The ECB’s low interest rate policy: The German economy at risk

The European Central Bank (ECB) continues its low interest rate policy. Since it relies on the average price development in the euro area for its monetary policy, a key rate currently amounting to 0.15 percent appears to be appropriate as inflation is low and the economic recovery is sluggish. However, the member countries are in different situations as far as the business cycle is concerned, which means that the level of interest rates is not appropriate for all economies. Monetary policy has already been too expansionary for the German economy for a number of years now. And due to the unconventional measures, the degree of expansion is even intensified. Consequently, a boom is imminent in Germany which is typically associated with substantial undesirable developments, in particular the misallocation of capital. This increases the risk to financial stability and could lead to a massive economic setback.

A common gauge for the degree of expansion of monetary policy is the Taylor Rule, named after the US economist John Taylor. This rule has been established in economic research to describe the behavior of central banks. In common economic models, the rule is referred to as a norm: if the central bank follows this rule, the inflation target is achieved and economic fluctuations are kept as low as possible. The appropriate interest rate is determined by the difference between the current inflation rate (or inflationary expectations) and the inflation target as well as the rate of capacity utilization in the economy. While the estimate of the “correct” interest rate is subject to substantial uncertainty, since, for example, the natural interest rate is also included in the rule, the values for a practical analysis can be approximated quite well ex post.

If the “appropriate” interest rate for a national economy can be derived in this manner, it is likewise possible to interpret a deviation from the standard in such a way that the interest rate is either too low or too high to ensure macroeconomic stability. John Taylor has been using this standard himself time and again in order to show that the policy of the U.S. Fed had been too expansionary prior to the outbreak of the financial crisis. In the period from 2002 to 2006, the key interest rate was significantly below the level that would have been an appropriate monetary policy according to the rule. The excessively low interest rates contributed to the boom and to the real-estate bubble; hence monetary policy contributed to the current crisis.

By analogy, it can be shown for the first several years after the start to the European Monetary Union that the uniform key interest rate was much too low for some member states. For instance, the economies of Spain and Ireland experienced a veritable boom after 1999, with substantially higher inflation rates than the euro area average. During this period, real interest rates were even negative for quite some time. As a result, the boom was fuelled by an explosion in lending, and private debt soared.

Measured according to the Taylor Rule, the key interest rate for Spain should have been about 400 basis points higher in the period from 1999–2006 according to our calculations. Just to avoid any misunderstanding: this is not a criticism of the ECB’s policy in this context. The ECB can justly point out that it reached its inflationary target in this period on average. However, it is natural in a monetary union that the single, uniform key interest rate cannot be appropriate for all countries if there are differences in terms of inflation rates or cyclical positions.

The German economy has been very robust, and the inflation rate is slightly higher than average, even if it still remains low to date. Real interest rates are also negative, which is likely to stimulate economic activity. Hence, in the absence of any new bad news the German economy will probably experience an economic boom along with all the undesirable developments. For example, many investments are only being undertaken because the interest rates are excessively low. Even if no house price bubble can currently be observed, construction activity is likely to be stimulated, and private households will probably pile up an increasing volume of debt.

Does a comparison with Spain make sense? It does not appear to be the case at present, and it is also unlikely that the situation will escalate in a similar manner. For instance, lending standards are more restrictive in Germany, not least on account of lower lending ratios. Nevertheless: a boom induced by monetary factors is hardly avoidable. The key interest rate has already been below the rate derived from the Taylor Rule for Germany for about four years now. This gap will most probably even widen in the coming years as the ECB is unlikely to raise its key rates for the time being. And if it does take first steps of tightening monetary policy, the level of capacity utilization and inflation will have risen considerably and more sharply than it will be the case in the rest of the euro area.

According to the forecast of the Kiel Institute for the World Economy, the interest rate for Germany will remain far too low for another four years. In other words, we will be facing Spanish conditions as far as the monetary conditions are concerned. This is an important challenge for economic policy in Germany which should try to reduce the undesirable developments arising from the boom induced by monetary policy. However, this requires that policymakers will actually agree with this diagnosis and will not merely “enjoy” the presumably favorable economic conditions which will not last forever. Above all, the primary objective will be to limit systemic risks for the German economy. This begins with an approach for big banks to limit their risk of their own accord because they can no longer expect to receive government bailouts. Beyond this, however, stricter financial market rules within the scope of macro-prudential policy would be sensible; in particular, these include a considerable increase in the capital buffer as well as lower debt leveraging. This would be an important step in order to reduce the vulnerability of the financial system in the wake of the correction of the boom.

(Slightly revised version of an op ed in Börsenzeitung of 9 May 2014 entitled "EZB-Niedrigzinspolitik ist ein Risiko für Deutschland".)