ECB Crisis Coping: Not Everything Can Be Solved by Money-Pumping & Rate-Slashing
The European Union has been plagued by crises for many years now. In fact, during the last fifteen years, the EU has been in an almost permanent crisis mode. Starting in 2007, the American subprime crisis turned into a worldwide financial crisis in 2008. Europe was also strongly affected, with many nations suffering sharp economic downturns. This crisis almost seamlessly transitioned into the European sovereign debt crisis in 2010. As a direct result of the recession, Southern European nations that had for years been able to borrow cheaply were now faced with lower tax revenues and higher social security expenditures. This also brought to the fore the many structural problems those nations have – tax evasion, corruption and both excessive and non-efficient government spending. Consequently, investors were still willing to lend, but only at much higher risk premiums.
After Cyprus and Greece’s “rescue” (both of whom had to pay a high price in the form of taxation of bank accounts and harsh austerity measures) in the spring of 2013 and the summer of 2015, respectively, the European debt crisis seemed to be over. Then, in the autumn of 2015, the migrant crisis broke out, with almost 2 million non-Europeans (mainly Syrians) seeking refuge in Northwestern Europe, giving the EU another massive problem to cope with. In 2016, the British decided to leave the EU, largely as a result of the migrant and debt crises. After a long and arduous process – possibly because the EU wanted to send a message to other member states that leaving the EU comes at a “high price” – January 2020 finally saw the UK’s official exit from the EU. Shortly after, COVID-19 reached Europe. After two years of harsh measures, the expectation was that the situation would relax in 2022. But then the Russo-Ukrainian conflict, which had been ongoing in the Donbass region of Eastern Ukraine for almost nine years, escalated even more destructively than ever with Russia’s invasion of Ukraine on the 24th February 2022. As if that were not enough, the mainstream media and parties would make us believe that the “climate crisis” is actually the most important and urgent crisis of them all.
The ECB’s Response – Lower Rates & Pump Money into the System
The financial crisis and COVID-19 measures pushed Europe’s economies into a downturn, and Southern European nations have additionally been feeling the pain of austerity measures since 2010. Stock markets also reacted with sharp losses in 2008, 2011, 2020 and 2022. The European Central Bank’s response to the economic problems essentially consisted of lowering interest rates and cranking up the money press to buy up sovereign bonds. The economic theory behind this is allegedly that when interest rates are lowered, spending and investing money should become more attractive, compared to saving it. Consumers will be tempted to spend more and companies can borrow and invest more easily. By purchasing government bonds, the ECB also pushes down bond rates – their purchases drive demand for bonds, leading to higher bond prices, resulting in lower yields. So goes the theory, but is that also the case in practice?
Lowering Rates: A Blunt Instrument
From 2014 to the beginning of 2022, the ECB deposit facility rate (the rate banks get for overnight deposits with the Central Bank) has been negative. The amount of money used for the ECB’s programmes is almost unimaginable. As of mid-2022, over 5 trillion Euros in the form of asset purchase programmes and COVID relief packages have been pumped into the financial system. However, many structural economic problems simply cannot be solved by slashing interest rates or with endless purchase programmes. For example, how can low or negative interest rates fix the supply problems as a result of the COVID measures and sanctions against Russia? Clearly, other measures targeting the problem directly are in order here. Companies also cannot profit from lower rates if banks are not willing to lend money to them. This was an issue for many companies, large and small, in the years following the worldwide financial crisis, and many small companies still frequently experience that borrowing money is harder now than it was before the crisis. Furthermore, self-conscious citizens saving for their retirement will realise that lower interest rates mean that they need to save more to reach a certain level of retirement income, thus leading to them saving more instead of spending more. More importantly, low interest rates have many negative side effects. First of all, near-zero or even negative interest rates lead to asset price bubbles in stock and real estate markets. When savings accounts and bonds simply offer no return anymore, there is often no other alternative than investing in risky assets. Institutional investors (insurance firms, pension funds, etc.) that normally invest most of their proceeds in low-risk sovereign or corporate bonds are now also faced with low returns. As a result, many of them are becoming more attracted to alternative investment opportunities, which they often do not fully understand and often carry hidden risks. On the societal level, low interest rates also cause collateral damage by contributing to a growing division between the rich and the poor – well-to-do citizens profit from higher real estate and stock prices, whereas the lower classes see the real value of their savings decline and are faced with higher rents.
Lowering rates isn’t contributing to a sustainable solution to the European sovereign debt crisis either. Southern European nations can continue to borrow cheaply, which, at first glance, might seem to be an advantage, but in this way, they also have less incentive to structurally improve their finances. It also leads to a convergence of fiscal and monetary policy on the EU level.
Last, but not least, increasing the money supply faster than the amount of goods and services produced will eventually cause inflation. As long as the additional money stays on the banks’ balance sheets and does not enter the real economy (economists call this the “velocity of money”), it will not cause inflation. But sooner or later, it will. This is exactly what we are seeing now. In addition to an increased demand and energy supply problems, all the new money that has been created by the ECB is slowly entering the real economy, thus diluting the money pool. When it boils down to it, money represents labour – it cannot simply be generated out of thin air.
Increasing rates is often proposed to combat inflation. The theory is that higher rates make it harder for companies to borrow money, thus forcing them to lower prices in order to generate cash. This might work in some cases, but many companies are faced with stiff competition and low margins, meaning they have almost no possibility to lower prices. Companies and governments will also have to pay higher rates to investors when borrowing money.
The ECB’s Dilemma
The ECB is now faced with a genuine dilemma – raise interest rates to combat inflation, or keep them low so the Southern European states can continue to borrow cheaply? If the ECB opts for the former – as it appears to be doing currently – Southern European countries might soon reach the “point of no return”, whereby borrowing costs will eventually spiral out of control. With the public finances of Germany and other contributing EU member states strained, it is doubtful whether this time they are able to – or even want to – financially rescue Greece, let alone Italy.
The ECB’s board is also very divided on this. In fact, multiple board members have already left during the last ten years as a result of internal conflicts regarding the handling of the various crises. Speaking metaphorically, the financial markets are on drugs. Stock prices have long been kept artificially high by keeping interest rates low and price changes are often mainly driven by small changes in interest rates. The ECB will likely try to find some “middle ground”, so to speak, and raise rates only relatively slowly. However, there will be no escape from the sobering, and the European sovereign debt crisis could very well return in full force.
The Future: A Smaller Eurozone Might be Better for All
The only long-term solution might be for Southern European nations to leave the Eurozone. This will be painful and chaotic at first, but they will be able to determine their own monetary policy again, thus taking a part of their sovereignty back into their own hands and allowing them to become more competitive economically by devaluing their currencies. Countries such as Germany will also profit by not having to support Southern European Eurozone member states any further. Thus the further turmoil that is to be expected might, after all, be a blessing in disguise.
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