The ECB’s existential dilemma

by Jürgen Stark, Thomas Mayer and Gunther Schnabl

Our fiat money regime requires an institutional anchor that credibly and decisively ensures a stable price level and long-term confidence in the euro. Credibility is a central bank’s greatest asset, because it underwrites confidence in the purchasing power of money. And credibility, in turn, rests on the central bank’s independence from political influence, and on its commitment to monetary stability.

Viewed in this light, the European Central Bank has been in dangerous waters for several years. It has jeopardized its political independence and compromised its primary objective. Actions that are clearly intended to anticipate political pressure leave no doubt that it has exceeded its mandate.

For example, during the euro sovereign debt crisis that began in late 2009, the ECB actively participated in the restructuring of Europe’s Economic and Monetary Union (EMU). With its Security Markets Program, it abandoned important monetary-policy principles, including the ban on monetary financing of government debt and the requirement of a single monetary policy for the eurozone. The ECB also took a leading role in rescuing EU member states hit hard by the crisis, even though this was the respective national governments’ responsibility. The boundaries between monetary and fiscal policy thus were deliberately blurred, leading to close coordination between the two.
With then-ECB President Mario Draghi’s unilateral commitment to “do whatever it takes to preserve the euro,” the ECB set itself up as lender of last resort for the eurozone. The attempt to attach conditions to this role in the ECB’s “outright monetary transactions” program failed. Indeed, the program was never activated and has since been replaced by the Asset Purchase Program and the Pandemic Emergency Purchase Program.

ECB causes incentives for higher debts

By purchasing government debt, the ECB has fundamentally distorted bond markets, arguing that it is trying to prevent market fragmentation. But now that risk premiums have leveled out and market access with favorable conditions has been secured for all eurozone member states, governments have an incentive to increase their already exorbitantly high public debt levels. Highly indebted states such as Italy and France presumably will rely on this safeguard indefinitely.

Worse, the ECB’s operations exceeding the limits of EU treaties and statutes have intensified during Christine Lagarde’s presidency. Invoking “secondary objectives,” the ECB has committed itself to promoting a “green transformation.” The ECB wants to help improve financing conditions for “green” projects and ensure that the collateral and bonds it accepts are environmentally “sustainable.”

Until 2021, the ECB’s growing politicization did not trigger any major conflict over its core mandate of ensuring price stability. But with higher inflation becoming more apparent, the situation has changed. To be sure, leading ECB representatives still dismiss today’s inflation as temporary. No one disputes the fact that some factors influencing inflation are temporary. But the problem is that other factors may persist longer than projected.

Hence, it is becoming increasingly clear that inflation will gain momentum without monetary-policy countermeasures, auguring the end of the era of price stability. That puts the ECB in a difficult position because it will simultaneously be confronted with several acute problems of its own making.

First, the ECB’s monetary financing of new sovereign debt has created a money overhang, and now robust demand is running up against the supply constraints caused by the pandemic. The result is higher prices, which are likely to become endemic through subsequent wage increases. The ECB must take seriously the risk of a wage-price spiral, even if there are few hints of this happening at present.

Monetary policy turnaround for greater price stability

Second, it is becoming increasingly clear that the “green transformation” will not be possible without a surge of inflation. Ideally, fossil-fuel energy sources should become more expensive to the same extent that renewable energy becomes cheaper through the expansion of the relevant capacities and infrastructure. The change in relative prices should alter the structure of demand while the overall price level remains stable. In fact, production capacities for brown energy have fallen faster than new capacities for green energy could be created. As a result, fossil-fuel energy prices have risen without renewables prices falling accordingly to compensate.

Owing to the ECB’s open displays of activism and demonstrated willingness to coordinate monetary, economic, financial, and climate policies, it now faces a serious predicament. Because its core mandate is to ensure price stability, it needs to be ready for a monetary-policy turnaround.

That would mean consistently taking steps to dampen demand by reducing the money overhang (selling off the government bonds that have piled up on its balance sheet) and raising interest rates more quickly (contrary to its previous communications). Such tightening would create serious problems for highly indebted eurozone members, not only in financing new debt but also in refinancing maturing debt. Declining tax revenues and rising unemployment as the economy cools would exacerbate the problem further. The future of some countries’ EMU membership would quickly be called into question again.

But if the ECB tolerates rising inflation, it will lose credibility, owing to growing doubts about its willingness or ability to keep the value of money stable. Rising inflation expectations would lead to increasing inflation dynamics and exchange-rate depreciation, which would further increase inflationary pressures.

Like Shakespeare’s Hamlet, the ECB is faced with a quandary. Should it consistently stick to its mandate and risk another acid test for the EMU, or should it accept higher inflation, lose credibility, and seal the fate of the euro as a soft currency? 

In the play, Hamlet never can decide. That is why it is a tragedy that ends in disaster.

Copyright: Project Syndicate, 2022.

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