Vítor Constâncio: International headwinds and the effectiveness of
monetary policy
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
25th Annual Hyman P Minsky Conference on the State of the US and World Economies at
the Levy Economics Institute of Bard College, Blithewood, Annandale-on-Hudson, New York,
13 April 2016.
* * *
Ladies and Gentlemen,
I want to start by thanking the Levy Institute for inviting me again to address this important
conference honouring Hyman Minsky, the economist that the Great Recession justifiably
brought into the limelight. His work provides crucial insights not only identifying the key
mechanisms by which periods of financial calm sow the seeds for ensuing crises, but also
the specific challenges that economies face in recovering from such crises.1 Moreover,
Minsky displayed a keen understanding of the damaging effects of uncertainty, not just on
economic performance but also, ultimately, on the fabric of civil society and democratic
institutions.2 These insights have acquired renewed urgency in view of the world-wide
resurgence of "easy-answer populism" whose simple but flawed solutions to complex
problems become more appealing the greater the uncertainty.
This year's conference has a very topical title "Will the Global Economic Environment
Constrain U.S. Growth and Employment?" Indeed, the prospects for the full recovery of the
U.S. economy and the normalisation of its monetary policy are of utmost importance but can
only be properly assessed in an international context. Conversely, international spillovers
from the U.S. to the other economies must be well understood, to appreciate the most likely
scenarios for the global economy.
Nine years after the inception of the Great Recession, it is no secret that economists and
policy-makers are baffled and disappointed with the lacklustre nature of the ongoing
recovery. The perplexities and anxieties generated by the present situation were summed up
in a rather open and pessimist way by the Governor of the Bank of England in a recent
speech, who noted that: "the global economy risks becoming trapped in a low growth, low
inflation, and low interest rate equilibrium".3 But, equilibrium implies a prolonged stable
situation, and while that might be emerging in economic terms, the same is not the case in
social terms. Put differently, the social equilibrium is not stable. Advanced economies must
either radically change their economic prospects by generating growth and jobs, or they will
be forced to adjust their social systems in uncharted ways.
In the rest of my remarks, I will first discuss some of the hypotheses put forward in the
literature to explain the determinants of this prolonged, low-growth period, sometimes
characterised as a global liquidity trap. I will then review some of the proposed measures to
exit from the liquidity trap, including fiscal and structural policies. While each of these
measures has specific benefits, they also all have limitations or are subject to constraints.
Against this background, it is important to emphasise that, while having to resort to
nonstandard tools, monetary policies also remain effective in fighting the global liquidity trap
even against international headwinds. For the euro area, I will conclude that only an
encompassing policy mix can deliver stability and prosperity.
Global liquidity traps
The literature about liquidity traps and their international contagion is vast. A subset of that
literature considers the implications of a liquidity trap in the open economy and highlights the
importance of a global response to the trap.4 For example, Jeanne (2009) demonstrates how
a recessionary shock in a country can lead the world into a global liquidity trap. This is
particularly the case when monetary policy interest rates reach the Lower Bound (or LB). The
author argues that increasing the expected inflation rate in both countries through monetary
policy, if feasible, is the more efficient response to the global liquidity trap, more efficient than
an increase in public expenditures.
Hélène Rey (2013) shows how monetary policy spillovers from major advanced economies
create a global financial cycle that reduces the efficiency of monetary policy even in a regime
of flexible exchange rates.5 The trilemma of international economics (free capital
movements, and independent monetary policies being only possible with flexible exchange
rates) is thus reduced to a dilemma that can be resolved with capital controls and effective
macroprudential policies to limit the leverage of the financial system. Cook and Devereux
(2014) use a two-country, new Keynesian model to illustrate how the liquidity trap can
propagate from one country at the LB to the world economy, through the interconnected
international financial system. This international contagion undermines the effectiveness of
domestic monetary policy even in a regime of floating exchange rates. Capital controls are
proposed as a solution to restore the independence of monetary policies.
