Category: Economics

It was not that long ago when development economics was underrated and not recognised by the classical economists as a worth studying field. The issue was that the macroeconomists who were interested about these subjects always focused on one specific country, such as South Korea, and tried to understand what had driven it to outperform other economies. Meaning that they acknowledged what led to each countries’ development, but they could not implement that in another place, due to the fact that the conditions in each case study were unique and intrinsic to the countries’ features, so they could not be replicated on another location.

This has changed since figures like Esther Duflo, Michael Kremer or Abhjit Banerjee stranded their position on the world of development economics.

Previous studies on development economics had a major flaw that prevented them from discovering the most efficient treatments to ultimately eradicate poverty, across all fields, such as health, education, corruption, among others. By studying a specific countries’ case, economists were never fully able to state whether an intervention had a causal effect on the combat against poverty or not, even if it such relation was heavily supported by economic theory. The reason behind that is the lack of a counterfactual effect – economists were incapable of observing the outcome in the case that individuals had not benefited from the intervention previously made. Without directly observing a counterfactual effect, conclusions on previous studies about economic research were most likely biased from previous economic theory already conducted, and no causal effect could be stated.

Aiming to overcome this handicap in economic research, these economists borrowed a key tool from clinical medicine: the Randomized Controlled Trial (RCTs).

In order to be able to conduct causal inference, they took a brand new approach to economic research that, very simply put, was characterized by the following:

• The creation of a treatment/intervention that, supported by economic theory and empirical evidence, is believed to be able to diminish poverty in a certain field

• The collection of a random sample within the same field, to which half, randomly assigned, would benefit from the treatment – the Treatment Group -, whereas the other half would perform as the Control Group, not receiving any treatment.

Basically, the creation of this control/base group of individuals was what ultimately able these economists to be Nobel Prize winners. Having a Control Group randomly assigned enables economists to observe the so wanted counterfactual effect of an intervention, giving their studies enough strength to conduct causal inference, and this was crucial for the advancements on development economics discoveries.

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“The Miracle of Microfinance? Evidence from a Randomized Evaluation” was a study conducted by Duflo, Banerjee, (two out of the three Nobel Prize Winners), Glennerster & Kinnan (2013) that perfectly exhibits the power of RCTs.

Microfinance has created big enthusiasm and hope for fast poverty eradication. Through the lending of microloans, it was believed that small enterprises would be able to grow and expand, and therefore generate welfare at an individual level in the developing world. However, the above study concluded that microcredit generated no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and women’s empowerment. This study was conducted on a sample of 104 slums in India, where half of it was randomly selected to benefit from a loan product from a particular microfinance institution, whereas the other half received nothing. As such, given the strength of an RCT, it was enough to ultimately refute economic theory, proving that, in reality, microfinance has no impact at all. This study is just one, among many others, that serves as an example to explain the strength that RCTs have when stating economic conclusions and results.

As such, by conducting RCTs, we are treating development economics exactly as the science it actually is. When in a sample of mice, half of it receives a drug whereas the other receives nothing, with the goal of discovering cures for illnesses, scientists and doctors are using RCTs. However, one might think: is it ethical to treat individuals, or small enterprises, merely as guinea pigs from a scientific experience?

Accordingly, many authors and researchers have been criticizing the RCTs approach to conduct economic research. One of the first studies using RCTs was done in Kenya in the 1990s, whose goal was to increase school attendance through the eradication of parasitic worms in children. Despite the great results this paper generated, one cannot forget that these results came at the expense of many children not benefiting from free deworming pills, only because they were unlucky enough to be in one of the schools which were part of the Control Group of the experiment. As such, it is fair to argue that ethics should have a higher role in economic research, and that the poorest cannot be seen from economic researchers merely as experimental subjects from their experiments.

However, the flip side of the coin regards the effectiveness of RCTs. The strength of its results is enough to compensate the unlucky parties of the Control Groups, since in the long-run the Control Group will also be better due to the intervention. They claim that, only because of the results of RCTs, the lives of the worst-off people around the world will be improved.

