European Affairs

Before the ECB meeting on March 9 and 10 in Frankfurt, what does the report card show for performance in the five benchmarks for success that the maestro, ECB head Mario Draghi, himself and others set? Has QE staunched the hemorrhaging? Prevented deflation by inducing inflation? Lowered the euro’s value to boost exports? Stimulated corporate borrowing and, thereby, growth, by lowering interest rates? And, eased banks’ burden of public debt and non-performing loans by purchasing public and private assets?

First, a summary of the origins of the Eurozone (EZ) crisis before explaining how the ECB responded and then assessing the effectiveness of those initiatives.

The unraveling of the EZ economy resulted from massive private and public borrowing throughout Europe to fuel government spending and to finance asset investments (such as real estate) as part of what became a speculative bubble. “From the euro’s launch till the Crisis, there were big capital flows from EZ core nations like Germany, France, and the Netherlands to EZ periphery nations like Ireland, Portugal, Spain, and Greece,” a group of economists explained.[1]

Meanwhile, the meltdown in the U.S. financial services sector occurred as financial instruments, including derivatives, became worthless and the insurance to protect investors’ holdings of these instruments, credit default swaps, was grossly underfunded to cover the losses. The fallout roiled the United States, Europe, and the world, the so-called "contagion" effects of the 2007-2009 subprime mortgages crisis.

SOURCE: Servaas Storm and C.W.M. Naastepad, “Myths, Mix-ups and Mishandlings: What Caused the Eurozone Crisis?” April 11, 2015. .

As a global recession set in, sovereign debt in Europe, especially for the southern economies, expanded rapidly, far beyond the ability of those countries to repay the debt they were accumulating as an antidote to the economic slowdown. Banks and their governments became caught in a vicious cycle, which economists dubbed the “doom loop.”[2]
SOURCE: Konstantin M. Wacker, “Eurozone Capital Flows, Illiquidity, and Germany’s Liquidity Trap.” October 24, 2015. .

In response, the ECB implemented three major initiatives that pundits placed under the umbrella of “quantitative easing,” thereby drawing similarities with the Federal Reserve’s efforts.[3] In 2014, the bank cut a key interest rate to below zero, the first negative rates set by a supranational central bank (Denmark was the first national bank). “There is no precedent in economic history for negative nominal interest rates.”[4] In October 2014, the ECB began buying covered bonds — debt secured by a pool of loans, such as mortgages — and in November 2014 added asset-backed securities (bonds or notes backed by financial assets, mortgages, home-equity and auto loans, and credit card receivables). Last December, Draghi announced a slight reduction in the deposit rate paid on reserves held at the central bank – the rate falling further from negative 0.2 percent to negative 0.3 percent – and a six-month extension from September 2016 to March 2017 for the ECB’s €60 billion-a-month ($65 billion) program to buy certain debt (including regional and local government bonds). As the global economy posted signs of a slowdown since last September—led by China’s sharp drop in demand for oil and other commodities, and more recently by emerging markets’ problems—Draghi reiterated in January his vow “to do whatever it takes.”[5] With downside risks mounting, Draghi said "it will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in March.”

SOURCE: Gregory Claeys, Alvaro Leandro, and Allison Mandr, “European Central Bank Quantitative Easing: The Detailed Manual.” Breugel Policy Contribution Issue 2015, March 2, 2015. .

SOURCE: Jana Randow, “Europe’s QE Quandary: Battles Over Bond Buying.” Bloomberg, December 4, 2015. .


Staunch the hemorrhaging.

How much worse could the EZ economy have been if the ECB had not intervened? Did the economy improve as the ECB’s measures were implemented? There is much debate over both questions, but Draghi’s moves changed market sentiment and initially forced the Euro down after each ECB measure was announced. Seismic shifts in monetary policy take time to show the medium-term effects after the initial impact wanes, such as day movements in the Euro, stocks, and bonds in direct response to ECB announcements. The EZ unemployment rate slid over the past year, standing at 10.3 percent in January, reaching the lowest level since August 2011. For the EU, unemployment rate was 8.9 percent in January, down from 9 percent in December and reaching the lowest level since May 2009. Unemployment rates, though, can be misinterpreted, since these statistics do not fully capture those who have abandoned their job searches.

Consumer spending posted gains in the first two months this year, reflected in retail-sales increases in some EU member-countries, with year-on-year growth up 2 percent.[6] All are encouraging signs of progress, but ones that lack the robustness needed when the economy stumbles, as invariably happens during the initial phases of a rebound. Europe’s financial markets reversed course in 2016 after gains in 1015, with Germany’s stock index, the DAX 30, after posting an all-time high (12374.73) in 2015, slid down 8.55 percent through March 3 (to 9,824.17). A similar reversal occurred with France’s barometer, the CAC40.

