Eurozone hooked on the monetary methadone the ECB cannot resist dispensing
While several among its peers are already tapering QE (the Bank of Japan, the Central Banks of Canada, Australia and New Zealand) or have announced the intention of doing so (the Bank of England; the Swedish central bank has announced the intention not only to taper but to stop QE) and the US Fed continues to dither in a fog of talking about thinking about the possibility of tapering, in the meantime the ECB is determinedly heading in the opposite direction. This week ECB President Christine Lagarde announced that QE in the eurozone will not only continue but at a greater magnitude and for the foreseeable future. Her concern is in her view the inability of the bloc to overcome powerful long-term deflationary pressures, the ones she believes make it difficult to achieve the central bank’s 2% inflation target consistently. Firmly in the ‘transitory’ camp, she refutes the arguments of the heads of the national banks of Germany and Belgium that incipient runaway inflation poses a real structural threat, and she is prepared to weather any short-term inflation hiatus believing it will soon pass.
Lagarde is no traditional central banker; a lawyer and a former politician, she is very politically aware. With the current element of the ECB’s QE labelled the Pandemic Emergency Purchase Programme, it would be politically insensitive to be seen to be withdrawing central bank support for post-pandemic recovery in the very month the EU begins at long last disbursing funds from the €750bn Covid loans-and grants life-boat fund.
But economically her position is perverse, undermined by the evidence of 6 years of uninterrupted QE and negative interest rates in the eurozone: bearing in mind since 2015 the ECB has purchased multiples rather than percentages of the total value of sovereign bonds issued by member states, thanks to what economists refer to as a “failure of the transmission mechanism”, those high-level injections of liquidity have failed to percolate down to the real economy. The frictional costs of application plus the regulatory requirements placed on lending banks to maintain prudent reserves mean much of the economic effect is diluted to the point of immateriality. But worse, as QE becomes embedded in the economic fabric, despite obeying the laws of diminishing returns nevertheless the eurozone economy becomes increasingly reliant on the crutch provided by QE to keep it upright. We have drawn the analogy before that the eurozone is like a QE addict, reliant on monetary methadone; weaning it off the regular injections without resulting economic cold turkey seems remarkably difficult. And as we have discussed before, stopping QE is a pre-requisite of raising interest rates; those who saw the restoration of at least a zero percent interest rate, if not a positive one, have just witnessed their ship disappear below the horizon.
Further, there is ample evidence that the combination of QE and negative interest rates is itself a contributor to deflationary pressures. Darwinian monetarist economic theory says that a vibrant, self-sustaining, expansionary economy which generates national wealth is reliant upon the most efficient allocation of capital and labour. QE and negative rates undermine that. Poorly run companies in trouble which under the Darwinian model would have gone bust are instead allowed to refinance at accessible funding costs under the modern monetary conditions in which bond yields and interest rates are artificially held at levels below what would be the norm in a free-market system. It leads to the “zombie” economy with all the knock-on effects of surplus capacity in output, capital and labour, a feeder into the decade-long trend of below average productivity.
Monetarists will argue that if Lagarde’s aim is to combat deflation, she’s going about it in a very odd fashion. Germany argues that her position is both immoral and illegal, negative interest rates rob German savers of their cash by charging them to deposit funds in commercial banks. The ECB’s policy committee is divided both on views of the immediate economic outlook, but more profoundly about economic ideology. More broadly, the consensus on monetary policy across the major democracies is actively diverging. Oh, to be a fly on the wall at next month’s central bankers’ annual symposium at Jackson Hole, Wyoming!
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