Nevertheless, despite the divergence of opinions that RCTs are creating, there is no doubt that this approach is truly disrupting development economics research, and the world in general. And the fact that these three development economists were finally recognised by the community is a sign of the changing times we are living.

Central banks are today some of the most important institutions in the economy, charged with regulating interest rates and the overall flow of money supply. This makes them responsible for a nation, or group of nations, monetary policy. Normally, since they have this responsibility central banks are charged with keeping inflation and prices stable, but some reserve banks have added duties, such as the FED which also has to keep unemployment low.

In order for central banks to pursue these objectives it’s generally assumed that they should be independent from political power and decision making. Nonetheless, lately central banks have seen their autonomy being challenged, such in: the US, where Donald Trump has repeatedly criticized the FED’s actions, Modi’s India where the governor resigned in December over clashes with the PJP’s leader, Turkey in which Erdogan fired the governor for allegedly refusing to lower interest rates or Argentina where Mauricio Macri’s government is hoping that the central bank will issue more pesos.

But why were central banks given more autonomy in the first place?

To answer this, we first have to go back to the 1960s and 70s when reserve banks where far more influenced or out-right controlled by government policy. Around this time, economists and specially politicians believed that you could lower unemployment by increasing inflation, a theory backed by the Philips Curve, so general wisdom demanded central banks to increase money supply to curb unemployment. This theory made it irresistible for politicians to pressure central banks to stimulate the economy ahead of an election, so as to boost their chances of winning. Everyone knows that an incumbent leader is more popular with a low unemployment rate and a bustling economy. This was what exactly happened with Richard Nixon ahead of the 1972 election in which he pressured the FED’s chairman, at the time, to increase the money supply. However, this decision is largely seen as having left the US economy vulnerable to the great increase in inflation the world saw throughout the 70s that was largely caused by the oil embargo. Nonetheless, the monetary paradigm of the time is widely seen as a reason for the prolonged inflation bubble.

It was from this point on, that the world started coming to the conclusion that giving independence to central banks could largely be a positive outcome. From the graph below, we can see that countries such as Germany and Switzerland, home to very independent central banks had lower inflation rates than countries such as the US or UK where the reserve banks were not as independent.

After all it makes sense that central banks should be independent, since chairman’s have a long-run view of the economy instead of just the next election year cycle. It’s much harder for politicians to pursue unpopular measures that might bring short term difficulties, but they are necessary to assure the overall health of the economy in the long run. To raise interest rates or cut budget deficits in an election year, are examples of those unpopular measures. Given this, the world gradually moved in the direction of giving more autonomy to central banks in the 1980s and 90s, and the results have been clear. Inflation has been far more stable as well as interest rates. This in turn has helped consumers and businesses by not having to adapt to new prices and interest rates in very short spans of time.

Times of change

Nevertheless, the 2008 global recession has changed the view of many with regards to central bank independence. Many believe that central bankers don’t have necessarily the public interest on their minds and that their actions are too secretive, pointing to the fact that they are not elected and are autonomous from public branches, and thus some believe they should have more oversight. Others point out that too much reserve bank’s independence may cause a contradiction between monetary policy and fiscal policy, which is a government responsibility. Which in turn could destabilize the economy and make it more difficult to wither recessions. Moreover, the general rise in populism has also put these institutions under threat of attacks both by the right in the case of Donald Trump and by the left, in the case of Jeremy Corbyn which criticizes the Bank of England’s actions and wants to use it as a tool to finance bigger public investment.

With this, central banks dependence or attempts to curb their autonomy, have become a good indicator of authoritarian like regimes. One such example is Venezuela, where inflation has reached 10 000 000%. Another one is Zimbabwe where inflation reached 89.7 sextillion percent year-on-year in mid-November of 2008. So, there is a tendency for authoritarian regimes to attack central bank autonomy and make reckless decisions with regards to monetary policy.

