Is the ECB doing the right things?

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Euro coin gears and cog wheels

I participated in a conference about ECB policy a few days ago. The programme was set up in such a way that one speaker was critical of ECB policy while another (me) was speaking in support of the ECB's actions and a third represented the 'view from Germany'. Let me summarise the discussion here by going through the arguments of the other speakers and my response to their points. I have not checked this text with them, so I do not know if they think I am representing their views adequately here. That is why I will keep this anonymous.

Defenders of aggressive monetary policy argue that there is a persistent lack of demand in the economy and that the ECB's policies are an effort to prop up demand. Han de Jong Han de Jong Chief Economist

The (very) critical assessment of ECB policy was built on three pillars. First, it was asserted that the ECB was not set up to be an inflation targetter and that what the ECB is doing is its QE-programme is de facto illegal. QE on the scale the ECB is doing is monetary financing even if the ECB has found a clever way to argue that it is not. The second argument was that the ECB's assessment of the current economic situation is wrong. The third argument was that the very low level of interest rates and QE is doing more damage than good.

The 'view from Germany' consisted of many points, but I just want to highlight the argument that ECB policy is causing enormous trouble for (life)insurance companies. By extension, Dutch pension funds are also in trouble because of the low level of interest rates.

Is the ECB an inflation targetter?

I think this is a complicated discussion. I did not participate in ECB discussions about its strategy framework. And it may well be true that the ECB originally did not want to be an inflation targetter. However, circumstances change and for all intents and purposes, I think we must now consider the ECB an inflation targetter.

I would not want to argue with the assertion that QE is effectively a form of monetary financing. The Treaty on which the ECB is based, forbids monetary financing, so I can see the problem. But what is easily overlooked in my view is that we must realise that the ECB was set up when inflation risks were taken seriously, but deflation risks were not. The ECB was, therefore, left with tools to fight inflation, but not deflation.

Is the ECB's assessment of the situation wrong?

Defenders of aggressive monetary policy argue that there is a persistent lack of demand in the economy and that the ECB's policies (as well as other central banks', for that matter) are an effort to prop up demand. But the critical argument was that there is always scarcity as people always have unfulfilled desires. I think that last observation is very true, but the problem is that you need money to turn desires into demand in an economic sense.

Another discussion focussed on the question of how bad negative inflation really is. One can make a distinction between good and bad deflation. Good deflation occurs as a result of technological progress pushing down prices. Alternatively, if import prices fall, this could also trigger prices to fall economy wide. The combination of falling prices and stable or rising incomes implies an improvement of purchasing power. That is good. Bad deflation occurs if prices are lowered when companies try to sell their stuff when demand is weak and in order to protect their profits, they lower wages. If all companies do this at the same time, the result will be that overall income falls and demand is even weaker. A downward spiral of prices wages and output may then occur and debt levels will rise in real terms even if they remain unchanged in nominal terms. That is bad. I think we probably have a combination. In some areas of the economy, prices are falling thanks to technological progress. But in other, weak demand is probably the key driver. If we only had good deflation surely economic growth would be stronger.

Nevertheless, I think it is a fair question to ask is the ECB is overreacting to the alleged deflation threat. Bad deflation is a nasty process and we are clearly not in such an unpleasant spiral at this point in time. However, a common view, and certainly my view, is that the best defence against deflation is not to fall into it in the first place as it is painful and it is very hard to get out of it. What seems to have triggered the ECB was the drop of inflation expectations in the course of 2014. The idea is that expectations determine behaviour and should inflation expectations turn into deflation expectations, they may become a self-fulfilling prophecy. The problem with the ECB's view in 2014 is that inflation expectations fell largely as a result of falling oil prices, which would represent 'good deflation' for the eurozone, an energy importer. So whether or not you think the ECB is overreacting is clearly a matter of judgement, not something that can be determined objectively. Unfortunately for the ECB, they can count on criticism either way. Should the economy fall victim to painful deflation, the ECB will be criticised for not having done enough. And if deflation is avoided, critics will see that as proof that such aggressive policy was not necessary. So even afterwards, we will probably not been able to determine objectively if aggressive policy was justified.

I actually think that the key here is the output gap, or the slack in the economy. Disinflationary pressures are the result of the output gap. The recessions of 2009 and 2012/13 led to a lot of slack in the economy. While the recovery started in 2013 and slack has been reduced, there is still slack left and it may be this persistence of slack over an extended period that could trigger deflation. Therefore, a serious effort to close the output gap is.

Are low interest rates and QE doing more damage than good?

This is an argument often made. The idea is that low interest rates do not encourage spending and in fact only force people to save more. In addition, it is argued that low interest rates make low-return investment projects look viable, pushing the economy into a low-return, low-productivity growth mode. Last, it is argued that low interest rates reduce the pressure on governments to implement structural improvements in their economies in order to raise potential growth.

