Time and again, Ms Lagarde, the first President of the European Central Bank (ECB) warned the European Union (EU) governments against the COVID-19 pandemic turning into a calamity. The pressures have been mounting as the largest economies of the Eurozone like France and Italy crumble. The EU, one of the world’s largest economies, has decided to take certain measures via its monetary policy, however, the question is how much can the ECB afford?
Ms Lagarde, however, is of the view that monetary policy is not the first line of defence and feels that fiscal response must be given much more importance. The persistent heterogeneity in the Euro area has also been a long-standing concern for the single monetary policy. It severely complicates the conduct of this policy. The current crisis exposed these vulnerabilities, once more.
Ever since 2008, the EU has been in a non-stop crisis mode. Even the interest rate it charges to the commercial banks is almost nil leaving very little margin for further rate cuts to stimulate the economy out of this rut. The ECB has acknowledged how they are facing an unprecedented crisis with historic consequences which might just push the European economy to worse than what it was in 2008. If the crisis is not controlled by the stimuli, it risks pushing the already wobbly European economy to the state of recession.
On April 16, the ECB went ahead and announced the measures it will be taking on the monetary policy front while it gives time to the respective governments to formulate fiscal policy measures. The ECB took certain measures to prevent the crisis from becoming a full-blown financial crisis with two broad objectives: first, to restore the orderly functioning of presently volatile European financial markets, and second, to ensure that the accommodative monetary policy measures support firms and households in incurring the social and economic costs of the crisis.
The ECB response consists of three major mutually reinforcing grounds. The first one relating to broad-based asset purchases to address illiquidity and volatility in core segments of the European economy. The temporary Pandemic Emergency Purchase Programme (PEPP) constitutes the core of this component. The economies in the entire Eurozone have been struggling with tightening fiscal and economic conditions, the PEPP expects to release the pressure on these economies. It foresees purchases at a volume of €750 billion of eligible private and public securities throughout this year, and longer if needed. The ECB also aims to mitigate the impact of the crisis on the funding conditions of businesses and banks. For the same, it has decided to divert a considerable fraction of the additional €120 billion purchase envelope under the Asset Purchase Programmes (APP), as well as of the PEPP, for eligible private sector bonds. However, one cannot turn a blind eye to the fact that the bank has already been conducting purchases of government bonds, and now, it does not have much to re-purchase.
Additionally, measures to ensure that the banks remain effective carriers of the monetary policy of the ECB have been introduced. The enhanced Targeted Longer-Term Refinancing Operations (TLTROs), as well as a comprehensive set of collateral easing measures, form part of this component. The interest rate on all targeted TLTROs was reduced by 25 basis points to -0.5% from June 2020 to June 2021. Measures to ensure the solvency of banks by holding up the role of lender of the last resort to the banks which will help the ECB drive the way for economic growth. This becomes all the more necessary considering that the European economy is majorly a bank-based economy than a financial market one, so just supporting the financial markets would not help alleviate the effects of the crisis.
Measures for small and medium-sized firms are equally necessary, which include bank lending and loan guarantee schemes to protect the already overdrawn credit lines by cash strapped firms.
In Italy, for example, bank lending conditions for firms remained remarkably resilient in recent years despite significant swings in market-based funding conditions of the banks and firms. Again, the measures can provide a valuable bridge to the future and help keep aggregate external funding costs of firms stable until the economy recovers and uncertainty diminishes further. This also includes accepting a wider range of assets as collaterals from small and medium-sized firms along with consistently working on the liquidity conditions of the banks.
If the ECB fails to improve liquidity indirectly through these measures, it always has the option to exercise its right to issue ‘helicopter money’. This alternative would put the money straight into the ‘hands’ of the people.
Through these measures, the ECB hopes to improve liquidity and market behaviour in the sovereign yield bonds market, which in turn form the basis of pricing of assets in the economy. The ECB uses the GDP-weighted Euro area government bond yield curve as a measure for the effectiveness of the economy, but currently, this curve has been badly disrupted. So the ECB will focus on stabilising this curve and reversing the steepness of the same.
In conclusion, while the Eurozone faces an increasingly threatening risk of a slowdown in the economy, which can take years to recover from and get back to the normal levels, the ECB and various governments are taking steps to tackle this challenge. The cluster of countries has recovered from far worse situations in the past, like the global economic crisis of 2008, and emerged stronger than ever. It remains to be seen what other steps the European Union takes as a much worse crisis than COVID-19 awaits the global economy and how the relief package unravels for the Union.
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