All in all, one thing is clear, central banks are going to have to change the way they operate and adapt it to the new reality. Even top figures, such as Mario Draghi, recognize that monetary policy and, therefore, central banks have to act in a more coordinated manner with fiscal policy (government) in order to allow for a more cohesive strategy when dealing with the economy and achieving more stability. The world is changing and the central banks’ operation process is too.

Once mistaken for the janitor by an employee’s parent, Alibaba Group’s CEO Daniel Zhang will be replacing Jack Ma as chairman of the company. What are the prospects?

In 1999, the biggest e-commerce and retail company in the world was created in an apartment in Hangzhou by a team of 18 individuals. One of the co-founders, Jack Ma (7.8% stake), then became the enterprise’s CEO and chairman and, consecutively, China’s wealthiest man, with a net worth of around US$42 billion. On September 2018, Mr. Ma publicly announced that he would be stepping down as Alibaba’s chairman and, one year after, on the 10th of the same month, the role of executive chair was passed on to Daniel Zhang. But what legacy did Jack Ma leave behind?

The Alibaba Group provides business-to-business – B2B – (Alibaba.com), business-to-consumer – B2C (Tmall) and consumer-to-consumer – C2C – (Taobao) sales services. It is considered the largest e-commerce company, with a gross merchandise value in 2018 of US$854 billion, outperforming Amazon3 and eBay4 combined. Furthermore, the company had the highest initial public offering (IPO) in history, with an astonishing value of US$228 billion when Alibaba raised more shares shortly after getting listed in the stock market5. As of 10th September 2019, when Jack Ma resigned from his position, the Alibaba Group had a market cap of US$455.6 billion.

It looks as if Daniel Zhang has some really big shoes to fill, and the Chinese situation is very precarious at the moment, with its economic growth slowing down (6.2% yearly growth rate, the lowest since 1992), the trade war with the US and due to the protests in Hong Kong, that have already resulted in delay of a stock offering that could have raised US$20 billion for the company.

However, Mr. Zhang has proven so far to be extremely competent for this task. He joined the Alibaba Group in 2007 as CFO of Taobao (comparable to eBay) that, despite being the most visited website at the time, was suffering from severe losses and fraudulent sellers. In the following year, he was put in charge of the development of Tmall (comparable to Amazon) and, in order to attract brand names to this subsidiary of Alibaba, not only did he provide top merchants with relevant information regarding their buyers – who was buying what, area of residence, which ads were more effective – but he also installed a more complex security system concerning copycats and, as a result, sales rocketed. Daniel Zhang was also responsible for the creation of Singles’ Day, which is an annual deals-fest whose sales amounted to US$31 billion last year alone, outdoing the values of Black Friday in the USA.

And it does not stop here: as a chairman, Daniel Zhang has revealed initiatives to place Alibaba in fields such as finance, healthcare, films and music. He has stated in an interview with Bloomberg:

“Every business has a life cycle. You have to be innovative and create new businesses with new technology, with a new model. Then that can make our entire business sustainable. We always say that we want to build a sustainable, long-term business. But most of it is not evergreen. I strongly believe that if we don’t kill our existing business, someone else will. So I’d rather see our new business kill our existing business.”

Of many projects that Zhang has been developing, however, there is one remarkably ambitious and innovative, Freshippo. This is a start-up of the Alibaba Group that would unite the concept of a grocery store, a restaurant and a delivery app all together, along with the aid of robotics and facial recognition. With 150 stores across 17 cities, Daniel Zhang states that Alibaba is determined to take 50% of the food delivery sector. Moreover, on the 25th of this month, the enterprise unveiled its first chip developed for artificial intelligence, becoming the most recent non-traditional chipmaker company to develop its own AI hardware.

