Benoît Coeuré: What can monetary policy do about inequality?
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the International Day for the Eradication of Poverty, Intergroup "Extreme poverty and
human rights, Fourth World Committee" event, European Parliament, Brussels,
17 October 2012.
* * *
I would like to thank Ana Lamo, Jirka Slacalek, Frank Smets and Oreste Tristani for their contributions to these
remarks. I remain solely responsible for the opinions expressed herein.
Members of the European Parliament, Professor Banerjee, ladies and gentlemen,
I would like to thank the European Parliament for inviting me to participate in this panel.
Economic growth has sharply reduced the incidence of poverty in "developed" economies. In
Europe, it is one of the great achievements of the Single Market and of Economic and
Monetary Union (EMU) to have delivered growth and job creation over a prolonged period,
contributing to this objective. The euro area has created about 14.4 million new jobs since
1999, compared with approximately 10.7 million in the United States. Nevertheless, the past
five years have been a time of hardship, owing to the financial and economic crisis. The
Great Recession of 2008-09 and the subsequent crisis in the euro area have dented growth
in our economies, pushing millions of workers into unemployment or forced inactivity, and
adversely affecting living standards for our entire population. Moreover, they have left a
shadow of uncertainty over long-term growth prospects and run the risk of creating a lost
generation.
I would like to bring to this discussion a central banker's perspective on the theme of
inequality. Inequality is a cause for concern for all European institutions, since social
cohesion is one of the statutory objectives of the EU. For the ECB, the question naturally
arises as to whether monetary policy can make a difference, and whether it is mandated to
do so. Musgrave and Musgrave's traditional description of the functions of economic policy1
can help to explain the role of monetary policy in the economic constitution of EMU. The task
of the ECB under the Treaty on the Functioning of the European Union is to ensure price
stability in the medium term. It thus focuses on income and wealth stabilisation rather than on
the allocation of economic resources, or on redistribution. In Tommaso Padoa-Schioppa's
concise words, monetary policy is focused on stability rather than on efficiency or equity. This
should be the starting point of any discussion of the role of monetary policy in addressing
inequalities.
Does this imply that inequalities are irrelevant for central bankers? Not at all, as first,
monetary policy may have an impact on inequalities, and second, stability is conducive to
equity. To the extent that it stabilises economic activity, monetary policy can help shield from
poverty the lowest income classes of society, especially during recessions.
I will address these two issues in turn, starting from a few facts on the rise of inequality in
recent years. I will maintain that preserving price stability over the medium term is the best
contribution that monetary policy can make to economic stability. The ECB has achieved this
goal throughout the crisis, thanks to its standard and non-standard monetary policy
measures. Our recent decision to undertake Outright Monetary Transactions can also be
seen in this context, to the extent that it helps to restore confidence in the integrity and
irreversibility of the single currency.
Inequality/poverty is a cause for concern also in the euro area
It is well known that the relationship between inequality and growth is complex and not
necessarily monotonic.2 On average, inequality in developed economies has increased in
recent years. The Gini coefficient, a standard measure of income inequality that ranges from
0 (when everybody has identical incomes) to 1 (when all income goes to only one person),
stood at an average of 0.29 in OECD countries in the mid-1980s. By the end of the last
decade, it had increased by almost 10% to 0.32. It rose in 17 of the 22 OECD countries for
which long-term data series are available. Of the eight euro area countries for which we have
data, inequality increased in five, changed little in two and declined in one. Thus, although
incomes remain more unequally distributed in the United States, the data suggest that
inequality is also on the rise in the euro area.
The increase in inequality since the 1980s largely reflects a faster increase in household
incomes at the top of the income distribution.3 More precisely, greater inequality in labour
income, which represents about three-quarters of total income across the working age
population, emerges as the most important driver of household income inequality. In
particular, most of the microeconomic studies find a continuous and sharp increase in wage
dispersion in Anglo-Saxon countries over the last 30 years.
Microeconomic evidence is, however, mixed across countries. In countries such as Sweden
and Spain, inequality has followed a downward trend over the same period of time. In
Germany and Italy, the changes in wage distribution are more erratic and do not show a
clear upward or downward trend.4
Developments in labour participation, which also affects labour income, are more
heterogeneous across countries. It is also difficult to find clear patterns in developments in
capital income inequality, owing to measurement difficulties.
