ECB PERFORMANCE: FROM ORIGINS TO THE BANKING CRISIS OF 2008
During the period from its origins in 1999 to the banking crash of 2008-09, the ECB’s primary central banking function was limited to managing the money supply. The ECB had no bank supervision function at this time, which remained in the hands of the national central banks. Nor was there any test of its function as lender of last resort. The central bank was tasked primarily with launching the Euro as the new currency and the task of converting national currencies to the new one until around 2002; thereafter providing sufficient liquidity to fuel the boom in intra-Eurozone exports and imports that escalated from roughly 2003 to 2007. This was a period of financial asset bubbles that mostly impacted economies outside the Eurozone: the global currency crisis of 1997-98 affected mostly Asian economies, the series of sovereign debt crises that followed impacted select emerging market economies and east Europe, and the dotcom tech bust of 2000-02 involved mostly North America and Japan. The ECB was allowed to focus on managing the new Euro money supply, targeting price stability, and employing its key interest rates of marginal lending facility (MLF) and discount facility (DF) as the primary tools for injecting liquidity into the new regional economy.
It is a well-known fact that when the Eurozone countries began the conversion of their domestic currencies to the Euro, Germany and other northern core economies’ currencies were overvalued. They thus received an excessive share of the Euro allotments.
The M1 money supply grew by 104% from 1999 through 2006, as the ECB pumped excessive liquidity into the regional economy in order to jumpstart intra-Eurozone trade, which was heavily weighted as exports from the core northern Europe economies of Germany-Netherlands-Belgium-France to the periphery economies of southern Europe and Ireland. That expansion of liquidity was nearly 25% faster than GDP economic growth during the same period. In other words, the money supply was increased at a greater rate than the rate of real economic growth. Rising at double digit rates annually, the excess liquidity was in turn reflected in total Eurozone bank credit, which rose at an annual rate of 6.72% from 1999 through October 2007. Banks were taking the ECB liquidity and lending it out at a rapid rate. Where was the bank lending going? From the northern core banks to the periphery economies.
Core banks were lending to private banks in the periphery, as well as to periphery private businesses directly. They expanded their operations in the periphery, including investing into partnerships and buying into periphery banks. Non-bank corporations in the core economies were also funneling loans from their core banks as direct investment into the periphery economies, expanding operations there, making acquisitions, launching new subsidiaries. Their borrowings from their core banks were redirected to the periphery in turn. The ECB was also providing liquidity to the NCBs in the periphery economies, which were then also lending to their private banks and non-bank businesses. Money capital was flowing from core to periphery in volume through various channels throughout the 1999 to 2007 period.
Much of the inflow of capital was going to finance housing and commercial property investment, especially in the economies of Spain, Portugal, and Ireland where property booms were growing. By mid-decade, the credit flowing to the periphery was also increasingly employed to purchase northern core export goods, especially from Germany. That country had compressed wages and retooled its manufacturing as it implemented its version of the EMU’s Lisbon Plan, which called for austerity and labor reforms to reduce labor costs to make export goods more competitive. Germany thereafter began to gain an ever-greater share of total exports within the Eurozone. The Euro conversion made it the pre-eminent production for exports powerhouse within the Eurozone after 2004-05.
While the lending of the excess liquidity and money capital to the periphery enabled an explosion of property investing, as well as acquisitions of periphery banks and businesses by core banks and businesses, it also raised general income levels in the periphery that enabled consumers and businesses there to purchase the ever-rising volume of German-core exports to their periphery economies. In short, as a consequence of the core bank lending, core businesses’ direct investment into the periphery, and the rising standard of living in the peripheries, the money capital was flowing to the periphery economies and then recycling right back to the core as interest payments to core banks and as purchases for core exports. German-core banks and businesses were enjoying record profits from production for exports, as well as from investment and speculation on rising property prices in the periphery. But the credit extension to the periphery enabling it all was meanwhile piling up debt in the periphery economies.
It is important to note, however, that this debt buildup was initially largely private sector debt, and not sovereign debt. While some government spending was also increasing to provide infrastructure expansion in the periphery and as social payments to sectors of the populace not directly benefiting from the property and export booms—enabled by rising GDP and tax revenues that were occurring—government debt as a percent of GDP was not accelerating particularly excessively in the periphery economies from 1999 through 2006. That government or sovereign debt would not escalate rapidly until the banking crash of 2008-09, and the shift of private sector debt in the periphery to periphery governments that occurred after 2008.
When the 2008-09 crash came, the inflows of credit to the periphery dried up. But the debt repayments from the prior credit-debt buildup remained to be paid. Thereafter, money and liquidity provided to the periphery economies would increasingly assume the form of additional loans—i.e. debt—in order to make payments on the previously accumulated debt. Credit and debt was extended to repay debt. And fiscal austerity was imposed on the periphery economies as the means to finance the debt repayments in exchange for the EC-IMF-ECB (called the ‘Troika’) providing more debt to repay debt.
