Monetary Voodoo

DraghiCaptioned
DraghiCaptioned

The governors of the European Central bank met on December 2 and decided to make a further small reduction in already negative lending rates, while extending their bond purchasing program by another six months to March 2017, writes Prince Michael of Liechtenstein.

In its unsuccessful way, the ECB is trying to resolve a trilemma. It wants to spur economic growth through low to negative interest rates, hit its targeted inflation rate of 2 per cent by increasing money supply, and relieve the fiscal pressures on member states by a huge bond purchasing program.

The idea is that by paying negative rates for deposits at the central bank, the ECB will prod commercial banks to increase lending to corporations and consumers, rather than maximize liquidity. In addition, commercial banks are expected to pass these negative rates along to depositors, discouraging savings and boosting consumption.

This plan is understandable and logical, in a shortsighted way. The difficulty is that it is detrimental to the economy in the long term and completely unsustainable.

I have yet to hear a convincing explanation of why the magic figure of 2 per cent inflation is beneficial.

In order to alleviate the debt servicing problems of all-but-bankrupt European states, the ECB began quantitative easing in March 2015. The central bank purchases 60 billion euros of sovereign debt each month under this program. Counting the latest six-month extension, the total cash injection provided by QE comes to 1.46 trillion euros.

This policy of flooding the economy with liquidity has not spurred growth. While inexpensive credit can support expansion in a healthy economy, it cannot create growth. What cheap money does do effectively is to destroy savings, especially retirement savings.

Sustainable growth happens when businesses decide of their own free will to invest. To make such decisions, companies need to have confidence in the future. Today, this confidence has been undermined by erratic policies and overregulation.

The quickest way to restore trust would be to introduce the dreaded (by politicians) structural reforms that truly unleash private investment. Public spending on useful infrastructure could play a supporting role in this recovery plan.

Bond buying is not solving the euro area’s sovereign debt problem because member states continue to overspend. What it does do is buy time, which the national governments use to put off reforms.

Consumer price inflation has not returned to 2 per cent, but asset inflation is evident in stocks, bonds and real estate prices. This kind of sustained growth normally ends in a bubble.

In voodoo and tribal religions, priests intercede with the supernatural to ensure the welfare of the community. Looking at the long term causes and consequences, there appears as much logic in a witch doctor’s potions to dispel evil spirits as in the ECB’s efforts to heal the economy. Except the witch doctor probably causes less harm.

Related statements:

Yearning for the central banks of yore

Scandalised and bored by the Greek saga

Secular stagnation must not be accepted

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