Analysis of ECB monetary policy: From central banker to central planner?
January 2016
In recent years, the ECB has greatly expanded its mandate. This is a thorn in the side of many critics, which Mario Draghi is likely to feel again on Wednesday during his visit to the Bundestag, although this expansion of power cannot be adequately explained using a purely political science approach – the expansionary logic of monetary policy must also be taken into account.
Unique historical circumstances gave the European Central Bank a unique statute: The Maastricht Treaty of 1992 combined maximum independence with the minimalist mandate of ensuring monetary stability alone. On paper and in practice, the early ECB resembled less a traditional central bank than a pure “monetary policy rule”: its task was to manage its key interest rate and inflation expectations, and its meetings and accompanying reporting were correspondingly unspectacular.
Twenty-five years later, little has changed on paper. In practice, however, the pendulum has now swung in the other direction – today the ECB is more reminiscent of a central planner than a central bank. How can this seemingly central planning-like form of economic management be explained at the heart of an otherwise increasingly market-based capitalist system? Is it a temporary development – an anomaly that will disappear when the economy returns to calmer waters?
Large financial sector, large central bank
Whether in London, New York or Tokyo – central banks in the world’s financial centers are now actively participating in the market on a large scale. The ECB’s expansion is therefore not an isolated case. This expansion also began before the financial crisis of 2008, and a reversal is still not in sight almost a decade later. In short, the rise of central banks to become one of the most important organs of global economic policy is neither a purely European nor a short-term phenomenon. Rather, it coincides with the growth of the financial markets in terms of both geography and time.
The central planning-like central bank action is the necessary counterpart to the expansion of “free” but fragile and unstable financial markets
This observation forms the basis for the following article. The ECB’s expansion is examined in terms of three dimensions – expectation management, market construction and securities purchases. The central finding is that central planning central bank action is the functional (albeit problematic) counterpart to the expansion of “free” but fragile and unstable financial markets.
Financialization and macroeconomic management
The question of the relationship between big finance and big central banking is central to our understanding of both “financialization” as such and the possibilities and limits of macroeconomic control policy.
The term “financialization” refers to the increase in importance and power of the financial markets compared to other economic sectors, which has had a decisive impact on the development of capitalism since the 1970s. The shareholder value principle in corporate management, the growing indebtedness of households and companies, the privatization of social security systems and pension provision, the invention of ever new ways of transforming future cash flows into investable securities – all these developments reflect various facets of financialized capitalism.
From a historical perspective, this form of capitalism can be clearly distinguished from the “Fordist” production regime of the post-war decades. This regime was largely based on the containment of the financial markets through strict regulation at national level and capital controls at international level. This containment gave the states a certain amount of economic policy leeway. The most important macroeconomic control instrument here was fiscal policy: the government stabilized the economy by increasing or decreasing government spending.
The lifting of capital controls in the 1970s and the deregulation of the banking sector since the 1980s set financialization in motion. This contributed to a paradigm shift in economic policy in favor of inflation control. The result was a shift in the center of macroeconomic control from fiscal policy to monetary policy, and thus from parliament and the Ministry of Finance to the central bank.
In the mid-1990s, there was an astonishing degree of agreement on the nature and objectives of monetary policy. Central banks were committed to maintaining price stability. In return for this narrow focus, they were given extensive independence. This was also and above all true of the ECB, which began operations in 1999. And then? Everything changed completely. The central banks – above all the ECB – began to expand.
The expansionary logic of monetary policy
The extensive political science literature on the ECB is all too often based on the idea that the ECB is one of many administrative institutions of the EU bureaucracy. As such, it seeks to expand its sphere of influence. However, this perspective blocks the view of the political-economic, structural aspects of central bank action. The central bank must be taken seriously as a bank.
The ECB acts by acting – with money and with securities
Central banks have a special position within the institutional structure of capitalist societies – democratic or not. Like other arms of the government apparatus, they are endowed with certain state privileges. In particular, they are legally guaranteed the monopoly to create central bank money and the authority to oblige banks to hold money reserves. However, these privileges merely form the legal basis for the central bank’s ability to act. Unlike the other legislative, executive and judicial bodies, it does not act through legal or administrative acts, but through market transactions. The ECB acts by trading – with money and with securities.
The idea that a free market can only exist where the state withdraws is rightly considered outdated. Even financial markets cannot exist without the rule-setting and regulating state. However, the role of the central bank goes beyond this. It acts as an active market participant itself – above all in the money market, but also in the capital and foreign exchange markets. In other words, although the ECB is the central bank, it remains a bank at heart.
The transmission mechanism of monetary policy
The ECB’s macroeconomic management capability is based on the fact that its lending operations in the interbank market are transmitted to the economy as a whole. Being dependent on this transmission mechanism is also the central bank’s greatest weakness. After all, it would be hard to imagine a more cumbersome way of influencing macroeconomic development.
Unlike fiscal policy, the central bank’s lending operations on the interbank market are an indirect macroeconomic control instrument that is susceptible to disruption. The transmission mechanism of monetary policy is highly complex. It is a long way from the main refinancing rate set by the ECB via the short-term interbank interest rate in the money market to long-term market interest rates and the general price level of the economy.