It was a vicious downward cycle, but nonetheless one with origins in the excessive liquidity injections of the ECB during the 1999-2007 period—excess liquidity that led to excessive private debt accumulation in the periphery economies that would transform into sovereign debt after 2008. One might therefore reasonably conclude that the ECB’s central bank function of managing the money supply was not so well performed in the run-up to the 2008 crisis. Indeed, the debt it enabled was central to the crisis and its aftermath.
ECB PERFORMANCE FROM BANKING CRISIS TO QE: 2008 to 2015
The ECB’s interest rate management policies also clearly contributed to the 2008 crisis and, for Europe, the even more serious 2010-2013 double dip recession and related sovereign debt crises that wracked the periphery economies from 2010 to 2014.
As the general Eurozone economy heated up by 2006, the ECB began to raise its key interest rates, the marginal lending facility (MLF), and discount facility (DF). But it continued raising rates for too long—for an entire year from March 2007 through July 2008, well after it was clear that a property bubble was already contracting. Only after the US banking crash in September-October 2008, did it shift course. Even then it was not particularly aggressive in reducing rates. The ECB similarly proceeded slowly in injecting liquidity into the banks, that were now beginning to hoard cash as their financial assets and balance sheets began to collapse.
Even more damaging was the ECB’s reversal of interest rates at the worst possible time. Instead of continuing to reduce rates, in April 2011 it raised rates again just as the Euro economy was sliding into its second, double dip recession. The 2011-2013 recession was in some ways even worse than the 2008-09 global contraction and the ECB was at least partly responsible for precipitating it by raising rates in 2011 into the economic downturn. In short, ECB interest rate policies were counterproductive, both in 2007-08 and again in 2011. These inopportune shifts were clearly demonstrated the central bank’s poor performance so far as management of its traditional monetary policy tools was concerned.
Money Supply Function
While the US and UK central banks quickly engaged in non-traditional, experimental tools to more quickly inject liquidity into their collapsing banking systems, the ECB did not. It would not turn to tools like quantitative easing until 2015. In the interim, it attempted to provide liquidity to Euro banks by expanding its traditional bond buying operations and tweaking new approaches.
The problem in banking crises is that liquidity quickly dries up. The prior excessive liquidity injections, accumulated before the crash, end up being hoarded by banks once the crisis emerges. Liquidity may also get wiped out by widespread financial asset price collapse, defaults, and bankruptcies. Losses on banks’ balance sheets exceed banks assets and liquidity that remain. Banks then stop issuing credit, i.e. lending, to non-bank businesses. A credit crunch ensues (or a more serious credit crash, where no loans are available). Unable to borrow from banks that won’t lend, non-bank businesses severely cut back production and beginning mass layoffs, cutting wages and benefits, and suspending payments to banks for loans they previously took out. The banks and financial sector thus propagate the financial crisis to the non-financial side of the economy. Non-bank businesses’ suspension of repaying the principal and interest on their debt to the banks lead to further bank losses and curtailment of credit. The real economy thus causes a further deterioration in the financial sector. And on it goes, vice versa, in a downward spiral of general contraction. Prices for goods and services as well as for financial securities together stagnate and then deflate. With deflation, the value of the prior debt incurred that remains actually rises in real terms even further. It’s a nasty cycle that requires action to break the causal relations that continue to feed upon themselves. Somehow price deflation must be checked and reversed, and begin to rise again—or the massive debt overhang must be offloaded from the banks, businesses, and households’ balance sheet. Or the banks must be allowed to go under. From their perspective, unthinkable—not only from the precedent it may set but also from the contagion effects, unknown even to the banks, that the complex relationships of inter-bank debt might lead to!
The central bank’s task in such conditions is to get the banks to lend once again. But that’s easier said than done. The central bank can provide extra liquidity to the banks and lower the cost of borrowing (interest rates) from the banks, but if non-bank businesses and household consumers’ incomes are declining due to the recession in the real economy, it doesn’t matter how low interest rates go or how much money supply banks may have on hand to lend. The demand for credit takes precedence over the cost of credit (rates) and if credit demand is contracting faster than interest rates or liquidity injection, bank lending won’t result. So the central bank keeps lowering interest rates and futilely pumping more and more liquidity into the banks hoping if they have a massive excess to lend, some of it will leak out into the real economy.
A problem in recent decades is the excess liquidity provided by the central bank to the banking system produces an insufficient ‘leakage’. The banks take the central bank’s liquidity but then may simply hoard it on their balance sheets. Or loan it to the ‘safest’, large multinational corporations that redirect it to offshore markets and investment. Or the bank loans are used to speculate in financial asset markets that typically recover before the real economy. Or non-bank businesses borrow the money from the banks and use the credit to buy back their company’s stock or increase their payout of dividends to shareholders. In all these ‘leakage’ events, the consequence is bank lending does not recover despite the emergency liquidity injection programs of the central bank. The liquidity doesn’t get where it is intended, in other words, and the real economy continues to stagnate for lack of borrowing for the purpose of real investment. That’s exactly what happened in the case of the ECB after 2008—as it did with the US and UK economies.
