ECB 's Tools and Strategies Literature Review

Open, View, and/or
Download this Document

Total Length: 5055 words ( 17 double-spaced pages)

Total Sources: 15

Page 1 of 17

ECB’s Role in Stabilizing the Euro: Literature ReviewIntroductionIn 1999, the European Central Bank (ECB) took on the role of overseeing the monetary policy for the EU to ensure a stable currency. During the nearly two decades that have passed since, the ECB has faced two significant economic crises: the first very early on its new role, and the second approximately half a decade later when the Great Economic Crisis sent waves throughout the global economy. In order to understand the uniqueness of the ECB’s challenge in overseeing monetary policy in order to ensure stability in the Euro, is that the EU is not one nation but several nations, distinct in culture and economy, brought together under one umbrella monetary management system as it were. Navigating the widespread differences and establishing a policy to manage them so that both Germans and Greeks, for example, can share in the benefits of the Euro, has proven to be problematic—mainly because of the dysfunctional nature of the Eurozone itself, as De Grauewe and Ji (2015) point out. Nonetheless, understanding the main strategies and tools that the ECB has used to bring the Euro to its current position is worth knowing if only to understand the methods used by the central bank and what they portend for the future.Purpose of the ECBAccording to its statute, the ECB’s primary purpose is to ensure price stability of the Euro throughout the Eurozone over the medium term. The common expectation of price stability is inflation of 2% or lower—i.e., a low but stable rise in inflation over time. As Hall, Swamy and Taylas (2012) note, to achieve this objective, the ECB gives more focus “to the longer-term relationship between money growth and inflation than most, if not all, other major central banks” (p. 153). The goal of the central bank is not to influence the financial choices of individuals and businesses but rather to free them to apply the Euro as they see fit (Poole & Wheelock, 2008). Why is stability important for a currency—particular a currency like the Euro, which is relatively new among the world’s currencies and represents nearly two dozen different European economies? The reason is simple: “uncertainty about the price level makes it difficult for firms and households to determine whether changes in individual prices reflect fundamental shifts in supply and demand or merely changes in the overall rate of inflation. By eliminating this uncertainty, a monetary policy that maintains long-run price stability eliminates a potential drag on the efficient allocation of resources and, hence, on economic growth” (Poole & Wheelock, 2008, p. 6). Indeed, the most powerful tool of the ECB to stimulate growth in the economy is price stability—and this is the implicit reason for the ECB’s focus on the stability of the Euro as its main raison d’être.Tools and StrategiesPrice stability as the primary tool of the ECB reflects the central bank’s overall strategy of cross-checking monetary trend analysis with economic analysis. The monetary policy strategy that the ECB constructs and implements is then based on the overall assessment of the risks identified by the central bank to price stability of the Euro. As the main goal of the ECB is to ensure that the Euro is stable, it pays close attention to monetary and economic trends and has thus been highly reactive, rather than proactive, in its character (Hall et al., 2012).A critical aspect of the ECB’s strategy of Euro stability is located in identifying the effects of inflation differentials among the various states of eurozone. The Harmonized Index of Consumer Prices (HICP) is the main indicator used to monitor Euro stability. The HICP is a consumer price index compiled of data from among the EU members using the Euro currency. By making sure HICP is below but close to 2% over the medium term, the ECB is said to fulfill its objective. Price stability is not only conducive to promoting economic growth (the secondary aim of the ECB in the sense that it aims to support the EU’s economic policies), it is also conducive to aiding in “the reduction of fluctuations in real economic activity and the management of financial and/or liquidity crises” (Poole & Wheelock, 2008, p. 6). The way the ECB does this is different from the American central bank, which adds liquidity by purchasing Treasuries. The ECB adds liquidity by lending to the national banks based on creditworthiness.Unconventional Monetary Policy: Quantitative Easing (QE)Since the Great Economic Crisis, which has defined the past decade in terms of how monetary policy is conducted, the ECB has engaged in a strategic policy of quantitative easing, designed to send “trillions of euros into the eurozone’s financial system” (Van Lerven, 2016, p. 237). While QE tends to prop up market prices, the expected outcome on currency is one of devaluation: it is a simple theory—the injection of liquidity into the market leads to an increase in the supply of the currency. A rapid increase in the supply of money leads to inflation. The more money that is pumped into a system, the less value it has: it is the basic principle of supply and demand. However, in spite of this principle, it appears that the Euro has indeed not lost value but has rather stabilized mid-range between its historical extremes, judging by its value against the premier reserve currency of the world—the USD.Questions remain, however, as Van Lerven (2016) notes: “after more than a year since its initial inception, a review of the programme’s impact reveals that policy makers should think twice before further expanding the programme–and could benefit from considering more direct ways of increasing spending in the real economy” (p. 237). Does this mean that the ECB’s monetary policy tool of quantitative easing, applied to help the eurozone absorb the shocks of the Great Economic Crisis, has been successful in stabilizing the Euro? Or does it mean that the Euro has simply kept track with the other currencies of the world mainly because all of the biggest central banks of the world were engaging in the exact same QE strategy—from the Federal Reserve in the US to the BOE to the BOJ to the PBOC? Had the ECB not used QE as a tool, it is highly likely that the Euro’s value would be much higher with respect to the USD, the pound, the renminbi, and so on (Haitsma, Unalmis & de Haan, 2016).Though this might benefit European importers, it would be hard on European exporters—and thus this fact is kept in mind by the ECB, which aims for stability overall. Yet, there remains another problem to consider. Though in stabilizing the Euro, it would appear that the ECB’s strategy has been effective; however, an elephant in the room scenario exists, which is the ECB’s balance sheet: it has increased dramatically as a result of QE (Reis, 2017). What is the ECB to do with this balance sheet engorgement? Enlarging the balance sheet is meant to have the effect of stimulating the economy, but at some point that balance sheet will have to unwound and the question of whether the eurozone can absorb that unwinding is one that remains to be answered.The other consideration that should be made with respect to the ECB’s QE tool is that it suppresses interest rates, which increase the incentive to borrow but which can lead to an over-leveraged economy that can be a considerable challenge for pension funds or insurance companies, who require a defined yield in order to meet liabilities that they face in the future. QE may have stabilized the Euro in the short to medium-term, but in the long term the question of just how the Euro will fair when the pain of permanently low interest rates begins to be felt by large segments of the EU will be another story completely.AnalysisWhatever It Takes?The study by Gencer and Musgolu (2014) explains how the ECB’s below but close to 2% inflation target rate in the medium term, via a “whatever it takes” approach using QE is ultimately a time bomb for the currency—i.

