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Archiv: October 2013

Pushing on a String: LTRO, Endogenous Money and the Eurozone Crisis

24. October 2013, von Alexandre Abreu, Comments (1)

(slightly wonkish, as Paul Krugman would put it)

At a press conference about a month ago, the President of the ECB, Mr Mario Draghi, raised the possibility of a new round of LTRO (Long Term Refinancing Operation), which, for those less familiar with the topic, consist of large-scale, long-term, low-interest loans to commercial banks across the eurozone, which serve to increase what’s called the ‘monetary base’. While many people think and use the analogy of ‘printing more money’ as the equivalent of undertaking expansionary monetary policy, the reality is that the vast majority of money consists of deposits and is created by the banking sector through credit provision. By extending loans to customers and crediting those loans to their accounts, banks effectively create money (i.e. generally accepted means of payment); and by extending loans to commercial banks, the ECB enables the former to increase the amount of credit, hence money, made available to the economy. The relationship between the monetary base and the total money supply is called the ‘money multiplier’ and the standard view, widely taught to economics undergraduates around the world, is that central banks are largely able to control the total money supply, namely by expanding or contracting the monetary base.
However, this ‘standard’ account of how monetary policy works is shattered to pieces by the abundant evidence provided by developments in the eurozone since the onset of the crisis. As shown in the Figure below (taken from here), between 2008 and 2012 the ECB more than doubled the eurozone’s monetary base (through such programmes as the LTRO), and, lo and behold… there was neither runaway inflation (as most delusional neoclassical economists might have expected) nor anything vaguely resembling a solution to the crisis (as some crude Keynesians might have expected). Quite simply, the enormous expansion of the monetary base did not translate into an increase in the total money supply, i.e. into more credit extended to the economy (M3 in the Figure).

Source: European Central Bank, Statistical Warehouse.

Source: European Central Bank, Statistical Warehouse.

The reason for this, as explained by the largely-ignored Post-Keynesian school, is that banks aren’t actually constrained by the monetary base or fractional reserve requirements when it comes to extending credit: as even bankers themselves will tell you, banks neither function as mere intermediaries between depositors and borrowers, nor do they give out loans to the extent allowed for by the amount of reserve deposits that they hold with the central bank: rather, they extend loans first, credit them into their customers’ accounts and only subsequently do they deposit a fraction of that new credit with the central bank. So in the real world, banks are virtually unconstrained in their ability to create money. Unconstrained by reserve requirements and the monetary base, that is, for in reality they are constrained by other things – crucially, by the demand for credit on the part of potential borrowers, with potentially profitable investment projects, who provide sufficiently good guarantees of paying back the loans.

And that’s exactly where the problem lies. In a situation where aggregate demand for goods and services in the eurozone is constrained by both a massive debt overhang and widespread austerity, many firms are unable to take out additional loans due to over-indebtedness, and the vast majority of the remainder are much less willing to undertake productive investments due to the slim prospects of getting a return on those investments. Thus the attempts on the part of the ECB to control the money supply become like pushing on a string: additional narrow money creation doesn’t actually get pumped into the economy, or only does so to a very limited extent, instead causing the banking system (or some parts of it) to accumulate excess liquidity. Indeed, the reason why the monetary base has been decreasing in the last few months (see Figure above) is that many banks across the eurozone have been paying back their own loans to the ECB so as not to hold on to liquidity for which they don’t have any use. There aren’t that many profitable productive investment opportunities around these days, and even the financing of asset-price bubbles – housing, gold, food derivatives – no longer seems as attractive as it used to.

Now, to be accurate, it’s not necessarily the case that monetary policy has been entirely ineffective: it is probably true that the money supply in the eurozone would have collapsed were it not for the unprecedented expansion in the monetary base. However, the complete breakdown in the stability of the money multiplier shows quite clearly that: i) money is created endogenously in the economy by banks and effectively limited by aggregate demand; ii) we’ve reached a point where narrow money creation is neither inflationary nor expansionary – it’s largely ineffective; and iii) the root cause of the problem is stalled aggregate demand across the eurozone as a whole, owing to rising inequality and over-indebtedness built up over the course of the last 2-3 decades and only made worse by austerity. So whether or not a new round of LTRO is indeed implemented won’t really make much of a difference, at least for the purpose of reviving the eurozone economy and overcoming the crisis.
Want some really ‘structural reform’? Reconnect fiscal and monetary policy, so that the latter is backed up by sufficient stimulus to aggregate demand, and actively promote 5%-6% inflation, so that the debt overhang can be gradually overcome. Of course, the chances of this occurring without major political and institutional overhaul are, well, zero – as are the chances of overcoming the eurozone crisis in the next few years.