An added problem in the ECB case was that the central bank’s emergency liquidity injections in 2008-09 weren’t even as aggressive as the US and UK. They were not as large and they came late. And, unlike the US and UK economies, the Eurozone lacked what are called ‘capital markets’. These are alternative sources for borrowing by non-bank businesses apart from traditional banks. In the Eurozone more than 80% of all sources of credit come from the traditional banks. The Eurozone still has undeveloped capital markets. The combination of weaker initial liquidity injections by the ECB, undeveloped capital markets, and the greater relative reliance on traditional banks for loans meant that bank lending stagnated even more in Europe after the 2008-09 crash than it did in the US and UK.
Furthermore, the ECB was still raising rates in mid-2008 as the global crisis was unfolding. It started lowering rates late into the crisis by October 2008, but then did so relatively slowly., The ECB’s main rates, MLF and DF, were reduced from peak highs in July 2008 of 5.25% and 3.25%, to 3% and 2%, respectively by year end 2008, while the US Federal Reserve, in contrast, lowered its key federal funds ten times in 2008, thus far more aggressively as the crisis erupted, and by December 2008 had reduced the rate to a mere 0.15%. It was virtually free money for the banks.
Similarly, with regard to non-traditional liquidity programs, the US Fed immediately introduced special programs in 2008 that provided an additional $1.159 trillion to US banks and financial markets by the end of December 2008, while the ECB simply tweaked an existing program called the Long Term Refinancing Option (LTRO), by raising the duration of loans to banks from 3 months to 6 months. Furthermore, to get the LTRO loans the banks had to put up certain narrowly defined collateral which many did not have. The ECB’s increase in short term lending accomplished little in terms of stimulating bank lending to non-banks. What the banking system needed was more long term lending to banks—without collateral of any kind if necessary— if the banks were to resume lending again to non-bank businesses in turn. More free money, in short.
The ECB was reluctant to do that. Continuing its go-slow liquidity strategy the ECB diverged even further from the US in 2009. As the US central bank launched even more liquidity programs, the ECB virtually stopped expanding even its traditional programs. It wasn’t until May 2009 that the ECB again raised its LTRO lending, and then modestly, by offering loans of 12 months duration instead of three and six months. And not until July 2009 did the central bank introduce its first new program, the Covered Bond Purchase Program (CBPP). However, the CBPP was limited to liquidity totaling only a token 60 billion Euros.
Meanwhile, Euro banks’ lending was rapidly drying up. From the 6.7% annual average growth of total credit by EU banks, from 1999 through 2007, in 2008-09 annual bank credit growth declined to 3.14%. Thereafter, in each of the next five years, 2009 through 2014, bank credit would collapse to an annual average growth of only 0.8% over the five year period. Bank lending had virtually stopped. Real economic activity in the region slowed sharply thereafter, and with it, government tax revenues. In 2008 Europe’s GDP declined from $14.1 trillion to $12.9 trillion. It would fall again in 2009 and thereafter essentially stagnate over the next five years while bank lending continued to either decline or stagnate as well.
The stagnating Euro real economy was producing rising deficits and government debt in the periphery economies. According to the Bank of International Settlements (BIS), the northern Europe core banks were exposed to $1.579 trillion in periphery economy government debt by 2010. In May 2010, the ECB therefore launched what it called the Securities Markets Program (SMP), which involved ECB indirect purchases of sovereign bonds and other securities. Over the next two years up to 210 billion Euros of liquidity would be provided through the SMP. But in 2010 and 2011 it was not enough or fast enough to contain the sovereign debt crises that were deepening in the periphery.
The damage from the ECB’s delays in 2008 in rate reductions and its insufficient liquidity injections were growing evident. By 2010 the ECB and Eurozone was now also facing a general sovereign debt crisis throughout its periphery, focused on Greece and Ireland but also Portugal. New non-ECB sources of liquidity had to be created to refinance the periphery governments’ debt—this time raised by the European Commission instead of the ECB. These new programs were the European Financial Stability Facility (EFSF), created in 2010, and succeeded by the European Stability Mechanism (ESM) in 2012.
The EFSF was set up as a private corporation in Luxembourg. Euro member states each contributed financing in the form of guarantees of the bonds that were to be issued by the EFSF, up to a total of 440 billion euros. The EFSF was authorized to issue and sell bonds up to 440 billion. A fund was established from the bond sales proceeds from which Governments in trouble—i.e. Greece, Ireland, etc.—could borrow. The borrowed funds could be used to bail out their private domestic banks. So it offered not just a government bailout but also a way to provide liquidity to banks in trouble. However, there was a hitch. A condition of borrowing was that the governments had to introduce fiscal austerity measures to reduce their spending to ensure they could repay the loans from the EFSF. The governments thus incurred additional debt with which to bail out their banks even though “The chief aim of the exercise was to help banks strengthen their balance sheets rather than support struggling peripheral states”.
More ECB liquidity measures followed targeting injection of funds into the national central banks and/or their domestic banking systems. In July 2011 the 6 month LTRO program was extended, followed by a far more massive much longer term, 3 year LTRO program that provided 489 billion euros to 523 banks at year end 2011. The ECB allowed a broader definition of collateral for these loans. It also reduced the banks’ reserve requirement, releasing another 110 billion euros for potential lending.
