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The eurozone is in a bind. Despite successive doses of monetary stimulus by the European Central Bank, inflation remains stubbornly below target. Conventional monetary policy and even quantitative easing evidently have limited potency when interest rates are at or near zero.[...]The obvious event precipitating this return would be a recession. And when this downturn materializes, the ECB will have limited room for offsetting action, again because interest rates are already low.
The solution to this conundrum suggested by ECB President Christine Lagarde is greater reliance on fiscal policy. By purchasing government bonds bearing negative interest rates, investors are literally begging European governments to borrow. So long as growth rates remain stuck at low levels because of anemic private spending, a bit of additional public spending is just what the doctor ordered. If the economy nonetheless sinks into recession, fiscal stimulus can be ramped up still further.
The problem is that national policymakers in a number of eurozone countries, starting with Germany, are dead set against fiscal expansion. [...]
This impasse has prompted suggestions that the ECB should pursue fiscal policy by stealth. For example, it could adopt a policy of dual interest rates. It could pay positive rates when taking deposits from commercial banks, cushioning the banks’ profitability. It could then lend to those same banks at sharply negative rates, giving them money on such concessional terms that they would find lending it irresistible. The ECB has experimented with these policies on a small scale under its so-called TLTRO-II program.
But by expanding a policy under which it paid more on its liabilities than it charged on its assets, the ECB would incur losses and erode its capital. [...]
Critics in Germany and elsewhere will therefore challenge the legality of such policies, citing the strict separation between monetary and fiscal policy in the European treaties. One response is: who cares? [...]
But the legitimacy of the ECB depends on more than legal formalities. Fundamentally, it derives from public support. And public opinion toward quasi-fiscal measures by the ECB would be strongly negative in countries like Germany. The German government, channeling this popular indignation, could protest in a variety of ways, such as refusing to participate in EU decision-making processes requiring unanimous consent. [...]
Rather than attempting to circumvent the intent of the ECB’s statute, the resources of the European Investment Bank should be enlisted. The EIB has €70 billion of paid-in capital and reserves and €222 billion of callable capital. It has a board of directors from all 28 EU member states, limiting the danger of capture. [...]
EIB lending is limited to 250% of the capital subscribed by its shareholders. To make a difference now, much less in a recession, this capacity would have to be scaled up significantly. To be sure, proposals for doing so will meet with political resistance from those who fear that a larger EIB would be a loss-making EIB. But significant losses are unlikely in an environment where borrowing costs are only a fraction of the return on equity investment. [...]