When old central bankers know what is wrong but can’t bring themselves to saying what is right

Last Friday (October 4, 2019), a group of former central bank governors and/or officials in Europe, issued a statement damming the conduct of the European Central Bank. You can read the full text at Bloomberg – Memorandum on ECB Monetary Policy by Issing, Stark, Schlesinger. The timing of the intervention is interesting given the change of boss at the ECB is imminent. As I explain in what follows, the Memorandum should be disregarded. Its central contentions are mostly correct but the alternative world it would have Europe follow would be a disaster for many of the Member States and the people that live within them. It would almost certainly result in the collapse of the monetary union – which would be a good outcome – in the face of massive income and job losses and the social and political instability that would follow – which would be a bad outcome. What it tells me is that the monetary union is a massive failure. It would be far better to dissolve it in an orderly manner to avoid those massive income and job losses and to support the restoration of full currency sovereignty and national central banks. That would be the sensible thing to do.

My analysis of the ECB’s latest monetary policy decisions were in this two-part blog post series:

1. ECB confirms monetary policy has run its course – Part 1 (September 17, 2019)

2. ECB confirms monetary policy has run its course – Part 2 (September 18, 2019)

Essentially, the ECB is pushing its available policy space into rather ridiculous terrain as it faces an economy that is moving towards recession and doesn’t anticipate any reasonable fiscal response coming from Brussels.

The crazy monetary policy parameters are demonstrating the dysfunctional architecture of the monetary union that was deliberately created as an expression of neoliberal ideology.

The design of the EMU was never going to be capable of resisting a major economic downturn and events proved that to be the case.

The only reason the common currency is still intact after the GFC is because the ECB stretched its mandate – violated its Treaty obligations – and became a de facto fiscal authority.

But it also undertook this role in a highly compromised manner because, in saving governments from insolvency, they also enforced damaging conditionality on the same governments which locked them into a vicious cycle of stagnation and fiscal trauma.

In this role, and more formally as a member of the Troika (with the European Commission and the IMF), the ECB gave up any pretense of being an ‘independent’ player in the monetary system.

As one of the austerity enforcers, the ECB undertook a ‘political’ role, exactly what the so-called ‘independence’ myth eschews.

So for anyone to come out now and claim the latest ECB policy gymnastics are compromising the ‘independence’ of the ECB and financing government deficits in contravention of the Treaty rules is to miss the boat by a decade or so.

But to be fair, some of the signatories have a long history of making these sorts of allegations against the ECB and making rather caustic assessments even before the EMU had formed.

For example, Dr Helmut Schlesinger was the Bundesbank boss during the ‘Summer of 92’ when the 1992/93 monetary crisis played out leading up to Black Wednesday.

This was a time when the politicians and European Commission bureaucrats managed to construct the near meltdown of the European Monetary System as a demonstration of why a single currency was needed rather than a reason to abandon their half-baked plan before any more damage was done.

Any reasonable interpretation, based on an understanding of what happened and why, would conclude that a single currency would be very destructive for some, if not most, of the 12 nations that were in the process of surrendering their currency sovereignty to join the EMU.

When the EMS was formed in March 1979 they were all obligated to keep the fluctuations in their exchange rates within certain bounds. Further, the stability that the EMS experienced in its early years were due to the operation of capital controls.

As part of the neoliberal ideological agenda, the Single European Act of 1986 stipulated that all capital controls were to be abolished by July 1, 1990.

Once capital controls were eliminated, central banks became vulnerable, as they had to focus policy on defending the nominal exchange rate parities. And with the rising instability associated with the treaty, this vulnerability became acute.

And here, Helmut Schlesinger’s role became crucial.

Amidst the currency turmoil that was developing, the Bundesbank didn’t help matters when it pushed up interest rates on July 16, 1992 because of its concern for rising inflation associated with the reunification.

This had the effect of further reinforcing the view that the mark was undervalued.

This was especially the case given that US interest rates had been cut on July 2, 1992 as America battled to avoid recession. The obvious happened. International currency speculators sold the US dollar, the lira and the pound and shifted massive volumes of funds into the mark.

By pushing interest rates up in Germany, the Bundesbank demonstrated its fundamentally could not, both anchor the value of the mark and conform to its obligations under the EMS.

The Bundesbank decisions were particularly problematic for Germany’s neighbours because they faced recession and unemployment was already high.

But, the increased German interest rates forced them to increase their own interest rates beyond the levels deemed prudent given their domestic circumstances.

