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A rogue central bank

In previous posts I tried to explain why the euro is a flawed currency and how its flaws can be traced into the function and the balances of TARGET2. In all fairness however, one cannot put the blame for the euro crisis on TARGET2 since after all it is nothing more than a payments system. This post focuses on the institution bearing the responsibility for eurozone’s plight: the European Central Bank. While millions of lives in the continent are shattered, while Europe’s social structures are dismantled and its economy is liquidated, this institution has managed to weather the crisis so far practically unchallenged. Its workings call for a critical assessment.

The ECB’s objectives

As the issuer of a currency shared by multiple countries, the ECB has been a special case among central banks. But despite its idiosyncrasies, the ECB is still a central bank with objectives, policies and instruments similar to those of any other central bank.

Its primary objective is to “maintain price stability” (as per article 2 of the Statute of the ESCB) over the medium term, which also translates into preserving the value of the currency it issues. This goal is formulated and quantified in the ECB’s explicit target of an inflation rate that is close to but below 2% per annum. The Harmonized Index of Consumer Prices (HICP) is used as the proxy of inflation. The ECB aims to achieve this goal through the active influence of the euro money supply using tools such as minimum reserve requirements and short-term interest rates on loans to/from credit institutions.

Article 2 of the Statute sets forth also a secondary goal. Without prejudice to the goal of price stability, the ECB should “support the general economic policies in the [European] Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union [TEU]”. The objectives of the Union as per article 3 of the TEU include among other things the promotion of the well-being of its peoples, the sustainable development of Europe based on balanced economic growth, full employment, social progress, social cohesion and solidarity among member states. Interestingly, the predecessor of this article, article 2 of the Treaty establishing the European Community (TEC) used different wording, explicitly stating non-inflationary growth as well as convergence of economic performance as the Union’s objectives.

These two goals are part of the ECB’s mandate. The objectives of the ECB also extend to objectives generally pursued by central banks. The most important among them is to ensure the financial stability of the eurozone, namely the stability of the banking sector. This is generally achieved by standing ready to act as a lender of last resort to financially sound (i.e. solvent) credit institutions which face liquidity problems. This role is paramount in instilling confidence in the banking system and in guaranteeing the convertibility of bank deposits into banknotes and coins at all times. In order to succeed in this goal, the ECB and the rest of the Eurosystem are granted the right to supervise every financial institution that operates within the eurozone.

Lastly, it is also of importance to consider not only the objectives of the ECB but also the framework within which the ECB operates. The most overlooked parameter concerning the ECB’s actions is the necessity of the ECB to guarantee the singleness of the monetary policy across the euro area, since the states participating in the currency union had at least at the time of the euro’s inception economies with similar characteristics and therefore required similar monetary policies in order for the EMU to work. The absence of a fiscal union makes this requirement even more imperative.

A terrible record

The euro crisis is the first one in an unprecedented monetary union experiment. It is only logical that ever since the euro crisis broke out, the actions of the ECB should be the subject of exhaustive examination by every analyst. Nonetheless, an ever-rising number of truisms continues to be served as an explanation to the crisis, while the analysis of the ECB’s actions has so far been cursory at best. For as far as this blog is concerned, the euro crisis is a spectacular failure of the ECB to achieve or even remotely contribute to the achievement of any of its objectives. The list that follows is a summary of the individual failures of the ECB but may not be exclusive, since the Governing Council keeps doing its best to expand it.

1. Monetary policy divergence

All too often, commentators of the euro crisis blame the one-size-fits-all monetary policy model of the euro as one of the main causes of the crisis. This is by far the most stupid explanation about the origins of the euro crisis as there is not a single evidence of a common monetary policy across the eurozone, especially since 2008. The main reason for the lack of a common monetary policy is the balance of payments (BoP) imbalances of the individual countries. When a country faces a BoP deficit and another faces the offsetting surplus, the money supply in the deficit country decreases while increasing in the surplus country. The existence of the BoP imbalances is by itself the clearest proof that the countries of the eurozone do not have a common monetary policy and for as long as these imbalances are permitted it won’t ever have one.

