With its latest decisions, the European Central Bank has added yet another element to its strategic shift. The reorientation of the ECB’s monetary policy has been expedited as part of its crisis management since late 2011. The central bank has garnered praise and recognition for its efforts.
What is being overlooked is the fundamental distortion in market conditions caused by the ECB’s policies. The necessary correction, whenever it happens, could lead to another serious crisis.
To be legitimate, a decision-making process on monetary policy requires that the following questions be addressed: 1. Do the measures produce the desired outcome within the framework of the mandate? 2. Can unwanted side effects be accepted as a necessary evil? 3. Is a trouble-free exit from the approved measures possible?
In light of the latest decisions by the ECB Governing Council, all three questions can be answered in the negative. The reduction in the benchmark interest rate by 0.1 percentage points to 0.05 percent would be laughable if the situation were not as serious as it is. It could be dismissed as symbolic if it didn’t represent the first time the ECB has pursued an exchange rate objective and the targeted weakening of the euro exchange rate, a goal French and Italian politicians repeatedly stress.
However, near-zero interest rates will not produce a single euro in additional lending, and in the longer term this lack of effectiveness will further undermine the ECB’s reputation, among other adverse effects. Nevertheless, shortsighted financial markets and European politicians are welcoming the decisions: The president of the ECB has “kept his word.” In fact, he has even delivered more than expected.
The decisions taken in June 2014 to make additional, long-term liquidity (until 2018) available to banks, along with the most recent decision to have the ECB buy up asset-backed securities, or ABSs, from the banks, will expand the balance sheet of the Eurosystem – the network of central banks governing Europe – by an estimated €1 trillion ($1.29 trillion), or about 50 percent. In other words, markets will be flooded with additional liquidity at a time when there is already excess liquidity worldwide.
The negative side effects, in the medium term, of pursuing an overly lax monetary policy for too long are undeniable. The Bank for International Settlements (BIS) in Basel, Switzerland, has been pointing out this problem for years.