The power of the European Central Bank – Social Europe

Social Europe
politics, economy and employment & labour
by on 29th September 2021
With inadequate fiscal policy, monetary policy labours to compensate, creating damaging economic distortions in the eurozone market.
The pandemic has left millions of Europeans out of work and many underemployed, their businesses partly closed. Yet some are flourishing as never before. For European bourses, it has been marvellous. As the price of stocks has climbed, so has the wealth of those who own them.
Never have we seen such a disconnect between the real economy, the home of democracy, and the financial markets, the domicile for capitalists. And one institution has been at the centre of it all—the European Central Bank.
The ECB is perhaps the most powerful yet least understood institution in the eurozone. It has the power to engender economic, social and political change. Following the global financial crisis, the bank embarked on an epic experiment in monetary economics.
There are two macroeconomic levers: fiscal and monetary policies. Before the introduction of the euro, both largely belonged to European Union member states. With monetary union, monetary policy moved to Frankfurt, centralised in the headquarters of the new ECB. Fiscal policy, such as tax-rate formulation, belonged to member states, but under the Maastricht treaty’s Stability and Growth Pact the European Commission supervised.

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The lead-up to the crash saw profound capital misallocation in the eurozone. Pre-euro, ‘currency risk’ tempered financial venture-taking. A Munich-based bank would undertake due deliberation before converting Deutschmarks into Irish punts, due to the variability of exchange rates. Currency volatility played a risk-mitigating role, moderating investment allocation. Foolhardy owners of financial assets bore their losses and had no compensating recourse to the political domain.
But monetary union and the centralisation of monetary policy in Frankfurt abolished much of the muscle memory developed in the yesteryears of cross-currency investing. After the euro’s introduction, the credit-rating institutions mistakenly assumed the abolition of currency risk equated to the elimination of risk. Risk premia fell, driving a misplaced confidence, which saw euros freewheeling around the currency block.
The abandonment of fiscal policy as a lever became obvious when write-downs on irresponsible investment were hindered by political pressures. With short-term politics governing the long-term economy, monetary policy, the one-club alternative, stepped in.
The 2008 crunch and the politically facilitated bailouts of financial institutions grew the debt piles of member states. This led to the sovereign-debt crises of peripheral eurozone economies. In July 2012, Mario Draghi, then president of the ECB, delivered his infamous ‘whatever it takes’ speech. An epic experiment to create vast amounts of schemed money out of thin air began. With a printing press in the bank’s basement, Draghi asserted that ‘the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.’
The new authority to conjure money, for exclusive use in European money markets, represented a massive expansion of ECB power. ‘Whatever it takes’ turned into an extravaganza to inject trillions upon trillions of euro into the eurozone’s financial system. By July 2021, under the orthodoxy of ‘asset-purchase programmes’, over €4.2 trillion showered on to its thumping heart. As vast swaths of assets were hoovered up, the prices of these securities rose—along with the wealth of their owners.
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‘Quantitative easing’ is technical jargon used by the ECB when it opens the money spigot to buy assets in financial markets. QE is predicated on the hope that lower interest rates, a Trojan horse for higher asset prices, will spark more spending and borrowing throughout the economy. By design, the asset-purchase programmes drive down long-term interest rates, making bond yields unattractive.
Cash-enriched from ECB purchases, investors speculate further out on the risk curve. From 2012 until 2019, returns on risk, as measured by the Euro Stoxx 50, rose 54.4 per cent. Investors love the ECB’s easy monetary policy.
The ECB has good intentions, including increasing labour-force participation. Nevertheless, the tools used by the central bank may not only be increasing wealth inequality but also harming the real economy.
Interest rates are to finance as gravity is to Newtonian physics—a fundamental law. QE programmes manipulate interest rates. By paying good money for financial assets, the ECB lowers interest rates. But untampered interest rates are the bread and butter of economics.
