Does the mere thought of monetary policy and finance make you stressed? Stress no more because E&M‘s author Merle Schulken is here to break it to you in simple terms. Explaining how European Central Bank works and how its policies affect issues like climate change and inequality, she shows that monetary policy deserves the interest of all citizens, not only experts.
What is your first association when you hear the term Central Banking? I wouldn’t blame you if your head was now filling with gray images of bank notes, awfully long numbers, and old men debating how much money to print to keep the inflation level stable. Monetary policy has long been the domain of technocrats – supposedly far too complex for the average citizen to wrap their head around. But this is changing!
In exchange for 10 minutes of your time, in the following paragraphs I hope to convince you that making the effort to engage with this, admittedly somewhat odd, policy field is absolutely worth it. In fact, current debates about monetary policy may be more closely linked to the policy issues you care about deeply – such as the future of the EU, affordable housing or climate change – than you think!
Current debates about the ECB
When the economic consequences of the Covid-19 pandemic became apparent, the ECB was the EU’s economic institution to respond the fastest. It announced its so-called Pandemic Emergency Purchasing Program (PEPP) as early as mid-March, soon after scaled up other asset purchasing programs (also called Quantitative Easing) and implemented special measures to keep EU banks liquid. In simple language, the ECB created new money to buy corporate and government bonds (debt obligations) from banks or other financial institutions like pension funds or insurances. The ECB also made sure that EU banks hold enough cash and central bank reserves at all times so they don’t stop lending to one another or to the public. The ECB argues that their response was necessary and successful in protecting Eurozone governments’ public finances from the whims of financial markets, averting a financial crisis and laying the groundwork for a post-pandemic economic recovery.
But now that the initial excitement is over, debates have started about what role the ECB should play in the long-run economic recovery process. In this context, some commentators are advancing policy measures that were long thought taboo – like the so-called monetization of public debt. Meanwhile, not everyone is excited about the prospect of more monetary expansion. Just in May, the German Constitutional Court ruled that the ECB failed to demonstrate the “proportionality” of its sovereign bond purchasing program over the past couple of years as it would have been required to do according to the EU treaties that regulate the ECB’s competencies. This tension surrounding the correct interpretation of the treaties in turn has led other commentators to speculate that in the long run a re-negotiation of the articles in question might be in order.
It would far exceed this article to explain, let alone evaluate, different proposals for the future mandate and competencies of the ECB. Instead, I will try to show why these debates matter to policy areas of interest to young Europeans.
While the ECB responded to the economic downturn following Covid-19 with monetary policy packages, member states announced fiscal (i.e. taxpayer or government debt-funded) support programs to prop up their national economies. However, different member states have different fiscal capacities (tax income or ability to issue more debt), which, like in the case of Italy or Spain, sadly did not match how strongly they were affected by Covid-19. One reason why the ECB’s Pandemic Emergency Purchasing Program (PEPP) includes the ability for the ECB to purchase government bonds on financial markets is to prevent a bondholder panic whereby many institutions try to sell government bonds of affected countries at once. Keeping the demand for these government bonds high also serves to maintain favorable (i.e. cheap) conditions under which these governments issue new bonds.
However, the PEPP is merely a band aid for the still-looming threat of the very high levels of debt in some member states becoming unsustainable. By unsustainable I mean that, for example because of low economic growth rates in the coming years, the tax revenues in these countries will no longer suffice to service the debt while sustaining other vital policy programs, like education or pensions. A form of debt monetization, which allows governments to fund some of their fiscal spending through the creation of new money by the central bank rather than through issuing more debt, could be a viable alternative to a long-run continuation of the PEPP or joint fiscal responses, such as the much-debated Eurobonds. In any case, the debate about whether to break this taboo could matter greatly to whether there will be another Euro crisis in a few years with the political and social repercussions the last one brought.
Income and wealth inequality
Another reason to discuss the prolonged continuation of quantitative easing (QE) policies like the PEPP is the concern that they may be exacerbating inequality. As explained earlier, quantitative easing means that the central bank buys corporate and mostly government bonds on financial markets at a big scale. The intention of doing this is to increase the prices of these bonds, thereby driving down overall interest rates in the economy while creating more so-called liquidity in the financial system. This in turn is supposed to stimulate more bank-lending and investments into the productive economy, creating jobs and economic growth and, eventually, an inflation rate close to 2%.