Conditions continued to deteriorate into 2012. Spain and Italy could not obtain new loans to refinance their debt. Speculators were destabilizing government bond prices. Deflation was growing. It was feared that the Euro system itself might implode. The ECB quickly reversed its interest rate direction and cut rates. It was at this time that ECB chair, Mario Draghi, made his famous public declaration in July 2012 that the central bank would “do whatever it takes’ to bail out the banks, stimulate lending again, and get the real economy growing once more. He immediately introduced yet another new bond buying program in September 2012 called the OMT (Outright Monetary Transactions), which promised to potentially buy an unlimited amount of bonds and thus provide ‘whatever it takes’ in liquidity injection. The prior SMP program was rolled into the new OMT. The OMT is estimated to have added another 600 billion euros, inclusive of the remaining SMP liquidity.
In short, an institutional framework for addressing liquidity needs of both governments and banks was being created ‘on the fly’ as the crisis continued and deepened in 2012. But the proliferation of liquidity programs were still just variations on the theme of adjusting or tweaking existing approaches to liquidity provisioning by the ECB. The liquidity provided by all these measures from May 2010 through 2012 did not reflect a significant rise in the M1 money supply—i.e. which meant the liquidity was not being loaned out and getting to the economy at large. From January 2010 through 2012 the M1 for the Eurozone rose from 4.53 trillion euros to only 5.10 trillion.
With the recession coming to an end in early 2013, the ECB slowed its liquidity and bond buying programs. An expansion of the CBPP in 2014 added another 228 billion euros and a new Asset Backed Securities Purchasing program (ABSP) added a further 23 billion. By 2014 the ECB’s balance sheet reflecting the liquidity provided by the various programs from 2010 through 2013 had risen to a level of 2.27 trillion euros after partial repayments to the central bank. That was not appreciably higher than the ECB’s balance sheet of 2.07 in 2008. The modest net growth in the central bank’s balance sheet is another indication that the liquidity injections after 2008 were not all that effective—either in increasing the money supply or in generating bank lending.
No new programs were introduced in 2013-2014, as the worst of the recession ended. The ECB again grew complacent. Prices were essentially stagnant from spring 2013 through fall 2014 and then began to deflate by late 2014 as the Euro economy weakened again and threatened a possible third recession by late 2014. The preceding five years of liquidity injections through various traditional approaches had not resolved anything in terms of creating sustained economic recovery, rising prices, or renewed bank lending. Calls for an even more aggressive liquidity program along the lines of the US and UK ‘quantitative easing’ (QE) initiatives were raised throughout the region. The ECB prepared to embark on its own QE program for 2015, which was announced in January of that year.
Bank Supervision Function
Bank supervision has also been weak throughout much of the ECB’s history. Prior to 2008 the ECB’s authority did not extend to bank supervision. That was left to the country NCBs and other regulatory national institutions. This lack of ECB bank supervision authority would continue until late 2014.
With the eruption of the sovereign debt crisis in Europe in May 2010—behind which was a more fundamental banking crisis—proposals for providing the ECB with banking supervision authority grew. But it was only talk. Nothing much came of it throughout the period of the first sovereign debt crisis in the Euro periphery. It was only when the double dip recession of 2011-2013 threatened a collapse of the entire banking system in 2012 that serious consideration started to be given to the idea of having the ECB assume elements of the critical central bank function of bank supervision.
The event that precipitated the new consideration was the collapse of the large Spanish bank, Bankia, in May 2012, requiring tens of billions of euros to bail out from the Euro Member States’ financed ESM bailout fund. Rather than just waiting for bank collapses and pouring money after them, the idea finally dawned on members of the EC and the GC of the ECB that perhaps it might be preferable, and less costly, to properly supervise the banks in order to avoid such costly bailouts. As much as Germany disliked the idea of shifting bank supervision authority to the ECB, it disliked even more having to pay for bailouts post hoc, so it too supported the shift of supervisory authority to the ECB. The Single Supervisory Mechanism, SSM, was therefore created in November 2013. After a year of transition, the SSM took effect in November 2014.
The SSM was set up as a division within the ECB. Under the SSM the ECB was given authority to conduct on-site inspections of banks and set what are called ‘capital buffers’ at the banks, in order to protect against future bankruptcies. This was essentially ‘micro’ supervision, bank by bank. The SSM did not have authority to address ‘macro’ supervision, i.e. supervision designed to prevent a system-wide banking crisis. Nor did the SSM’s authority extend to the shadow banking sector or the wholesale debt securities markets or the derivatives markets and derivatives trading houses. There were other problems. The SSM authority extended only to the largest banks. Bank inspections required involvement of national regulators and were to be carried out jointly—i.e. an arrangement conducive to bureaucratic infighting and inertia. The information the SSM could require from the banks was also strictly limited. The largest banks’ operations elsewhere in Europe, outside the Eurozone, were subject to supervision—but only if those countries signed on to the SSM. Operations outside Europe were excluded from supervision. Another big exemption was financial institutions that did not qualify as ‘credit institutions’ under the EMU. To qualify as such, the institution had to accept retail depositors. This meant that financial entities like stock and bond brokers and dealers were not subject to SSM jurisdiction. The SSM was not even given the responsibility to monitor financial system risks and stability. That role remained with another agency altogether, the European Systemic Risk Board. Finally, there was the question of adequate staffing and resources even to perform on-site inspecting. ECB inspections and staffing have barely expanded since the SSM was established. Many critics conclude therefore that the ECB’s SSM lacks the competency and the institutional capacity to carry out the bank supervision function it assumed in late 2014.