How wages evolve over the business cycle depends both on the reasons why growth moves
up and down, and on the way the labour market is organised.5 At first sight, a rigid labour
market may appear to shield the poorest from economic shocks, as wages will not easily
adjust downwards in a recession. However, the lack of reaction of wages is a clear symptom
of an ill-functioning labour market, leading to a costly and prolonged adjustment in
employment. Taking into account fluctuations in wages and unemployment, a typical finding
in several countries is that inequality in earnings at the bottom of the distribution tends to rise
during recessions.6 Moreover, households that do not receive labour income face even
higher hurdles when labour markets do not function well and protect insiders at the expense
of outsiders. What this means is that the poor suffer most in relative terms in and after a
recession. In fact, the pain they suffer does not fully disappear once the recession is over
owing to the persistence of unemployment and the malfunctioning of labour markets.
With regard to developments since 2007, recent research finds marked differences across
countries depending on whether they have also experienced large corrections in house
prices.7 Nevertheless, for most OECD countries for which data are available, there is thus far
little evidence of changes in household income distribution in the two years following the start
of the downturn, from 2007 to 2009. Once more data become available, however, larger
changes can be expected over the coming years, especially in countries like Spain that
suffered a severe slump in the housing market and massive job losses in the construction
sector, mostly for temporary workers.
Taken together, these factors suggest that unemployment remains a crucial determinant of
inequality and poverty. There is a need for a comprehensive strategy to support job creation
and ensure that the unemployed are employable. In the global economy, the comparative
advantages of European economies rest very much on human capital and skills. Active
labour market policies and investment in higher education are the most powerful instruments
at the disposal of governments to counter rising inequality and to foster employment.8
This
leads to a simple policy message. At a time when fiscal policies are being reorganised in
European countries, reflecting the crucial need to restore the sustainability of public finances,
it is essential that the composition of fiscal adjustment preserves governments' ability to
invest in skills and recreate comparative advantages in their economies, and that they are
supported by mobilisation of EU instruments.
Can monetary policy affect inequality and poverty?
But let me now return to the contribution that the central bank itself can make to reducing
inequality and poverty. Is there evidence that monetary policy affects inequality? I will
discuss this question from two perspectives: first, the immediate distributive effects of
monetary policy and inflation; and second, the benefits of macroeconomic stability for the
more vulnerable.
Because monetary policy is transmitted through many channels, direct and indirect - interest
rates both current and expected, credit extension, asset prices - and because households
differ in many respects - with regard to socio-demographic factors, such as age and
education, as well as economic variables, such as income, wealth, employment status and
housing status - monetary policy does not affect all households in the same way. Many
channels through which monetary policy affects individuals in different ways may be at work,
and it is a daunting task to disentangle and quantify these channels empirically.
Inflation has a direct effect on income inequality through changes in the real (i.e. consumer
price-adjusted) valuation of financial and non-financial assets. Clearly, an unexpected fall in
interest rates and an increase in inflation tend to hurt savers and benefit borrowers - the
mechanism John Maynard Keynes referred to as the "euthanasia of the rentier".9 Careful
studies based on US data demonstrate that inflation hits in particular richer and older
households, which hold the bulk of the economy's wealth and whose asset holdings are
typically imperfectly insured against surprise inflation.10
Can this evidence be interpreted as suggesting that the higher inflation is, the lower income
inequality will be? Or that higher inflation should be pursued as a way to reduce income
inequality? My answer is no, because inflation is also particularly harmful to the poorest parts
of the population. First, poorer households tend to hold a larger fraction of their financial
wealth in cash, implying that both expected and unexpected increases in inflation make them
even poorer. In addition, monetary policy shocks and surprise inflation can have an impact
on inequality through other sources of income. Income from labour and the unemployment of
less-skilled workers tend to be adversely affected to a disproportionate degree during
recessions. All in all, recent studies suggest that a higher inflation rate is accompanied by
greater income inequality.11 At the same time research on the US data finds that also
contractionary monetary policy actions appear to increase inequality in earnings and total
income.12 A stability-oriented monetary policy, which aims to smooth the cycle and reduce its
amplitude, ought therefore to cushion the impact of negative shocks on poorer households.
However, it is not only the extent of income and wealth shocks that affects consumers'
welfare, but also the fluctuation in their consumption expenditure. All households are not
equal in this respect. Some of them are able to insure against wealth shocks and can thus
mitigate the adverse consequences of such shocks for their well-being. But poorer
households have limited or no access to the financial system (let alone to financial markets)
and do not have adequate buffers in the form of precautionary savings. Consequently, their
consumption and welfare are particularly vulnerable to adverse shocks. Even if all
households were hit by negative shocks to the same extent, poorer, less-insured households
would suffer from more volatile consumption and lower welfare.
Studies of these effects have so far focused almost exclusively on the United States and
their findings may not be applicable to the euro area, where countries are characterised by
different tax/benefit systems and different institutions, and where households do not access
financial markets in the same way. We in the Eurosystem are aware of the need for more
empirical research at the household level and, partly for this reason, we have been collecting
such data. Our "Household Finance and Consumption Survey" (http://www.ecb.int/home/
html/researcher_hfcn.en.html) documents the extent of wealth heterogeneity and the
structure of household balance sheets across the euro area member countries. To enhance
the analysis and understanding of issues such as whether and how different households
react to shocks in different ways, the data will be made available to researchers in early 2013
together with a detailed public report on the results.