Monetary policy was locked into ensuring the exchange rates were stable and higher unemployment was the casualty.

The increasing political backlash to the high unemployment raised further doubts in the financial markets as to the commitment by policy makers to maintaining the ‘no realignment’ policy.

The EMS was now on very shaky ground.

As the Italian currency entered crisis mode, more capital was flooding into Germany which forced the Bundesbank to sell marks in the foreign exchange markets as part of its EMS obligations to keep the alignments.

The Germans, as expected, felt that the growth in the supply of marks would worsen their inflation and they were reluctant to hold the fort for too long.

The European finance ministers and central bankers met in Bath (as UK Chancellor Norman Lamont was chair of the Ecofin committee) over the weekend, September 4-5, 1992.

Lamont demanded that Germany cut its interest rates.

According to the New York Times article (October 8, 1992) – Bundesbank Chief Is at Eye of Currency Storm – a German central bank official said that:

Mr Lamont, at one stage pounded his fist on the table and shouted at Dr Schlesinger ‘Twelve finance ministers are all sitting here demanding that you lower your interest rates. Why don’t you do it?’

Lamont was told that Germany would not risk inflationary pressures building up by being forced to honour the agreement to intervene symmetrically to stabilise the European currencies.

In the following week, Schlesinger, made two public statements, which suggested both the lira and pound were overvalued, which further fuelled expectations among the currency traders that there would be realignments. This was an explosive intervention.

The New York Times article said that while “Dr. Schlesinger regretted public statements he made that started a run on the pound sterling in European currency markets last month, leading to three weeks of disarray in the financial markets as well as much public shouting and finger-pointing among European officials”, the outcome “was just what Dr. Schlesinger wanted: a realignment of European currencies that raised the value of the German mark against most of the others, to help the German central bank push inflation down.”

At the time it was clear that Germany did not see itself as playing on the same field as the rest of the Member States.

A German central bank officials recounted that:

We don’t see interest rates the way many people in the United States or in Britain do, as a way of influencing unemployment or stimulating business activity … We see them as a tool we use to do what our statute requires us to do: to keep the money sound and the rate of inflation low.

So they were prepared to cause stagnation and rising unemployment rates elsewhere in Europe and in the US in pursuit of their irrational inflation obsession.

That obsession explains a lot of the motivation for the current Memorandum intervention last Friday (see below).

The fact that the ECB has been unable to generate higher inflation despite its policy gymnastics which has seen its balance sheet expand beyond the level imagined by mainstream economists as being ‘safe’ (with respect to inflation) should condition our reaction to the Memorandum intervention.

As to Otmar Issing, on February 15, 2010, he wrote in a Financial Times Op Ed – Europe cannot afford to rescue Greece – that any ‘bail out’ for Greece (this was in the period leading up to the bail outs):

… would violate EU treaties and undermine the foundations of Emu. Such principles do not allow for compromise. Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.

His view was that the by “joining Emu, a country accepts its rules” and that the “Emu is a ‘no transfers’ community of sovereign states”.

And that “Transferring taxpayers’ money from countries that obeyed the rules to those that violated them would create hostility towards Brussels and between euro area countries”.

He also considered that Greece had “wasted potential savings in a spending frenzy” and, as such, the crisis was of their own making and that they should solve it.

He didn’t offer a solution to Greece’s plight at the time other than to lay blame at its doorstep and to offer gratuitously that:

This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances.

In other words, endure more or less permanent depression.

He did not comment in 2003, when Germany became the first of two nations to break the Stability and Growth Pact and then bullied the European Commission into having the rules relaxed. France was its partner in crime.

During the recession in 2003 it became obvious that Germany would violate the SGP rules and the Commission placed them within the ‘Excessive Deficit Mechanism’, which required Germany to “put an end to the present excessive deficit situation as rapidly as possible”.

The European Commission solution – following the Issing mindset that rules have to be obeyed – made matters worse in both Germany and France.

The question should have been about why the ‘rules’ were deemed to be appropriate benchmarks for the Member States to achieve rather than imposing them without context.

I wrote about that extensively in my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale.

You can read the trail of notes on this specific topic that I compiled as part of the writing exercise for that book starting with this blog post – Options for Europe – Part 63 (April 11, 2014).

Another contributor to the Memorandum published on Friday, Jürgen Stark, is also behaving in a consistent, if misguided fashion.