Perhaps the best indicator of poor bank supervision record under the ECB is the chronic and significant overhang of non-performing bank loans (NPLs). NPLs that remain on bank balance sheets have a major negative impact on bank lending. Stagnant or declining bank lending in turn stifles investment that might create jobs and wage incomes that in turn might generate inflation. NPLs generally translate into reduced investment, poor wage-income growth, and therefore stagnant prices or even deflation for goods and services. When the SSM was established there was more than a trillion dollars in NPLs in the Eurozone. Two and a half years later that total has not measurably declined. Not until March 2017 did the ECB even issue guidelines as to how to address the NPL problem.
The effectiveness of the ECB’s bank supervision under the SSM has continued to fester. German discontent with the SSM’s handling of the ongoing Italian bank crisis and the Eurozone’s conservatively estimated 920 billion euro NPLs continues into 2017. The SSM has still not restructured the Italian bank, Monte dei Pasche, which is technically bankrupt. The SSM continues to stall. As Daniele Nouy, its director, replied to German critics of the SSM’s lack of progress resolving the Italian and general NPL problem, “We are definitely willing to use our powers…but we have to be fair. As supervisors, we have to demonstrate we are developing the issues with proportionate action”.
The creation of the SSM represents the belated recognition that the ECB in 2012 was not a bona fide central bank and could not therefore carry out a central bank’s primary functions. The SSM was viewed as a step toward transforming the Eurozone into a truer form of banking union. In addition to managing money supply in a stable manner, and supervising banks at both a micro and macro level, a banking union also required some form of ‘deposit insurance’ system, as well as some organization to manage what was called ‘bank resolution’—a fancy term for winding down, dismantling, merging, or otherwise financing the restructuring of banks that fail. The ECB had none of that authority before November 2014. By 2017, although it has been granted bank supervision and resolution authority it has hardly been able to exercise it for various reasons. The test case of bank resolution—i.e. Monte dei Pasche and the Italian banks in general—remains as evidence of the ECB-SSM’s general ineffectiveness at bank supervision.
Lender of Last Resort Function
There are two ways of looking at the lender of last resort function. One is how well the central bank performs in rescuing individual banks that may become insolvent. The other is a more ‘macro-prudential’ view of how well it performs in ensuring or restoring financial stability to the entire banking system in the event of a major banking crash and crisis.
Assessing the ECB’s performance with regard to the latter ‘macro’ task is difficult, since bailing out banks in a general crisis in the Eurozone before 2014 involved bailing out the national governments as well in 2010 and 2012. As shown, debt by banks is highly integrated with the debt of the national governments. By EMU rules, moreover, the ECB was precluded from directly lending to national governments. Yet national governments and their national central banks were critical to rescuing their private banking systems. Furthermore, the domestic banks of the periphery economies held large volumes of their governments’ debt in turn. As noted previously, one cannot be bailed out without bailing the other.
Given the EMU rules, in the Eurozone periphery economies from 2010 through 2013 the lender of last resort function by definition had to be a joint effort involving the ECB with the participation of the European Commission and the IMF. The EC in fact provided the major share of the direct government bailout—a kind of ‘political’ liquidity injection—while the ECB participated by providing loans to the NCBs of the countries in question—mainly Greece, Italy, Portugal, Spain and Ireland. Were the ECB (and EC-IMF) therefore successful as collective lenders of last resort? Yes, in a sense, private banks and their governments were both saved from total collapse in 2012. But did lender of last resort financing resolve anything? Were the banks fully restored? Did bank lending resume? Were the banks prevented from collapse but remain technically insolvent coming out of 2012, overloaded with non-performing loans? Here the answer is no. Much of the bad loans and non-performing loans remained on most banks’ balance sheets after 2012. The banks were rescued only temporarily. The lender of last resort function was therefore not completely fulfilled.
Targets and Tools Before QE
As noted previously, price stability was the only ‘target’ of the ECB since 1999 and remains so to this day. Targeting price stability failed during the 2008 to 2015 period. Prices stagnated at best, and often deflated on various occasions during the period. So it cannot be said that the ECB performed well in terms of achieving its target of price stability.
So far as central bank monetary tools are concerned, the ECB explored various ways to buy bonds as a means by which to provide liquidity to the private banking system, from government or sovereign bonds to ‘covered bonds’ to even asset-backed securities. More than two trillion euros were injected into the Eurozone economy by such measures. Were the tools effective? Apparently not. The ECB could not get the price level up to the target of 2%, and struggled to keep it from deflating. The bond buying did not stimulate investment and thus the real economy; the 2011-2013 severe recession occurred simultaneously with the bond buying. NPLs were not removed from banks’ balance sheets and bank lending did not improve much despite the massive injections. On the other hand, the liquidity provided jointly by the ECB, EC, and IMF did eventually stabilize the sovereign bond market, bringing soaring bond prices for Spanish, Italian, Greek and other bonds back down from the heights. It took a lot of liquidity to accomplish just that. If the bond buying was only partly effective, it was certainly not efficient in any sense.