The ECB’s influencing of interest rates removes the investment guardrails essential for effective capital allocation and investment appraisal. Its manipulations incentivise economic agents to direct their corporate horsepower into the financial domain protected by the central bank, rather than the real economy, retarding productivity.
Capitalism’s gift to democracy is efficiency. In reciprocity, democracy grants capitalism the rule of law and the sanctity of property rights. Capitalism may not however deliver efficiency within a rigged interest-rate market—it needs price discovery of the interest rate, which requires the central bank to close the QE spigot. The easy-money ECB profligacy risks eroding efficiency and consequently imperils capitalism’s symbiotic relationship with democracy.
From 2000 to 2020, public debt in the euro area increased from 69 per cent of gross domestic product to almost 100 per cent. Private debt increased by a greater amount: the median ratio to GDP increased from 136 per cent to 189 per cent (by 2019).
As with any factor of production, when debt capital is overused it suffers from the law of diminishing returns. Bad money begins to chase out good money and productivity declines. Average euro area nominal labour productivity declined, if EU = 100, from 108.9 in 2009 to 105 in 2020, or by 3.2 per cent (see chart).
When the economy of the eurozone runs into financial difficulties, it is better electorally speaking for the central bankers to take charge. Insolvency is not good at the ballot box. If it occurs, short-term solutions are preferred. Modern European democracies cannot sell austerity as a means to tackle escalating debts, whether derived from recklessness or unforeseen events such as pandemics. This keeps the eurozone on the elevated debt path. Titanic debt, in the absence of strong long-term fiscal policies, requires loose monetary economics, such as that espoused by the ECB, still in its experimental phase.
It is highly unlikely political leadership will embrace living within our means as a method to repay obligations. Austerity is political kryptonite and consequently disfavoured as a fiscal-policy response. Therefore, the price variable of monetary policy remains shoehorned towards the zero bound, resulting in a fantastical under-pricing of risk. That there may be unintended consequences is a real concern—one cannot just extend the debt and pretend everything is okay.
Walter Bagehot, a 19th-century titan of finance, cautioned that low interest rates instigated bubbles. ‘Bagehot’s dictum’ is that the lender of last resort should lend freely at high rates of interest and on good banking securities.
When European democratic institutions choose not to use fiscal policy—for instance to recapitalise their banks—they project capital misallocation into the realm of the monetary domain, a province wholly ill-equipped to deal with it. Yet the medicine of low interest rates and high asset prices is far more palatable than treating the underlying disease of insolvency, with the associated painful debt restructuring.
Capital misallocation begets lower interest rates, which beget even more capital misallocation, begetting ever-lower interest rates and so on. What Europe should be doing is forcing painful debt write-downs to allow the interest-rate lever to rise above the zero bound—more ‘monetary space’ in the jargon. Stimulating the economy with just monetary torque is anathema to the spirit of democracy, as it exacerbates wealth inequality and reduces efficiency.
Those in authority have assumed the financial system is knowable and controllable, when more humility in their modelling would be appropriate. Financial history tells us markets are not controllable, cannot be determined and do not equilibrate—and bad things can happen. Unlike Newtonian physics, macroeconomics is not deterministic: it is a complex system with tipping points and unintended consequences.
Rising asset prices rob younger generations of their purchasing power and sacrifice the role of money as a reward for social co-operation. As Ben Bernanke, former chair of the Federal Reserve Bank put it, ‘The problem with QE is it works in practice but it doesn’t work in theory.’
Much will depend on whether the ECB doubles down on the paradigm of ultra-loose monetary policy as the panacea to cure all ills within the macro economy. The beating heart of the financial system is now certainly addicted to its astonishing stimulus. Separated from the short-term politics of fiscal policy, monetary policy is widely accepted as the only game in town.
Bercan Begley is a fellow chartered accountant with Chartered Accountants Ireland with over 18 years of experience working in complex international financial and digital matters. He has worked as a senior associate with PwC and as a director with NQSN Limited, where he advised companies operating in financial, aeronauctical and technology sectors. He is currently working as a consultant with ARHS Technologies.
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