Just after the ECB introduced its Securities Markets Program (SMP) in May 2010, which effectively saved the Eurozone from breakup, there were a series of high-level resignations from the ECB Executive Board.

The fiscally-conservative boss of the Bundesbank, Axel Weber, who was being touted to replace Jean-Claude Trichet as head of the ECB, announced he was resigning, ostensibly in protest of the SMP and the bailouts offered to Greece and Portugal.

In a speech presented to the Shadow Open Market Committee (SOMC) symposium, New York City on October 12, 2010 – Monetary policy after the crisis – a European perspective – Weber demonstrated that he knew quite clearly that the ECB was:

… blurring the different responsibilities between fiscal and monetary policy. As the risks associated with the SMP outweigh its benefits, these securities purchases should now be phased out permanently as part of our non-standard policy measures.

In November 2011, ECB Executive Board member, Jürgen Stark followed suit and resigned in protest over the SMP.

Stark told the Austrian daily, ‘Die Presse’ (September 21, 2012) in an interview – Stark: “EZB bewegt sich außerhalb ihres Mandats” – that the ECB was heading in the wrong direction by pushing aside the crucial no bailout clauses that provided the bedrock of the EMU.

He said that (my translation) “within hours, an important economic foundation of the Economic and Monetary Union was simply pushed aside: the no bail-out clause … the ECB is moving away from its mandate …”

He also said that the ECB had panicked by caving in to the pressure from outside of Europe.

His concern?

… the potential for inflation has grown enormously.

Whatever spin one wants to put on the SMP, it was unambiguously a fiscal bailout package. The SMP amounted to the central bank ensuring that troubled governments could continue to function (albeit under the strain of austerity) rather than collapse into insolvency.

Whether it breached Article 123 is moot but largely irrelevant.

The SMP reality was that the ECB was bailing out governments by buying their debt and eliminating the risk of insolvency. The SMP demonstrated that the ECB was caught in a bind.

It repeatedly claimed that it was not responsible for resolving the crisis but, at the same time, it realised that as the currency-issuer, it was the only EMU institution that had the capacity to provide resolution.

The Germans were consistently opposed to the ECB acting in this way but there opposition was effectively reflecting their inflation angst – which is a paranoia that distorts reasonable judgement.

The events that have followed in Europe and Japan’s experience since the early 1990s indicate that their fears of inflation were not based on any fundamental understanding of what actually was happening.

The Memorandum – October 4, 2019

The memorandum was signed by:

– Herve Hannoun, former first deputy governor of the Bank of France

– Otmar Issing, former member of the ECB’s Executive Board

– Klaus Liebscher, former governor of the Austrian central bank

– Helmut Schlesinger, former president of Germany’s Bundesbank

– Jürgen Stark, former member of the ECB’s Executive Board

– Nout Wellink, former governor of the Dutch central bank

Apparently, “Jacques de Larosiere, a former governor of the Bank of France, shared their judgment.”

The Memorandum is predictable, given the past history of its contributors.

It rails against what it claims is the ECB’s current commitment to pursue:

… this extremely accommodative path for quite some time yet.

They list six concerns.

First, while the inflation target (price stability definition) is formally “an average annual increase in the price level for the euro area of below 2 percent” and the ECB, has for years now, “failed to meet its self-imposed target of raising the euro area inflation rate to a level of below, but close to, 2 percent”, it has deemed an inflation rate of “1.5% as unacceptable”.

Hence, the continued “accommodative path”.

The Memo claims that there is no “danger of a deflationary spiral” and so no reason for the stimulus measures.

So all these characters care about is the narrow definition of ‘price stability’ rather than a broader concept of an acceptable inflation rate.

The ECB is clearly sensing that the monetary union is heading back towards recession and while its ‘official’ role is narrowly confined to meeting some price target, its behaviour has demonstrated that it also knows it has to play a fiscal role, even if they construct their interventions in monetary terms, to appease those who want to drag it before the ECJ again.

The problem with thinking that the 1.5 per cent inflation rate is a sign of stability and contentment is that it actually signals a near-recessed economy which desperately needs a spending stimulus.

Given the design dysfunction of the EMU, the ECB is the only policy institution available to address the stagnating economy. The problem is that monetary policy is really incapable of making that sort of difference and fiscal policy is tightly constrained.

Second, the Memo doubts that, in the context that “after years of unsuccessful ‘inflationary policy'” (failure to meet the self-stated targets) that the ECB would be able to stop inflation once it starts to accelerate.

