The "Monetary Policy Transmission" Problem
When Mario Draghi recently opined that the ECB had lost the ability to transmit its policy across the euro area, he was not exaggerating. What can currently be observed in the euro area is that this central economic planning institution has de facto lost its power to influence interest rates across the currency union.
The extent to which this has become true has been revealed in a recent Goldman Sachs research piece. Here is a pertinent quote:
"The reaction of retail bank rates to national sovereign yields is not unique to the crisis. It existed before the crisis, but was not so obvious because sovereign yields were so stable and spreads so tight (This relationship may help to explain the well-documented sluggishness in the response of retail bank rates to changes in the monetary policy stance.)
With the crisis, official ECB rates have lost their influence on retail rates in Italy and Spain, while they have gained influence in Germany and France. This can be seen from the fact that most long-run coefficients on official rates ceased to be statistically significant in Spain and Italy during the crisis. By contrast, the importance of the ECB policy rate has increased substantially (and has remained significant) in Germany and France.
Borrowers in the periphery feel the pain more quickly than before:
Euro area retail bank rates have always proved sticky in the short term. This contrasts with the U.S. experience, where retail interest rates are more generally indexed to market conditions and therefore move quasi- automatically with them (and thus with policy rates). Our analysis here suggests that retail bank rates have overall become less sticky since the onset of the crisis."
According to Draghi and many of his colleagues, this is "bad." After all, the central bank bureaucracy is supposed to know better what market interest rates should be than the market itself. This opinion is shared by the great bulk of mainstream economists. For instance, the Goldman Sachs research piece quoted above bemoans that (paraphrasing) "the ECB's easing measures don't reach the regions where easing is needed most." It also regards the euro area's financial system as "dysfunctional," which is of course a legitimate way of putting it.
Since many of the banks currently still operating in the periphery are de facto insolvent and only kept alive via central bank funding, they have become "zombies." Zombie banks are per definitionem "dysfunctional." They become a burden to society, as keeping them alive either requires the squandering of tax payer funds or an inflationary dilution of the money stock. Given their state of suspended animation, they will of course not extend much credit.
However, what credit they do extend will reflect their higher funding costs. In other words, the market-based assessment of their lack of creditworthiness directly impinges on the interest rates they will charge to putative borrowers. These rates will however also reflect the higher credit risk posed by borrowers themselves in view of current economic conditions.
Over the past few days we have written quite a bit about the measures that the ECB might take. Goldman has offered up a few additional thoughts on that particular topic, which we will briefly discuss further below.
Is It Really "Bad" that Interest Rates in the Periphery are Higher?
As noted above, the conventional view is that Spain, Italy and other peripheral countries are those that require lower interest rates "most urgently." Therefore, it is deemed to be a bad thing that the ECB can no longer manipulate them.
But is this really true? Why should it be "bad" when interest rates reflect actual market conditions rather then the central bank's manipulations? In an economic and financial crisis, interest rates are always pushed up, not down, if they are left to market forces. It is easy to see why: liquidity must come at a premium, both due to the rising demand for it on the part of distressed borrowers and the greater risk creditors will take if they lend out their funds.
Interest rates therefore should reflect this heightened risk premium. This has two advantages that may not be immediately obvious, which are however quite important:
1. malinvested capital will be liquidated much faster and no additional malinvestments will be heaped atop the ones the expired boom has left behind
2. savers will be induced to increase their savings as the higher level of interest rates makes saving more attractive. This works as a self-regulatory mechanism – the more new savings are accumulated, the lower interest rates will go over time, ceteris paribus. Of course in Spain's particular case this effect is still masked by the growing risk premium.
What the ECB and most mainstream economists argue in favor of is to reduce the influence the market has on interest rates in the periphery in favor of the influence the artificial rate setting by the central bank is normally supposed to have.
Note as an aside here that Goldman Sachs is not entirely correct when it asserts that the "ECB's policy transmission works better in France and Germany." In reality, money is fleeing from the periphery to these perceived 'safe havens" – in short the lower interest rates enjoyed in the "core" nations are very likely also largely a market-based phenomenon (admittedly it is impossible to disentangle the rate setting policy of the ECB entirely from these observations; we cannot state categorically what has the greater effect).
