The primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set.
In 1999, 12 European countries joint in a monetary union, adopting a single currency and taking the same monetary rules. To conduct the common monetary policy, it was created an independent institution, the European Central Bank (ECB). According to the statutes, the European Central Bank must ensure price stability which was defined by the Governing Council as year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below, but close to 2%. In order achieve it, the main instrument used is interest rate.
Until 2007, there are no big doubts that the ECB was able to fully commit with its objective. However, after this period, the objective was harder to attain. In fact, after 2007 inflation was more volatile and consequently the price level was not so stable as before. In 2007, a set of events happened that made monetary policy harder and create some challenges. Actually, the crisis of 2008 is called the Big Recession that is only compared with the Big Depression of 1929. From 2007 until the most recent days, some actions and speeches affected the course of monetary policy in Europe. In this article, I will focus on that, presenting the economic intuition for them.
2007 – 2009: Lack of confidence and liquidity problems
The first incident was an injection of €94.8 billion by the ECB in the Eurosystem, at that time the biggest one ever, to deal with a liquidity crisis of the banking system. The origin of this injection was a lack of confidence of commercial banks that put the interbank interest rate (EONIA) at maximums. BNP Paribas, one of the largest European banks, made a declaration suspending three funds that were based on Asset Backed Securities whose associated products had started to have ratting problems. After that, EONIA continue to increase because banks no longer trust in each other and the liquidity of the system vanished. To try to solve the liquidity crisis and avoid a big financial crisis, the ECB had to intervened lending to almost 50 commercial banks. As we know today the crisis was not avoid, only postponed, and despite of that, some economic historians consider the 9th of August of 2007 as the start date of the Big Recession.
Nevertheless, only on the 15th October of 2008, the first big commercial bank felt and the consequences of the international financial crisis arrived to Europe. The European monetary policy start changing through altering interest rates. The rate on the main refinancing operations went from 4.25% to 2.50% during 2008. This was the response of the central bank to the problem that surged in the interbank market. Banks did not belief each other any longer, since nobody was sure about the risk it was to lend to another bank. Economically speaking, there were enormous asymmetries of information on the real value of assets of banks’ balance sheet. In response, the interbank interest rate continued to grow, in other words the market breakdown – there was no price that cleaned the market. The action of the central bank of decreasing interest rate made EONIA fall, as expected, and inflation rate went up reaching historical maximums of roughly 4%. Several economists criticize the action of ECB because it failed on assuring price stability, its main responsibility.
2010 – 2013: Spend, Indebt, Rescue. Repeat
But the crisis had already installed giant problems. With the subprime crises, GDP stop growing which led the major developed economies into a recession, including the European countries. European governments, following the recommendations of the European Commission, increased public expenditure which created huge public deficits and a problem related with sovereign debt. Indeed, European countries in 2010 had enormous public debts, most of them above the 60% limit imposed by the Maastricht Treaty. Until these days, markets had always trusted the capability of countries to pay its debts. However, back to that time markets became very suspicious and started doubting on the credibility of some countries to pay. Interest rates of public debt of Greece, Ireland, Portugal, Spain and Italy reached very high values that some countries were not able to deal with. On top of that, and especially in these five economies, the health of the financial system was weak.
Between 2010 and 2013, five European countries received financial help from troika (ECB, European Commission and IMF). The first was Greece to deal with the high levels of public debt and solve several structural problems, receiving 3 different financial rescues (€110bl+ €130bl+ €80bl). Ireland came after with a help to deal with the financial system problems that were contaminated with the subprime of USA (€80bl). The third country was Portugal that received the money (€78bl) in a time where there were several doubts on how to pay the salaries of public servants in an economy with very high levels of external debt, especially public debt. Spain and Cyprus have also received international financial help, when they felt a sudden stop that closed international financial markets to them. The money was essentially to the financial system, namely the banking system that was full of troubles. During this time, several other European countries received small amounts of money to be able to deal with problems in their financial systems and avoiding self-fulfilling crisis.
2013 – 2016: Super Mario fights the Euro Zone monster
In the middle of this time, the ECB president changed and with the new president some policies were implemented. In the very beginning of his mandate, Mr. Mario Draghi created a program of very long-term loans with the aim of increase the security of the banking system. In July of 2012 he delivered one of the most famous speeches during the crisis, where he said that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” These two sentences changed the way how markets thought about ECB. With this speech, Mr. Draghi said that the central bank will not only commit with price stability, but also with the survival of euro. In the very same day, he launched a program to buy public debt of countries in need, namely the ones that were under financial help programs. Also, since this day the interest rate felt in a consistent way.
Still, these conventional policies were not enough. Between 2013-2015 the Euro-Area lived afraid of another “economic monster”: deflation, i.e. the fall of price level. Thus, the European Central Bank had to create other measures to avoid it, which are called non-conventional measures. One of the first ones was the forward guidance, where the Central Bank gave guarantees of the interest rate for the medium and long term. The idea is to stabilize expectations of monetary policy for a longer-term and protect the Euro zone from other exogenous shocks.
Furthermore, the ECB had also extended the program of buying assets with a big emphasis on public debt, acquiring €60 billion per month. In March of 2016 it increased to €80 billion per month to finally destroy the monster of deflation and, on top of that, in the same day, the official interest rate was set to zero percent. European economy is in a liquidity trap, it reached the zero lower bond. Conventional instruments are not enough and only with extra measures, as the quantitative easing is possible to produce real effects on the European economy.
2017: After a storm comes a calm
More recently, in 2017, the risk of deflation has already gone and inflation rate have been consistently increasing (in September of 2017 it was 1.5%). In March of 2017, Mario Draghi announced a reduction in the asset buying program returning to €60 billion per month. Nonetheless, interest rate is still at the zero lower bond. In the last October, it was announced another decrease of the asset buying program to €30 billion for September of 2018, but fragile economies as Portugal will continue to be supported by the Central Bank that will buy its public debt. Moreover, the interest rate will stay low, further beyond the stimulus program of ECB. Indeed, the prediction of inflation rate for the next periods is still below the target of 2%. The ECB wants to keep the Euro zone together.
- Agarwal R., Kimball M.; “Breaking through the Zero Lower Bound”, 2015
- Armstrong A., Caselli F., Chadha J., den Haan W.; “Monetary policy at the zero-lower bound”; 2 Aug. 2015
- “As seis fases de uma década de crise na Europa“; Jornal de Negócios; 12 Aug. 2017
- Draghi M; Speech in 26 Jul 2012
- “ECB injects €95bn to help markets.”; Financial Times; 10 Aug. 2007
- Stark J.; Speech in 9 Nov. 2009
- Statistical Data Warehouse – ECB, accessed in Nov 2017
- Treaty of Functioning of the European Union, Article 127º 1