ECB headquarters, Frankfurt, Germany (DXR, CC BY-SA 4.0)
CE Financial Observer: In comparison with other central banks in the world, the European Central Bank is a young institution, only 20 years old. How do you assess the first decades of its operation?
Ricardo Reis: Indeed, the ECB has not been around for long, and recessions and crises do not happen very often. Therefore, we do not have satisfactory data to undertake a full and unambiguous assessment of this institution. However, these 20 years of the ECB’s work have been quite interesting. The activities of the ECB can be assessed on the basis of five criteria.
Firstly, the task of stabilising prices. Here, the ECB has succeeded. Inflation has been, and still is, very stable, and although it is slightly below the inflation target, in my opinion it is not so important. Despite the recession, the financial crisis and the risk of the Eurozone disintegrating, the ECB kept inflation in check. However, this could have been due to coincidence or to the imitation of others, and not due to the good work of the institution itself.
The second criterion is therefore an institutional criterion: whether the ECB is an independent, self-thinking institution. In this area, I believe, the ECB has also succeeded. Despite political tensions, it managed to put up with the pressure of politicians when it was necessary, and to work together with them when it was reasonable. Neither Jean-Claude Trichet nor Mario Draghi abandoned their independence. The ECB has therefore become a respected institution throughout the world, not least because of the quality of the economic research that its scientists carry out and the innovative monetary policies that it has applied.
Janis Varoufakis, the economist and former Greek Finance Minister, would not agree with the opinion that the ECB maintained its independence. In his opinion, during the Greek crisis the ECB played as Germany and France dictated and did not look for an optimal solution of the problem, but the one that would satisfy these two countries. How do you comment??
Janis Varoufakis is one of the worst finance ministers of all time.
That is a strong statement.
Let us start with the fact that the ECB was part of the so-called Troika, together with the European Commission and the International Monetary Fund, and therefore, by definition, was a subject of great pressure from various groups. The bank had to look for solutions in very difficult circumstances and found them. The fact that, in the end, the Troika spoke with one voice was a sign of compromise, and not of someone dictating the ECB what to do. Mr. Varoufakis in the performance of his duties did not discuss the substance of the solution and threatened the Troika that Greece would never repay the bonds that the ECB bought back. He also said that Greece would leave the Eurozone and introduce its own currency. The ECB dealt with these threats by, for example, introducing controls on capital flow in the monetary union. It was a bold move, but it was the right one. The bank also made it clear: fiscal transfers are outside its mandate, and that is what Varoufakis wanted — the ECB to become a fiscal transfer vehicle in the Eurozone. That would be the politicisation of the bank.
However, I disagree with the statement that the ECB is doing an excellent job. Eurozone countries are going through crisis, they are almost not growing and are indebted. The ECB must have something to do with this.
Slow down. There are three more ECB assessment criteria that will respond to your objection. In addition to the task of controlling prices, the ECB is also supposed to stabilise economic activity and, in particular, prevent crises. That is clear: the ECB did not prevent crises. Of course, as far as the global financial crisis of 2008 is concerned, it could not have done much itself, but it could have addressed the other crisis in the Eurozone, a public debt crisis in Greece and then Italy.
Meanwhile, under Trichet, the ECB responded to the first signs of problems too late. For example, the stress tests of European banks were carried out too late. There was no reflexing and this translated into deeper problems. Let us go further — the fourth criterion, namely the EUR as a global reserve currency. The goal was to outdistance the USD, even the Chinese were supposed to accumulate the EUR. They do not. Significant reserves of the EUR are held only by Central and Southeast Europe (CSE), due to their proximity to the Eurozone. Here, the ECB failed all along the line. Fifthly and finally, the ECB’s capacity to regulate financial markets and implement macro-prudential rules for banks, and to ease restructuring processes. I doubt whether the ECB will be able to cope, and my doubts are exacerbated, for example, by how the way it dealt with the bankruptcies of banks in Portugal and Spain, which is not very well. That is not being discussed, because they were small banks.
Over the last four years, a lot of research based on counterfactual analysis has been published. „What would have happened if the Eurozone countries had never entered it?” It turns out that many of these countries would have done better, and we are talking about the dynamics of GDP. Perhaps the ECB oversees an organism that subdues economic growth and even makes its own contribution?
In fact, you are asking two questions at the same time. One is whether the ECB’s policy hurts the economic growth of the Eurozone countries, and can it be blamed for the poor performance of Portugal, Greece, Spain or Italy? I don’t think so. The ECB has pursued a good monetary policy, and the problems these countries face are linked to the productivity of their economies, which is too low and is too influenced by their governments, not by the ECB. Secondly, do these countries’ problems stem from the fact that they have joined the Eurozone at all? There is no clear answer here.