This strand of literature is also linked with the "savings glut" explanations of the Great
Recession. Put forward by Ben Bernanke in 2005, it was later used by him in 2007 and
20106 to justify how capital inflows had depressed U.S. medium-term interest rates and
fuelled the subsequent housing bubble. Despite being contested, this hypothesis has been
quite influential and has been supported since 2008 by the theory which explained global
imbalances by a "shortage of safe assets" in countries with underdeveloped financial
systems. The ensuing search for those assets, particularly in the U.S., generated capital
flows, decreased medium-term yields and allegedly conditioned U.S. monetary policy. Until
2008, the imbalances resulting from excessive savings in search of safe assets could be
equilibrated by the decrease of interest rates. After the crisis, the decrease of yields was
accentuated by the reduction of the stock of assets resulting from weaker private issuers and
from weaker European sovereigns. Interest rates were therefore pushed down to the LB and
the phenomenon propagated to other countries through the financial markets.
The recent paper by Caballero, Farhi and Gourinchas (2015) models what happened after
the LB was reached.7 With interest rate variations prevented by the LB, the supply and
demand of safe assets could only be balanced through recessionary variations of output.
This would explain the weakness of the worldwide recovery and the temptation felt by all
countries to try to use the exchange rate as a way to stimulate their own economy - hence
the expression "currency wars" in the paper's title. The authors highlight that the U.S., by
adopting a very expansionary monetary policy earlier, was able to benefit from a depreciating
U.S. Dollar (USD), but this changed after 2014 when both Europe and Japan embarked also
in a more expansionary unconventional monetary policies. Due to a non-Ricardian treatment
of public finances, there is a role for fiscal policy in dealing with the situation. The paper also
finds that countries with more wage and price flexibility have a smaller share of the world
recessionary trend but "at the global level, more downward price or wage flexibility
exacerbates the global recession".
The idea of a prolonged global liquidity trap is connected with the notion of secular
stagnation, i.e. the possibility of a prolonged situation of low inflation and low growth at the
global level. The secular stagnation hypothesis in this case refers to the demand-side version
promoted by Larry Summers8, where a trend of planned savings systematically higher than
planned investment implies a situation of persistent lack of demand and a negative output
gap, interest rate at the LB and low inflation or even deflation. The real equilibrium rate that
ensures the savings investment balance at full employment may indeed become negative as
recent estimates for the U.S. indicate.
Eggertsson and Mehrotra (2014) and Caballero and Farhi (2015) modelled secular
stagnation in a closed economy and more recently, Eggertsson, Mehrotra, Singh and
Summers (2015)9 presented a model of secular stagnation in a multi-country context in which
exit policies may include a global increase of the inflation target (if made credible), fiscal
policy stimulus or capital controls for the countries with a domestic positive real equilibrium
interest rate. The effectiveness of both monetary and fiscal policy is strongly amplified by
possible international co-ordination of their use.
Some exit solutions
The whole literature on global liquidity traps provides an overall consistent view of how the
world economy works and leads to a bleak outlook on the feasible exit solutions from the
present quagmire.
The first solution is credible forward-guidance about future policy rates linked to a somewhat
higher inflation target in order to influence inflation expectations. In the type of models used
in this literature, forward-guidance is the only available monetary policy tool. The measure
would be more efficient if applied simultaneously by all major jurisdictions. The shortcoming
of this approach is the lack of a sufficiently credible commitment mechanism that would
convince markets about the central bank "committing to be irresponsible", no matter what.
The second solution is to use the exchange rate as a policy target in order to stimulate
growth via net exports. Obviously, this is a zero-sum game if all countries try to do it.
Recently, the hope in many countries has been to depreciate against the dollar as a result of
U.S. recovery, but the more recent months have proved that this is not an assured
development, or perhaps that the U.S. is not ready to accept these consequences. I will
return to this point later.
The third exit solution proposed in the literature is the use of capital controls that would
restore independence to national monetary policy, so that real equilibrium interest rates could
differ across countries. For those with a positive real rate, capital controls would avoid the fall
into the LB. It is indeed the case that the international community and the IMF have now
lightly condoned the use of capital controls as a macroprudential tool in developing countries.
However, the implication of the literature would be to use capital controls among advanced
economies, an option that stands out as unrealistic for political and ideological reasons.
The fourth exit solution is to use tariffs and protectionism. Jeanne (2009) illustrates this
option in his model, but points out that it would be less efficient. Going beyond models, a
generalised rush towards protectionism would aggravate, rather than solve, the world
economy predicament.
