A central bank cannot monetise away a liquidity trap

As was expected, today the ECB cut its penalty interest rates on banks‘ deposits further into negative territory to 0.4 from 0.3 per cent. Additionally, the ECB also cut its main refinancing operations rate to zero from 0.05 per cent and increased the volume of its QE purchases to 80 billion Euro per month, from 60 billion. As always, the ECB cited sub-par inflation due to slow credit growth as the reason for this policy move.
To my mind, this policy move is merely cosmetic, to keep up the mirage of the ECB’s prowess, where there is actually nothing Frankfurt’s Ostend can do to end Europe’s slump. For years now, Europe is stuck in a liquidity trap. And as we all know, in a situation where the transmission mechanism is broken, more liquidity will not help, that’s why it is called a trap. It seems worth to repeat, that no central bank, no matter how powerful, can monetise away a liquidity trap. Not even the ECB, not even with the fancy, shiny new policy tools of negative rates or QE. Europe’s problem is not liquidity supply, given QE and ultra-low interest, ultra-long provisions, money is everything but scarce. But two features of Europe’s economies make all this supply virtually void.


First, banks are still in the process of increasing their equity ratios, because they are (rightly so) required by law to do so, and because they preferably would like to survive the next crisis. Hence they are reluctant to ramp up their assets by giving out credits, especially not to feeble, risky companies in Europe’s periphery. The Eurosystem has long since run a surplus with its banks, where a liquidity deficit would be required for the orderly conduct of monetary policy. This is a sign, that monetary policy has reached the end of its effectiveness, not at all talking about efficiency.

Second, economic confidence is low – no wonder given the unemployment rates of France, Spain, Italy, Greece. People either have no job and hence demand is curbed or people save in order to shield themselves against future joblessness. Ageing and saving societies, like Germany’s, do not help either. All this is bad for growth prospects of firms, hence investments are delayed or cut, cutting the demand for money, no matter how much liquidity is injected by the ECB. This delay of investment curbs also the prospects of another discussed recklessness, namely ‚helicopter money‘ where the ECB would give freshly printed Euros to firms, so they can buy new machines. Some firms might do so, but I think that resorting to something as batshit-crazy as helicopter money would decrease confidence even further, in turn decreasing profit perspectives.

Now what?

Monetary policy is done. All the ECB can do is cosmetics. Since we are talking about real variables, that is growth and jobs, monetary policy is the wrong tool anyway. To sort out the mess that is Europe’s economies, fiscal policy needs to get moving after years wasted. Given the historically low interest rates and low oil prices, the opportunity should not be foregone.

Let’s start with us. Germany needs to roll over debt to decrease the interest rate burden. The money saved should be put into infrastructure. There are enough bridges, rail-roads and Autobahnen that are in desperate need of fixing or replacement. Mobile broadband and fibre optic cables would also increase productive capacity. We need homes and integration measures for all the migrants. This would increase demand in the short run, maybe up to the point where spare construction capacity from abroad must be utilised, e.g. Spanish firms and workers, constructing German infrastructure. As a side-effect this would also bring down our loathed current account surplus.

France desparately needs the labour market reforms, President Hollande and PM Valls should not be irritated by the unions‘ wrath. In the end, these reforms will bring down French unemployment and increase confidence and demand. Italy must continue to clean-up its banks and reform its labour market. Only with growth, it may escape its crushing public debt burden that makes it difficult to invest in public infrastructure. Spain, well … Spain needs a government for starters. Then, much like France and Italy, it needs to strengthen the labour market to bring down sky-high unemployment. Germany’s labour market reforms from the early 2000s could be a model, since it is better for people to work a low-paid job and being propped up by the government than to not work at all.

Like in almost every other subject, everybody in Europe needs to do his part. Blaming each other is as pointless as blaming a powerless ECB. Only if real growth and jobs pick up over all of Europe, so will prices and finally, the ECB will have power again.

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Benjamin

Bloggt über Wirtschaft und Politik. Nimmt Ordnungspolitik ernst. Promoviert über Währungsunionen. Blogs about Economics and Politics. Takes Ordnungspolitik seriously. Studies monetary unions for his doctorate.

3 Gedanken zu „A central bank cannot monetise away a liquidity trap“

  1. Agree with most of your points…except your somewhat pessimistic view on helicopter money…while you are right to point out that fiscal policy should be deployed to increase nominal demand, the world is full of governments that feel unable to do this not least due to already high debt burdens in a number of countries. (A country that has ample „fiscal space“ is – as you pointed out – Germany. Unfortunately, there is no indication that the German government will actually do anything.)

    Fortunately, this does not mean that we are „out of ammunition“. As Adair Turner (and others) rightly argue, governments could run larger fiscal deficits which are financed with non-interest-bearing central-bank money. This would indeed increase nominal demand , thereby leading to higher real GDP growth and higher Inflation (on this and on the role of structural reforms see the recent article by Lord Turner at https://www.project-syndicate.org/commentary/monetizing-fiscal-deficits-benign-by-adair-turner-2016-03#4piQlK1sk8HpdMHZ.99).

    1. Thanks Tobi,
      my concerns with helicopter money is not really about the effects (which I think are small anyway) but that such a move will be perceived as desperate by the public, hampering confidence even more.
      And yes, the German government is obsessed with the „black zero“ (which is actually stipulated by the constitution), though I have to admit that I am a bit obsessed about it, too. Still, rolling over debt or cutting useless expenses such as early retirement could raise enough money to have some sizeable fiscal stimulus without actually adding to the deficit. The crucial point in all fiscal stimuli across Europe is that the expenses increase productivity and decrease costs.

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