Saturday, 14 July 2012

Student Guest Post: Monetary Folly Edition

As part of our series of ITFD student project summaries as guest posts, here is the latest thinking (by Alex Ballantyne, Julian Ebner, Thomas Jones, and Sam Chapman) on the potential benefits of QE in the Eurozone:

Last week the ECB cut their main policy rate by 25 basis points in response to decreased inflationary pressure stemming from weak growth outlooks in the Eurozone. Policy rate adjustment is unsurprising given the evolution of financial and economic indicators in the second quarter; however, in light of the severity and persistence of the current crisis it appears trivial. Indicators show that the relief provided by large injections of liquidity from the ECB’s Longer Term Refinancing Operations (LTROs) in December 2011 and February 2012 was only temporary. Once again rising sovereign bond yields and uncertainty over banks’ solvency (particularly within Spain) dominate the headlines of the financial, and mainstream, press. Alleviating Europe’s woes requires addressing three inter-related trouble spots: sovereign default risk, bank solvency, and weak growth prospects. It is unrealistic to believe that small adjustments in the ECB’s policy rate will have a substantial impact in all these areas.

There is mounting evidence that large monetary interventions from the ECB are not only desirable, but necessary. The LTROs were a much publicised attempt at providing such an intervention; however, evidence suggests that their impact has been confined to the banking sector alone and left the other two trouble spots largely unaffected. An impaired bank lending channel has failed to improve lending conditions for non-financial firms, thus preventing the transmission of liquidity to the real economy (left graph). The LTROs’ effect on sovereign yields appears to have been confined to Italy and Spain and even there it has been mostly temporary (right graph).

In place of liquidity provision to banks, monetary policy should address all three trouble spots in a more direct fashion. Evidence from the recent Bank of England and Federal Reserve interventions suggests that purchases of sovereign bonds on secondary markets, commonly referred to as quantitative easing, have been effective in lowering sovereign yields. In turn, this provides banks with the opportunity to improve liquidity while reducing their exposure to sovereign risk. Stimulating growth through improvements in non-financial firms’ borrowing conditions is a less tractable objective. Lending to banks conditional on loan expansion, or even direct lending to non-financial firms, by the ECB are attractive policy options. Recently, the UK Treasury and Bank of England have embarked on a joint initiative to ensure liquidity provided to banks is transmitted to non-financial firms. The ECB should follow suit with similar policies.

Objections to such unconventional policies are often raised, usually stressing the costs of inflation and moral hazard. Exactly how high these costs would need to be to outweigh the benefits of the policies proposed above is nearly impossible to pinpoint; however, a slightly higher, yet stable, level of inflation is quite unlikely to tip the scales. In any case, the costs of non-intervention are starkly evident and only increase with further hesitation, potentially endangering the prosperity of an entire generation. An obsession with one-dimensional monetary policy targets has proven destructive in past crises, most prominently the Great Depression. If the ECB continues down its current path, one would be tempted to cast it in the role of Nero, fiddling as Rome burns. 

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