The fifth and final solution is to rely on fiscal policy, the traditional way-out in situations of
liquidity traps. All the models concur with this prescription, which is particularly efficient at the
LB10, and amplified if adopted internationally in an effort of international co-ordination. Fiscal
policy, however, seems to be out of bounds in all major economies. In the euro area, fiscal
policy is strictly conditioned by the legislation of the Stability and Growth Pact and in the
U.S., it is seemingly blocked by political partisanship. Apparently, only if the state of the world
economy deteriorated considerably, would governments step up the use of all the tools at
their disposal.
One can therefore understand the dispirited conclusion of Caballero, Farhi and Gourinchas
(2015): "Unfortunately, this state of affairs is not likely to go away any time soon. In
particular, there are no good substitutes in sight for the role played by US Treasuries in
satisfying global safe asset demand. With mature US growing at rates lower than those of
safe asset demander countries ... its debt and currency are likely to remain under upward
pressure, dragging down (safe) interest rates and inflation, and therefore keeping the world
economy (too) near the dangerous ZLB zone."
Nevertheless, as I will argue later, this list of solutions to the global liquidity crisis dismisses
too easily non-standard monetary policy tools. Thanks to such tools, international headwinds
may hamper, but do not annul the effectiveness of major central banks in influencing
economic outcomes.
The structural reforms solution
Before moving on to monetary policy, let me first recall that another proposed option to boost
the recovery is to increase growth potential in the medium and long-term through structural
reforms. However, structural reforms entail short-term contractionary effects many times.
Eggertsson, Ferrero and Raffo (2014) highlight that such contractionary short-term effects
are amplified at the LB, because they cannot be off-set by expansionary monetary policy
through a reduction in interest rates.11 A recent IMF working paper by Bordon, Ebeke and
Shirono (2016) concludes that "Existing studies have shown that the long-run effects of
structural reforms on growth and employment are positive.12 However, the evidence on the
short-run effects of structural reforms is rather mixed and limited." The recently published
April 2016 IMF WEO agrees and writes: "Product market reforms deliver gains in the short
term, while the impact of labor market reforms varies across types of reforms and depends
on overall economic conditions. Reductions in labor tax wedges and increases in public
spending on active labor market policies have larger effects during periods of slack, in part
because they usually entail some degree of fiscal stimulus. In contrast, reforms to
employment protection arrangements and unemployment benefit systems have positive
effects in good times, but can become contractionary in periods of slack. These results
suggest the need for carefully prioritizing and sequencing reforms."
To summarise, the effects of structural reforms are contingent on the state of the cycle and
the degree of slack in the economy as well as on the accompanying stance of
macroeconomic policies. That is why the IMF WEO pleads for the use of structural reforms
accompanied by fiscal policy when there is fiscal space, a concept that has several different
interpretations. In their recent Shanghai meeting, the G20 pleaded for the same approach,
although one can be sceptical about delivery. We can recall the embarrassing results of the
G20 agreed plan in Brisbane two years ago to generate an additional 2% in world growth via
a long list of concrete reforms put forward by the IMF and the OECD. Less than half was
implemented and in fact, the world economy now risks not even attaining what was then
considered the baseline scenario.
So, on both the demand and supply sides, there are constraints to effective policy action. I
would like to add two key issues to this discouraging perspective: one that aggravates the
challenges with a different version of secular stagnation and another that offers some hope
related to the role of monetary policy.
Another version of secular stagnation
The version of the secular stagnation hypothesis promoted by Robert Gordon in a series of
papers and in his recent magisterial book is a supply-side phenomenon.13 The two broad
frameworks for secular stagnation are not mutually exclusive. One emphasises supply-side
factors that lower potential growth while the other points at chronic weakness in demand as
the root cause of secular stagnation. Demand and supply factors may, in fact, reinforce each
other because a chronic weakness in demand would amplify and exacerbate supply
constraints as, for instance, persistent unemployment may hamper workers' set of skills,
thereby curtailing the productive capacity of the economy.14
Gordon diagnoses a slow-down in the pace of innovation with regard to so called
generalpurpose technologies, consisting in inventions that revolutionize living standards and
business practices. As he points out, many of these technologies, such as electricity, clean
running water, cars and planes, as well as vaccines and antibiotics, were brought to large
sections of the population in the time between 1870 and 1970, which he has dubbed the
"special century"15. By contrast, he argues that current innovations, such as the internet,
improve existing technologies in a less spectacular and more marginal way. The reduction of
total productivity growth in the U.S. and other advanced economies, decade after decade
since the 70s, offers a compelling empirical case for Gordon's views.
