Real and Imagined Constraints on Euro Area Monetary Policy



Patrick Honohan | Peterson Institute for International Economics


Although the European Central Bank (ECB) has been pursuing an aggressively expansionary policy since 2012, previously the ECB was behind the curve in lowering interest rates and making asset purchases to combat the prolonged euro area recession. This paper argues that part of the delay can be attributed to the multi-country nature of the euro area. Over-interpreting the limitations of the ECB’s statutory mandate, some ECB decision makers were wary of being accused of circumventing the prohibition on monetary financing by intervening in the market of the debt of weaker governments. Some were also mesmerized by the relatively strong performance of the German economy in the crisis and attributed the slower post-crisis recovery of most other member states to national policy failures that should not be offset by euro area monetary policy. All of this was exacerbated by the ECB’s adoption of and (at least until 2011) adherence to a seductive but analytically flawed “separation principle,” which misled some of its decision makers into overestimating the adequacy of the monetary expansion that was being applied. The ECB’s toolbox is indeed somewhat limited by its statute, reflecting multi-country considerations, but abandonment of the separation principle should help ensure a more effective, holistic approach to monetary policy design in the future.


Why was the European Central Bank (ECB) slower than other central banks in the financial crisis to lower interest rates and to start buying government debt?

To some extent, the explanation lies in the institution’s collective delay in recognizing the gravity and likely duration of the macroeconomic collapse and the extent of the need for expansionary policy. Influential also, and linked with this, was a persistent institutional conservatism dating back to the early years of the euro, reflecting a determination at that time to establish a reputation for being as vigilant against inflation as the Bundesbank had been in previous decades.

But there is more. Two influences specifically relate to the multi-country character of the euro area…

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