When Germany’s Constitutional Court ruled on the legality of the European Central Bank’s asset purchase programme on 5 May, it sent shockwaves through financial markets.
In one fell swoop, the red-robed judges accused the ECB of going beyond its mandate of monetary policy and the European Court of Justice of covering up the breach. In doing so, it put the future of the ECB’s crisis management in doubt.
It was a controversial decision, not least because the German court delivered an unprecedented slap in the face to Europe’s highest judges.
But it also had practical implications because the court demanded that the Bundesbank must withdraw from the ECB’s quantitative easing programme unless a new proportionality assessment is made within three months. The court ordered the Federal Government and Parliament to urge the ECB to produce such an assessment.
Over the past days, the impact of the court’s decision on the ECB has become clear. More than ever, the ECB now needs to explain and defend its actions. If the ECB wants to keep the Bundesbank on board, it must show that whatever it does is proportional to the challenges it faces – and compatible with its statutory mandate of price stability.
It was in this context that Isabel Schnabel, member of the Executive Board of the ECB, delivered a substantial speech on the ECB’s response to the crisis on Saturday. She followed up with an opinion piece in a major Sunday newspaper. Meanwhile, and according to another media report, the ECB has compiled its view on the legality of its actions and passed it on, classified, to German parliamentarians.
Taken together, the public now has a good idea of how the ECB is thinking about the Covid-19 crisis.
From the ECB’s perspective, Covid-19 has not resulted in an acute economic crisis but will have long-lasting structural effects. Economic activity in the eurozone will fall by 9 percent in 2020 and not return to last year’s level for at least the next couple of years. Similarly, unemployment will also remain high even after this acute crisis is over.
As Schnabel put it, the “changes to our economy induced by the pandemic are therefore in all likelihood not only temporary, but structural. Global value chains are already being put to the test, productivity in many service sectors may be permanently affected, and certain industries will probably never return to their pre-crisis levels.”
She then went on to lay out why the ECB responded with unprecedented ammunition to the crisis. Her arguments are logical and consistent, they make sense from within the view that it is the role of the ECB to keep financial markets working, prevent broad falls in prices and widespread corporate collapse.
It is hard to argue with this logic. Of course, that is precisely what the ECB is achieving with its policies. By purchasing bonds through the extension of its existing quantitative easing activities and the €1.35 trillion of the new Pandemic Emergency Purchase Programme (PEPP), it is pushing money into the markets, stabilising asset prices and increasing its balance sheet.
Altogether, the expectation is now for the ECB’s balance sheet to top €7 trillion sometime next year. That would be about two thirds of eurozone GDP. Just by comparison, over the first decade after the Euro’s introduction, the balance sheet hovered near €1 trillion or 11-15 percent of GDP.
This flood of new money has unsurprisingly stabilised financial markets and asset prices. Take the yields on Italian 10-year government bonds. These are trading at around 1.3 percent – which is lower than they were two years ago – in spite of the fact that Italy’s public debt has since exploded and its economy tanked.
Another example is European stock market indices. The DAX, the CAC40 and the IBEX35 are all trading between 10-20 percent below their levels earlier this year. That is a correction, no doubt, but the big falls happened in March and the stock markets have been in stabilisation or recovery mode ever since.
It is difficult to reconcile these stock market movements or Italian bond yields with Schnabel’s statement that the pandemic has structural and serious effects on the European economy.
Except it is possible to reconcile these market developments with the fact that the ECB has intervened so much. Markets now mainly reflect the extent of the intervention, not the actual level of economic damage caused by the pandemic.
The Constitutional Court asked if the ECB’s measures were required, suitable and proportionate. The answer is that it depends on the bank’s goal. If the goal is to prevent short-term deflation and damage to asset values, then the ECB has done what it needed to do.
If, however, the goal is to enable markets to reassess risks and asset prices, given the biggest economic contraction in decades, then the ECB’s actions make a reassessment difficult if not impossible.
Because of the ECB’s interventions, struggling or insolvent companies will survive, leading to a zombification of the European economy. In the same way, the ECB will also allow countries to increase debt to levels which are not sustainable – and certainly unsustainable should interest rates ever return to more normal, positive levels.
It is the macro-economic equivalent of trading on while insolvent. All these interventions are papering over the cracks in the European economy, but they are not solving them. They are putting the crisis on hold and only delay the inevitable, which is a painful readjustment of the eurozone. Perhaps it would be more honest to allow this to happen rather than to adjust more central banking tranquillizers to a terminally ill patient.
For the ECB’s Schnabel, however, the bank is doing the right thing: “Without the PEPP, we would probably have found ourselves by now in the middle of a severe financial crisis with unforeseeable consequences for the economy, employment and price and wage developments in the euro area,” she said.
“Through the stabilising effect of our measures, the current course of the ECB’s monetary policy has decisively contributed to effectively preventing the fragmentation of the euro area, alleviating the financial consequences of the crisis and, by doing so, preserving jobs and investment.”
From her perspective, this conclusion must sensibly satisfy the Constitutional Court’s demands.
Yet for the long-term future of the European economy, it may still turn out to be a disastrous policy choice.