Credits : Felix Scheuenstuhl
Many of us CoE-students want to work, one day, in the European Institutions. For ECO-students the holy grail is without doubt the European Central Bank. Even though it is located in Frankfurt, not really Germany’s most beautiful city, the independent and powerful Central Bank of the Eurozone is one of the most attractive places to work. Just imagine being one day President of the ECB… A wonderful dream or a nightmare?
For Christine Lagarde, President of the ECB since a little more than 100 days, it seems to turn out to be a nightmare. The Corona-crisis is a perfect storm, combining a health crisis with the biggest economic shock of the century. Lagarde’s and the ECB’s actions will determine whether the euro will survive this crisis or whether it will fall into pieces.
So let’s have a look at what the ECB can actually do
The traditional instrument of central banks in times of crisis is lowering the interest rates. But since 2016 the interest rates of the ECB are at 0,00 percent, not leaving much room for action, with the exception of negative interest rates. In these situations, central banks can still inject liquidity into the market via purchasing programmes on secondary markets, most famously known as Quantitative Easing. In 2015 already the ECB started buying assets, mostly bonds, from commercial banks in order to boost economic growth in the euro-zone.
The ECB explains the effects of quantitative easing the following way: when a central bank buys bonds from commercial banks, it increases the price for bonds and thus creates money in the banking system. As a consequence, interest rates fall and loans become cheaper, which allows businesses and consumers to borrow cheaper and invest or consume more. This boosts the economy and creates jobs. But most importantly, this creates higher inflation pressure, bringing the currently too low inflation rate closer to the 2% target.
Hasta la vista - ECB pulls out the bazooka
Last Thursday, 19th of March 2020, Christine Lagarde announced that the ECB will put in place a Pandemic Emergency Purchase Programme. With the announcement of purchasing up to almost €1.000 billion in sovereign and corporate debt on the secondary market, the ECB takes out what is called among central bankers the “bazooka”. This represents approximately 7.3% of the Eurozone’s GDP.
In 2012, Mario Draghi had already declared that the ECB would preserve the euro, “whatever it takes”. It was time on Thursday for Lagarde’s Draghi-moment, stating that “there are no limits to our commitment to the euro.” The first reactions of the markets were encouraging, with dropping spreads of sovereign bonds for countries like Italy. But will this be enough?
The last resort - Make it rain…Cash!
Credits : Felix Scheuenstuhl
While Draghis announcement turned out to be a self-fulfilling prophecy, for Lagarde’s ECB it could be insufficient. With most of the European economy not only being slowed down, but put on hold and consumers locked in their homes, the upcoming economic crisis might be much stronger than the previous financial crisis in 2007-8.
“Cash not credits” is what the Eurozone needs said Wolfgang Münchau in a recent opinion article for the Financial Times. Milton Friedman had already suggested in the 1980s to drop cash from helicopters when conventional monetary policy is ineffective. Instead of channelling money through the banking system, the ECB could put money directly in consumers’ and companies’ accounts. This would allow to fight the shock on the demand and supply side.
While consumers will be happy to wake up with €1.000 more on their bank accounts, it will take a bit more for companies. However, just as children get used to Christmas presents, citizens and companies might be expecting with each new crisis a big cheque from the ECB. This moral hazard might make citizens, companies and ultimately governments also, less willing to restrain expenses, because they know that in this case, Christine Lagarde will bail them out.
Extra-ordinary times require extra-ordinary measures
For now, we cannot say whether the ECB’s record purchasing programme of almost €1.000 billion will be sufficient to extinguish the fire. Without doubt countries and markets will need a lot of support from the ECB to deal with the economic effects of the corona crisis. Whether we see Lagarde making it rain cash will depend on the following question: How desperate are European central bankers, if more firepower is needed?
This article is the first of the series: Three Women to save the Euro – Economics in times of Corona. The first article will focus on the European Central Bank’s reaction to the corona-crisis. Later articles will investigate how the EU with its Commission President Von der Leyen prepares the EU for upcoming economic crisis. Lastly, it will be analysed how a member state, in this case Germany governed by Angela Merkel, wants to protect its companies and workers.
Written by Felix Scheuenstuhl, 23rd of March 2020