The future, however, is uncertain, as many start-ups strive to compete for leadership of the food delivery market, and expansion has been challenging. Alibaba has already sunk US$4 billion in attempts at expanding to Southeast Asia and Donald Trump’s administration is considering the banning of Chinese companies listing in the US as a move in the trade war, which will greatly impact Alibaba’s shares, that have gone down by 4% since the news were released.

In order to analyse the outlook for Alibaba, it is important to consider its current presence in global markets while comparing it to China, its main source of revenue. One of Jack Ma’s long-term goals was to have half of the revenue coming from outside of China, but it is clear that the company is far from independent of the Chinese market provided that, in this year, its e-commerce revenues from international commerce only amounted to a mere 10% of Alibaba’s total revenues. However, both its subsidiaries Taobao and Tmall are clear leaders in the overall global markets when comparing gross merchandise value.

All things considered, although the leadership of Daniel Zhang has been looking promising for the company, there are many key factors that are weighing Alibaba Group down, so large global expansion opportunities might be jeopardized by several adversities. The question that lingers is: Will Daniel Zhang leave triumphant or was he at the right place at the wrong time?

Finland, Norway, Sweden, all these countries are seen as the dream country to raise your children, but have you ever heard about Switzerland? I’m not talking about its chocolate, inventors or its capability to shelter its entire human population in nuclear fallout shelters in the event of a nuclear war; in fact, what is more intriguing it’s their education system and the possibility of it being strongly related to the Swiss economy.

Swiss Education System in a Nutshell

The Swiss educational system is decentralized, and the cantons (member states of the Swiss Confederation) are responsible for providing educational services. Therefore, some content may vary significantly from one canton to another. Nevertheless, the general structure consists of eleven years of free compulsory education. Now, here’s what’s peculiar: at the end of the primary cycle (6th grade), students make some theoretical and psychotechnical tests in order to be selected to different schools according to their specific characteristics, competences and psychotechnical trends. Students with lower grades or with more practical competences go to Oberstuf, a school more vocationally oriented; depending on their success as students, they can choose the area they want to study and take a 3-year course in a dual system – 1 day per week having theoretical classes and 4 days doing an internship. Everyone can take as many as courses they want to. On the other hand, students with the best grades tend to go to Gymnasium, ending up with more theoretical and intellectually demanding programs so they are well prepared for tertiary education.

Now, while this intervention and channeling of students from an early age may seem discriminatory, cruel and rushed, in fact, it may be a key factor for the Swiss Economy success. It is also interesting and useful to compare the performance of Switzerland with another European country. In order to do so, Portugal was chosen.

Note: The analysis will be focused on the population with upper secondary and post-secondary education. All statistical data was provided by PORDATA.

Key indicators

I. Early Leavers from Education

Concerning the early leavers from education and training between 18 and 24 years old, both countries show a significant decrease. However, Portugal has made a bigger effort on this, by lowering the rate of 40,1% in 1996 to 12,6%, in 2017. Switzerland, on the other hand, already had a very low rate of early leavers in 1996 (6,1%), even though it also got lower over the years, reaching a rate of 4,5%.

In both countries if students are having low academic performance, school is in charge of talking to their parents. However, in Switzerland they give a special attention to the discouraged students by having social workers that make sure they do not drop out easily of the courses: if they don’t like the course, they’re immediately accompanied in order to find the course that fits them better. This may explain the low rate of early leavers in Switzerland when compared to Portugal.

II. Population with upper secondary and post-secondary non-tertiary education 

The part of population with upper secondary and post-secondary non-tertiary education, in percentage of the population between 25 and 60 years old, increased in Portugal and decreased in Switzerland. However Switzerland’s values are still very high comparing to Portugal’s. In Portugal, it started with a 10,8%, in the first year of analysis, and had a 23,9%, in 2017. However, Switzerland shows significantly bigger values in these periods, having 61,4% in 1996 and 42,5% in 2017, twice Portugal’s rate.

