project should take.

__________________________________________________________________

[1] OFCE, Sciences Po

[2] Sciences Po, Centre d’études européennes

[3] OFCE, Sciences Po, (@fsaraceno)

[4] Sciences Po, Ecole de droit et Centre d’études européennes

By Céline Antonin, Christophe Blot, Sabine Le Bayon and Danielle Schweisguth

This text summarizes the OFCE’s forecast for 2014-2015 for the euro zone economy

Will the euro zone embark on the road to recovery, or will it sink into a deflationary spiral? The latest macroeconomic indicators are sending out conflicting signals. A return to growth is being confirmed, with three consecutive quarters of rising GDP. However, the level of unemployment in the euro zone remains at a historically high level (11.9% for the month of February 2014), which is fuelling deflationary pressures, as is confirmed by the latest figures on inflation (0.5% yoy for March 2014). While this reduction in inflation is partly due to changes in energy prices, the fact remains that underlying inflation has fallen under 1% (Figure 1). In these conditions, a turnaround in inflationary expectations cannot be excluded, which would undoubtedly push the euro zone into deflation. The ECB has been concerned about this situation for several weeks and says it is ready to act (see here). However, no concrete proposal for a way to ease monetary policy and ensure that expectations are not anchored on a deflationary trajectory has been set out.

After a fall in GDP of 0.4% in 2013, the euro zone will return to positive growth: 1.3% in 2014 and 1.6% in 2015. Even so, at this rate of growth, there will still be an open output gap in most of the euro zone countries, reflecting the idea that the euro zone is only slowly pulling out of the crisis. Indeed, although efforts to reduce deficits will be curtailed, fiscal policies will still be pro-cyclical. Furthermore, financing conditions will continue to improve. The end of the sovereign debt crisis, thanks in particular to the announcements by the ECB in July and September 2012 [1], has reduced the risk premiums on the market for government bonds. The impact of lower long-term market rates has been partly reflected in bank interest rates, and credit supply conditions are generally less restrictive than they were between early 2012 and mid-2013. But there will still not be sufficient growth to trigger a recovery strong enough to lead to a rapid and significant reduction in unemployment. Indeed, the level will fall only very moderately, from 11.9% in the first quarter of 2014 to 11.3% at year end 2015. While Germany will enjoy almost full employment, mass joblessness in Spain and the other countries of southern Europe will persist (Figure 2). Unemployment should stabilize in Italy and continue to grow in France.

However, this continuing underemployment is giving rise to the risk of deflation. It is holding back growth in wages and contributing to the weakness of underlying inflation, which was in fact zero in Spain in March 2013 and negative in Greece and Portugal. For the euro zone as a whole, we do not expect deflation in the short term, but the weakness of growth is increasing the likelihood that private agents’ expectations are not anchored in a deflationary scenario.

The situation in the euro zone is reminiscent of Japan in the 2000s. The country began to experience deflation in 1999 [2] following the recession associated with the Asian crisis. At that point, despite average growth of 1.4% between 2000 and 2006, prices failed to pick up, and the country’s central bank did not find a way out of this trap, despite trying expansionary monetary policies. This is precisely the dynamic threatening the euro zone today, making it crucial to use all possible means to avoid this (monetary policy, fiscal policy and the coordination of wage policy [3]).

[1] In July, ECB President Mario Draghi declared that the central bank would save the euro “whatever it takes”. In September, the ECB announced the creation of a new mechanism called Outright Monetary Transactions (see the post by Jérôme Creel and Xavier Timbeau), which enables it to engage in unlimited purchases of sovereign debt.

[2] It should be pointed out that there was an initial period of deflation in 1995 following three years of economic stagnation.

[3] All these elements are discussed in detail in the previous iAGS report (2014).