02 Jul 2018

"The Problems We are Seeing Today Did not Happen by Accident”

SAFE Policy Lecture: In the view of Ashoka Mody of Princeton University, the ECB has suffered serious damage in recent years

Since March 2015, the European Central Bank (ECB) buys securities, most recently for 30 billion euros a month. The aim of the purchases is to reach the price stability target of an inflation rate below, but close to, 2% in the euro area. In mid-June, the ECB announced that it would end its purchases by the end of the year. According to Ashoka Mody, Visiting Professor at Princeton University's Woodrow Wilson School and former head of missions of the International Monetary Fund about financial stability in Europe and Germany, the ECB is between a rock and a hard place: if it actually stops the buying programs as announced, Mody expects the euro to devalue and interest rates to rise which could increase financial fragility in the euro area, especially with regard to member states such as Italy. Should the ECB nevertheless continue the purchase programs and thus continue to buy Italian government bonds, it risks high losses from Mody's point of view. At a SAFE Policy Lecture on 22 June, Mody talked about his assessment of the situation in the eurozone, whose historical development he outlined in his book "Euro Tragedy: A Drama in Nine Acts".

In his presentation, Mody initially addressed the history of the origins of the euro: he recalled the role of Chancellor Helmut Kohl, who had pushed ahead the project of the common European currency as a guarantor of peace. According to Mody in 1998, Kohl emphasized that, according to the Maastricht Treaty, member states did not advocate for the debts of other member states and that there would be no further financial transfers. Other core elements of the Maastricht Treaty were the deficit rules of three percent of gross domestic product, a price stability target and an independent European central bank. There was resistance to these agreements: "France disapproved of the ECB's independence, as well as the deficit rules," Mody said. The ideological differences between France and Germany were so clear early on.

The euro area is put to the test

He also recalled that the construction of the European Monetary Area was criticized at an early stage, especially by economists from the Anglo-Saxon area. Paul Volcker, the former president of the US Federal Reserve (Fed), warned against a too independent central bank, as this would lead to a lack of accountability to the public and policymakers. The strong emphasis on price stability was criticized, for example, by economists Franco Modigliani and Robert Solow, as this would lead to excessive interest rates and worsen unemployment in the currency area. "The problems we are seeing today did not happen by accident," Mody said. Rather, they are the result of a historical process.

The euro area has been tested several times, first in 2001 with the bursting of the New Economy bubble. The reaction of the ECB and the Fed was very different back then, Mody recalled. While the Fed cut interest rates sharply, the ECB reacted more hesitantly - in the eyes of Mody, a consequence of the internalized, too-strong price stability target. The recovery in the US therefore started earlier than in the euro area.

Referring to the 2007-2010 financial crisis, Mody said that the US has put much more emphasis on expansionary fiscal policy than the euro area. To this end, the ECB supplemented this with an initially tight monetary policy and even increased the interest rate in the crisis in July 2008, when the Fed already lowered it. The result from the perspective of Mody: Once again, the US recovered faster than the euro area.

The next momentous error followed from the economist's point of view in July 2011, when the ECB raised key rates, while economists warned against deflation. The crisis continued to worsen until ECB President Mario Draghi delivered his "Whatever it Takes" speech. In September 2012, the Outright Monetary Transactions Program (OMT) was adopted. By mid-2013, US and euro area inflation rates had been declining steadily, with Europe's inflation rate plummeting, according to Mody. In his view, the Eurosystem decided too late for Quantitative Easing (QE), inflation initially remained at a low level and developed strongly in member countries such as Italy and Germany. "That means that the key rate is far too high for Italy and too low for Germany," said Mody. For him, this is a direct consequence of the common monetary policy in the euro area. "The policy alone is unable to deal with two countries that diverge economically," Mody said. The ECB also failed all in all to depreciate the euro through QE in order to boost demand and fuel inflation in the euro area. The strength of the euro would ensure that economically weaker member countries would be at a competitive disadvantage, Mody said.

In his view, the ECB has suffered serious damage. There is no explanation for the mistakes and omissions of recent years, so Mody. "In my view, the ECB has lost credibility in successfully fighting recessions and deflation," Mody said. In the market, these doubts would persist.

In the following discussion, Mody was pessimistic about whether there could ever be a fiscal union in the euro area. "There is no historical basis for this," Mody said. Likewise, he does not believe that France will agree to the transfer of French tax revenue for a common budget. He described the scenario of Italy's exit from the Eurozone as "catastrophic". Such an event would have the potential to trigger a new financial crisis, Mody said.