The ECB Needs a Plan B for Its Monetary Policy

With the introduction of a negative interest rate on excess bank deposits, it has become clear that the ECB is running out of options. The institution's most important financial political tool - the interest channel - has failed in its objective to encourage lending for investment to curb deflation.

When a hike in interest rates by the ECB aims to put the brakes on a boom and indirectly dampen rising inflation, the interest channel works fairly efficiently. If, however, during an economic downturn, the ECB tries to encourage investments and growth by lowering interest rates, this is significantly less effective. In a tough recession a monetary policy based on interest channels is barely workable because investments, even with low interest on credits, are not economically viable if the additionally produced goods and services cannot be sold. Without demand there are no sales revenues and thus no profits with which to pay back credit. Even the ex-Chief Economist of the ECB, Jürgen Stark - not one to question Keynesian demand-policy - admitted in a Deutschlandfunk-Interview at the beginning of June that banks would not make loans if projects were not viable. This comes back to the key point: we are lacking economically viable investment options.

A second monetary tool for the ECB

If monetary policy no longer works via the interest rate channel then the ECB has lost its operating capacity and cannot fulfil its mandate, which includes preventing deflation. Therefore it urgently requires a fiscal transmission channel as a second tool. This could mean the ECB buying government infrastructure, educational or environmental bonds in exchange for newly created money. Much needed investment in public infrastructure could be paid for. The expansion of renewable energies could be kick-started, and serious youth and long-term unemployment tackled. The ECB could directly boost the European economy without being reliant on the lending policies of the banking sector.

The standard accusation that financing public expenditures through money creation by the central bank is inflationary is unfounded. New money is created only when new investments and additional public services come into existence. The new money and the real economy produce synchronised growth. Direct payment for the production of new goods and services would not lead to excess money or asset bubbles.

The introduction of a fiscal transmission channel would restore the traditional right of the state to gain from currency creation and expand its financial capacity to act. An institutional process would determine the economic conditions under which the EU is permitted to finance new production via money creation of the ECB in order to prevent inflationary misuse. The creation of excess money would also be unlikely because it can be assumed that banks will borrow less new money from the ECB if they already have the resources necessary for their refinancing from additional customer deposits.

The current problem lies primarily in avoiding deflation. Slightly more inflation would be useful because central banks cannot work with negative real interest rates. The introduction of a fiscal transmission channel would enable central banks to meet their varied goals. With the interest rate as a single financial tool they would no longer have to follow two contrary objectives. With an increase in interest they could tackle asset price inflation whilst at the same time, via the fiscal channel, increase productive investments.

Exit Strategies

To calm any remaining concerns, there are two exit strategies with which an inflationary business cycle and excess lending can be curbed. Firstly, any central bank can increase the minimum reserve requirements for banks and thus effectively limit their lending options. Secondly an institutional regulation can oblige governments to buy back their bonds from the ECB from tax revenues if the boom overheats. This would curb excess demand and reduce surplus money.

But although the fiscal transmission channel would allow the ECB to regain the ability to fulfil its mandate, current ECB rules forbid government financing. Thus the mandate of the ECB prevents it from fulfilling its contractual obligations.

If the Euro is to become a fully sovereign currency, the ideological prohibition of monetary government financing must be abolished and replaced by an effective monetary transfer channel. The introduction of this prohibition was grounded in the irrational German fear of hyperinflation based on a misunderstanding of the Weimar experience and its unique causes. It would be tragic if the Euro project failed because of an insistently cultivated neurosis in a single member state.