I do not think these are very compelling arguments. For sure, some people will save more in the face of very low interest rates. But this can hardly be true in aggregate. That would put all ideas economists have about how interest rates affect the economy upside down. If low interest rates reduce spending, should interest rates be raised to encourage spending? This has never been tried and rightly so. In addition, lower interest rates mean a drop in financing costs for borrowers and they can spend their interest cost savings even if they do not borrow more.

As for locking in low-return and low-productivity growth, I can see that this could be the case. However, there is nothing stopping people engage in high-return projects with strong productivity growth. The problem is that that is not happening. If low-return investment projects are the only ones around, it is better to have them than not to have them.

I also agree with the idea that low interest rates reduce the pressure to make economies more dynamic by implementing structural reform. At the same time, I must say I never noticed any great appetite for such reform when interest rates were much higher. So I am not sure if that pressure really works.

Smaller government and lower taxes

The speaker who was very critical of ECB policy expressed the view that what we needed to improve our growth potential is smaller governments and lower taxes. While I am much more supportive of the ECB policy than this critic, I could not agree more with him on this point.

Is ECB policy working?

In my own talk at this conference, I did not only argue against points made by others, I also raised the question if aggressive monetary policy is successful. I think the answer to that question is 'yes'. In the case of the Fed, I think most people would agree with that. In the case of the ECB, views are probably more diverse. But I note that the working of the credit channel is improving, bank lending is growing again and economic growth, while unspectacular, is able to make some of the slack in the economy disappear.

While I am positive about aggressive monetary policy under current circumstances, I always stress that this is a huge experiment. There are all sort of side effects. The covered bond market, for example, is very distorted and, arguably, so are government bond markets. We cannot be sure what that will lead to.

I am surprised and (very) irritated by politicians in a number of countries attacking the ECB. In fact, I think they have considerable egg on their faces. The main reason for low interest rates is that potential growth of our economy is low. Eurozone politicians have focussed on the straightjacket of the Stability and Growth Pact, resulting in significant austerity, aggravating the downturn in recent years. In fact, these politicians have failed to make their economies more dynamic. In fact, I think their failures are forcing the ECB to do the things it is doing.

Perhaps it is also good that the ECB is going through this experiment now. Inflation and interest rates have been on a downward trend since the early 1980. Of course, interest rates have moved in a cycle, not a straight line. But peaks and troughs in this cycle have been consistently lower than previous peaks or troughs. This probably means that during the next cycle, the ECB will hit zero-interest rates very soon, forcing them to look for alternative policies.

Pension funds and (life)insurers

Low interest rates are causing problems for pension funds and (life)insurers. As I am more familiar with pension funds, let me focus on them. I checked the data for Dutch pension funds, comparing data at the end of 2007 to data at the end of 2015. The annual return on investment over this period has been 6% according to my calculations. That is not bas considering that equity market returns over this period have, on balance, been very subdued due to huge losses in 2008 and then also sizeable losses in 2011. Falling interest rates have, obviously, been very beneficial for investment returns of pension funds. This strong investment performance has allowed pension funds to grow as a percentage of GDP. At the end of 2007, pension fund assets in the Netherlands amounted to 109% of GDP, by the end of 2015, this had gone up to 163%. I estimate that 5%-points of the rise was due to premiums paid have exceeded pension payments. That still leaves a rise of 49% of GDP in pension fund assets resulting from investment returns over an 8-year period. Not bad, I would say.

ECB critics argue that the ECB is responsible for the very low level of interest rates. I personally think that the ECB has merely tried to make sure that actual interest rates are as close as possible to the 'natural interest rate'. But if one blames the ECB for low interest rates, one must also thank them for the investment returns made on bond holdings. Instead of being grateful, people are worrying about the low funding ratio of pension funds. The present value of pension fund liabilities has obviously risen faster than asset values due to the decline in interest rates. As a member of a pension fund, I get an annual update about my entitlements. Apart from building up these entitlement by a small amount very year, I do not see a spectacular rise in my entitlements. Yet, I do see a spectacular rise in total pension fund assets as percentage of GDP.

Should I be happy and feel comfortable? Not if you listen to most commentators. It makes me wonder in what sort of world we are living. The answer is fairly obvious: it is a world ruled by actuaries. I understand that it is hard to achieve high investment returns in the future starting with large bond holdings at current extremely low (and even negative) yields. But that simply raises the issue expected returns on other asset classes and of asset allocation.

I apologise to the reader for ranting. It is just that I feel strongly about this. Perhaps it is OK to make a last point. If one takes the view, which I do not, that ECB policy has made life for pension funds so much more difficult (I think it is the rules by which we govern our pension funds that have made life difficult) then one must ask if that really should be a strong consideration for the ECB while setting monetary policy. I think not.


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