The Euro-crisis is transforming the continent radically. One of the consequences of the decisions taken by the European Council on May 9 could be the end of the conservative ordo-liberal German model of social market economy. The European Central Bank may become the best ally of Europe’s left.
As part of the €750 bn. rescue package for the euro, the European Central Bank will now conduct open market operations from which it has so far abstained. German Bundesbank president Axel Weber has been a lonesome opponent to this decision. He claims that it would bear ‘significant risks for stability’. He is wrong. But if he feared that it could be the end of the German economic policy model, which has dominated and hampered European growth for decades, he would be right. The Euro Area may finally turn into a ‘normal’ economy, where monetary and fiscal policies interact to generate high growth, low unemployment and stable prices.
In a modern economy, money is provided by the central bank to the commercial banks, which then lend it to private companies, households and governments. In most countries, central banks fulfil this function by buying government bonds from banks. Not so in the Euro Area. Here, the ECB lends money to banks against the collateral of private and public debt. In the US or UK, the central bank becomes the owner of government bonds, while in the Euro Area banks remain the owner of their collateralised securities. Given that short-term interest rates, at which banks borrow from the central bank, are usually very low, while bond rates are higher, the ECB’s repo business is good for banks and bad for central banks. Banks pay little for liquidity, but cash in on high yields from government bonds. The ECB only earns little income, and therefore generates low revenue for governments. Thus, open market operations could help to lower deficits. However, open market operations may also have long run consequences for economic growth.
After governments responded to the financial crisis in 2008 by massive stimulus packages, economists debated whether public deficits would stimulate economic growth. Mainstream economists in America and leading international financial institutions have argued that government borrowing was necessary to compensate for the lack of spending in the private sector. In the crisis, deficits are unavoidable and should only be cut when the private sector has become the engine of growth again. These policies were inspired by the insights of J. M Keynes in the last world economic crisis.
Others have held against this argument that there is no free lunch. As private households realise that they will have to pay back the government debt plus accrued interests, they will increase their savings now and, as a consequence, there is no net stimulus of demand in the economy. Fiscal policy is inefficient. This economic theory is called the Ricardian equivalence.
However, if part of the public debt is held by the central bank, while the private sector holds cash, future tax liabilities are reduced, because governments do not have to service this part of their debt. Hence, public debt owned by central banks generates a net wealth effect. Firms and households will start to borrow and invest and thereby stimulate economic growth. In other words, whether public deficits stimulate the economy or not depends on whether the central bank buys government debt in the open market.
This is why the ECB decision is a turning point in Europe’s economic model. No doubt, public finances must be consolidated in most EU member states. The question is how? Should one focus on radical cost cutting in the public sector, or should one generate more revenue by stimulating demand and future income? The German model has focused on tough spending reductions, because German policymakers believe in the principle of the Ricardian Equivalence. It has corresponded to the old ECB practice. However, the experience has shown that the ‘Keynesian’ model of fiscal stimulus and open market policy has been more successful, as in the US where growth and jobs are improving more rapidly than in the Euro Area.
The worry is, of course, that such fiscal policy cum monetisation could ignite inflation. However, there is no logical or practical link between open market policies and inflation. The ECB is independent and committed to price stability. Agreement with other institutions is not a sign of weakness, but of the capacity of independent judgment. As long as the central bank keeps the growth of broad money supply in line with the potential growth of output, inflation cannot emerge. The ECB has rightly insisted that it would withdraw excess liquidity if price stability came under threat.
The announced policy change transforms the euro-economy. The Euro Area may not longer stagnate like Germany, but function like the US economy, with price stability assured, and higher economic growth. This would be good for Europe, and for Germany too.