The ECB’s monetary policy undermines reform incentives in the periphery

Euro area governments and the ECB are not pulling together. On the basis of its mandate and according to its own official statements the European Central Bank’s policy is aimed at guaranteeing monetary stability. In order to ward off the danger of deflation in the Euro area, the ECB is pursuing a highly accommodative policy, but this is enjoying ever less support from the national governments in the form of the implementation of structural reforms.

Especially the periphery states are facing growing internal political resistance, which is clearly eroding their readiness to implement reforms and impose austerity measures. At the same time, the former crisis states are benefiting from the fact that the risk premiums on EMU government bonds are distorted to the downside because of the ECB’s policy and the incentive for commercial banks to hold government bonds. Given their high levels of debt these countries have an interest in the continuation of the PSPP, which allows them to continue to refinance themselves cheaply.

While the ECB cannot do anything against the lack of readiness to implement reforms in the Euro area, ECB Governing Council Member Cœuré is already saying that it may be necessary to extend the non-conventional monetary policy measures even further. The EU Commission, by contrast, says it is powerless as any significant sanctions against the deficit-sinners would presumably fail to get past the resistance of the EU’s finance ministers.

Meanwhile, the heavily-indebted Euro area countries are missing an opportunity to pay down debt. They also run the risk of market distortions as soon as the ECB sees a chance of reducing the volume of its purchases again. In this case, risk premiums could rise steeply and these countries would again have to be saved from bankruptcy with aid programmes.

In the worst-case scenario the Euro area could enter a vicious circle if renewed aid programmes and the regulatory-related heavy demand for government bonds from commercial banks were to cause Euro area countries to postpone the implementation of necessary reforms even further despite a renewed bail-out. Since it is to be feared that the Euro area states could become permanently dependent on bailout loans and on banks, an important initiative could be to set higher capital adequacy requirements for banks with respect to EMU government bonds. Since the political will to reach an agreement among the European governments is hardly likely to grow, even in the event of a renewed crisis, such an initiative would probably have to be launched from outside. International banking supervisory bodies or institutions such as the IMF would come into question here in particular. Higher risk weights could help prevent risk premiums decoupling from the fundamental factors and mitigate macroeconomic and financial market risks.

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