Finally, it should be mentioned that monetary policy can impact geographical inequalities,
insofar as it contributes to smoothing unevenly distributed shocks to households' wealth and
income across countries or regions. The ECB's non-standard measures, as described below,
have limited the risk of negative feedback loops at country level within the euro area, arising
in particular from the tight link between the creditworthiness of banks and of sovereigns, and
more recently from the unjustified perception of a risk of euro break-up. To this extent,
monetary policy has helped cushion the impact on the crisis on the less well-off households
in jurisdictions under financial stress.
Price stability and economic stability: the role of ECB measures
There is a broader point on the relationship between monetary policy and the fight against
poverty, a point that I would like to stress now. Social equality is better served by economic
stability. A large body of theoretical and applied academic literature and the experience of
the past decades indicate that monetary policy's best contribution to economic stability is to
maintain price stability. Moreover, credible central banks have a comparative advantage in
this area, as the return to price stability becomes possible at lower costs in terms of output
volatility.13
The available empirical evidence supports the view of a complementarity between price and
economic stability at the aggregate level. Price stability appears to be conducive to economic
growth, low unemployment and subdued income volatility. Recent developments in the main
advanced economies in terms of volatility of inflation and GDP growth confirm this insight
and show that there has been no trade-off between the two variables.14 Volatility has been
low in both variables in the euro area by comparison with other major economies.
The crisis period is illustrative of this complementarity. After 2007, output and inflation
volatility increased everywhere, but the combination remained more favourable in the euro
area, which suggests that the recent policy easing aimed at checking deflationary risks also
helped to sustain the economy. The ECB responded boldly to the bankruptcy of Lehman
Brothers and to the subsequent crisis with a sequence of cuts in the policy interest rate and a
range of measures such as fixed rate liquidity provision with full allotment, the extension of
the list of eligible collateral, very long-term refinancing operations and, most recently, the
Outright Monetary Transactions. The ultimate justification for such measures was the need to
pre-empt negative inflationary pressures and avoid a collapse in money and credit creation.
By achieving this goal, the measures helped to cushion the effects of the financial crisis on
the real economy.
Existing studies are consistent with the hypothesis that ECB measures were instrumental in
preventing deflation and in containing the fall in economic activity at the height of the
recession.15 Among our early non-standard measures, the switch to fixed rate tender
procedures with full allotment appears to have been especially effective. Had the
unprecedented increase in the demand for liquidity following the financial crisis not been
accommodated by unlimited liquidity supply from the ECB, money market rates would have
increased strongly. A larger fall in credit growth would have ensued. Estimates suggest that
the euro area inflation rate would have been about 1 percentage point lower and the GDP
level would have been more than 2% lower by the first half of 2010.
From a broader perspective, our non-standard measures have prevented more adverse
economic outcomes by helping in particular the euro area countries which were most
affected by the crisis, and by preventing a halt in the flow of credit especially to small and
medium-sized enterprises (SMEs). According to the latest survey conducted by the
Eurosystem, in the second and third quarters of 2011 access to finance remained one of the
most pressing problems for SMEs, which continue to rely mostly on banks for external
financing. Maintaining a flow of credit to SMEs was particularly important because they
employ 72% of the euro area's labour force and have significantly higher gross job creation
(and destruction) rates than large enterprises.
Conclusions
Let me conclude.
I have focused on the narrower question of whether inequality can be affected by monetary
policy. More evidence has to be collected before we can produce robust stylised facts.
However, it is clear that, by ensuring price stability over the medium term, monetary policy
also contributes to broader economic stability. During recessions, it also has stabilising
effects on employment and poverty.
This role of monetary policy has been especially important during the crisis. An increase in
the overall demand for liquidity by banks - when unmatched by the central bank - can cause
a downward spiral in asset prices, a credit crunch, bank failures and a severe recession.
Deflation accompanies these phenomena. The Great Depression - a combination of
recession, deflation and bank failures - is a clear historical example of what can happen if
central banks fail to provide liquidity to the financial system. The monetary policy measures
taken by the ECB have helped to avoid a collapse in money and credit and to eliminate the
spectre of the Great Depression. They have not only avoided a collapse of the financial
system, but also, and more importantly, prevented a surge in unemployment and poverty in
the euro area. In so doing, we have proven that the three objectives of stability, efficiency
and equity are mutually supportive, and that the ECB can effectively contribute to containing
inequalities within its Treaty mandate.
I thank you for your attention.
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