The banking nature of the ECB and the relative weakness of its management tools – these two concepts provide a theoretical framework that allows us to systematically understand the seemingly chaotic, multi-directional expansion of central bank action.
The three-dimensional expansion of the ECB
Market construction
The transmission chart shows that financial markets are crucial for the effectiveness of monetary policy. In order to bring the money market interest rate on the interbank market into line with the main refinancing rate set by the ECB, the ECB carries out so-called repo transactions. This involves purchasing securities from commercial banks, which receive central bank money in return. At the end of a predetermined period – usually one week – the banks buy back these securities at a slightly higher price. The price difference makes up the interest rate of the lending transaction.
From the very beginning, the ECB was committed to expanding the repo market in the eurozone. As the largest market participant, it set important standards that helped to make the repo market the central source of financing for the eurozone banking system. With far-reaching consequences – the temporary collapse of this market was a key factor in the banking crisis of 2008/2009. By providing the banks with unlimited liquidity in this situation, the ECB took over the role of the repo market. A very similar dynamic could be observed in the securitization market, which the ECB initially rescued in 2008 and has strongly promoted since then.
Expectation management
Until the early 1990s, secrecy was considered a virtue among central bankers. Alan Greenspan, the legendary head of the US Federal Reserve, once said:
“If my statements were too clear to you, then you must have misunderstood me.”
Today, there is a consensus to the contrary: the more transparent the central bank’s communication, the more effective its monetary policy. The development of the ECB’s communication strategy can be described as a constant expansion of its expectations management into the future. In doing so, the ECB gradually increased both the frequency and the information content of its macroeconomic projections. This development reached a new dimension when the ECB, under Mario Draghi, began to set its interest rate policy course over longer periods of time. With this forward guidance, the ECB is attempting to extend the reach of its expectations management further into the future and thus exert greater influence on long-term market interest rates. This strategy is the communicative counterpart to the ECB’s greatly expanded securities purchases in recent years.
Securities purchases
As shown, securities purchases (in the form of repo transactions) are the bread and butter of monetary policy. Traditionally, however, they were limited to the shortest-term segment of the money market: the interbank market. Under “normal” conditions, this instrument was sufficient to influence the future expectations of financial players and thus the macroeconomically much more important long-term market interest rates.
From 2010, however, the ECB began to intervene directly in markets for securities with longer maturities. It initially did this by purchasing government bonds on a comparatively small scale. Later, it did so indirectly by providing long-term and cheap liquidity, which the banks in turn used to purchase government bonds. Here, too, the government bond purchase program launched in March 2015 (quantitative easing, see also Gesellschaftsforschung 15/1) was part of a series of previous measures.
The limits of central bank planning
The common goal of expectations management and securities purchases, the long-term market interest rate, was taboo for monetary policy for a long time. It was regarded as a barometer that aggregated the future expectations of countless market participants and condensed them into an assessment of the overall economic situation. Today, however, the long-term interest rate reflects the monetary policy measures of the ECB and other central banks more clearly than before.
This development can be illustrated by the shifts in the yield curve for government bonds of the eurozone member states. The vertical axis shows the yields that can be achieved with bonds of different maturities (horizontal axis).
In December 2010, for example, government bonds with a remaining term of one month yielded an average of 1.2%, while those with a remaining term of 30 years yielded 4.4%. The effect of the expectation, announcement and actual start (in March 2015) of quantitative easing on long-term interest rates can be seen in the yield curves from April 2014 to September 2016. During this period, the three-month interest rate fell from 0.2% to -0.4%, while the 30-year interest rate fell from 3.6% to 1.4%.
Even if it is not solely attributable to the ECB, this “flattening” of the yield curve nevertheless reflects the enormously increased reach of monetary policy. At the same time, the repo and securitization markets, whose continued existence seemed questionable at times, are benefiting from the ECB’s massive support measures.
Regardless of the question of legal legality, the ECB has long since abandoned the spirit of its original minimalist mandate. However, a purely political science approach falls short in explaining this dramatic expansion. It can only be understood if the expansionary logic of monetary policy is taken into account. The growth of the financial markets led to an upgrading of monetary policy compared to fiscal policy. However, excessive expectations of monetary policy’s ability to steer the economy overstretch the central bank. The ECB has to reach further and further into the financial system in order to achieve the desired macroeconomic results. Central bank planning is therefore neither an anachronism nor an anomaly. Nevertheless, its limits have probably been reached.
To the author:
Benjamin Braun is a research fellow at the Max Planck Institute for the Study of Societies in Cologne. His research focuses on the political economy of monetary policy management in the Eurozone and on the political economy of “asset manager capitalism”. Braun’s dissertation on the institutional preconditions for the effectiveness of monetary policy instruments was awarded the Sir Walter Bagehot Prize in Government and Public Administration by the British Political Studies Association. He is spending the 2016/17 academic year as a John. F. Kennedy Memorial Fellow at the Center for European Studies at Harvard University. He can be found on Twitter under @BJMbraun.
Note:
This article first appeared in Gesellschaftsforschung (issue 1/2016), the newsletter of the Max Planck Institute for the Study of Societies.
By Social Research