The Euro in Crisis: Decision Time at the European Central Bank

Executive Summary The European Central Bank (ECB) is one of the most important actors in the Financial Crisis and the sovereign debt crisis in the Euro-zone. The way, how the ECB was operating before the crisis was strictly based on the monetarist concept of central banking, reducing central banks to the guardian of consumer price inflation. Inflation of financial asset prices was ignored, not to speak of financial stability, growth and employment.

This reflects basic faults in the design of the ECB, in particular its monetarist obsession with consumer price inflation and its completely undemocratic, nontransparent and unaccountable status in the institutional arrangement of the EU. The report makes a critical assessment of the ECB’s role before the financial crisis and identifies it as a player, which contributed with its monetarist approach even to a certain extent to crisis.

After the ECB had recognized that there was a crisis, it made a pragmatic Keynesian crisis management, serving as lender of last resort with some biases toward the interests of the financial industry and started indirect government financing. However, at present (April 2011) it is unclear whether this is a signal towards a paradigmatic change. The attitude of the ECB in the European debt crisis points into another direction.

The report also compares the main features of the ECB with the US Federal Reserve Bank, the Bank of Japan and the Bank of England. The conclusion is, that the ECB represents more than its homologues a pure monetarist approach to central banking. Several proposals for reform are discussed such as a role for central banking in combating asset price inflation and macro-prudential regulation, control of credit expansion at macro level, mitigating exchange rate volatility and government funding.

Also more transparency and democratic accountability are While there was a consensus, that the proposals all reflect desirable goals, it was controversial whether a broadening of the mandate and competences of the ECB would not give too much power to this institution and that many of desirable tasks in financial governance could not be better done through other institutions and instruments.

The crisis and the debate on reforms present a window of opportunity to push for alternative visions of the central banking in Europe. 4 1. Introduction The European Central Bank (ECB) is one of the most important actors in the financial crisis and the sovereign debt crisis in the Euro-zone.

However, there is almost no attention of civil society – NGOs, trade unions, social movements – for this key player. It is the purpose of this report to trigger more interest for what the ECB is doing, because its behaviour and its decisions are not only affecting heavily the financial sector but the entire economy and hence wages, social systems and in the end the every day life of all citizens. The way, how the ECB was operating before the crisis was strictly based on the monetarist concept of central banking, reducing central banks to the guardian of consumer price inflation.

Already the inflation of financial asset prices was ignored, not speak of systemic financial stability, growth and employment. It is therefore not surprising that the ECB did not see the crisis coming. In early July 2008, when the US subprime crisis was already ravaging and some European banks such as the German IKB had collapsed, the ECB decided an increase of the interest rate to the historic high of 4,25%. An extraordinary case of blindness of such an institution vis a vis the reality. After the Lehmann collapse the ECB made however a surprising turn.

It played the role of a lender of last resort to the banks in trouble, although being very generous and allowing a lot of windfall profits. The ECB also broke with some of its own rules by giving – indirectly – money to governments under stress through the purchase of government bonds at the secondary market. There are some basic faults in the design of the ECB. The most important are: – its monetarist obsession with consumer price inflation and – its completely undemocratic, non-transparent and unaccountable status in the institutional arrangement of the EU.

Of course, inflation is an issue to be taken serious, but reducing the role of central banking to the one and only function of inflation targeting reflects a dogmatic point of view, which with the financial crisis has definitively proven to be flawed. The financial crisis has been transformed into a sovereign debt crisis, which is threatening not only Greece, Portugal and Ireland. The future of the Euro as the common currency of 17 European countries is at stake, and hence the future of the central bank for this currency.

The traditional receipts of structural adjustment with painful austerity programs for the ordinary people don’t’ work, as the case of Greece demonstrates. In spite of dramatic reductions in public spending with highly negative consequences for future growth perspectives, the debt burden is increasing. The crisis is far from being over. New and innovative ways out of the crisis have to be found. This means also, that the ECB cannot continue with business as usual. Substantial changes are required, otherwise the collapse of the Euro-zone will be inevitable.

This report is trying to put the future role of the ECB as part of an overall alternative to the present crisis management on the agenda of civil society. Of course, it cannot discuss exhaustively all the issue of central banking. Its main purpose is to draw attention of civil society, that without changes in central banking it will not be possible to establish a fairer, more stable, sustainable and equitable economic order in the EU. The report is based on the European Expert Meeting “The role of the European Central Bank in the Financial Crash and the Crisis of the Euro-Zone” which took place in Berlin on April 12th 2011, organised by WEED.