Interest rates as a tool also proved largely ineffective during the 2008-2014 period. After the ECB’s error of raising rates in summer 2011 as the Euro economy was entering its double dip recession, it shifted interest rate policy and began cutting rates again. By 2014 the DF rate was zero, and the MLF rate at an historic low of 0.75%. But like the bond buying measures, interest rates had virtually no real effect on the economy. It was what economists call the classical ‘liquidity trap’. The central bank could provide all the increase in money supply it wanted. Rates could be zero. But banks would still not lend.
With near zero rates and after two trillion or more of bond buying, what was to be done? In 2014 it looked once again that the Euro economy was headed for another, third recession in 2015. At this point the ECB embarked on a path of introducing more experimental liquidity injection programs, like the US-UK and Japan had already done. It launched its own version of ‘quantitative easing’, QE, and then adopted an even more radical program of negative interest rates (NIRP).
ECB PERFORMANCE UNDER QE & NIRP: 2015-17
QE and NIRP became the centerpiece of ECB monetary policy action starting in 2015. On January 22, 2015, the ECB announced what it called its Public Sector Purchase Program (PSPP). The central bank in March began purchasing not only sovereign bonds from euro governments but also debt securities from banks and agencies, at a rate of 60 billion euros every month. Prior programs of Asset-Backed Securities Purchasing (ABSPP) and the CBPP-covered bond buying program, were carried over and expanded as well.
A year later, in March 2016, the central bank expanded QE further by purchasing corporate bonds. It additionally raised the monthly total of purchases to 80 billion euros a month.
The problem with the program in 2015-16 was that the ECB’s purchase of bonds—both public and corporate—did not actually reduce the level of bonds held by the banks. If the ECB was buying bonds at such an enormous rate of 80 billion every month, bond supply on euro banks’ balance sheets should have been reduced significantly but it wasn’t. “This suggests that government bonds purchased under the PSPP have mostly been purchased from non-bank entities and foreign banks”.
Credit to non-financial corporations continually declined for four years, 2012-2016, stabilizing around zero by 2016. Thus it didn’t accelerate significantly during 2015-16 due to the introduction of PSPP. So one may reasonably conclude that QE in its first two years failed to significantly stimulate bank lending—and therefore investment and economic growth. Not surprising, nor did prices rise to anywhere near the 2% price stability goal.
When QE (PSPP) was announced in January 2015, prices had already deflated to their lowest level ever in the Eurozone. Inflation was -0.6% that month. Once QE was launched, prices had risen three months later but only to a tepid 0.3%. Thereafter for the next 18 months, into the summer of 2016, inflation ranged between -0.1% and 0.3%. Prices were more often deflating than stagnating. This was far from the ECB’s price stability target of 2%. One can only conclude therefore that QE failed during its first two years, 2015-2016, in so far as enabling the Eurozone to attain its price stability targets.
Although economic growth and recovery is not a target or mandate of the ECB, the effect of QE on GDP and employment was as unimpressive during its first two years as it was for attaining its price stability target. GDP for the euro region averaged approximately 1.7% in both 2015 and 2016. But most of that was German growth. Italy and other periphery economies averaged growth rates of less than 0.5% on average, and other economies like Greece fared far worse.
Official studies commissioned by the European Parliament concluded that QE’s contributions to growth were “small relative to the size and type of monetary policy interventions”. The effect of QE on unemployment was similarly weak, as the same studies concluded “there does not seem to have been a significant effect from QE on the pace of unemployment reduction”. This minimal to negligible impact of QE on inflation, economic growth and employment occurred despite the ECB growing its balance sheet as a consequence of QE from 2 trillion euros at year end 2014 to more than 4.1 trillion euros by 2017.
In contrast to QE’s failure with regard to price stability and economic recovery, there are three areas in which the ECB’s QE program appears to have had a noticeable effect: On stock prices. On the Euro currency exchange rate. And on income inequality within the Eurozone. As soon as QE was announced, the dollar-euro exchange rate plummeted, from 1.4 to 1.1 in the ensuing months making German and other Eurozone exports more competitive. It has remained in the sub-1.10 rate since. Stock prices also immediately surged, then later moderated somewhat. But in the process raised Eurozone capital incomes while high unemployment and lack of wage gains in the region lowered labor incomes. The consequence of this dual effect on incomes created more income inequality.
The QE program was adjusted again at the close of 2016 as Draghi, the ECB’s chairman, announced a reduction in the rate of bond buying under QE from the increase to 80 billion euros per month announced in March 2016 back to the original 60 billion, but indicated as well that the program would be extended beyond its scheduled earlier 2017 expiration to the end of 2017. The QE program had injected an approximate 1 trillion euros of liquidity in its first two years. And it has been estimated that, if the QE program continued through end of 2017, it would add another 780 billion euros to the ECB’s total balance sheet, raising that total to just under 5 trillion euros by the end of 2017. Demands for its phase-out continued to grow by late 2016, intensifying into 2017.
