ECB Policy for a Liquidity Trap: Firing Bullets in the Dark?

July 8th, 2012
in Op Ed

by Dirk Ehnts



The NY Times commented on Thursday ( 05 July 2012):

The E.C.B. cut its benchmark rate to 0.75 percent from 1 percent, which was once regarded as the lower bound on the official rate. Economists and political leaders are likely to welcome the cut, which was expected by most analysts, as offering welcome relief from strains in the euro zone. But it also carries risks.

With interest rates now close to zero, the bank and its president, Mario Draghi, will have a dwindling selection of conventional monetary policy tools they can use to combat the crisis. The cut Thursday is likely to increase speculation that the E.C.B.’s next step to contain the crisis would be massive purchases of government bonds, similar to the quantitative easing undertaken by the U.S. Federal Reserve.

Follow up:

I don't know whether what is reported here is true for the right reasons. Economists are likely to welcome to the cut? It should have been done much earlier. And the reason why this needs to happen is to prove that we are in a liquidity trap. Investment will not be jump-started, since that depends not only on the ECBs interest rate. Anyway, the ECB made sure that it's latest policy step is successful.

The FT understands the important part:

The ECB also cut the interest rate on its deposit facility to zero, marking a bold step in its attempts to reduce general market interest rates and stimulate interbank lending.

The deposit rate is what the ECB pays banks for their overnight deposits with it. It in effect sets a floor for market rates, since banks have no incentive to lend to each other for less reward than they get for parking money safely at the central bank.

So, banks no longer get money for nothing, or, well, parking funds overnight at the central bank, which is a couple of key strokes more than nothing. As the euro declines against the US dollar right now, I would expect that banks move available funds from Europe to the US. They still pay the .25 over there. If this happens, it will show up in the data soon. Whether this has any consequences for the real economy is doubtful. If it doesn't, there is no denying: conventional monetary policy (cutting interest rates) won't do it. I would guess that exotic monetary policy (quantitative easing) won't do it either.

At least we are getting somewhere now. The ECB will not be blamed for not firing its last bullets before the situation deteriorates further ...


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About the Author

Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101Curriculum Vitae.

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  1. *----

    The author subscribes to the outdated notion that cutting interest rates stimulates an economy. There is no factual support for this myth, though it commonly is believed.

    The author also does not seem to understand the difference between Monetary Sovereignty (the EU) and monetary non-sovereignty (the euro nations), so does not understand that the later require infusions of euros (not loans) to survive.

  2. Admin (Member) Email says :

    Rodger - - -

    I should let the author respond but I will interject this anyway.

    You have made a too superficial reading of this short piece. The author has actually said he doubts the interest rate cutting process will work. He says is good about what is happening is that no one can say the process failed because the ECB didn't cut rates.

    If they cut them and it doesn't do any good then his point is that is a good thing. FAILURE OCCURRING TO PROVE A POINT.

    The difficulty here which has tripped you up is that Dirk has invoked a logical double negative.

    Perhaps I had an easier time in understanding this rather subtle point because I have read everything that Dirk has blogged for several years. He is not an ideologue and deals with what can be measured.

    If you are going to read just one of his articles to get a better perspective of Dirk's thinking, this might be the one:

    Dirk is a young outsider in the European economics world. His primary advantage at present is that he has a better prospect of being active in that community in 30-40 years than most of his less well informed and more crippled thinking contemporaries who are older.




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