5 The main speakers were: Marica Frangakis, Poulantzas Institute, Athens, Dominique Plihon, University of Paris, Mario Tonveronachi, University of Siena, Lucas Zeise, Financial Times Germany. The report draws very much on their inputs. Errors in this report are, however, at the sole responsibility of the authors of the report. Also more than 20 German and international participants contributed to the discussion with their expertise coming from universities, trade unions, research institutes, civil society organisations, political foundations, parties and parliaments.

The paper summarises the discussions of this meeting. While opinions differed on some issues – see in particular chapter 7 – all participants agreed upon the fact that the ECB’S mandate, tasks and instruments as well as its role in the new financial architecture need to be substantially reformed. 2. Some basics on central banking A central bank is a public institution that manages the monetary policy of a country or – in the case of the Euro-zone – a group of countries.

This usually includes

  • the mandate to regulate money supply,  
  • to control the interest rate and 
  • to manage foreign exchange reserves or exchange rates.

In most cases central banks (but not the ECB) also have supervisory functions over the banking sector (i. e. commercial banks) or control of credit supply. In times of financial crises, central banks have an extremely important role as lenderof- last-resort. This means that they take exceptional measures to insert liquidity into the banking sector in order to avoid a credit crunch and a collapse of the finance system. This function is often described metaphorically as financial fire-brigade.

They may also act as the Government’s banker by lending to government. Depending on their specific mandates, central banks may pursue a number of general goals. Since the monetarist theory has become dominant (see chapter 2), the most prominent goal is to maintain price stability of consumer prices, which usually means keeping a steady, low rate of inflation.

This function has become a kind of mantra, which – until today – is broadly hegemonial in most industrial countries, whereas the inflation of financial asset prices, i. e.the bubbles at the financial markets, are ignored both by monetarist theory and the policies of central banks. With regard to their formal or official mandate central banks have – with the exception of the ECB – had or still have additional goals, such as supporting economic growth, creating jobs, maintaining stable exchange rates and ensuring the stability of the financial system. 3. Historical changes in central banking1 The dominant perception of central banking as key instrument to combat inflation appears today to many people as quasi natural.

But as a matter of fact, Central banking is historically embedded and has undergone several phases and considerable con- 1 Chapter 3 and 4 of this report draw on Marica Frangakis’ presentation on the WEED ECB expert meeting, “The role of the European Central Bank in the Financial Crash and the Crisis of the Euro-Zone”. The full paper is available on the WEED homepage. 6 ceptual changes. In each of these phases, the understanding of the role of central banks has differed significantly. In the post-World-War II period, the scope of central banking was very broad and included policy advice and the management of the entire financial system.

After the Bretton Woods system had collapsed in 1972, a new and quite different phase of central banking started, which was heavily influenced by the theory of Monetarism. This theory, which can be considered to be the “theoretical backbone of neoliberalism” has been popularised by Milton Friedman. 2 It defines money supply as the single most important factor in the governance of the economy. A stable quantity of money circulating in an economy is, according to the theory, decisive for economic growth. Consequently, the primary goal for central banks should be to combat inflation.

Until the crisis, most central banks have adopted more or less monetarism as theoretical fundament and have aligned their policies accordingly. In the new era, central banks were assigned a very limited role: maintaining consumer price stability. At the same time, independence from governments was considered crucial for the functioning of central banks. The concept of independence is strongly embedded into neoliberal theory in general and into the theory of political business cycle in particular. The latter states that politicians mainly pursue their own interest of being re-elected.

Thus, they tend to orient their fiscal and economic policies toward elections. While they might be willing to cut spending at the beginning of their term, they will spend more than reasonable before elections. In order to limit inflationary pressures from government spending, the central bank should not be an instrument of government, but rather create a counterbalance. This is, according to the monetarist concept, only possible if the central bank is completely independent from the government.

Institutional design and tasks of the ECB. Many central banks around the world have been shaped according to the monetarist theory in the 1980s and 90s. However, the design of the European Central Bank (ECB) follows more than any other central bank the monetarist concept. 2 US economist. 1912-2006. Nobel price for economy in 1976. Probably the most influential economist of the 20th century after Keynes.