The ECB’s partial pullback of the program was in part its response to a growing critique of the program’s effectiveness and demands that it should be ‘tapered’ and phased out altogether in 2017-18. Once again the opposition was driven by Germany, which argued that the extended period of low interest rates was making household savers pay the price of providing free money to buyers of bonds of the periphery economies—in effect subsidizing investors at the expense of households. This of course was correct. A direct consequence of QE in all cases, not just in Europe, is an extended period of artificially low interest rates that results in small savers earning no interest on their savings, while investors everywhere get to borrow money at virtually no cost. ECB interest rates by 2017 had been lowered to either zero or, in the case of the central bank’s DF rate, to negative -0.4%. QE thus creates a direct income transfer that contributes significantly toward growing income inequality—one of the direct negative consequences of QE programs everywhere.
2017 witnessed the growing assertion of German and its political allies’ opposition to QE. The ECB’s chair, Draghi, had been able to expand the role and function of the central bank on a number of fronts since the 2012 crisis—bank supervision, direct bond buying of sovereign debt, etc.—but as the Eurozone economy appeared to have improved by 2017 (due to global economic developments) Draghi and the ECB were once again on the defensive.
The question in 2017 is whether the German-led opposition can reassert its hegemony over the central bank and force it to exit its QE free money program and start reducing by year-end its 5 trillion QE-bloated balance sheet. The ECB appears reluctant to do so. It looks at the possibility of political instability in Europe negatively impacting the economy. It looks at what the US Fed and Japan central banks will do in terms of raising their interest rates. It looks at the possible negative effects of Brexit. And it is still not convinced that the recent growth blip in Europe (as elsewhere) is not just a temporary response to expectations of renewed fiscal stimulus by the US Trump administration. So the ECB holds steady with its policy of QE and general liquidity injections that drive its balance sheet in 2017 even in excess of the US FED’s estimated $4.5 trillion QE-generated balance sheet.
The other major monetary policy development during the 2015-17 period in the Eurozone was the descent into negative interest rates. First introduced by the ECB in June 2014 the total euro bonds in negative territory rose to more than $5 trillion by 2016. When followed by Japan in February 2016, global negative bond rates thereafter more than doubled in less than a year during 2016, peaking at $13.3 trillion in September 2016. In December 2016 German bond rates hit a record low of -0.8%.
The logic behind the shift to negative rates is that if banks have to pay to deposit their money at the central bank they will instead lend it out in order to avoid the cost. Thus negative rates are theoretically envisioned as a way to stimulate stagnant bank lending and thereby stimulate investment and economic growth. A parallel problem with negative rates, however, is that it raises bank costs somewhat, but perhaps not enough to generate more lending. The net effect is higher bank costs that discourage lending. Negative rates may also encourage businesses to hoard cash instead of investing it. Another problem is what if banks pass on the charge by raising charges on their customers’ checking accounts and even charging for depositing their savings with the banks? That may actually reduce spending and slow the economy. If not an actual fee on checking-savings accounts, it certainly reduces even the rates that banks might otherwise pay their household and business depositors. Negative rates also signal to household savers, businesses and investors that the central bank is engaging in desperate, extreme measures, the effects of which are unknown. That creates uncertainty and fears that maybe something is really wrong with the economy that is not publicly known. So that psychological effect of negative rates also discourages business borrowing and consumer spending.
Another accurate criticism of negative rate policy is that it distorts financial markets. The central banks’ policies of near zero rates (ZIRP), exacerbated the past two and half years by negative rates (NIRP), destabilizes sectors of the economy such as pensions and insurance. Pension funds and life insurance companies (selling annuities) heavily invest in fixed income securities in order to finance their retirement payouts. But if rates are extremely low, they cannot meet their retirement payment liabilities. The problem is exacerbated with negative rates.
The period of zero-bound rates (ZIRP) central bank policy—which was initiated by the US Fed in 2008-09—is approaching a decade. ECB and Japanese NIRP has been in effect for nearly three years. How much longer pension funds and insurance companies can hold out without collapsing is unknown. ZIRP and NIRP have forced the pension funds/insurance company industries toward ever more risky investment alternatives in order to achieve the returns necessary to fulfil their retirement payment commitments. These critical and very large industries of the shadow banking sector which invest in trillions of assets may become the focal point of the next financial crisis, should ZIRP and now NIRP central bank policies continue much longer.
The threat from negative rates receded somewhat at the end of 2016 and by early 2017, as a sell-off in the bond markets globally resulted in interest rates on bonds rising. The sell-off has been the product of investors’ expectations that the US Trump administration will stimulate the economy and the US FED will follow suit by raising US rates, a move that will raise the value of the US dollar. The post-US election effect reduced the $13.3 trillion in negative bond rates by $2.5 trillion by year end 2016.