Stuck Writing Your "ECB 's Tools and Strategies" Literature Review?

View All Our Example ECB 's Tools and Strategies Literature Review

Have A Custom Example Essay Written

e., a strategy that will ultimately result in “a massive erosion of the value” of the Euro (p. 247). While currently the EUR USD index sits within the midrange of its near-two decade span (range bound between 1 and 1.5 approximately), this range is likely to be supported by the ECB through continual usage of a QE policy strategy. However, with some assessment of the marketplace, the price or value of assets, the spillover from debt purchases (which the ECB has engaged in by buying corporate bonds of all things), one sees that a trigger mechanism is in effect whereby central bank intervention leads to inflation across asset classes that are not necessarily detectable by HICP (Haitsma et al., 2016). The Euro currency, in other words, remains stable in comparison with other currencies such as the USD, where a similar devaluation process or strategy is underway, but in comparison with asset class prices the stability of the currency is certainly not the case.One need only examine the Euronext 100 IDX, which has risen nearly 50% over the past five years during which the ECB’s policy of QE has been enacted. Or one can look at the DAX, which is up more than 60% over the same time period. Or there is the CAC 40, which is up more than 40% over this time frame as well. One may look to the US to find the same situation, with the S&P 500 up over 60% since QE. Were the Euro also up in value between 40% and 60% compared to the world’s premier reserve currency, there would be no problem. But it is not. It is essentially where it was when it was introduced to the eurozone nearly two decades ago. The cost of assets has risen dramatically—because that is what happens when a central bank like the ECB dramatically increases the money supply by trillions within a short span of time: the currency loses purchasing power. Should the Euro truly be considered a stable currency in this respect? The Euro may have stabilized in…

[…… parts of this paper are missing, click here to view the entire document ]

