CAMBRIDGE, Massachusetts ― The European Central Bank needs to ease monetary policy further. Eurozone-wide inflation, at 0.8 percent, is below the target of “close to 2 percent,” and unemployment in most countries remains high. Under current conditions, it is hard for the periphery countries to reduce their costs to internationally competitive levels, as they need to do. If inflation in the eurozone as a whole is below 1 percent, the periphery countries are condemned to suffer painful deflation.
The question is how the ECB can ease policy, given that short-term interest rates are already close to zero. Most of the talk in Europe concerns proposals to undertake quantitative easing, following the path taken by the U.S. Federal Reserve and the Bank of Japan. This would mean expanding the money supply by buying member countries’ government bonds ― a realization of ECB President Mario Draghi’s “outright monetary transactions” scheme, announced in August 2012 in the midst of growing uncertainty about the euro’s future (but never used since then).
But QE would present a problem for the ECB that the Fed and other central banks do not face. The eurozone has no centrally issued and traded Eurobond that the central bank could buy. (And the time to create such a bond has not yet come.) By purchasing bonds of member countries, the ECB would be taking implicit positions on their individual creditworthiness.
That idea is not popular with the eurozone’s creditor countries. In Germany, ECB purchases of bonds issued by Greece and other periphery countries are widely thought to constitute monetary financing of profligate governments, in violation of the treaty under which the ECB was established. The German Constitutional Court believes that the OMT scheme exceeds the ECB’s mandate, though it has temporarily tossed that political hot potato to the European Court of Justice.
The legal obstacle is not merely an inconvenience; it also represents a valid economic concern about the moral hazard that ECB bailouts present for members’ fiscal policies in the long term. That moral hazard ― a subsidy for fiscal irresponsibility ― was among the origins of the Greek crisis in the first place.
Fortunately, interest rates on Greek and other periphery-country debt have fallen sharply over the last two years. Since he took the helm at the ECB, Draghi has brilliantly walked the fine line required to “do whatever it takes” to keep the eurozone intact. (After all, there would be little point in upholding pristine principles if doing so resulted in a breakup, and fiscal austerity alone was never going to return the periphery countries to sustainable debt paths.) At the moment, there is no need to support periphery-country bonds, especially if it would flirt with illegality.
What, then, should the ECB buy if it is to expand the monetary base? For several reasons, it should buy U.S. treasury securities. In other words, it should go back to intervening in the foreign-exchange market.
For starters, there would be no legal obstacles. Operations in the foreign-exchange market are well within the ECB’s remit. Moreover, they do not pose moral-hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for U.S. fiscal policy). Finally, ECB purchases of dollars would help push down the euro’s exchange rate against the dollar.
Such foreign-exchange operations among G7 central banks have fallen into disuse in recent years, partly owing to the theory that they do not affect exchange rates except when they change money supplies. But in this case we are talking about an ECB purchase of dollars that would change the euro money supply. The increase in the supply of euros would naturally lower their price. Monetary expansion that depreciates the currency is more effective than monetary expansion that does not, especially when, as is the case now, there is very little scope for pushing short-term interest rates much lower.
Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and reviving their export sectors. Of course, they would devalue on their own had they not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt). If abandoning the euro is not the answer, depreciation by the entire eurozone is.
The euro’s exchange rate has held up remarkably during the four years of crisis. Indeed, the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting. Thus, the euro could afford to weaken substantially. Even Germans might warm up to easy money if it meant more exports.
Central banks should and do choose their monetary policies primarily to serve their own economies’ interests. But proposals to coordinate policies internationally for mutual benefit are fair. Raghuram Rajan, the governor of the Reserve Bank of India, has recently called for the advanced economies’ central banks to take emerging-market countries’ interests into account via international cooperation.
ECB foreign-exchange intervention would fare well in this regard. This year, the emerging economies are worried about a tightening of global monetary policy, not the policy loosening that three years ago fueled talk of “currency wars.” As the Fed tapers its purchases of long-term assets, including U.S. treasury securities, it is a perfect time for the ECB to step in and buy some itself.
By Jeffrey Frankel
Jeffrey Frankel is professor of capital formation and growth at Harvard University. ― Ed.