In other words, they are doubting, without admitting it, that monetary policy is an effective macroeconomic policy tool.

I concur with that assessment but in the case of the EMU there is no other option. That should be the focus of such an intervention. But, then, these characters have a record of arguing for strict adherence to rules (including tight fiscal policy) so they really present no credible alternative policy approach.

All they are saying is – no attempts at monetary stimulation should be allowed.

Third, the Memo says that:

There is broad consensus that, after years of quantitative easing, continued securities purchases by the ECB will hardly yield any positive effects on growth.

I concur.

In other words, monetary policy is ineffective as Modern Monetary Theory (MMT) has always noted.

Which then casts doubt on the primacy of monetary policy in the New Keynesian mainstream approach.

But the point the Memo wants to make, which is a point I made above (and extensively in my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale) is that QE (massive government bond buying) is motivated by:

… an intent to protect heavily indebted governments from a rise in interest rates … From an economic point of view, the ECB has already entered the territory of monetary financing of government spending, which is strictly prohibited by the Treaty.

Exactly true.

The European Commission has been playing ‘nod, nod, wink, wink’ with the ECB since the crisis began.

When convenient, the EC invokes the Treaty to threaten Greece or Italy or whoever, but it knows as well as anyone that without the massive QE programs (in their various guises) the monetary union would not have survived the certain insolvency of several key Member States (such as Italy in June 2012).

So they all play along with the charade that the massive expansion of the ECB’s balance sheet is to facilitate liquidity arrangements in the cash markets, when they know full well, the ECB is playing a fiscal function, to make up for the deliberate neglect of such a function in the Treaty.

It is pathetic really.

But the question and focus should be to demand such a fiscal function be created at the ‘federal’ level rather than demand the ECB cease keeping Member States from insolvency.

Fourth, the Memo rails against the “very low or negative central bank interest rates”, claiming that such measures are deflationary.

MMT economists have long pointed out the same conclusion. Increasing interest rates are likely to exacerbate inflation because of the income effects.

Cutting rates to negatives, undermines income flows to the non-government sector and as the Memo notes deprives people “of the opportunity to provide for their old age through safe interest-bearing investments.”

As I noted last week, the financial market players I met with in Europe are crying out for fiscal action to provide growth and investment opportunities given that many pension funds and insurance funds are teetering on the edge of insolvency due to maturity mismatches and increasingly riskier investment positions as they chase yield in this negative interest rate environment.

The conclusion is that a reliance on monetary policy has destabilised the whole financial system and a return to fiscal dominance is essential.

Of course, the Memo only acknowledges the first part of that conclusion and would eschew the second part (although is silent on it).

Fifth, the Memo reinforces the last point by noting that “significant negative effects of very low or negative interest rates also include a “zombification” of the economy” as a result of propping up “weak banks … and weak companies”.

I concur.

But the alternative, in the context of zero fiscal responsibility being shown by governments, who are in a straitjacket as a result of the fiscal rules that Germany always stands ready to enforce (as part of their inflation angst obsession), is chaos and financial collapse.

Finally, the Memo is concerned that “In extending and further strengthening forward guidance”, the ECB is compromising “central bank independence” because it is “threatened with the end of its control over the creation of money”.

And, that compromise occured years ago because the ECB knew that if it didn’t add reserves to the system via its bond purchases, bond yields would go to levels that would be unsustainable for the struggling Member States and they would ultimately lose access to the bond markets.

The question the Memo avoids is that this compromise is a direct result of the creation and design of a monetary union that could never withstand a major negative spending shock.

By surrendering their own currencies, and, adopting a ‘foreign’ currency (the euro), the Member States became the prey of the bond markets. Only the exercise of the ECB currency issuing power which gives it the unlimited capacity to buy any debt issued in that currency (government and private) has stopped the bond markets from pricing governments out of regular funding.

The problem is not the loss of independence but the fact that their is no fiscal authority that can insulate the Member States from insolvency.

Conclusion

The Memorandum should be disregarded.

Its central contentions are mostly correct but the alternative world it would have Europe follow would be a disaster for many of the Member States and the people that live within them.

It would almost certainly result in the collapse of the monetary union – which would be a good outcome – in the face of massive income and job losses and the social and political instability that would follow – which would be a bad outcome.

What it tells me is that the monetary union is a massive failure.

It would be far better to dissolve it in an orderly manner to avoid those massive income and job losses and to support the restoration of full currency sovereignty and national central banks.

That would be the sensible thing to do.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.