Expansionary monetary policy has been in place for eurozone economies for almost five years, and the results have been disappointing. Authorities in Brussels and Frankfurt had hoped that a few months of low interest rates, unlimited support for commercial banks and implicit guarantees to worried government-debt holders would be enough to restore confidence, shore up aggregate demand and jump-start growth. That has not happened.
Recent economic history shows that there is no magic wand. When people realize they have been living above their means or misusing resources – the legacy of the pre-2007 years – they take stock and revise their plans. Those who had been consuming too much increase savings in order to finance future consumption, for retirement or for emergencies. Those who had been investing too much, or into bad projects, will lick their wounds and think twice before they make the same mistake again.
Within this framework, printing money and reducing interest rates does not persuade consumers and investors to turn a blind eye to what might happen in the future, especially if the future does not seem particularly bright. This explains why solving the crisis and boosting production by printing money – quantitative easing, or QE, in central bankers’ parlance – has been an exercise in wishful thinking.
Before the Keynesian illusion swept the world’s economic departments and beguiled policymakers, most economists knew that the best course of action was to let the market make the proper adjustments and never succumb to the temptation to use monetary and fiscal policies to try to manipulate people’s behavior. It now seems that central bankers have realized that pre-Keynesian economics contained much wisdom; that aggressive monetary policy is pointless and that quantitative easing has ended up giving policymakers room to postpone the painful structural reforms their economies badly need.
One would think the scenario ahead would therefore be rather straightforward. Frankfurt (and perhaps London as well) would soon pull the plug on quantitative easing and stop buying government bonds. Interest rates would reflect the actual supply and demand for financial resources, governments would eventually pay the true cost of their profligacy and commercial banks would revert to their original business – borrowing and lending money at market interest rates.
However, central banks are hesitant to return to sound policies. There are a few possible explanations for this, each of which suggests different scenarios for the next few months. One explanation is that central bankers fear what might happen if they stopped QE. The second is that while quantitative easing failed to offset the business cycle and spark economic growth, it might have been a success in a different way – bailing out banks and governments.
Fear the unknown
There is no doubt that policymakers do not want to acquire a reputation for having rocked the boat, even if the boat had already run aground. Over the past couple of years, European Central Bank President Mario Draghi has repeatedly invited national authorities to carry out structural reforms as a way of enhancing growth and making government debt sustainable. However, he has been much less straightforward in informing the public about what the future holds for public finances and banks. Average citizens know that these two areas are fraught with problems. They also believe, however, that the problems are not dramatic, that the cost of past mistakes will be paid by banks’ shareholders, and that government-bond holders are safe as long as national authorities do not clash head-on with the bureaucracies in Brussels or Frankfurt.
This situation suits everybody, as long as everybody is happy with no growth and plenty of paper money available to silence those who might ignite a banking crisis or refuse to refinance public debt. Authorities might change the goal of their policy from enhancing aggregate demand and growth, to making people accustomed to zero growth and doing what it takes to avoid alarm.
However, it is not obvious that pumping money into the economy to keep interest rates down is the only recipe for keeping panic at bay. The contrary might be true. There is evidence that zero or negative interest rates are badly hurting commercial banks – including the healthy ones. When many banks are hurting, trouble may not be far away.
Moreover, it is far from apparent that backtracking from the easy-money approach would lead to higher interest rates in the market. Uncertainty and mistrust towards policymakers is a recipe for high rates of saving and low rates of investment. One need not be a professor of economics to conclude that an excess supply of savings results in very low interest rates.
There is no need for aggressive monetary policy to keep real interest rates down. Erratic and insecure policymaking are more than enough to achieve the same outcome. If this is true, ending quantitative easing and near-zero interest rates might show that monetary policy is useless, but will hardly make a difference.
QE to the rescue
There is a second set of scenarios if the aim of quantitative easing was not to spur growth. Rather, and despite some rhetoric to the contrary, the real goal was and continues to be rescuing troubled banksand ensuring that governments do not go broke. From this standpoint, low interest rates reduce the cost of financing government debt, while money printing ensures that financial institutions can rely on enough ammunition to fight off a bank run and that governments find a buyer for their bonds. If this is correct, two scenarios could ensue.
The first boils down to business as usual. After all, today the worlds of banking and of public finance are hardly healthier than three or four years ago. The irony of this scenario is that since easy money is originated by bad banking and too much public spending, bankers and politicians have little incentive to clean up their affairs. Their very incompetence and avarice ensures that the euro authorities maintain the current safety nets in place.
In the second scenario, the European Central Bank would act consistently with its message: it would withdraw support from nonperforming banks and governments that have failed to address their domestic financial weaknesses. At the same time, Mr. Draghi could promise ongoing assistance to virtuous banks and national politicians.
Time running out?
There is no doubt that the winners of the easy-money policy in recent years have been banks’ shareholders and bondholders, as well as improvident politicians. The losers are all those who badly needed structural reforms and more encouraging prospects for productivity, employment and growth.
It is hard to foresee how long the easy-money policies will prevail. It is tempting to argue that there is no reason why Frankfurt and Brussels should stop helping undeserving bankers and political elites. However, the current course is not sustainable. Low interest rates succor governments but hurt healthy banks.
Since it is becoming increasingly difficult to please both at the same time, sooner or later Mr. Draghi will decide whom he wants to dump. If he decides that stabilizing the world of finance is more important than helping slothful rulers, then the period of negative interest rates could end earlier than expected.