Learning from Japan: the European Central Bank and the European Sovereign Debt Crisis

Abstract

What shapes central banks’ learning from the policy experiments of their peers? Both economic ideas and organizational interests play important roles. Thus, New Keynesian ideas led central banks to interpret Japan’s experience with quantitative easing through the impact on risk spreads, although the Japanese central bank never intended such effects. In turn, scholars and policy-makers alike ignored one critical lesson: successful policy innovations depend on banks’ funding models. I argue that this was a crucial omission because the shift to market-based funding impairs the effectiveness of the traditional crisis toolkit. Central banks must intervene directly in asset markets of systemic importance for funding conditions, as the Bank of Japan did by buying government bonds. Hence, market-based finance engenders a trade-off between financial stability and institutional stability defined through central bank independence. During critical periods, central banks cannot preserve both. The ECB illustrates this trade-off well. Early in the crisis, it outsourced financial stability to a (largely) market-dependent banking system to protect its independence. With the introduction of Outright Monetary Transactions in September 2012, the Bank recognized that the market-based nature of European banking required outright purchases of sovereign bonds. This new instrument gave the ECB additional powers to shape national fiscal decisions in the name of an independence that no longer has theoretical justifications.

Keywords: unconventional monetary policy, liquidity spirals, ECB, market-based financial systems, collateral swaps, yield curves, interest spreads

JEL Classification: E58, E42, E52, E63, E65, G21