Why the ECB is a powerful and undemocratic institution
by Stefan Ederer
Unlike many other areas of policy in the EU, monetary policy is completely centralised. The EU Treaties stipulate that it is determined and implemented by the European Central Bank (ECB), with the primary objective being price stability. According to the Central Bank’s interpretation of this term, price stability is achieved when annual inflation is just under two per cent. The ECB is independent, autonomous and determines the instruments used for monetary policy at its own discretion. The highest decision-making body is the Governing Council, which consists of the ECB’s Executive Board and the national central bank governors.
The main instrument of monetary policy is the key interest rate (main refinancing rate). According to prevailing economic theory, interest rates are to be raised in times of good economic growth and high inflation in order to dampen business investment and thus avoid an “overheating” of the economy. In a weak economy, the opposite should occur. The (short-term) key interest rate – or “policy rate” – is the only rate that can be adjusted directly by ECB. (Longer-term) lending rates and interest rates on government bonds, which are more important for the real economy, are (indirectly) affected by the key rate, but also depend on other factors. The perceived probability of the default risk of loans and bonds also plays a role, as does the profitability and risk appetite of banks. It has become evident that in times of crisis, it is no longer possible to control the state of the economy using the interest rate alone: a cut in key interest rates has little impact on productive investment and employment.
Monetary policy further includes the provision of liquidity to the financial sector. Normally, banks require only a small number of loans from the Central Bank, since they manage savings deposits and lend each other money in the interbank market. If confidence in individual banks or in the entire financial sector falls – perhaps because it is unclear how many “bad” loans and securities are on the balance sheets – then people prefer to hold cash, leading to a bank run. Lack of trust can also mean that banks are no longer willing to lend money to each other. In these cases, the Central Bank grants loans to commercial banks in exchange for collateral. However, this option is available only to banks rated as solvent by the ECB and is intended as a short-term bridging solution. For states and other public institutions, there is no such financing option: the EU treaties prohibit the ECB from directly financing state budgets.
Monetary policy before and after the crash
From the beginning of the monetary union in 1999 until the outbreak of the financial and economic crisis, monetary policy was considered “conventional” from the point of view of mainstream theory. Inflation was close to two percent and confidence in the financial sector remained strong. However, growth in this phase was, to a large extent, driven by credit and asset price bubbles, a fact to which the ECB paid insufficient attention. The lack of regulation of financial markets meant that these bubbles got bigger, burst and, spreading from the USA, caused the financial crisis in 2007.
From 2008, monetary policy changed dramatically. Interest rates in the eurozone were sharply reduced. The ECB provided large amounts of liquidity to the European banking sector, which had been brought to the brink of bankruptcy by speculation and credit bubbles. However, the ECB’s monetary policy soon reached its limits: although interest rates had been reduced to zero, the economy was still not gaining momentum. This also led to a steady decline in inflation, which at times hovered dangerously close to the zero line. Deflation – i.e., falling prices – would have further dampened demand and possibly led to a prolonged stagnation of economic output.
Due to the bank bailouts and the severe economic crisis, public debt in the euro area increased significantly. Because of this increase and the ECB’s explicit contractual ban on government financing, interest rates on Greek government bonds began to rise from spring 2010 onwards – yet the Central Bank only reacted once speculation had spread to Ireland, Portugal, Italy and Spain.
The first purchase programme for government bonds was approved once the troika – with the input of the ECB – had agreed on a loan arrangement with Greece. But the purchases were only half-heartedly communicated and were also somewhat non-transparent, with the result that in the spring of 2012, interest rates in Italy and Spain rose sharply once again. Finally, in July 2012, the ECB President announced that he would do “whatever it takes” to save the euro, which was interpreted as the willingness – where necessary – to buy government bonds. As a condition of this purchase, it was stipulated that the country in question must agree to a loan programme with the EU. As it turned out, however, the ECB announcement alone was enough to prevent further increases in interest rates.
Finally, in 2015, a programme was started under which large numbers of government bonds (quantitative easing) were purchased indirectly via private financial institutions, thereby increasing their profits. An unconditional government bond guarantee, which is provided as a matter of course (at least implicitly) in countries such as the United States or the United Kingdom, still does not exist in the Eurozone. As a result, speculative attacks on government bonds and the resulting sovereign debt crises continue to be unavoidable. Since 2016, the ECB has also extended the purchase programme to include corporate bonds – a move that primarily benefits large corporations, particularly in the automotive and extractive industries.
The inglorious role of the ECB in Greece
The ECB played a highly inglorious role in the 2015 Greek negotiations, where it teetered on the brink of legality. A few days after Syriza’s electoral victory in January, the Governing Council of the ECB took the unprecedented step of stating that Greek government bonds would no longer be accepted as collateral for lending by the Central Bank. The official reason was that it could no longer expect the bonds to be fully repaid; however, the move was justified solely on the basis of statements and remarks, not on concrete decisions by the new Greek government. As a consequence, Greek banks were effectively cut off from any influx of liquidity from the Central Bank and rendered dependent on emergency loans from their own central bank. This dramatically increased uncertainty about their future and triggered a creeping bank run.
In March 2015, the ECB piled another log on the fire: in its capacity as the regulator, it banned Greek banks from buying more Greek government bonds, which further limited the governments’ room for manoeuvre. At the height of the negotiations and on the eve of the June referendum, the ECB increased the pressure once more: it stipulated that the Greek central bank was no longer permitted to increase the level of its emergency loans. In doing so, it cut off the entire Greek banking sector from its source of liquidity and forced the government to introduce capital controls to prevent the collapse of the banking system. For months, the gradual cutting off of funds was also accompanied by the stoking of fears by the ECB. Rather than preserving the stability of the financial sector as required by EU Treaties, the ECB risked its stability to increase pressure on a left-wing government and influence negotiations on the third loan package at the expense of the Greek people.
A renewed flare-up of the euro crisis could happen at any time. Because of this, we need a central bank that, where necessary, can shore up the public sector and provide direct funding to create employment. The financing ban for public institutions should be deleted from the EU Treaties. Furthermore, the central bank should support a large-scale, EU-wide investment programme for the socioecological restructuring of the economy, for example by buying up bonds issued by the European Investment Bank. Finally, democratic oversight of the ECB by the parliaments should be strengthened, which could help prevent the central bank misusing its powers in the same way it did during the Greek negotiations.
Realistically, however, we can assume that the rules of monetary policy will not undergo any significant change within the next few years. The ECB is likely to gain even more power, and it is not improbable that a similar approach will be pursued against non-conforming, progressive governments as was pursued in Greece in 2015. As a result of this, the sole option remaining to individual member states is to attempt to reduce their dependency on the financial markets and the Central Bank by broadening their revenue base. This could be achieved through measures such as taxes on immovable assets, although little support from the EU institutions can be expected in this regard.
The only way to increase the stability of the financial sector is through in-depth restructuring. Public financial institutions, whose functions are limited to the true core activities of banks, could be one way to achieve this. Any scope for action that is still available to national regulators should be used to downsize and break up banks, reducing the vulnerability of this sector to crises. Overall, however, individual governments are likely finding it difficult to challenge the neoliberal functioning of monetary policy and the financial system, firmly embedded as it is in the architecture of the EU.