In Switzerland, as you finish any vocational course you are considered specialized in that area, having a certificate that is highly valued by the companies. This is an incentive for students who want to take these courses. Unfortunately, in Portugal, professional courses are not as valued by neither the students nor the employers – they’re seen as an alternative way of ending compulsory education rather than being a way of getting instructed in a future viable employment. The exception seems to be tourism and hospitality schools, which have been rated as good and reliable vocational schools. In the end, this is a possible reason for this difference between the rates. This said, a lot of firms find themselves constrained in their business growth due to the lack of qualified workers in the industrial area, such as electricians, mechanics or even locksmiths.

III. Unemployment rate by level of education

 When analysing the unemployment rates (considering population from 15 to 74 years) in these two countries, it’s clear that they are both increasing, with Portugal at a higher pace than Switzerland. Between 1996 and 2017, Portugal went from a rate of 7,4% to 8,87% while Switzerland went from 3,7% to 4,8%, keeping it substantially low.

 When going through the unemployment rate by levels of education, one can observe that this rate is higher for people with lower education, referring to 2017, in both countries. However, concerning post-secondary non-tertiary education, there is a huge difference between the two countries:

None or Primary Education:

• Portugal: 9,8

• Swiss: 8,3

Post-secondary Non-tertiary Education:

• Portugal: 9,9

• Swiss: 4,7

Tertiary Education:

• Portugal: 6,5

• Swiss: 3,8

The lower rate of Switzerland may be explained not only by the facts supra mentioned but also due to the fact that at the end of the vocational formations, most of the students are automatically hired by the firms where they worked during the 3-year internship, as they already have confidence in their abilities and commitment.

Furthermore, this education system reflects the real needs of the country: they change the number of course vacancies depending on the demand and supply of the labor market. This way, one could say that the government tries to maximize the efficiency between unemployment rate and the lack of people in some sectors. This is one of the strongest points where any kind of relation between the existing courses in the education system and the economy of this country can be inferred.

Wrapping up

 Swiss companies do not need to waste their main resources – time and money – in workers’ training – the employees already know exactly what to do and how they should behave within the company. This is one of the most impactful advantages of the Swiss system. Firms obtain young and qualified workforce and schools obtain a high level of employability in their courses, while students get a certificated course and will find a job much more easily. Besides being excellent for the macroeconomics of the country, it also allows everyone in the country to have professional and inclusion opportunities.

Switzerland is a country that regards knowledge and education as a key of its development.

Mariana Inglês Vladyslava Shturma

The past weeks have been tense for the financial markets, with the stock market reacting negatively to the inversion of the Yield curve, one of the most preeminent indicators of recession in the past, which adds up to the failures registered in the last two years in making the economy dynamic again (via extremely low interest rates).

The truth is that the alarms are starting to ring in several fronts. Tensions between the US and China increased concerns among investors, and may deteriorate the whole economy, taking another step towards the recession. Investors have started to leave the common equities to take refuge in sovereign debt and gold, with the latter one being traded at around 1500 dollars (28.3% increase in the last 52 weeks according to Bloomberg), the highest since 2013.

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Germany

Financial data about Germany, the strongest economy in the eurozone, also shows that an economic breakdown could be just around the corner with the country’s interests in sovereign debt negative in all the available periods (including the 30 years bonds) helping keeping the country slightly above the recession line.

The PMI (Purchasing Managers’ Index), a widely used economic activity indicator, stated a decrease in the country’s performance (43.5 in a scale from 0-100 where values below 50 indicate an expected retraction) and the industrial production registered the biggest fall of the last ten years (being affected by the US-China trade war in the exports field).

If we add up all this data to the fact that in the last year the country barely avoided a technical recession (GDP contraction for two consecutive quarters), it might be possible that the recession in the eurozone’s biggest economy is close to happening and with that its main traders will suffer repercussions.

To support this opinion, the reading of this year’s data about Germany’s economic performance is recommended, since this last quarter (April-June) the economy sank 0.1%. Next quarter prospects are not that good as well, but will depend on the markets’ reactions to the new quantitative easing programme (which will be launched in November).