The research you mention indicate that if you join a monetary union with an undeveloped financial market, you risk a large influx of capital that you may not be able to deal with. Then speculative bubbles are created, new investments are often misguided, productivity is not rising. It is not, therefore, monetary union that is to blame, but that capital in such a situation does not encounter any barriers and flows in an uncontrolled manner into not-prepared countries.
Do you suggest that capital flows should be controlled from the beginning in Portugal, Italy, Greece and Spain?
One of the fundamental principles on which the European Union was built is the free movement of capital, so that would be contrary to this principle. I also think that the free movement of capital, goods, people and work is the overriding value, despite the fact that, like everything else, it also has its costs. If we start to expose these costs too much, we will come, for example, to the conclusion similar to the one the British came; that a further influx of Poles into their country is not advisable.
The EUR was established on the basis of, among other things, the theory of an optimum currency area, which states that currency union works well where its members are economically similar. The other assumption was that the EU Member States strive for economic convergence on their own. How do you assess these theories in the light of the real experience of the Eurozone?
In terms of the optimum currency areas, this is an area of research that highlights the pros and cons of joining monetary unions. It is difficult to say that the experience of the EUR refutes or confirms it. However, I do not think that this theory is of any use in explaining the recent problems of the Eurozone, because it was a financial crisis and not the asymmetric trade shocks that it describes.
On the other hand, the convergence hypothesis states that the poor in the monetary union are growing faster than the rich. The Eurozone shows that it is incomplete. The poor did not grow any faster than the rich. However, when confronting theory and practice, let us not forget that the EUR was a political project from the outset, and it was politicians, not economists, who decided on the creation of a monetary union. Economists showed only pros and cons. It is also certain that the last 20 years have taught us a lot about the economy. For example, how important it is to have capital flows that sometimes lead to misallocations, or how much the financial markets can shake the economy. We already know now that it was a mistake to set up the Eurozone without at the same time establishing some kind of an asset to guarantee its stability. I am not talking about Eurobonds, because they would lead to a situation in which some people would pay for the mistakes of others, but about the asset which would be jointly issued by all the Member States of the Union, making it safer for investors.
What have the recent crises taught us about central banks themselves?
The fact that they can, if they remain independent and stick to the meritocracy, control inflation in the range of 0-2 per cent. That we should expect them to take care of the stability of the financial system and reduce the frequency of crises. Central banks have a role similar to that of fire brigades, which on the one hand have to extinguish fires and, on the other hand, try to make them less frequent by ensuring compliance with the safety regulations. However, we should not expect a central bank to speed up economic development or combat inequalities. It cannot do this.
One of the benefits of the existence of the ECB was to deprive national governments of the tools to finance debt through inflation.
Yes, because it is very well historically documented that any time a central bank starts to be used to generate fiscal revenue, there is hyperinflation.
But how do you explain the fact that investors lent money to the governments in the South European countries, knowing that they did not have monetary freedom and could be insolvent?
The answer is simple. Europe, like the rest of the world, has experienced a convergence of interest rates at a low level. Investors thought that the bonds of all the Eurozone countries were equally risky, even though it was a misjudgment, and they directed funds to countries with the highest interest rates. There were also no restrictions on how much a bank could hold its own country’s bonds. This guaranteed a steady demand for the bonds and fueled the debt spiral.
Some EU members, like the United Kingdom, never wanted the EUR and did not adopt the EUR. Has the UK lost or benefited from this move?
I think the United Kingdom has gained little, firstly, because it had efficient capital markets and, secondly, it did not borrow in foreign currencies. The country that, in turn, would be better off outside the Eurozone is Finland, which, in 2010 experienced trade shocks in the form of a collapse in trade with Russia, on which an embargo was imposed, and the collapse of Nokia. At that time, the exchange rate of the Finnish currency should have dropped by 30-50 per cent to cushion these shocks, but it could not, because they did not have their own currency, only the EUR. While Finland would have managed the crisis better without the EUR, the PIGS countries (Portugal, Ireland, Greece, and Spain) would not have done so due to institutional conditions. The decline in the value of the currency would be accompanied by a lack of confidence in the independence of a central bank, high inflation mentioned above would occur and the recession would be twice as deep. If you want to ask whether Poland should adopt the EUR, I do not know. There are arguments against, but there are also arguments in favor. And they are strong.
Ricardo Reis is a Professor at the London School of Economics, banking system specialist and macroeconomist.