Assessment: A fragile recovery is underway due partly to low-cost borrowing, but as the International Monetary Fund put it, storm clouds are gathering on the world economy, which may make that progress, however slight, tentative. Low interest rates, too, tend to result in poor future returns for equities, as economists at the London School of Business have shown.[7] Borrowing growth from the future is not sustainable, as an official with the Bank for International Settlements has noted.





SOURCE: Financial Times, February, 2016.


SOURCE: Financial Times, February 16, 2016.

Prevent deflation by inducing inflation.

EZ inflation deteriorated in February, with consumer prices falling to minus 0.2 percent in February from a positive 0.3 percent in January, according to EU data released on February 29. These are the worst levels since February 2015.[8] Another key barometer — the five-year, five-year forward inflation-swap rate —hit its lowest close (1.37 percent) since Bloomberg started tracking the data in 2004. [9]

“If we look at Europe at the moment, the danger we face is without any doubt deflation not inflation,” ECB Governing Council member Francois Villeroy de Galhau said in a recent interview. “If the low energy prices have sustainable long-term effects, we have to act. That seems to be the case, but we will see in March.” He saw inflation increasing in the second half of this year. "Once oil prices stabilize, we should see inflation turn slightly positive in the second half of the year," said Villeroy.[10] The consensus forecast among economists is that inflation will pick up in the second half of this year and reach 1.5 percent by 2018, and hover there at least until 2020.

Assessment: The inability for inflation to set root is explained by an unprecedented fall in oil and other commodities, and a weak economy that bars manufacturers and services providers from raising charges, with consumer markets highly competitive in price terms. Labor costs are equally constrained given high unemployment. History suggests that “cheap money,” or funds lent at abnormally low rates, invariably fuel inflation, but there’s a lag. Economists generally see that effect starting to occur in six to nine months, except if new problems emerge.

SOURCE: Alessandro Speciale, “Euro-area Consumer Prices Fall Most in Year as ECB Mulls Easing.” Bloomberg, February 29, 2016. .


SOURCE: Grégory Claeys and Alvaro Leandro, “The European Central Bank’s quantitative easing programme: limits and risks.” Breugel Policy Contribution, February 15, 2016. .



Lower the euro’s value to boost exports.

Since the ECB’s moves began, the euro’s value has typically been driven by speculation before ECB meetings and the announcements. Over the past year, that impact has been less and less. Negative rate campaigns by the central banks of countries in Europe and Japan compete with that of the ECB. In contradiction, the Federal Reserve has started to move U.S. rates upward, boosting the dollar’s value.

Assessment: The Federal Reserve’s plans to raise rates, if those continue amid signs of a global slowdown, will do much to hold down the euro’s value, since the disparity in dollar-euro exchange rates will increase the attractiveness of dollar-denominated investments.


SOURCE: Jon Sindreu, “The Euro Is So Far Unimpressed By Its Central Bank.” Wall Street Journal, March 7, 2016.

SOURCE: David Meyer, “Changing Dynamics in the Eurozone: The Global Effect.” Market Realist, February 16, 2016.

Stimulate corporate borrowing and, thereby, growth, by lowering interest rates.

Ultra-low rates in Europe have led U.S.-based companies to borrow money that has been largely used for stock buybacks, in other words, purchases by a company of its own stock as an investment of cash that it otherwise has no plans to use for expanding and/or modernizing its products and services.[11] As one commentator put it, “the world has become one big rate-shopping bazaar.” Will there be any other effects ahead? Financial information company Markit said its main gauge of business activity, its purchasing managers’ index, shows the EZ economy stuttering.[12] Two economists for the Bank for International Settlements, Morten Linnemann Bech and Aytek Malkhozov, emphasize the uncertainty ahead “about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period.”[13]

Assessment: Historically low rates alone do not simulate an economy by reducing the risks, the cost of capital, for companies to expand. The adage, if we build it, they will come, is not universally true. The sectoral and demographic changes underway in Europe may be more powerful forces shaping a low-growth economy for a generation, or longer, as Japan has experienced. These shifts limit the ECB’s effectiveness.


SOURCE: Lisa Ambramowicz, “America Invades Europe's Debt Market.” Bloomberg, March 2, 1016. .


SOURCE: Maartje Wijffelaars and Herwin Loman, “The eurozone (debt) crisis – causes and crisis response.” Rabobank Economics Report, December 18, 2015. .

SOURCE: Chris Papadopoullos, “Eurozone Recovery Stalls as Survey Shows Economy Flirting with Stagnation.” City A.M., March 3, 2016. .

Ease banks’ burden of public and non-performing loans debt by purchasing public assets.

