In order to understand the recent interest-rate decisions of the European Central Bank (ECB), one must recall the economic turmoil that Europe experienced after the introduction of the euro. The elimination of the exchange rate risks lowered interest rates on the EU periphery, triggering massive capital flows from Germany that fuelled the boom in these countries. Wages, incomes and the imports of the southern EU states increased rapidly, but as they became increasingly more expensive, their exports declined. The capital influx led to deficits in foreign trade.
Then the financial crisis hit and private capital was reluctant to keep flowing into the periphery. First it was hoarded, then it was invested at home, touching off an investment boom in Germany. The periphery encountered serious difficulties, because its competitiveness had been lost, and now private capital to finance the trade gaps was lacking.
The ECB helped out by diverting enormous credit flows from the German Bundesbank into the periphery. Since the beginning of the crisis, 340 billion euros in public credit have flowed via the socalled TARGET2 system to the GIPS countries (Greece, Ireland, Portugal, Spain), an amount roughly equal to their current account deficits over the period. This implies for Germany a credit risk of 114 billion euros.
The central bank of Greece, for example, lent newly created money to Greek commercial banks, which was not used for circulation in Greece but for paying import bills. This money flowed to Germany via the TARGET system, the international payment system of the euro countries.
When the payment was effected, Greece’s monetary base returned to its original level, whereas the Bundesbank had to create new money in exchange for TARGET claims against the ECB that it paid out via the commercial banks to German suppliers. In short, if the Greeks wanted to import a Mercedes, they called the Bundesbank and asked it to print money and send it to the carmaker – in exchange for a promissory note that they transferred to their national central bank. Since the markets were no longer willing to finance the GIPS countries’ imports, this system proved to be a golden goose for maintaining their standard of living.
But then the ECB got cold feet. This is why it exerted strong pressure on the governments of Europe to set up public rescue funds and almost forced countries such as Ireland and Portugal to utilise the funds. These countries would have preferred to finance their trade deficits via the ECB than with funds from the euro community (EFSF), since they pay only one percent interest to the ECB but 5.9 percent to the rescue fund.
The ECB knows that it is sitting on a time bomb, and is desperately seeking to replace the obscure TARGET credits with parliament-approved loans. The press has reported that Portugal had to resort to the rescue funds because the markets are no longer willing to finance the country. But in reality it is the ECB that is unwilling. The financing of current account deficits was perhaps justified in the crisis years 2008 and 2009, but here too the question arises as to whether such debt financing should not have required the approval of the respective parliaments.
In 2008 and 2009 it was a matter of coping with a historical crisis in the world economy. But by 2010 at the latest, the ECB should have changed its policy.
Critics of the turnaround in the ECB’s interest-rate policies argue that it will now be more difficult for the countries in distress to return to their former growth path. But this argument overlooks that such a return is itself hardly possible since the flows of private capital they would need are no longer available. The countries must reduce their excessive wages and prices so that they can become competitive again, and they may only run up foreign-trade deficits that can be financed by the markets. It is impossible to finance these deficits in the long run with public loans without the euro system going completely out of control. The continuation of the policy begun by the ECB would further inflate the foreign liabilities of the peripheral countries and in the end the ECB - and with it ultimately Germany – would become the proprietor of the countries on the southern periphery of Europe. This would break the euro’s back.
The ECB must undertake a radical turnaround and stop financing trade deficits. The recent increase in interest rates is only one of the necessary measures. The ECB’s full allotment policy by which banks receive unlimited amounts of central-bank money for an unlimited period must also be terminated. But that too will not suffice. Above all the ECB must place appropriate quotas on lending for the euro countries and cap the TARGET2 balances. Otherwise it will be accused one day of having abused its authority.
Professor of Economics and Public Finance
President of the Ifo Institute
Published as “Die EZB muss sich wandeln”, WirtschaftsWoche, No. 16, 18 April 2011, p. 44.