Mario Draghi’s Nightmare

A hail of statistics and forecasts from the IMF and the European Central Bank (ECB) is confronting us with an undeniable truth – the economy is not recovering fast enough. Growth rates, though positive, are mediocre. And the main indicator of economic recovery, namely anticipatory purchases and investments, i.e. inflation, has been revised downwards, despite the enormous injections of liquidity provided in Europe by the ECB.

Belatedly, the ECB has embarked on unconventional monetary measures (dubbed “quantitative easing”), which consist of buying up sovereign bonds to the tune of 60 billion euros by September 2016. The ECB’s statutes forbid it to finance States directly, which would be tantamount to becoming their discount bank. But in reality, sovereign bonds pass only fleetingly through the banks’ ledgers before being bought up by the ECB. In parallel to these measures, the ECB imposes a negative interest rate on the bank balances that are entrusted to it, in order to discourage hoarding.

To understand these measures, we need to recognise that money is both a stock and a flow. The ECB provides a stock of money, while the commercial banks create a money flow through the mechanism of deposits and loans. When this flow slackens, the ECB has to compensate by creating an additional stock of money. So the measures taken by the ECB meant that the money circuits could be made more fluid.

And yet, for the time being they are having no effect on growth, for two reasons.

First of all, the money created is still congealing in the banks’ books and is not being passed on fast enough to the real economy in the form of credit. Indeed, the economy is suffering from a demand crisis. Consumption and investment are insufficient to drive demand for credit. Moreover, Europe’s quantitative easing is, by its nature, less effective than the easing applied by the US Federal Reserve. This is because in the US, the financing of public authorities and enterprises is conducted directly through the financial markets, without passing through the banks’ balance sheets. So in the US, any easing is transmitted more rapidly and effectively to the real economy.

This suggests that the ECB will have to extend or expand this monumental creation of money. Excess public debt, which is itself growing, will be partially transformed into money supply. So money creation will be fuelled by public indebtedness. In the likely event of an expansion of monetary easing, the growth on the ECB’s books will keep pace with the refinancing of the States themselves.

This is the opposite of the German belief in financing public debt through already constituted savings rather than by creating money. The Germans’ thinking is that when money is created, money is depreciated, and that it is not a good idea to tamper with this token of confidence. This, incidentally, brings us to the core of the eurozone crisis, which is the lack of a consensus on the modalities of monetary policy among the countries whose currencies have been unified. At the European level, there are two schools of thought. To some, a minimum inflation policy becomes the benchmark, the corollary being a lethargic, even a deflationary, policy marked by high unemployment. Others feel that inflation should be no obstacle, as long as it does not reach disturbing levels.

But the real issue is how to get back out of this money creation. Without a vigorous recovery in growth, a let-up in monetary easing would be unimaginable. In other words, when the ECB reaches the end of this quantitative easing, it is unlikely to ask for repayment of the sovereign bonds that it will have accumulated. These bonds will be replaced by other securities, which will be issued when the time comes.

Otherwise, the outcome would be an immediate rise in interest rates. But an interest rate hike would work against growth and, above all, would place a heavier interest burden on public finances. That is why an end to quantitative easing could be envisaged only within a context of higher growth and inflation. But this simultaneous presence of low interest rates and inflation is risky because interest rates, as set by the markets, include a premium designed to compensate for the inflation expected.

So it is plausible to suppose that the coming years will be marked by “financial repression”, i.e. coercive measures intended to oblige the banks and the insurance companies to finance States at an artificially low rate of interest. In fact, this is already happening through regulations that exempt the financial institutions from covering sovereign bond holdings by means of share capital charges. Indeed, a cynic might wonder if States have not made a two- or even three-step calculation that consists of bringing interest rates right down in order to finance their debts on exorbitant terms while at the same time being able to discount them through the central banks, then watching as inflation depreciates these selfsame debts and/or enables a buyback on advantageous terms while impoverishing their citizens through a crushing inflationary levy. Is this an unlikely scenario? No, from a strictly theoretical point of view, it cannot be ruled out. And when inflation soars, it will face the public with insidious impoverishment but also with a challenge to be overcome. It will be a sort of implicit tax for which the State will be able to shuffle off responsibility.

The worst thing, of course, would be if the European economy did not recover and public debt inexorably continued to rise in relation to GDP. In that case, the ECB would inevitably be called upon to refinance the States, which would be unable to source this refunding from local or foreign financial institutions. The risk of State insolvability would then shift towards the ECB, whose assets would serve to consolidate a growing proportion of public debt. This would obviously be a step towards an insidious nationalisation of the commercial banks, whose prudential supervision has, by the way, been transferred to the ECB. It may be noted that States’ management of commercial banks and the ECB has grown to an extent that would have been unthinkable just a few years ago.

From being the keeper of the currency, the ECB would move on to shoulder the responsibility for the stability of public debt. It would then be the ECB that would have to residually absorb the effects of the economic crisis into its ledgers, by refinancing the States. The ECB would even become the essential means of exit from the sovereign debt crisis. And that is Mario Draghi’s nightmare.