Beyond the BoP imbalances however, no other indicator serves as evidence of a common monetary policy. The “periphery” suffers from asset deflation and the “core” from asset inflation; product price inflationary/deflationary pressures have also appeared, obviously with a lag; interest rates of either sovereign or corporate borrowers vary wildly among certain countries of the eurozone; credit has been expanding in some parts of the eurozone and contracting in others. This is hardly the monetary union that the member states envisaged.

2. Currency debasement

A common misconception about monetary policy is that central banks debase the currency they issue by purchasing government securities with newly printed money. Although this assertion is based on false premises and leads to fallacious conclusions, in the case of the euro this is to a large extent correct. As I explained in my description of TARGET2, a reduction of the money supply through the BoP in a given country in the eurozone makes full repayment of its debts a mathematic impossibility. The ECB, or rather the entire Eurosystem, through TARGET2 and the refinancing operations routinely stretches its balance sheet by rebasing ever increasing amounts of money on the very assets that the market destroys via structural current account imbalances and parallel capital account flows. Paradoxically, the more euros that the “core” earns the poorer it becomes, because the intrinsic value of these euros is at this level a decreasing function of its amount. While it is true that without TARGET2 the euro would have collapsed for accounting purposes very long ago, it still holds that the euro is currently backed in part with worthless assets. For as long as current account flows are not structurally offset by capital account flows, the debasement process will continue till the euro becomes entirely worthless.

3. Financial destabilization

Based on the above, the inability of the eurozone to maintain balanced balances of payments among the euro countries leads the banking system of the deficit countries to insolvency. It is important to note that the current structure of the eurozone would guarantee BoP imbalances no matter which countries participated in the EMU. Consequently, the banking system of the deficit countries would eventually go bankrupt, igniting a domino collapse of the banking system in the rest of the eurozone. While the ECB has averted the immediate collapse of the banking sector with the refinancing operations, it has done nothing to counteract the BoP flows in the real economy, despite its immense capacity to do so. With the refinancing operations the ECB has in effect only been addressing the symptoms and not the cause of the liquidity strains of the deficit countries’ banks. It is therefore not by its actions, but by its inactions that it destabilizes the banking system of the eurozone.

4. Targeting inconsistency

A necessary condition for a central bank to achieve its objectives is to have a policy that’s clearly communicated, understood and predictable by market participants. The consistency in the central bank’s actions is actually what differentiates a “policy” from a sequence of unrelated actions. The ECB has made clear that its monetary policy aims to achieve a modest, stable inflation rate in the area of 2%. Yet the ECB decided to deviate substantially from this rule the moment it took part in the well-known “troika” of lenders, the policies of which aim explicitly to deflate wages and prices in the borrowing countries. It therefore appears that the eurozone does not just lack a common monetary policy; it does not have a monetary policy at all.

5. Misallocation of resources

Quite clearly, the area of the eurozone that is in greater need of capital right now is the “periphery”. The periphery is also the area which for fundamental reasons can provide the best returns on capital since it is also the least capital intensive one. One of the main reasons the euro was formed in the first place was to provide the opportunity for capital accumulated in the “core”, faced with diminishing rates of return in the domestic market, to be invested in the less developed parts of the eurozone, boosting productivity, expanding the single market and raising the living standards of the entire eurozone. Since 2008 this process has been abruptly discontinued as the market realized that the risks that obstructed foreign investment in the “periphery” in the first place (namely foreign exchange risk) had not been extinguished, but rather were replaced by credit, liquidity, redenomination and regulatory risk. The eurozone has now become a capital black hole, where capital can be invested at either very high risk or at very low rates of return. In the same context of resource misallocation we can also account for the rising unemployment since labor is also a resource, an increasingly underutilized one in the struggling parts of the euro area. This is a failure shared by both the ECB and the EU.

