In the first week of November Mario Draghi, the new President of the European Central Bank (ECB), confirmed all possible prejudices about him (what with being Italian and therefore according to a widely held view seemingly genetically inclined to lower interest rates always and everywhere) when the ECB decided to lower its key interest rate during the first meeting under the new President.
Today, when European leaders gathered together for another crucial summit in Brussels, the ECB lowered its key interest rate once again, from 1,25 to 1,00%.
But still, after having watched the press conference afterwards, I feel a cheer for Draghi would not be misplaced.
Rate cut was not needed
Not because he lowered the interest rate, but because of something else. As for the rate cut, in my opinion it was not needed. When faced with a normal downturn, cutting interest rates is what a central bank is supposed to do. That way, borrowing is stimulated and saving money not so, meaning that consumption is getting a powerful boost. Savings does not pay much and borrowing to consume is cheap.
The key word here is ´normal´. The current downturn in the euro area is not normal. This is not a regular crisis but something more akin to once-in-a-century event. A central bank can make borrowing money free (like the US central bank has), heck it can even throw the money all around, it won´t help as almost nobody is in the mood of increasing his debt. And even if everybody was, banks have closed their money lending shops and are hoarding money. Consumers are looking for ways to reduce the debt burden, not increase it further. Banks are prepared to do everything to avoid increasing their risk profile.
If lowering interest rates was the way to go, then surely the euro area should have been in an borrowing orgy already, not to mention the US and the UK (neither of them are by the way). The Fed has slashed its interest rate to almost 0 % and the Bank of England has reduced its key interest rate to 0,5%. Consumer borrowing however, keeps hibernating.
Cheer nonetheless
Given the fact that lowering interest rates could lead to high inflation down the road and also reduces the buffer central banks might need in the near future if things get worse, the most prudent thing the ECB could have done was leaving the key interest rate unchanged.
But let us put that aside. How about that cheer for Draghi?
In the press conference after the meeting, there were questions on the euro crisis and the EU summit in Brussels obviously. More specific, there were questions on the role of the ECB. According to many, the ECB can and should play a larger role.
Germany has, rightfully so, blocked the direct route, I.e. ECB buying bonds of the weak member states without limit. This would amount to monetary financing of deficits and that is frowned upon in the euro area.
Immediately, various proposals have been put forward how to circumvent the ECB´s rules and, as they are part of the Treaty on the European Union, the Treaty itself.
One of the ideas was to make the emergency fund, the EFSF, a bank so that the ECB could lend it vast amounts of money the EFSF would then use to buy debt of distressed euro area nations. Another proposal was that the ECB could lend money to the International Monetary Fund and it then would use those funds to buy Italian and Spanish debt.
This is where Draghi has earned the cheers today. Loud and clear, the new President of the ECB said that those ideas might be legally kind of ok, I.e. they could be said not to violate the letter of the Treaty, but they would violate the spirit of the Treaty. Compare this for example to the proposal by the EU President Herman van Rompuy, that the EU could use a clever legal trick to change the Treaty without following the proper procedure for it, namely seeking ratification in the parliaments of all member states.
For this, Draghi is the hero of the day. It remains to be seen whether he will keep putting the spirit of the Treaty above the letter of it, of course. Let us hope he will. The Treaty is the foundation of the European Union. Violating it is akin to deliberately destroying the foundation the EU is built upon. Are you listening Mr. Van Rompuy? Or do I have to write a haiku to get your attention?
#1 by Victor on December 8, 2011 - 11:57 pm
The spirit of the Treaties is that state debts should ordinarily not be monetized.
The Treaties per se don’t prohibit ECB financing of the state, this is actually a myth. What the TFUE says is that the Council regulates how this is done. The Treaties have escape clauses. They are not as rigid as some think, because drafting a treaty with too strict terms would have been a straightjacket for a crisis such as the one of the past few years.