Keying off US rates and the dollar, the ECB (and Japanese) QE policies have been put on hold, as the ECB is now in a wait and see mode with respect to a possible fiscal policy shift by the Trump administration and therefore FED rates and the dollar, and the effect of that. Latest indications by the ECB is that it will continue its current level of QE bond buying. It has no intention of reducing QE or selling-off its balance sheet, and probably will not until the Fed begins to do so with further rate hikes and its balance sheet.
To sum up the Eurozone’s QE and NIRP programs’ effectiveness as central bank radical, experimental monetary policy tools: They have not proved particularly effective in stimulating bank lending and therefore investment and growth. They have not resulted in raising inflation and achieving price stability at 2%. The inflation rate increase that has occurred in early 2017 has been mostly due, as Draghi himself has admitted, to rising costs of energy and import prices as the euro currency has devalued. The inflation rate minus these effects is still well below 1% in the Eurozone. The bond buying has mostly been done by foreign banks and foreign investors. The low rates have stimulated corporations’ issuing of corporate bonds. There’s little evidence NIRP policy has stimulated bank lending and investment, but it has increasingly begun to distort other financial markets. On the other hand, QE and NIRP have contributed to lowering and keeping low the Euro exchange rate and stimulating Euro exports (from which Germany has gained the lion’s share of benefits).
ASSESSING ECB PERFORMANCE OVERALL
The ECB’s performance in general can only be described as marginally successful at best, and in some cases, dismal. This has been especially true since the 2008-09 crisis.
During its first phase from 1999 to 2007, the central bank was a key enabler of the structural distortions in the Eurozone economy. In converting to the euro from the national currencies it over-injected liquidity to the advantage of Germany and its northern core economy allies. This enabled a massive money capital inflow to the periphery economies and the buildup of excess private debt in those economies. The money capital accumulating in the periphery was recycled back to core banks and business in the north as interest payments and purchases of German-core exports. An internal trade deficit in favor of German-core developed. When the crash of 2008 occurred, the money inflow to the periphery dried up but the interest payments had to continue to prevent a Euro-wide banking crisis. The ECB was prohibited by the EMU charter from lending to any but central banks in the member states and thus could not bail out the periphery economies alone. Special government bailout facilities were slowly created in response to the continuing sovereign debt crises, which were necessary in order to rescue the banks as well, due to the tight integration of government and bank indebtedness.
The ECB lowered interest rates too slowly as the crisis developed, and actually raised rates twice at the worst timing, thus exacerbating the crises. The ECB also developed bond buying and lending facilities late and in insufficient magnitude or composition to effectively resolve banking conditions. The LTRO programs were traditional and did not inject funds directly into the banks. The loans were short term and required restricted collateral. The SMP was deficient in focus and volume. Bond buying was only from secondary markets and not direct. The OMT was more talk than a reality. Most important, all these pre-QE ECB lending facilities were required to be accompanied by what is called ‘sterilization’ in banking quarters. That meant for whatever liquidity they provided, an equivalent amount of money had to be taken out of the system by the central bank. The resultant net liquidity contribution therefore was not that great, as evidenced by the money supply growth record and the decline in credit availability from 2012-2016. In short, the ECB money supply function was poorly managed.
As a lender of last resort, the central bank was unable by itself to bail out the banks during the 2011-2013 recession and crisis. Other non-ECB pan-European government entities, like the European Commission’s Stability Mechanism, had to be created to do so. This was not all the ECB’s fault, as its charter since creation has prevented it from acting like a true central bank, though it evolved slowly toward becoming one after 2013, as it was given bank supervision and resolution authority. But that authority remains limited and restricted, especially in so far as system-wide financial instability is concerned. Its bank supervision function to this day remains deficient, as evidenced by the lingering problems of Eurozone-wide NPLs, especially in the case of Italy.
So the ECB as a central bank has performed poorly in terms of primary central bank functions of money supply management, liquidity provisioning for lender of last resort and bank supervision. It Furthermore, the ECB has never to this date achieved its primary target of 2% price stability, even as its balance sheet has ballooned to 5 trillion and as it has driven interest rates into negative territory with all the distortions that has produced. Not least, its experiment with non-traditional monetary tools like QE was delayed and not even introduced until well after its disastrous recession and debt crisis of 2011-2013. What QE has accomplished is subsidizing euro export-oriented companies while exacerbating income inequality trends still further.
It now faces the problem it created with its 5 trillion euro balance sheet: how to exit QE and reduce its balance sheet without further destabilizing the Euro economy and still troubled financial system? Selling off the massive bond totals it has accumulated won’t be easy. Sales of bonds in this magnitude will almost certainly increase their supply and therefore depress bond prices significantly. That will mean rising bond rates and costs of borrowing, which can only mean less borrowing, less bank lending, less investment, and slower growth and price deflation in the end. In other words, the ECB’s policies of injecting trillions of liquidity will likely eventually exacerbate the very conditions which the liquidity injections were supposed to resolve in the first place. Slower growth and more financial fragility may be the ultimate consequence of policies that were to stimulate growth and reduce financial instability.
The solution to the crisis creates anew and even amplifies the very conditions that lead to the next crisis, although ‘next time’ will almost certainly prove worse.