13 August 2012

Simon Wren-Lewis: ECB conditionality exceeds mandate

We have moved from a situation where the bad equilibrium does not exist, to one where it can. As the good equilibrium is clearly better than the bad one, there must be some very good reason for the ECB to impose this kind of conditionality, writes Wren-Lewis in his blog.

The ECB’s mandate is price stability. So without conditionality, would there be an increased risk of inflation? One concern is that printing more money to buy government debt will raise inflation. But that does not appear to be a concern in the UK and US, for two very good reasons. First, the economy is in recession, or experiencing a pretty weak recovery. Second, central bank purchases of government debt are reversible, if inflation did look like it was becoming a serious problem.

What about the danger that by buying bonds now, when there is no inflation risk, governments will be encouraged to follow imprudent fiscal policies at other times when inflation is an issue. But why would the ECB buy government bonds in that situation? Buying bonds now does not commit the ECB to do so in the future. No one thinks the Fed will be doing QE in a boom. OK, what about all those ‘structural reforms’ that might not occur if the bad equilibria disappeared? Well, quite simply, that is none of the ECB’s business. It has nothing to do with price stability. If the ECB is worrying about structural reforms, it is exceeding its mandate.

Cannot the same argument – that an issue is not germane to price stability - be used about choosing between the good and bad equilibria? No. The bad equilibrium, because it forces countries like Ireland and Spain to undertake excessive austerity (and because it may influence the provision of private sector credit in those countries), is reducing output and will therefore eventually reduce inflation below target. The only ‘conditionality’ the ECB needs to avoid moral hazard is that intervention will take place only if the country in the bad equilibrium is suffering an unnecessarily severe recession. The ECB can decide itself whether this is the case by just looking at the data.

So, in my view, to embark on unconditional and selective QE in the current situation is within the price stability mandate of the ECB. To impose conditionality in the way it is doing is not within its mandate. Unfortunately, as Carl Whelan points out, this is not the first time the ECB has exceeded its mandate [view Whelan's paper for the EP: The ECB’s Role in Financial Assistance Programmes]. As he also says, if the Fed or Bank of England made QE conditional on their governments undertaking certain ‘structural reforms’ or fiscal actions, there would be outrage. So why do so many people write as if it acceptable for the ECB to do this?

Full article

© Simon Wren-Lewis