Parallel Currencies are no Alternative for the Euro

21. October 2013, von Adriaan Schout, Comments (0)

Many are upset about the ‘TINA-type solutions’ for the euro crisis. ‘There-is-no-alternative’ (TINA) seems to have been an irrevocable characteristic of the euro right from the start. A sense of ‘having been forced onto the people’ was kindled by the fact that in most countries the single currency was adopted without referenda. Subsequently, many of the measures including EFSF, ESM, disputable bail-outs of governments and banks by the ECB, sharpening up of the stability and growth pact and the 2pack (which forces Member States to hand in national budgets before being adopted in parliament) have all contributed to the image of the euro as extremely risky and as an undemocratic intrusion on national competences. On top of this, many countries struggle with the constraints of the dubious 3% rule. If economic governance is to work, Barroso in his blueprint has given a clear insight into what it involves, including an EU finance minister and EU bonds.

There is a sizeable group in the eurozone that does not want these TINA-type steps towards a federalised and centralised EU. Many would like to leave the EU straight away. Others, such as German Professor Kerber and adepts of The Matheo Solution, suggest to introduce types of parallel currencies or currency units (calculation currencies such as the ECU). According to Kerber, if southern states do not want to leave the euro zone, then the countries with a current account surplus should introduce their own currency. He suggests that since the relevant northern countries are only Germany, the Netherlands, Austria, Finland and possibly Luxembourg, the new currency might as well be the DM under the watchful eye of the Deutsche Bundesbank.

Hopes of a parallel currency immediately lead to serious questions (even if we ignore the political complications and impossibilities). Firstly, there are legal questions about breaking away from the eurozone. Will the Commission use all legal means to ensure the integrity of the eurozone? Secondly, one should not think lightly of the consequences for the competitiveness of the new DM block when the DM revaluates. Thirdly, a break-up would complicate the necessary steps towards the banking union even more and thwart the internal market at least in financial services. With bouts of devaluations, any banking resolution mechanism would be frail. However, most worryingly of all would be the fall back towards the ERM (European Exchange Rate Mechanism) days when especially southern countries had to devalue repeatedly. This had profound economic consequences including financial losses while structural changes continued to be stalled and spells of high unemployment because countries mostly postponed devaluations to ensure prestige. (B. Connolly (1994), The Rotten Heart of Europe, Faber and Faber.)

The changes for successful reforms in countries outside the euro framework are (decidedly) lower than within the eurozone. The best options for structural changes in expenditures, labour market reforms, tax reforms, deregulation, anti-corruption policies, rule of law measures, banking supervision, etc. are within the euro system. This will, in the long run also benefit the eurozone and EU more broadly.

Evidently, the costs of dealing with the current bubbles in the eurozone are huge. However, these costs in terms of ban risks and government deficits have already been committed and have been shifted to, among others, the balance of the ECB. They will not go away with a break-up of the euro. Inside or outside the euro, adaptations will remain expensive.

Of course, we can throw away all hope for reform in countries such as France, Italy and Greece. If we are so negative, we would better dismantle the euro as soon as possible. However, it would be in all our interests to ensure reforms. Changes seem to be taking place in and, in any case, prospects for reform are best within the eurozone (ask the Dutch).

Parallel currencies show at least that alternatives for the euro do exist but it seems wise to keep such disruptive alternatives at bay for the time being. Thoughts about parallel currencies are signs of serious euro frustration but not of ‘cold thinking’.

Europe For Citizens

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Blog Authors

Adriaan SchoutAdriaan Schout

Dr Adriaan Schout is Deputy Director Research/Europe at Clingendael, Netherlands Institute of International relations. (read more...)

Alexandre AbreuAlexandre Abreu

Dr Alexandre Abreu is a 33-year-old Portuguese economist with a PhD from the University of London. Currently he is a lecturer in Development Economics at the Institute of Economics and Business Administration, Technical University of Lisbon, and a Researcher at the Centre for African and Development Studies of the same University.

Almut MöllerAlmut Möller

Almut Möller is a political analyst in European integration and European foreign policy. She is currently the head of the Alfred von Oppenheim Centre for European Policy Studies at the German Council on Foreign Relations (DGAP) in Berlin. (read more...)

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