Europe Has No Bubbles to Fear -- For Now
Talk to critics of the European Central Bank’s ultra-loose monetary policy and a common theme emerges: concern about financial stability. Quantitative easing is seen as creating dangerous asset bubbles. Negative interest rates are said to hurt bank profitability, making the financial system more vulnerable to shocks.
These concerns are widely misplaced. In fact, the real worry should be the risks that arise from ending monetary stimulus too soon. A premature tightening could cause euro zone government bond yields to spike, raising doubts over debt sustainability in the weakest member states.
There is little evidence so far that the measures the ECB has implemented to lift inflation and revive growth have had any dangerous side effects for financial stability. The Bundesbank has warned that the ECB’s unorthodox monetary policy has pushed up property values in Germany, adding that house prices in some German cities are now overvalued by up to 30 percent. However, while property prices may be climbing fast in some parts of the euro area, the increases are well in line with long-term valuations. When they are not -- for example in the case of prime commercial real estate -- the increase does not seem sufficiently widespread to threaten a financial crisis.
A second fear relates to negative interest rates. Instead of paying banks interest on their extra reserves, the ECB now charges banks a rate of 0.4 percent for storing their money. Some central bankers, such as François Villeroy de Galhau, governor of the Bank of France, are now warning against this policy, which they fear is eating too deeply into the profitability of the banks.
Still, the evidence that negative rates are hurting the banks is flimsy. True, between June 2014 and September 2016, the ECB’s monetary policy reduced the margin between deposit and lending rates for the median bank by 1 percentage point. However, only a quarter of this effect can be attributed to negative rates, according to the central bank’s own calculations. Meanwhile, the ECB’s easing package has delivered other benefits, for example improving the quality of credit by reducing the risk of default. The overall impact on the profitability of banks appears negligible. A much bigger challenge for banks -- in Germany and elsewhere -- is to adapt to the digital revolution, cutting costs and finding new revenue streams.
For now, the continuation of the ECB’s stimulus does not pose particular risks to financial stability. Its premature removal, however, would. As the latest issue of the ECB’s Financial Stability Review has shown, stress in the euro zone sovereign bond market has increased around the turn of the year. On aggregate, government debt for the currency area stands at around 90 percent of gross domestic product, which is high by historical standards. An increase in sovereign risk could have an impact on debt sustainability for the most vulnerable countries, such as Italy or Portugal, where debt is around 130 percent of GDP. And since many banks still hold large quantities of domestic government bonds, these tensions could easily spread to the financial system.
These risks suggest that the ECB should err on the side of caution when it withdraws its stimulus. Luckily, the central bank can afford to be patient: the inflation rate in the euro area -- once stripped of its more volatile components -- is still well below the central bank’s target of just below 2 percent. Unemployment remains high; the recovery has further to go before putting pressure on wages.
But there are risks that are beyond the control of the ECB. The most important one is the divergence between countries in the euro area. Mario Draghi, ECB president, has made it clear he will not withdraw the monetary stimulus unless the pickup in inflation is broadly spread across the currency union. However, it is possible that the recovery will be faster in some countries than in others. When the ECB chooses to wind down QE and raise rates, the most vulnerable member states could face an exceedingly tight monetary policy. This could spook investors, raising fears over debt sustainability.
With a one-size-fits-all monetary policy, the ECB is poorly equipped to deal with possible financial turmoil in one or a handful of countries. Governments must do their bit, keeping debt levels in check and seeking higher rates of growth. While the ECB can do a lot to preserve financial stability, it cannot act alone.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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