6. Member state bias

As if all that was not enough already, the ECB had to come up with the outrageous OMT program, its latest (futile) attempt to save the euro. The stated aim of the OMT is to “preserve the singleness of the monetary policy in the euro area”. The asymmetry in the monetary conditions across the euro area is not only caused by the BoP imbalances as described above, but also by rising local risk premia which lead to credit contraction. The ECB has done nothing at all to tackle this problem in the countries already in a “bailout” program (Greece, Ireland and Portugal). Countries that do not participate in a program and perhaps do not wish to, also face challenges of their own (like Slovenia) or even if they do request assistance they are unlikely to benefit from OMT if the government loses access to the capital markets entirely (like Cyprus). The ECB’s response at this stage is catered only to the needs of Spain and perhaps Italy and is yet another display of how too-big-to-fail institutions, whether banks or governments can enjoy benefits that smaller, too-small-to-matter countries do not.

7. Fiscal policy control

The even more disturbing feature of OMT is the unfathomable dependence relation it created between governments and the central bank. Even though the stated objective of the OMT is the effective transmission of the monetary policy within specific national economies, its implementation is conditioned on specific fiscal policies that the ECB itself endorses. On what legal or economic basis can the ECB condition the conduct of monetary policy on any action of the sovereign states? Central banks are instructed by the 17 national governments to implement the monetary policy in the eurozone with clearly defined objectives. The ECB cannot even challenge these objectives. Just like any other central bank in the world, the ECB is supposed to act as an agent of the sovereign(s) it is subject to. With the conditions attached to the OMT the ECB reverses the principal-agent relationship and effectively puts itself in control of fiscal policy making in (parts of) the euro area. This is the most profound evidence yet of the decaying democratic structure of the eurozone, as well as of the diminishing ability of political leadership to exercise its sovereign powers for the benefit of its people. This power is now quietly transferred to the unelected clowns in Frankfurt.

A rogue central bank

It is abundantly clear that the eurozone has degenerated into a place of economic despair and international expropriation. While the social, political and business structures of Europe collapse one after the other, the ivory tower of the ECB has stayed silent, unwilling to assume any responsibility for the biggest economic fiasco in history or perform its tasks in the manner it is legally obliged to. How can this farce still go on for so long already?

The first reason has to do with the natural self-preservation instinct of every person and every group of people. The Governing Council of the ECB cannot bring forth a proposal for correcting the ECB’s (non-existent) monetary policy without simultaneously admitting openly its failure so far to perform its duties. If it did, it would be immediately exposed to relentless public bashing from all sides of the EMU for various reasons and would be forced to resign en masse. It will instead prefer to use every opportunity to assign the blame to the fiscal structure of the eurozone, profligate governments, dubious statistics, market malfunctions, animal spirits, fairies and so on.

But a policy failure of this magnitude cannot occur in a well functioning State where multiple levels of control are in place. The ECB, even though responsible for the conduct of monetary policy in the euro area, it is always accountable to the European Parliament. And the actions, or omissions of both institutions are (supposed to be) daily scrutinized by the media and public opinion. Alas, the understanding of monetary policy by both the European MPs and the media has traditionally been limited. Parliaments around the world are seldom populated by members sufficiently educated in economics, let alone monetary theory or banking. The media from their side have their own terrible record in covering the crisis. Journalists, professional analysts and academics alike all repeat time after time the same mistakes about what caused the crisis and how it can be resolved. Public ignorance coupled with special interests in destroying the social welfare structures in Europe and beyond have made the media part of the same problem. The institutional handicap to control the actions of the ECB is thus a second reason for the continuation of the crisis.

Europe has evidently lost control of its central bank and its monetary policy. It has created a monster and then let it loose. Unless the ECB is tamed again and forced to do the job it was assigned to do, the crisis will not end until the euro is destroyed. With every day that passes implosion time draws nearer. To be honest, I am looking forward to it.


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