Prophets and loss

More than six years into the financial crisis, one cannot confidently state that it has definitely passed. Central bank interest rates remain close to zero in Japan, the US, the euro-area and the UK – a clear sign that the global economy has not returned to anything approaching normality. There is, however, enough evidence to address the question about the effectiveness of central bank action during the crisis. In order to do this, it is useful to recall the objectives pursued and the tools used during the Great Recession.

The objectives were the same as they have been traditionally: to stabilise prices and fight slumps. The difference between the single mandate of some central banks – establishing the predominance of price stability, and the dual mandate of others – committed to also protecting economic activity and employment, became irrelevant as the two objectives simply coincided during the crisis.

But the changes in tools were without precedent: interest rates were brought sharply down, until they met the lower zero bound, and central bank balance sheets exploded. Even more extraordinarily, central banks in advanced economies allowed fellow central banks to draw very large, in some cases unlimited, amounts of their liquidity, thus allowing them into the sancta sanctorum of central banking.

The question, then, is whether the unprecedented tools used allowed a successful pursuit of the traditional objectives of central banks? Regarding inflation, by and large, price stability has been preserved, even when the danger was of too low rather than too high price trends. For the first time since currencies lost their link to gold, the central banks’ resolve to symmetrically fight deflation as well as inflation was well tested and confirmed.

As regards economic activity and employment, any counterfactual analysis is fraught with difficulties, but the dominant prevailing opinion is that the crisis that started in 2007, and turned for the worse after the failure of Lehman Brothers in the autumn of 2008, had a destructive potential similar to that of the Great Depression of 1929-33, and that central bank action was decisive in avoiding this potential to fully manifest itself.

The second question – whether Europe is acting in line with Monnet’s prophecy and exploiting opportunities opened by the crisis to progress towards unity – requires a cautious answer. There are good prospects for the euro construction to exit the crisis stronger than when it entered it, and what has already been done is impressive. Peripheral countries have recovered competitiveness and reabsorbed the current account and budgetary imbalances that contributed to the crisis. Progress has been made in building tools, such as the European Stability Mechanism (ESM), that can mutualise idiosyncratic shocks hitting member countries. Economic governance has been reinforced with innovations aimed at dealing with weaknesses in the Growth and Stability Pact and backing fiscal governance with structural measures. Substantial progress has been made in moving away from the oddity of maintaining national bank supervision in a single monetary area.

But, much remains to be done. Economic adjustment is far from complete, especially when it comes to structural measures able to revive growth. Adjustment fatigue could stop or even reverse the progress achieved so far. The protection provided by the ESM may turn out to be insufficient and should be reinforced by bringing some cyclical fiscal expenses to European, or at least euro-area, level. It also remains to be seen whether the approved innovations in economic governance will be implemented in a way to exploit their full potential.

 In addition, the progress in moving banking supervision to the European level is just one of the three components of a fully-fledged banking union. The ECB has been given the responsibility to supervise all banks in the euro-area and is preparing to carry out a comprehensive balance sheet assessment and an agreement about a Single Resolution Mechanism for banks, capable of managing inevitable bank failures without macroeconomic repercussions, has been reached among governments, but the European Parliament is questioning whether it would work in real world situations. Finally, the discussions about establishing a single deposit guaranty scheme have not even started.

On a longer time horizon, the euro-area risks entering a long period of anaemic growth, not dissimilar to that of Japan over the last 15 years. The demographics of Europe are unfavourable, participation rates are low, innovation is insufficient, the accumulation of physical and human capital inadequate, productivity prospects dispiriting. As the acute phase of the crisis is passing, long-term growth is the new, difficult challenge Europe must confront.