This gloomy assessment has not gone unchallenged. Most prominently, Joel Mokyr, Erik
Brynjolfsson and Andrew McAfee argue that, given recent advances in robotics, genetic
modifications, 3D printing, and further innovative technologies, we stand at the cusp of a new
industrial revolution.16 This scenario is certainly desirable. But, as Robert Gordon has also
pointed out: even if innovation is not slowing in absolute terms, global economy is still facing
an uphill battle, given the challenges of population aging, rising inequality, failing education
systems and debt overhang.
The role of demographics is especially dominant here. As Charles Goodhart and colleagues
(2015) have noted, recent decades have benefitted from a positive global labour supply
shock, deriving from the baby-boomer generation in the 1970s, and from the integration and
expansion of emerging markets as part of the global economy. These demographic
headwinds are fading out, implying that another crucial source of growth is drying-up, at least
until a demographic reversal takes place in about 25 to 30 years' time.17
Beyond these factors, doubts can also be raised about the depth of the economic traction of
the innovations that are in the pipeline. The technological changes at the turn of the 20th
century and after the Second World War, led to the creation of mass products widely used in
association with the urbanisation explosion that is about to end. The second wave of income
growth was triggered by women's participation in the labour force and jump in education
levels, developments that cannot now be repeated to the same degree. So far, the new
products or services associated with the digital economy have not a similar impact on jobs
and income. Part of their value is not even paid for in a market, as is the case with the
internet or social media. To count these and other intangibles which clearly improve our lives
and personal productivity, would only be justified in an indicator of well-being but not in a
GDP concept that aims to measure traded goods and services that generate monetary
income and consequently, jobs. Robotics is expected to introduce an important new wave of
innovation, but that will only make the question of jobs more complicated, requiring
significant and difficult changes in the income redistribution systems of our societies.
This secular stagnation thesis and the related declining real productivity also provide an
explanation for the continuously decreasing real equilibrium interest rate. Other contributing
factors to this phenomenon are the demographic decline, greater income inequality and
lower public investment.
The declining real equilibrium interest rate cannot be ignored by monetary policy that
grounds its rationale in real variables and tries to achieve a real rate that ensures
macroeconomic stability with low inflation and a zero output gap. Facing the Great Recession
and this development of the real equilibrium rate, central banks had no alternative but to
reduce rates until the zero lower bound was attained.
In other words, the low level of nominal interest rates in advanced economies before and
after the crisis cannot be explained only by the "savings glut" view or by the "shortage of safe
assets" theory which is its mirror image. These views provide an explanation for what
happened to nominal market rates but not to the evolution of the real equilibrium interest rate
over time. What is more, monetary policy also has a decisive influence on interest rates that
cannot be explained by the loanable funds theory alone. Short-term market nominal rates are
directly influenced by monetary policy rates and via expectations of future policy rates, and
risk premia policy rates also influence medium and long-term market rates.
This means that monetary policy cannot escape responsibility for the low level of rates before
the crisis. It must however be acknowledged that central banks were doing so in pursuit of
their mandates, which exclude assets prices or other aspects of financial stability from their
primary objectives. In the period of the so-called Great Moderation, they ensured low inflation
and reasonable growth while the financial system brewed credit booms and instability. The
fact remains that central banks cannot pursue several objectives with the same instrument
and that, in order to ensure financial stability, they need to be given regulatory powers of a
macroprudential nature that can smoothen the financial cycle by controlling leverage of the
credit institutions. What happened before the crisis was a failure of financial regulation and
supervision that did not react to excessive leverage, credit booms and growing debt,
believing in the rhetoric of the efficient markets hypothesis that blessed all market practices
and accepting that the risk management techniques behind securitisation and the "originate
and distribute model" were safe and sound.