Non-performing loans held by European banks exceed €1 trillion euros, or roughly ten percent of their total outstanding loans and 7.3 percent of the EU’s GDP. The Stoxx index of these banks is down 18 percent since the year’s start, with the stocks experiencing the “longest stretch of declines since May 2008.”[14]

Assessment: European banks have excessively high levels of non-performing loans, coupled with new problems from financial instruments to raise their capital to meet regulatory reserve requirements. These are structural issues that the ECB program does not affect. European banks also carry sovereign debt on their balance sheets, the domestic bank-sovereign nexus that some call the “deadly embrace.”

What the negative rates affect is the operating margins of banks, and here negative interest rates crunch these margins, making it more difficult for banks to earn profits. Since negative rates are unchartered territory, nothing in the statements of the ECB or other central banks early suggests that they sufficiently saw the adverse consequences for banks with negative rates. Banks with an impaired ability to lend and an inability to make profits pose new risks to EZ economic growth.

SOURCE: Jochen Andritzky, Niklas Gadatsch, Tobias Körner, Alexander Schäfer, and Isabel Schnabel. “A proposal for ending the privileges for sovereign exposures in banking regulation.” March 4, 2016. .


Changes in monetary policy take time to demonstrate their effects, and central banks are limited in their ability to manipulate an economy as the constraints of a global economy widen and deepen, the tangles of interdependence. The intellectual underpinnings of monetarism are being questioned, since the economic dynamics today are changing, whether these are sectorial and demographic crosscurrents or the incapacities of central banks to redirect, if not “fine tune,” economies. The legacy of the global financial crisis remains. The ECB’s moves are brave, and their effects mixed. Ahead, as the Economist questioned on its cover, are the ECB, the Federal Reserve, the Bank of Japan, and other central banks “out of ammo”? Does this turn the attention again towards a fiscal boost, the “helicopter drops”? At the heart of these questions and more is the extent to which there is the political will and economic incentive to widen and deepen European integration.


[1]For example, see: Santillán-Salgado, Roberto J., A Fundamental Interpretation of the 2009-2012 Crisis of the Eurozone (November 17, 2015). Journal of Business and Economics, June 2015, Volume 6, No. 6, pp. 1213-1230. or

[2]Servaas Storm and C.W.M. Naastepad, “Myths, Mix-ups and Mishandlings: What Caused the Eurozone Crisis?” April 11, 2015. . “[T]he real cause of the Eurozone crisis resides in unsustainable private sector debt leverage, which was aided and abetted by the liberalization of (integrating) European financial markets and a ‘global banking glut.’ ”

[3]See: Brett W. Fawley and Christopher J. Neely, “Four Stories of Quantitative Easing.” Federal Reserve Bank of St. Louis Review, January/February 2013, 95(1), pp. 51-88. . “This article describes the circumstances of and motivations for the quantitative easing programs of the Federal Reserve, Bank of England, European Central Bank, and Bank of Japan during the recent financial crisis and recovery. The programs initially attempted to alleviate financial market distress, but this purpose soon broadened to include achieving inflation targets, stimulating the real economy, and containing the European sovereign debt crisis. The European Central Bank and Bank of Japan focused their programs on direct lending to banks—reflecting the bank-centric structure of their financial systems— while the Federal Reserve and the Bank of England expanded their respective monetary bases by purchasing bonds.”

[4]“Ultra-low or negative interest rates: what they mean for financial stability and growth.”
Remarks by Hervé Hannoun, Deputy General Manager, Bank for International Settlements, April 22, 2015. .

[5]For the original speech in which Draghi uttered those words, see: “Verbatim of the remarks made by Mario Draghi. Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London.” July 26, 2012.

[6]Retail sales available from various sources.

[7]London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton have worked the numbers out for 20 countries over more than a century. .


[9]Lukanyo Mnyanda, “Europe Bond Bulls Bolstered as Data Highlight Draghi's Challenge.” Bloomberg, February 25, 2016. .

[10]Leigh Thomas,” Euro zone inflation to turn positive in second half of 2016: ECB's Villeroy.” Reuters, March 2, 2016.

[11]Vivianne Rodrigues and Andrew Bolger, “US corporate borrowers flock to Europe.” Financial Times, February 25, 2015.

[12]Pan Pylas, “Eurozone economy stuttering along as stimulus decision looms.” Associated Press, March 2, 1016. .

[13]Morten Linnemann Bech and Aytek Malkhozov, “How have central banks implemented negative policy rates?" BIS, March 6, 2016. . “Since mid-2014, four central banks in Europe have moved their policy rates into negative territory. These unconventional moves were by and large implemented within existing operational frameworks. Yet the modalities of implementation have important implications for the costs of holding central bank reserves. The experience so far suggests that modestly negative policy rates transmit through to money markets and other interest rates for the most part in the same way that positive rates do. A key exception is retail deposit rates, which have remained insulated so far, and some mortgage rates, which have perversely increased. Looking ahead, there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period.”

[14]KnowledgeWharton, “Burdened by High Debt, European Banks Face a Reckoning.” March 6, 2016. .