There is much discussion about the net effect of QE on inequality. On one hand, QE has helped the economy recover after the financial crisis (and now after Covid-19), creating employment. This matters most to those who rely on having an income in the form of wages, such as the young and those without wealth. In fact, a recent modelling exercise by ECB macroeconomists suggests that this income-inequality reducing effect is the most influential effect of Quantitative Easing policy. On the other hand, QE has flushed massive amounts of money into financial markets – the bond market but, by extension, also the stock exchange and the property market (i.e. houses), propping up asset prices everywhere. Additionally, if regulation allows for it, one of the safest and most profitable ways for a bank to extend new loans is in the form of mortgages . And easier access to mortgages under QE may drive up house prices even further. It’s hard to say what would have been without QE, but it is true that house prices in metropolitan areas like London, Munich or Amsterdam have skyrocketed. And in any case an overall rise in asset prices primarily benefits those that own assets – usually the elderly and the wealthy. At the same time, higher rents caused by rising house prices put additional strain on those who don’t own property – the young and the poor (although, it must be noted that the distribution of home ownership throughout the population differs strongly between the EU countries)
To top it all off, just before the pandemic, the ECB was in the process of deciding how it should address climate change. As an EU institution mandated to serve EU policy objectives, I think the ECB should do everything in its power to support the transition towards a more socially and ecologically sustainable economy. But even within the narrowest reading of the ECB’s current legal mandate – that is a sole focus on maintaining price stability – aiding the transition away from fossil fuels falls within the core of the bank’s competencies.
Here is how: issues like climate change present a threat to financial stability through a concept called stranded assets. Assets can become stranded if – due to climate regulation or the physical consequences of actual climate change – they suddenly can’t be used anymore for economic purposes. Examples may include an expensive coal power plant being taken off the grid earlier than planned or agricultural land that can’t be farmed anymore because of frequent flooding or wildfires. The moment such assets lose their economic value, they must be written off the balance sheets of banks and other investors. If too many assets get stranded at once, this could cause a ripple effect of bankruptcies causing a yet unprecedented financial crisis. And if one thing is clear, it is that maintaining a stable inflation rate of “below, but close to 2%” will be impossible under such circumstances.
There are several ways the ECB could support sustainability transitions: aligning its asset purchasing programs and refinancing operations with the Paris Agreement, issuing lending guidelines to commercial banks or directly supporting sustainability investments via the European Investment Bank. At the same time, I think the ECB should engage with research on how to maintain a stable and just financial system in the context of lower or even negative economic growth rates as it seems unlikely that an economic system as dependent on economic growth as ours will ever truly become sustainable.
Unfortunately, it currently seems that the Covid-19 response has put these considerations on hold. This means that the ECB is missing out on a crucial window of opportunity to steer the financial system in the direction of sustainability presented by the European Green Deal and the EU-wide fiscal Covid-19 recovery programs.
To summarize: the ECB has been at the center of a variety of debates recently. In this context, interesting proposals for reforms are coming up and with them an opportunity to change the current monetary and financial system. I think that the voices of young Europeans should not be absent in these debates!
It may seem daunting to engage with monetary policy and I do admit that it takes a little bit of reading to get into it, but to quote US economist James Galbraith (1975):
“Few phrases have been endowed with such mystery as open-market operations, the Bank Rate, the rediscount rate. This is because economists and bankers have been proud of their access to knowledge that even the most percipient of other citizens believe beyond their intelligence.”
If one thing is for sure, then that the topics at stake now are far too important to be left to economists and bankers alone!
Piqued your interest? Reading recommendations:
- Where Does Money Come From? (2012) A Guide to the UK Monetary and Banking System
- How Is Money Created? – Everything You Need to Know. I actually don’t agree with everything being said in this video. But the way they describe money is quite useful.
- You can also check out the NGOs “Positive Money” and for the German speakers – “Dezernat Zukunft”.