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Monetary Policy

Negative interest rates? Once seen as an anomaly, negative interest rates are becoming increasingly more common since the last financial crisis. Among the countries/monetary unions with «subzero» interest rates we have Denmark, Japan, Sweden (the first to adopt the strategy), Switzerland and the Eurozone.

Mainly used as an extension of the traditional monetary policy tools to avoid deflation, encourage lending and promote economic growth, these policies have lost their catalyst power, with the economy being “trapped” into an inefficient mechanism that contributes more to feed the Assets and Real Estate “bubble” than to give a temporary stimulus for a sustainable growth in the future. (Housing prices in the US are 8% higher than at the peak of the real estate bubble in 2006, and the CAPE ratio, Cyclically Adjusted Price to Earnings Ratio, that is generally applied to broad equity indices to assess whether the market is undervalued or overvalued, is also higher than in 1929 and 2008).

In fact, the bond market with negative yields already reached 17 trillions, roughly 30% of its entirety, which reveals the uncertainty amid the remaining market (not to be confused with the bond market, which is historically safe), with people willing to lose some money in order to avoid major losses.

It is also worth mentioning that these measures do not give signs of stopping, since Mario Draghi decided to restart ECB’s economic stimulus efforts with a quantitative easing programme of €2.6 tn, an act heavily contested by some of his peers in the Central Bank such as Klaas Knot, Dutch Central Bank governor, who said “this broad package of measures, in particular restarting the asset purchase programme, is disproportionate to the present economic conditions” and also “there are increasing signs of scarcity of low risk assets, distorted pricing in financial markets and excessive risk-seeking behaviour in the housing market”.

The Central Banks of Thailand, New Zealand and India have also started to cut heavily on the interest rates, more than investors were expecting, putting the monetary policy concerns into a globalised proportion.

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Trade War

In the geopolitical arena, we have another big threat to the current weak balance of the worldwide economy: the worsening of the commercial tensions between the US and China, which has been speculated to degenerate into a currency war. This derives from China’s reaction to the implemented tariffs in every Chinese product applied by the US, that resulted in the devaluation of the Renminbi, with all the consequences that this measure means for the trade balance. Also regarding this topic, it is important to mention that China’s economy grew at its slowest pace in almost three decades in the second quarter of this year, as the trade war with the US took its toll on exports. Despite remaining with relatively good income and consumer spending growth rates, the year on year growth rate was “only” 6.2%, the lowest since 1992.

Maybe it is only one more episode in an endless novel, with both sides continuously failing to find a solution to their divergences, but as the time passes and the patience burns out, this might escalate into even more serious issues, with Bloomberg predicting a 0.6% decrease in global growth if the two countries expand their tariffs to all goods and services.

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Yield Curve Inversion

Even more distressing is the inversion of the Yield curve of US Treasuries, that basically retracts the evolution of the 3 months interest rate versus the 10 years’ one (we can compare several periods within this range), meaning that the cost of borrowing long term is falling below that of borrowing short term, which is the opposite of what it should be. This phenomenon reflects investors’ collective uncertainty towards the current economic outlook and is thought to be the biggest warning to the markets since the 2007 recession, with investors turning to safer assets, such as the 10-year treasury bonds.

This is supported by the fact that the last 5 recessions were all preceded by one of these inversions (approximately between 12 to 18 months after). Despite this historical data, it is also important to bear in mind the economic environment we face today, since the extremely low interest rates in the eurozone and Japan and the mistrust of the investors are increasing the demand for US treasury bonds.

Naturally, and following Alfred Marshall’s law (Demand and Supply), the prices of the bonds are increasing and consequently the yields are decreasing in the same proportion, contributing for the inversion of this curve.