In another criticism of the "savings glut" view of the crisis, Claudio Borio and Piti Disyatat
(2011)18 are correct in pointing out that "a focus on current accounts in the analysis of
crossborder capital flows diverts attention away from the global financing patterns that are at the
core of financial fragility. By construction, current accounts and net capital flows reveal little
about financing. They capture changes in net claims on a country arising from trade in real
goods and services and hence net resource flows. But they exclude the underlying changes
in gross flows and their contributions to existing stocks, including all the transactions
involving only trade in financial assets, which make up the bulk of cross-border financial
activity."
They also underline the importance of monetary policy in determining interest rates and other
analyses have added to the criticism of the vision that external influences were behind the
low interest rates that led to various asset price bubbles. Hélène Rey (2013) also indicates
that "A VAR analysis suggests that one of the determinants of the global financial cycle is
monetary policy in the centre country, which affects leverage of global banks, capital flows
and credit growth in the international financial system."19
To sum up, there are some good points against the view that the "savings glut" or "safe
assets shortage" theory, while useful in understanding key aspects of the present global
economy framework, contain all the truth. In particular, they fail to fully capture the
responsibilities of monetary policy of the major central banks. But they also fail to capture
their possibilities.
Possibilities and challenges of monetary policy
Turning to the challenges of monetary policy, perhaps the most salient issue to refer is that
monetary policy has gone beyond the lower bound on nominal interest rates and is actually
into negative territory even though, as there is a floor to negative rates, one can say that this
has only displaced the lower level further down. While this monetary policy move is
unprecedented in a historical perspective, it is entirely standard insofar as it relies on the
traditional interest rate instrument. From a purely monetary policy point of view, it is entirely
consistent to aim at negative rates when the real interest rate has itself turned negative.
Speaking from the perspective of the ECB, negative rates have only been applied to the
deposit facility which banks use to credit funds to the central bank at an overnight maturity.
The main objectives of this measure are twofold: first, to further lower money market rates
and the longer end of the yield curve via expectations effects; and second, to increase the
velocity of circulation of excess reserves in the interbank market towards the banks that need
liquidity to sustain or expand their credit portfolio. The banks with excess liquidity have an
incentive to pass it on to other institutions or use it to fund new loans. We have had some
success on both scores and the stimulus to demand has benefited the European and global
economies.
Many market commentators link negative deposit facility rates mostly with exchange rate
policy. This interpretation may well be correct in the case of small countries trying to avert the
risk of excessive currency appreciation. However, recent experience clearly demonstrates
that it does not work the same way for larger economies. In spite of the ECB's and the Bank
of Japan's decision to implement negative deposit facility rates, both the euro and the yen
have been appreciating against the US dollar. There is no inexorable link between the levels
of deposit facility rates and exchange rates, as even the possibility of some form of carry
trades depends on the general situation of risk aversion. Additionally, recent empirical
evidence points to a relatively limited pass-through of the exchange rate to the economy20.
It is, nevertheless, important to recall that there are clear limits to the use of negative deposit
facility rates as a policy instrument. First, there is always the possibility of hitting the limit
where the preference for cash withdrawals would set in, even if the threshold seems to be
significantly distant in view of the costs of cash storage, safety and insurance21. Second, the
instruments should not push banks to pass on their additional direct costs by turning deposit
rates negative or increasing lending rates to increase margins. Both developments would be
problematic for our monetary policy goals. Tier systems that simply pass direct costs at the
margin can mitigate this concern but cannot dispel it altogether.
Overall, broadly counting all the effects that negative deposit facility rates have on banks'
profitability, the aggregate result comes up positive for the euro area as a whole. Negative
money market rates reduce the cost of funding for many banks, the lowering of yields for
several assets produces capital gains and the support to the recovery reduces impairment
costs on non-performing loans.
In more general terms, there has recently been quite some pushback against monetary
policy in certain quarters, in particular questioning its effectiveness in the present situation.
More sophisticated critiques focus on the alleged exclusive, short-term effects of monetary
policy which can only buy time for other policies, presumably structural reforms, to do the
real job.
The main common idea behind these arguments is the more general view that monetary
policy is merely about the short-term with supply policies determining the longer term. This
separation between the short and long terms is an analytical device, a needed abstraction, to
build simpler models and theories. However, such distinctions are artificial when we consider
chronological real time. Monetary policy can stimulate demand and investment and as this
creates productive capacity, a link is established with the supply-side and the long-term.
