Monetary policy is at a turning point in modern history, and the European Central Bank [ECB] is having difficulty making the turn. Traditional monetary policy comes in two forms; expansionary and contractionary policy. Expansionary monetary policy focuses on increasing the money supply (often via lower interest rates), while contractionary policy involves increasing interest rates to lower the money supply. As we’ve come to see, however, extreme scenarios such as the global debt crisis in 2008 demand innovative policy that bodies such as the ECB are still struggling to implement.
In the United States, the Federal Reserve system responded to the Great Recession with unprecedented measures known as “Quantitative Easing” [QE]. This policy involved a series of bond purchases from banks and similar institutions, along with the federal government, to expand the money supply since interest rates were already at zero. Unlike today, economists once thought that interest rates could not go below zero. Only once before on the global stage had QE been utilized; Japan turned to Quantitative Easing when trying to combat deflation in the early 2000s. While QE was feasible for the Federal Reserve to implement quickly, the European Central Bank did not enjoy the same freedom to execute monetary policy as it wished.
The euro area is a monetary union of various countries operating under a single monetary policy, which forces the ECB to consider each nation’s situation when conducting policy. The worldwide economic crisis touched off rampant inflation and overspending in many European countries, particularly Spain, Ireland, Portugal, and Greece (which continues to demand financial assistance via comprehensive bailout plans). However, the ECB also had to consider member nations that were relatively unharmed such as Germany, and so the bank was limited in its ability to enact certain policies to advance the recovery. ECB President Mario Draghi, known as “Super Mario” to European bankers, relied heavily on lowering interest rates, cheap loans, and organized financial support measures, but the massive sovereign debt held by European banks significantly slowed down the process.
Despite comprehensive financial bailouts for numerous countries in recent years, this government debt continues to hang over the head of European policymakers. Yet, Super Mario insists that he has found the solution: structural reform, which entails establishing flexible labor markets and credible financial institutions. This can be done through accommodative monetary policy, which means zero percent interest rates and quantitative easing. Structural reform is best implemented upon a fiscal safety net or strong bank balance sheets; however, the EU’s debt overhang has banks and governments still trying to recover from monumental losses throughout the crisis. Idealy, this monetary policy would allow for more rapid investment benefits and economic growth, but the everlasting presence of sovereign debt in the Eurozone stands in the way.
Implementing Draghi’s structural reform at this stage in the recovery could leave the ECB bearing unsustainable fiscal and monetary costs, and financial institutions would be hard pressed to accrue benefits quickly. Furthermore, economic growth continues to be a significant problem in the Eurozone: estimates of potential growth were reduced to just one percent at the start of the month. This sour outlook is a direct result of the continuing debt problem across countries, which monetary policy both past and present is unlikely to resolve in the short run. Draghi’s confidence and initiative is commendable, but it might be time for the ECB to consider even more innovative directions for its monetary policy.