If they get their wish, it would no doubt lessen the economic plight in the peripheral countries in the short term. However, this would come at a long term price. The economic pain currently endured in these nations is after all a result of the preceding boom. While very unpleasant in the short to medium term, it will ultimately create a sound foundation for a sustainable recovery. The soundness of the economy cannot be improved by falsifying interest rates. At present, the liquidation (or where possible, transfer to better uses) of malinvested capital, the process of catching up with capital maintenance that was neglected during the boom and the reallocation of factors of production to uses that conform with the actual wishes of consumers are underway – a very painful recession is therefore recorded.
Obviously, these processes take time and will initially require far fewer workers than were needed during the boom. The many false economic activities that are now liquidated free up economic resources, but redeploying them to better uses can not be done immediately by simply snapping one's fingers. It takes time and the severity of the downturn naturally is a mirror image of the preceding boom – all of this is inevitable. If the central bank succeeds in artificially lowering interest rates in these nations, then it will only put obstacles in the way of the economy's healing process.
The relatively higher interest rates at present ensure that only those investment projects will be undertaken that promise to deliver a commensurate return. The economy's production structure will by necessity be shortened, until voluntary savings have been rebuilt to the extent required to once again allow longer term investment projects to be considered.
If artificially lowered interest rates lead to a renewed diversion of scarce resources into bubble activities that would not be profitable absent the interest rate manipulation, the short term performance of the economy would superficially appear to become "better," but even more real capital would be squandered as a result. A sustainable recovery would once again become a more distant and unlikely prospect.
We would therefore argue that the "unintended consequence" of erecting a supra-national currency system – namely to produce a relatively free market in interest rates across the euro area - should be welcomed instead of being condemned.
Likely Interventionist Measures
In closing we briefly wanted to comment on the interventionist measures Goldman Sachs" researchers believe could be in the offing. It is well known that the ECB's governing council is split regarding the efficacy of the "SMP" program and other proposals such as using the EFSF/ESM to buy government bonds of stricken sovereign borrowers in the euro area in concert with the ECB are likely to run into resistance from Germany and her "hard money" allies.
To quote from the above mentioned report, there are however many other possibilities to boost the euro area's money supply:
“Mr Draghi’s comments in London on Thursday 26 July (“within our mandate, the ECB is ready to do whatever it takes to preserve the euro.; and believe me, it will be enough.”) support our view that further nonstandard monetary policy measures may be implemented in the near future, so as to improve the functioning of financial markets and improve monetary policy transmission.
A key open question is whether such measures will focus on attempts to revive the sovereign markets or rather set out to bypass them by offering more direct support to the private sector.
In the past, the former approach has embodied outright purchases of government debt by the ECB through its Securities Markets Programme (SMP). But the resurrection of the SMP threatens to break the current internal compromise on the ECB’s decision-making bodies. And its effectiveness is open to question, given market participants’ concerns about subordination in the aftermath of the treatment of ECB holdings in the Greek debt restructuring.
The ECB may therefore look to support private-sector financing more directly, by further easing of collateral eligibility, increased liquidity support to the banking sector and outright purchases of private-sector assets originating in both the bank and corporate sectors.”
In short, what the ECB may well dish up later this week will be an even further lowering of collateral eligibility standards, a broadening of the types of collateral that can be submitted (as it were, Spain's banks are in the process of running out of eligible collateral under the current rules and therefore increasingly require "ELA" funding), as well as permission to the national central banks in the euro system (NCB's) to buy private sector assets outright. The reason why this will be delegated to the NCB's is that they will be asked to also bear the risk of such transactions, similar to the discounting of corporate loans that was introduced last year. Also, haircuts on the collateral that was allowed to be submitted hitherto may be lowered.
What types of private sector assets could be bought by the NCB's remains to be seen, but there is no limit to the potential inventiveness of the central banks in this regard (e.g. the BoJ even buys stocks of REITs). So this could include bonds, stocks, loans on the balance sheets of commercial banks and other securities.
If such a decision is made, then an artificial buyer with unlimited funding will appear on the scene and pump up the money supply with money created ex nihilo. Every purchase involving non-banks will increase deposit money in the euro area directly. Purchases of securities from banks may do so indirectly, if the banks in turn create new deposits to replace the securities they have sold. This policy would effectively amount to what is euphemistically known as "quantitative easing," or money printing.