Quantitative Easing and Lender of Last Resort: Lots of Confusion under the Sky
I have read an interesting article by Wolfgang Münchau, on the Financial Times. To summarize, Münchau argues that because of politician’s complacency, there is a chance that the new OMTs program launched by the ECB will never be used, and hence prove ineffective in boosting the economy. He therefore argues that the ECB should have done like the Fed, and announce an unconditional bond purchase program (private and public alike).
The piece is interesting because Münchau is at the same time right, and off the target. It is worth trying to clarify.
Münchau is perfectly right in his main point: the OMTs is not anywhere near a real quantitative easing program, and its conditionality does not make sense. A central bank wanting to support growth should provide liquidity to the system through open market operations and aggressive rate cuts (as long as there is a margin to do so).
Münchau misses the target, nevertheless, when he complains that OMTs will be ineffective because governments will not apply for it. He confuses the role of lender of last resort and the role of macroeconomic stabilization of monetary policy. The two roles can be linked, but remain distinct.
The task of a lender of last resort is to insure debt (in this case public debt), in order to convince markets that governments will be solvent, and to defuse speculation. The central bank commits to unlimited purchases of government bonds, thus reassuring markets that there always be a buyer for their holdings of government debt. The success of a lender of last resort is not measured by countries (or banks) needing to apply for its help, but rather by the contrary. If no country needs ECB help, that means that its role as an insurer is credible, and markets trust governments to be solvent. The efficacy of a lender of last resort is measured by market interest rates (that decreased after Mario Draghi’s announcement). I believe that the problem with OMTs is conditionality, but not because this may lead governments to abstain from demanding help; I repeat it, that would be the sign that the ECB is effective. Conditionality is a problem because it would lead to further austerity and hence hamper growth (and long term sustainability).
To assess the success of a central bank in supporting growth, on the other hand, one needs to evaluate whether the increase in liquidity provided to markets makes it into easier credit and therefore into increased private expenditure. I agree with Münchau that the ECB is not supporting growth in the eurozone, and that this is unfortunate (to say the least). But it remains important to clearly distinguish among the different tasks of a central bank, also in order to be more effective in criticism.
On a side note, I also believe that fiscal policy should be preferred, as the economy remains into a liquidity trap and the transmission mechanism of monetary policy is today dysfunctional. Still, Paul Krugman explains rather well why, even in a liquidity trap, quantitative easing could work.
It would be great if, like the Fed, the ECB were taking up both the role of lender of last resort and the task of supporting growth through a monetary expansion. But unfortunately, this is not in the cards today. The ECB cannot support growth in the eurozone, partly because its mandate is limited to a strict inflation target (and this is crazy. I said it a long time ago). And even more importantly, because it does not want to do so. The ECB and its President are trapped in the orthodoxy that choked Europe since the 1980s. The only solution they propose is structural reforms, and again structural reforms. When this will change, we will witness the real revolution in the eurozone.