Why easier monetary policy alone will not help the Eurozone

For banks to expand loan book in Eurozone, should consider rationalisation of risk-weightings in Basel capital rules.

Mario Draghi, President of the European Central Bank (ECB), rightfully deserves credit as the Eurozone’s saviour. I would argue — and few would disagree — that his pledge to ‘do whatever it takes’ during the bloc’s darkest hours saved the monetary union from ruin. Despite political wrangling over bailouts and debt restructuring, today, the Eurozone remains intact. That is an achievement. Its future, no doubt, depends on extending the currency union to a fiscal one; member states already appear to be taking initial steps in that direction through a banking union.

However, of late, the Eurozone economy faces a new threat: the prospect of Japanese-style deflation. Many commentators have called on Draghi to put his words into action. Given the bloc’s recent spell of very low inflation, critics say the ECB should engage in quantitative easing (QE) of the US/UK style. They have a point. The ECB’s reluctance to join its US, UK, and more recently, Japanese peers in expanding its balance sheet was owing to the fear of being seen as compromising on inflation targets. But now, with the Eurozone inflation at 0.7 per cent (almost a third of its ‘below but close to a two per cent’ target, surely the ECB could (and should) do more to stimulate prices. It probably will, after noting that even German inflation for April was below expectations.

But this is a short-term solution to a much bigger problem. Yes, engaging in QE will weaken the (currently strong) euro, enabling Europe’s economy to import inflation — and perhaps, provide some boost to the bloc’s exports. But that’s about it. In the long-term, the Eurozone faces the risk of low-growth/low-price, not just because its currency is strong or that peripheral countries need structural reform (which they do), but because domestic demand is weak and its main source of finance, the banking system, is broken. Firms continue to face difficulties in getting bank loans — in Greece, private credit continues to contract.

Many expect that liquidity provision through QE will result in an increase in bank lending to the real economy. There is little evidence to suggest that this actually happened in other countries. But more fundamentally, this view ignores the constraint on banks’ private lending due to the sovereign-debt bias in Basel capital regulations. So far, despite loose monetary policies globally (including at the ECB) and rebuilding of capital (some directly by governments), banks’ private lending has been disappointing.

In order to see banks expand their loan book in the Eurozone (and elsewhere), we should consider a rationalisation of risk-weightings in Basel capital rules. If the Eurozone crisis — or any other sovereign-debt restructuring in history — has taught us anything, it is that there is no such thing as risk-free asset. A continued emphasis on capital regulations that see investment in government securities as making the financial system safer (as Basel III does) only makes banks more reluctant to extend credit to the real economy when it needs it the most. Such a fundamental rethink would do a lot more for fixing the monetary policy transmission mechanism and revitalising the Eurozone, than loose fiscal and monetary policies alone.

Published in The Express Tribune, May 24^th, 2014.

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