What we are living through is a self-fulfilling prophesy created by the markets. Markets have made public debts unsustainable by completely changing credit ratings all of a sudden and therefore driving borrowing costs to unsustainable levels.
So the financial industry says “state borrowing can’t be sustained in the medium because it will be too difficult to sustain in the long term, so therefore lets make it difficult to sustain immediately so that (magically) it is easier to sustain in the short term”.
The thing is there is no magic. Money has to come from somewhere.
Europe (Euro zone and Eastern Europe) is living through a run by the financial industry on the state. The UK so far is exempt because the Bank of England has not allowed the markets to the wreck the economy. If this were a run on banks, they could go to the central banks in the short term to prevent the collapse of the financial system.
So why can’t states do the same? Why can’t states receive the money they need to roll over their debts? After all, banks have received more trillions than the states would probably need. Actually the states wouldn’t need any help if the financial industry wasn’t gambling with sovereign bonds.
The financial industry whose mismanagement created the crisis (by forcing states to rescue banks) is now demanding that the state take money from the middle class to balance the budget. So they are opposed to government help for the middle class, yet they aren’t willing to contribute through a financial transaction tax and they don’t see the hypocrisy of demanding austerity when they received astronomical bailouts.
Germany is right to oppose inflation. But it is fixed on just one of the lessons of the pre-WWII Great Depression. It is true that abusing monetary policy leads to instability. But it is even more true that high unemployment and rising economic disparities also lead to conflict.
The fact that unemployment and living standards in Germany haven’t been hit as hard as in the other countries doesn’t exempt it from economic laws any more than Greece’s lack of discipline would exempt it from inflation (or worse) if it had the drachma and decided to devalue or monetize the debt.
The question in the end is, who becomes richer or poorer when a policy is applied. So far austerity is demanding a lot from the people and the banks go on like nothing has happened.
It is difficult to understand how someone can recognize that this is a once in a century kind of event, yet goes on to cheer business as usual thinking.
It would seem the global plutocracy’s agenda is to save itself while transferring even more wealth from the hands of ordinary citizens into the offshore accounts of a few.
In the end this is not about inflation vs. fiscal responsibility or even about solidarity, this is about common sense and fairness.
#2 by Victor on December 9, 2011 - 6:58 am
Furthermore, Germany stupidly forgets that Allies´ abuse (led by France) dictating national sacrifice in order to pay foreign debt was at the heart of the rise of Nazism as much as hyperinflation.
The Treaties also have a more important objective for the European Central Bank which goes above fighting inflation, which is to guarantee the market economy with efficient allocation of resources. It is impossible to say that you could have a Central Bank willing to destroy the economy through a Depression just to keep inflation under 2%.
But more importantly, under the current circumstances, the financial players are not acting like capitalism (efficient allocation of resources), but are rather engaging in speculation, hoarding, sabotage and manipulation, all through their tendency to groupthink (herd mentality).
The 4 functions of the ECB are:
1) to contain inflation (price rises due to monetary and financial policy);
2) to contribute to growth (contain unemployment);
3) to guarantee capitalism (rational liquidity);
4) to strengthen European union.
As long as inflation remains subdued and the potential for its rise mostly theoretical, the onus is on the ECB to prove why it would derelict its other 3 duties.
The notion of a central bank that is independent is not only anti-democratic, but also illusory and illogical. A central bank could never go against democratic wishes without putting its credibility in question, it could never provoke a strong recession (much less a depression) just to fight a pro-inflationary government policy that it didn’t like.
If a central bank could only inject liquidity into the economy when inflation is low, instead of when it is needed, then there wouldn’t be a need for a central bank at all. We might as well return to the gold standard.
#3 by Wim Roffel on December 26, 2011 - 11:15 am
Let’s not forget why Southern Europe has budget deficits: because it has huge trade deficits with Germany. And those trade deficits are the result of a very deliberate German policy to lower its wages and decrease government expenses.
In the end all those “rescue” operations serve to enable Germany to keep its surpluses. No “clever” policy will save this policy from its essential lunacy.