Governments Have Put the ECB in a Bind
If you think it will be hard for the U.S. Federal Reserve to normalize monetary policy, spare a thought for the European Central Bank.
The euro zone's monetary guardians have said they will continue to buy 60 billion euros a month in government and corporate bonds until the end of 2017. Headline inflation is running at 2 percent -- the central bank's target is "close to but below" 2 percent -- and the bloc's recovery is finally under way. Soon the ECB will face the challenge of getting monetary policy back to normal.
In this it will have one advantage over the Fed: Europe's policymakers will be guided by the U.S. central bank's experience. This means the ECB's exit process is likely to follow the same sequence. First, scale back bond purchases; next, start raising rates; later, deal with the stock of bonds on its balance sheet.
In other ways, though, the ECB's task will be a lot harder than the Fed's. Both central banks want to normalize monetary policy without spooking the bond market. In this, confidence that growth is sufficiently robust makes all the difference. The ECB hopes that by the end of the year that confidence will be in place. For the euro zone as a whole, it may be -- but the bloc includes countries such as Portugal and Italy, struggling with high public debt and feeble recoveries. A monetary tightening, though appropriate for the euro zone as a whole, will be dangerous for its weakest members.
The end of quantitative easing also risks exposing flaws in the design of the euro zone that were so evident during the sovereign debt crisis. Without fiscal transfers among members of the currency union, countries will have to persuade investors to continue funding their deficits. In principle, the ECB can now step in and buy the bonds of a government in trouble (through the Outright Monetary Transactions scheme), but this plan requires the borrower in question to have an agreed adjustment program, and it's never been tested.
To ensure a smooth exit, the ECB will therefore need help from governments. Politicians need to ensure that their countries can attract bond investors and won't have to test the ECB's safety net. Devaluation to improve competitiveness is not an option, so this will demand stronger efforts on structural reform -- ranging from deregulating markets for goods in Italy to reforming the market for workers in France.
In addition, it's past time for the euro zone to strengthen the bloc's institutional foundations. Governments need to complete the banking union -- providing, among other things, a system-wide deposit-guarantee scheme. Coordinated fiscal policy and other moves to fashion, in effect, a Treasury for the euro zone ought to follow.
Granted, to call all this difficult would be an understatement. At the moment, Europe's citizens don't much favor deeper integration, and their leaders have shown no interest in making the case. The less politicians do at the EU level, the more important it is to make bold reforms in the individual nations -- but governments are underperforming there as well.
As in the U.S., only more so, Europe's central bank will probably be asked to do too much because governments still aren't willing to do enough.
--Editors: Ferdinando Giugliano, Clive Crook
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