…move one way or the other. Therefore, it is unlikely that the sort of global leadership and policy coordination necessary to restore global economic prosperity will be seen from the ECB in the coming years.Draghi’s decision to do “whatever it takes” may be the last great effort of the ECB to control inflation before it sets off finally and takes the Euro down with it. For the world’s central banks it will indeed be a race to the bottom as every nation attempts to export its inflation. Prosperity, ala the kind that Europe once enjoyed before the EU solved everything, was temporary. Today, it is a talking point for the political elite. Is the ECB really able to stabilize the Euro in the long-term? No. That is why it only looks to keep inflation below but close to 2% in the medium-term: it knows there is no chance of keeping up this illusion of 2% inflation over the long-term. The rise in asset prices will betray the reality.Summing up the ECB’s Monetary Strategy and ToolsBy monitoring inflation and shooting for price stability, the ECB manipulates liquidity by lending to nation banks and increasing the money supply. This can help to put pressure on the Euro to keep it from rising to sharply in comparison with the USD. It is a strategy that works so long as the other central banks of the world are engaging in the exact same strategy. Should the U.S. Fed decide to no longer use QE (and currently it is in the process of tightening, raising interest rates—so as not to expose the myth of low inflation to the reality that hyper-inflation is what will be knocking on the door soon enough as a result of QE), the ECB will have to follow suit or else risk seeing the Euro lose value in comparison to USD. Though this would make exporters happy, it would cause problems for importers. The trick for the ECB is to find the right balance, because in balance is stability. The problem, of course, is that ECB’s tools are all meant for a short-term duration and a medium-term longevity at best. The ECB cannot control inflation for the long term and it knows it and that is why it does not describe this as its overall policy.QE has been the main tool of the ECB (as it has been for the Fed, the BOE, the BOJ, and the PBOC) for so many years now that it does not even appear to be possible to truly end it. Every market has become in this sense a market in a command economy, with the central banks functioning as the controllers. Stability for the Euro is only viewed from one perspective: the currency is neither too high nor too low when compared to the USD. This is not an appropriate measure of stability, however, as the Euro is not used solely to purchase other foreign currencies. In terms of the purchasing power of the Euro, one must look upon the various asset classes to see what the Euro can buy today. The success of the ECB in stabilizing the Euro can be artificially discerned by looking at HICP, but this only tells one side of the story (Poole & Wheelock, 2008). The other side of the story is that the ECB is running out of tools and Draghi’s claim to do whatever it takes reveals the desperation. The ECB is there to prop up the markets and serve as the backstop for the great experiment in collectivism that is the EU and its foray into managing a command economy. Price stability is the last thing that the EU will be able to provide if and when the bottom falls out of such an economy, as it did for the Soviet system at the end of its run.ConclusionThe ECB’s monetary policy tools and strategies are centered on price stability by keeping inflation below but close to 2%. The main policy tool that the ECB has used over the past decade is quantitative easing, which has helped to keep markets afloat but at the expense of the Euro’s loss of value in terms of certain asset classes like equities. The ECB is simply following suit and acting alongside the world’s other central banks, and when they all cease implementing QE, the results of this experiment in unconventional monetary policy will finally be seen and felt by markets. The Euro’s true value will be revealed, however, only over the long-term, which is not a timeframe that falls within the ECB’s purview. The central bank is engaged in monitoring and controlling inflation in the medium-term. It knows that it has no power to effect the outcome at the end—for the policies it enacts today and has been enacting since the Great Economic Crisis have only served to devalue the Euro in the long run. Devaluation—i.e., inflation—is what happens when the money supply is rapidly increased over a short span of time. If that does not define QE, then nothing does. And for that….....

Show More ⇣

     Open the full completed essay and source list


OR

     Order a one-of-a-kind custom essay on this topic


sample essay writing service

Cite This Resource:

Latest APA Format (6th edition)

Copy Reference
"ECB 's Tools And Strategies" (2018, April 13) Retrieved April 29, 2024, from
https://www.aceyourpaper.com/essays/ecb-tools-strategies-2177658

Latest MLA Format (8th edition)

Copy Reference
"ECB 's Tools And Strategies" 13 April 2018. Web.29 April. 2024. <
https://www.aceyourpaper.com/essays/ecb-tools-strategies-2177658>

Latest Chicago Format (16th edition)

Copy Reference
"ECB 's Tools And Strategies", 13 April 2018, Accessed.29 April. 2024,
https://www.aceyourpaper.com/essays/ecb-tools-strategies-2177658
   

Open, View, and/or
Download this Document
order custom essay example