Necessary, suitable and proportionate

Blog post by Isabel Schnabel, Member of the Executive Board of the ECB, in Welt am Sonntag

Necessary, suitable and proportionate

Since 5 May one term has been at the centre of the debate when it comes to monetary policy: proportionality. Proportionality – or at least the thorough substantiation thereof by the European Central Bank (ECB) – has been called into question by Germany’s Federal Constitutional Court. Now that a solution is emerging for the asset purchase programme that was criticised by the Court, many are wondering whether the new purchase programme created during the coronavirus pandemic would pass the same test. My answer is a clear yes.

The world is currently in the midst of a humanitarian and economic crisis of inconceivable proportions, causing production, trade, consumption and investment to fall dramatically. Eurosystem projections for 2020 foresee a decline in economic activity of almost 9% in the euro area, and of around 7% in Germany.

The duration and depth of the economic impact of the coronavirus will depend crucially on the economic policies implemented in response to the crisis. Many European countries have taken decisive fiscal policy measures at the national level, ensuring that firms have sufficient liquidity and cushioning the impact on workers. In addition, a fiscal response is emerging at the European level, with a view to getting Europe through this crisis as unscathed as possible, for the greater good of all.

The ECB has swiftly responded to the crisis. A key element of that response was a new asset purchase programme: the pandemic emergency purchase programme, or PEPP. It was designed as a response to this crisis and at first glance is subject to fewer constraints than the previous asset purchase programme, giving rise to questions relating to its proportionality.

Are the measures necessary?

At the start of the crisis financial markets were in turmoil, but swift action by the ECB succeeded in stabilising the situation. Without these measures, Europe would now likely be in the midst of a severe financial crisis with devastating consequences for the economy and employment. A sharp drop in price and wage levels would inevitably have followed, which would have run counter to our objective of price stability.

Despite this timely stabilisation, current projections only foresee a gradual recovery of the economy. Euro area inflation will decline significantly in the medium term and could remain close to 0% well into the coming year. The Governing Council of the ECB saw a risk of low inflation taking hold. Our monetary policy measures were therefore necessary.

Are the measures suitable?

But are these instruments suitable to bring inflation closer to our aim in the medium term?

The room for manoeuvre for “conventional” monetary policy measures – i.e. changes in the main policy rates – is very limited. As rates approach the effective lower bound, many central banks have little alternative but to employ “unconventional” measures to ensure that they continue to fulfil their mandate.

In turbulent times, bond purchases – together with liquidity-providing measures for banks – are particularly effective, as they have an immediate effect and help to avoid self-reinforcing price spirals that could destabilise the euro area as a whole. The flexibility of these purchases – over time, among jurisdictions and across asset classes – is particularly important, but it does not mean that we are calling into question the fundamental principles of the currency union, in particular the prohibition of monetary financing.

For this reason, we have also put in place clear safeguards for the PEPP that protect these principles. For instance, the ECB’s capital key serves as a guide for the distribution of our purchases across jurisdictions. However, we are willing to tolerate deviations from the capital key to ensure that monetary policy is transmitted to all parts of the euro area. Depending on market conditions, the reinvestment phase of the PEPP could be used to gradually reduce past deviations from the capital key.

Our measures have proven to be extremely effective: financing conditions for governments, firms and banks have improved markedly and macroeconomic developments have stabilised. According to ECB estimates, our measures add 1.3 percentage points to euro area growth between 2020 and 2022 and give inflation a noticeable boost. They are suitable.

Are the measures proportionate?

The final question is whether the measures are proportionate in the narrow sense, meaning that their benefits outweigh their costs. I would like to look at two potential side effects: the distributional effects of monetary policy and the impact on governments’ budgetary discipline.

All monetary policy measures have distributional effects, because central banks try to adjust incentives for saving and investment so that they are consistent with stable prices. Would the distributional effects be lower if we were to use different instruments?

Analysis by the ECB shows that we would have had to cut our main policy rate to around -1.7% – from its current level of -0.5% – to achieve the same effect on inflation as with our additional asset purchases. The associated losses for savers would have been almost as large as those over the past six years. By contrast, the additional losses for savers resulting from our new asset purchases are negligible. In addition, the ECB’s decisive policy response helps the weakest in society most because their jobs are most at risk due to the crisis. The distributional consequences would therefore have been much more far-reaching in the absence of our measures.

The second potential side effect relates to the incentives that monetary policy creates for the budgetary discipline of governments. Lower interest rates could lead to governments taking on more debt.

Primary balances in the euro area have in fact been improving since we started purchasing public assets in 2015. While this trend will end due to the COVID-19 crisis, this is not the result of moral hazard. Indeed, it is desirable that governments increase their borrowing so as to mitigate the health, social and economic impact of the crisis. Yet we are still seeing a gap between the fiscal response at the national level and the estimated economic consequences of the crisis, and there is a risk that this could lead to greater divergence in the euro area.

The ECB counters such fragmentation in line with its mandate. To avoid setting the wrong incentives in the long run, the asset purchases are linked to the length of the crisis and net purchases will be stopped once it is over.

Proportionate monetary policy

The PEPP is the ECB’s response to the worst economic crisis since the Second World War. If we had not taken decisive action, we would now probably be in the midst of a severe financial crisis. The PEPP helps to ensure the transmission of monetary policy, to preserve jobs and investment and to safeguard price stability. The benefits of our monetary policy measures clearly outweigh the costs. This means that the measures taken by the ECB in response to the crisis are necessary, suitable and proportionate – for the benefit of all European citizens.

This blog post first appeared as an opinion piece in the Welt am Sonntag on 28 June 2020.