Also, by speeding up the closing of output or unemployment gaps, monetary policy
influences future potential output and growth. By avoiding protracted periods of recession,
monetary policy helps avoid hysteresis22 that affects productive capital efficiency, when
equipment is not timely substituted, or when the quality of human resources deteriorates due
to periods of long unemployment. Both forms of hysteresis influence the supply-side and the
long-term potential of the economy. As Keynes wrote "Life and history are made up of short
runs" which implies that the long run is just a sum of many different short terms. Monetary
policy cannot be reduced to a short-term gimmick since our economies do not spontaneously
return quickly to zero output gaps and full employment.
U.S. and Euro Area Monetary Policy
After the crisis, monetary policy responded forcefully everywhere, particularly in the U.S. with
the early implementation of QE and credit easing measures. The U.S. recovery has been
stronger than in the euro area and for 2016 buoyant growth was expected, accompanied by
a gradual normalisation of interest rates. This would have been a vital development for world
economy and at the same time, an important proof that, even with a restrictive fiscal policy,
monetary policy can play a decisive role in generating a meaningful recovery and getting
firmly away from the LB. This would be a relevant disproval of the more sombre views about
the world economic system and monetary policy.
Although this possibility is still very much alive, it has apparently been delayed by some
mixed results since the fourth quarter of 2015. Turmoil in financial markets and the external
environment seem to have affected the economy. In the blogosphere and some market
literature, we could see minority views about a possible double dip or significant slowdown
and market expectations for further rate increases this year became quite weak. Importantly
Chair Janet Yellen has said recently that while "global financial developments could produce
a slowing in the economy. I think we want to be careful not to jump to a premature conclusion
about what is in store for the U.S. economy".
So, we can continue to hope that the centre of the world economy will hold and will prove its
resilience, independently of some external headwinds.
On our side, the ECB has confronted the severe and persistent disinflationary forces
affecting the euro area economy with a broad set of measures. In particular since mid-2014,
we have adopted a range of monetary policy tools that had been unprecedented in scope
and scale for the euro area. These tools have followed a three-pronged approach: first, they
have entailed targeted measures to revitalise specific market segments and strengthen bank
lending, which is a particularly relevant conduit of monetary impulses in the euro area;
second, they have effectuated a broad-based easing of overall financial conditions, most
notably through central bank purchases in the large and liquid sovereign debt market and,
third, they included cuts in the main ECB interest rates, including by taking the deposit facility
rate to negative territory.
Given that monetary policy takes time to transmit to the real economy, the full effects of
these measures on macroeconomic conditions have yet to fully materialise. However, the
adjustment in financing conditions, via which monetary policy transmission operates,
provides encouraging signals. For instance, since June 2014, the GDP-weighted average of
euro area 10-year sovereign bond yields has fallen by more than 130 basis points and bank
lending rates to euro area companies by about 95 basis points. The lion's share of these
declines can be directly attributed to the monetary policy measures that the ECB has taken
since then.
Our measures have also helped arrest the contraction of loans to companies, which have, in
fact, started to grow again and are granted at more favourable conditions. As a result, also
fewer SMEs report that credit is a limiting factor for their businesses.
Ultimately, what matters for the assessment of our measures is whether they contribute to a
sustained adjustment in the path of inflation. Applying a large and diverse set of models to
account for the uncertainties surrounding such analysis, ECB staff estimate a substantial
effect of our measures on growth and inflation. In the absence of these measures, inflation
would have been negative in 2015 and would be projected to remain in negative territory also
this year. Regarding growth, two thirds of one percent of the registered growth in the past
two years can be attributed to our monetary policy. We will continue to do whatever is
necessary, in accordance with our mandate, to bring the euro area inflation rate close to our
objective.
From a global perspective, monetary policy measures that strengthen the resilience of the
domestic recovery do not amount to a zero-sum game, in which different jurisdictions merely
aim to debase their currencies vis-à-vis each other. In fact, monetary policy accommodation,
by improving domestic credit conditions and stimulating nominal spending, creates additional
global demand, rather than just leading to demand-switching from one economy to the other
- as some observers