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Counterarguments

Nonetheless, it is important to mention that there are also positive signs within the economy that might, at least for a while, dispel the recession. These signs include the fact that the low bond yields are widely explained by the aggressive monetary policy stimulus, that might distort a little bit the effectiveness of its predictions. Also, in the yield curve “field”, its small amplitude when compared with the likes of mid 70’s and early 80’s in terms of percentage, until a certain extent reduces the urgency of the warning.

The fact that the S&P 500 is just a few points below July all-time high,which signals goods expectations among the investors in what concerns corporate earnings.

Lastly, and perhaps one of the most important indicators, the fact that wages are growing strongly and the spectrum of deflation, characterized by a general decrease in the prices of goods and services with its implications in terms of wages, is for now a distant reality. This is of huge importance for the US, given that their economy is based 70% on consumption. (Wages grew 4.7 percent annualized in the second quarter of the year, US poverty rate has fallen to its lowest level since before the last financial crisis and Bloomberg Consumer Comfort index that assesses buying climate and personal finances reached an 18 year high, motivated by the good atmosphere that surrounds both the job and equity markets, with its value being fixed in 67.4 by 14th July.)

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Conclusion

The past and the economic background that comes with it tell us that the inversion of the yield curve should be considered a serious foreshadowing of a recession, although the current economic atmosphere might have until some extent distorted the trustworthiness of this predictions. It is also important to state that a recession is not necessarily dreadful or horrific, it is indeed natural and takes part in all economic cycles.

However, alongside with continuous decreases in interest rates, trade wars, China’s growth deceleration, wealth and income inequality and others, a recession can be indeed “horrific” and “dreadful”, since it might trigger a more serious economic and political crisis, posing important challenges to government policies, that each day are getting more exposed with the decreasing power of one of its major mechanisms, the monetary policy.

On the 12th of September, the European Central Bank (ECB) decided, after three years of unchanged monetary policy, to cut the interest rate on deposits to -0.5% and to restart, although with small dimension, Quantitative Easing in November with purchases of 20 billion euros of bonds. At the end of his mandate, Mario Draghi, the ECB president, does a last attempt to fulfill the ECB objective: price stability. In this article, on the one hand, we explain how these two measures will fulfil the ECB’s goal and, on the other hand, possible outcomes for the European economy.

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An expansion for the last 10 years

The objective of the Central Bank is, indeed, to ensure price stability, that materializes in having the inflation rate below, but close, to 2%. Since the creation of the ECB, and up until the Great Recession of 2008, this goal was achieved, with some minor exceptions. However, since this major event, the achievement of this goal has been more problematic; in particular, in the last 7 years, the inflation rate was consistently below the target, with some years registering a negative inflation rate (meaning prices were falling). Furthermore, looking to the last year, we observe a fall in the inflation rate.

A Central Bank, and in particular the ECB, has several instruments to execute monetary policy. The conventional ones are the interest rate on the main refinancing operations (MRO), which provides the bulk of liquidity to the banking system; the rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem, and the rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. Besides that, the ECB also has unconventional instruments, from which the most famous is the Quantitative Easing programme that consists in the Central Bank buying government securities from the market, thus increasing the money supply, as an attempt to “directly” inject liquidity into the economy, thus encouraging lending and investment. This is an efficient alternative when short- term interest rates approach zero, and open market operations lose their effectiveness. During the last decade, the ECB has been decreasing their interest rates persistently and it was in 2014 that the deposit facility interest rate became negative for the first time.

In fact, Mario Draghi’s popular speech in 2012, when he said that he would do “whatever it takes” to battle deflation, has been the perfect representation of the dovish behaviour of the Central Bank.

This conduct has prevented economic slowdowns in the recent years and, again, it is being used right down to prevent the recession that is expected by the markets in the future, although this is out of the scope of the ECB, the latter being the major difference between the European Central Bank and the North American Federal Reserve.

