“The best way to destroy the capitalist system is to debauch the currency (Vladimir I. Lenin)
Now they’re going to do it. In the past few months Mario Draghi’s team has been systematically working towards this. The ECB plans to buy government securities on a large scale, at least 1.14 trillion Euros by September of next year, and in doing so it will definitively cross the fiscal Rubicon. Monetary policy is increasingly mutating into fiscal policy and the traditional politico-economic task is being turned upside down. With this unconventional monetary policy the ECB wants to drive out the volatile specter of deflation. It is intended that banks shall once again receive more money for lending, and even lower long term interest rates should “finally bring horses to drink once more“. More private investment will depend upon the demand side. And with an inflated central bank expectations regarding inflation rate will be raised. The ECB’s hope is that the fear of higher prices will stimulate consumer demand.
Disinflation instead of Deflation
The danger of deflation, invoked mantra-like by the ECB for months now, is nothing more than a carefully constructed scarecrow. Nowhere in Europe are prices of goods falling cascade across the board. First signs of such could at most be seen temporarily in Greece. It is also historically difficult to suss out a (demand side) deflation spiral. The Great Depression in the late twenties in the previous century was one of the rare cases. Nor is Japan a suitable example of a vicious circle of mutually contagious, explosively falling prices. That which we can currently observe in Europe is an ongoing process of disinflation. Moreover, a temporarily sharp drop in oil prices exerts an influence on prices of goods, but not from the demand side, rather from the supply side. They act as cost reduction program.
If in Europe we have neither deflation, nor is the danger of such a development to be seen, then why does Mario Draghi want to inflate the central bank, as was up till now only customary in times of war (Helmut Schlesinger)? The reason, the ECB gives us to understand, is the continuing “output gap“. Since the financial crisis, demand in the Eurozone has supposedly been growing more slowly than the production potential. This gap is meant to be closed via more private demand.Â A politics of “Quantitative Easing“ is thought to be the appropriate medicine. But the output gap has in fact been closed almost everywhere in Europe. Indeed, this occurred above all because the production potential in many countries has grown more slowly. Hysteric processes of devaluation of (human-)capital are admittedly old hat in economics, but also one which fits perfectly.
Structure instead of Cycle
The correct approach to better cope with the ongoing economic misery in the Eurozone is not to stimulate demand but is the realization of more flexible labor and product markets. This is also acknowledged by the ECB, at least when it comes to the crisis-hit countries in the EMU. And it is absolutely right. The wait-and-see position regarding private investments has little to do with the too high cost of finance but much to do with the significant rigidity of the supply side.Â Inflexible labormarkets, growing protectionism, rampant obsession with subsidies, galloping bureaucracy, rising taxes and tariffs are real obstacles to private investment across Europe. And politics further increases these barriers to progress, in that it further increases economic uncertainty through its erratic measures and shady rescue activities. This is poison for private investment.
With the new glut of money the ECB is making the reform gridlock in the Eurozone worse. The zero interest-rate policy has already led to gigantic misallocation of savings and investments. The planned huge scale buy out of government securities will only further amplify these negative developments. For some time already the ECB has pushed a first class growth inhibition program. This doesn’t do any good for the structural reforms urgently required almost everywhere. With the balance sheet extension the ECB is once more buying the crisis countries time to introduce the inevitable reforms. However, since 2011 experience shows that this bought time has been largely wasted by politics. The pressure of the markets on politics to begin reforms was noticeably weakened, and they were shelved. This time as well it will be no different.
Structural Reforms instead of a Glut of Money
The (fiscal) monetary policy of the ECB is counterproductive. There is a truism: monetary policy, including fiscal policy, does not solve structural problems. Of course the ECB knows this as well. Why then does it still engage in such policy? One answer is: it wants to accelerate the necessary adjustments via internal revaluation and devaluation. Inadequate structural reforms in the crisis countries of the Eurozone have so far prevented wages and prices from sinking sufficiently. An adjustment in the ECB is therefore only possible via different rates of inflation. The glut of money in connection with the buyout program will cause the rate of inflation in Germany to increase more strongly than it will in the crisis countries. In this way it is possible that the economic tensions in the Eurozone will decrease. However, already in the medium-term the rate of inflation in the EMU will increase, and further pave the way to the IMF’s goal of 4%.
A second answer is: the ECB must once again save countries and banks. Countries’ debt is still too high. This applies to the current debt level as well as new borrowing. The low interest rates for the crisis countries do not reflect the actual risks. They are the result of Mario Draghi’s “whatever it takes“ mentality. Even a slight increase in interest rates gets many countries in trouble and places the EMU in serious danger. All this gets the banks, which hold a large share of government securities, into big trouble. The ECB apparently has little confidence in its own banking stress test and the ESM. With the ECB’s planned buyout program banks will be partially relieved of the risks which they have taken onto their books the past ten years. A part of the burden will immediately be shouldered by savers via negative interest and another part later by taxpayers if things go wrong.
The fiscal monetary policy of the ECB features significant additional risks and side effects. With the announced buyout program it will bring Eurobonds in through the back door. National central banks purchasing government securities largely at their own expense doesn’t go far enough. If the worst comes to the worst all of the banks which participate in the ECB will be proportionally liable for toxic papers. The European taxpayers will be held hostage. With this policy the ECB installs a further element of a joint liability community in the EMU. Through fiscalization of monetary policy it monetizes the government debt and resorts to the Babylonian captivity of Politics. This is fatal for its political independence. When it adheres to the rules agreed upon at Maastricht but national policy fails to make its structural homework assignment, there is the threat of the imminent end of the EMU in its present form. However, if it continues further with the fiscal monetary policy it embarks on a direct path to political bondage. If Europe is not to be irreparably damaged, policy has to deliver, immediately and extensively.
Hinweis: Das ist die englische Fassung des Blog-Beitrages “Monetäre Fiskalpolitik aus Frankfurt. Mario Draghi führt die EZB in die babylonische Gefangenschaft der Politik.” Herr Michael Labate hat den Beitrag übersetzt. Herzlichen Dank.