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The implications of an Expansive Monetary Policy

However, there is a lot of controversy around the stimulus presented by the ECB. On the one hand, by decreasing even more the deposit interest rate, the ECB discourages banks to deposit their money in the Central Bank and, therefore, encourages them to lend it to their customers more easily or to invest it in financial markets. In fact, it is important to have larger amounts of currency in circulation, since this way, households will spend more because they feel wealthier and investors will have more funds to allocate in their portfolios. In other words, the goal is to stimulate consumption and investment and, hence, economic growth.

Moreover, the banks themselves also have greater incentives to invest their surplus (this is, the amount of money they have besides the minimum reserves stipulated by the ECB) since, with negative deposit rates at the Central Bank, investments in financial instruments that are considered nearly as safe as deposits (for example, German bunds) yield a better return, and thus are seen as better investment opportunities. In this way, also the financial markets are stimulated and there are more flows of capital for investment. With the purchase of assets through QE, the ECB can, effectively, when the financial system is under stress and risk premia are high, raise prices of assets, reducing their yields. Consequently, governments have more incentives to increase public investment. This is, indeed, a concern of the ECB, as it has been demanding, from national governments, more fiscal stimulus.

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Problems of a long-lasting monetary policy

There are also several problems associated not only with negative rates, but also with the asset-purchase program. Given that rates are at historic lows, each additional stimulus will have to be reduced and, therefore, the effect will not be sustainable enough to provide economic growth; instead, may have adverse effects on fragile banks of the Eurosystem, taking into account that banks are forced to reduce interest rates on deposits for their customers and, as such, suffer great reductions in their profits. Furthermore, the ECB already has 25% of the bonds issued by Eurozone governments, which means that the values of these assets are superficially higher and as such, the balance of the assets of euro area banks does not reflect their true value, which at the end of the QE program will cause major problems for banks. Something to also keep in mind is the risk of being at the famous “zero lower bound” (also known as “liquidity trap”) when the next recession hits. If the interest rates set by the ECB are still this low when the European Economies start really slowing down, the monetary policy will have no room to stimulate the economies and have them grow again. In an era where the southern European countries are still plagued by the large debt levels from the aftermath of the Great Recession, and thus have limited capacity to conduct expansionary fiscal policies, stimulating methods could very well be running short.

Finally, another problem underlying the ECB’s policy is that this is not a normal central bank, but a central bank that serves a confederation of countries and, as such, is subject to conflict of interests from each part in their decision process. In recent years, it has been evident a big difference between the northern countries (such as Germany and the Netherlands), who do not want more stimulus since their inflation figures are above the Euro-area average levels and not so far from the 2%; and the countries of the south, such as Spain and Italy, facing situations of political instability and inflation figures close to zero and needing that extra help to see their economic output grow. As such, the President of the ECB must consider a wide range of realities and, consequently, the decision process results in delays and half measures and the effect is not as substantial and immediate as it should. One example is that this announcement lead to the decrease of more than 20 basis points of the Italy’s 10 years bond yield.

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Where will policy be heading next

Currently, it seems that there is no reason for worries and no need to anxiously implement stimulus in the economy since, although economic activity has weakened in recent quarters, it is still much better than in March 2015, when the ECB introduced the QE program. Headline and core inflation are also at higher values as well as inflation expectations from customers. As said by the Dutch central bank chief Klaas Knot, “the only observation [about the Euro Area economy] is currently that the inflation outlook lags behind the ECB’s aim”. However, there are, undeniably, some international threats as such the trade war which may affect some sectors of activity (mainly, manufacturers) in the euro system economies; Brexit, whose future is still very uncertain and entails mistrust for firms and investors; and, among others, political instability in Italy. Hence,

European countries will go through unknown paths in the next months and the future of the economy is quite unpredictable nowadays.

This is why Mario Draghi decided to bring back in the end of his mandate the monetary weapons, that allowed him to win some battles in the past and called governments to action by saying that monetary policy alone is not enough and fiscal policies are also important to keep economies moving in the right way.

Tiago Bernardino Diogo Costa