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BY DR. JIM LEONTIADES
Cyprus International Institute of Management
Mario Draghi, the new president of the European Central Bank (ECB) is the soft spoken type of Italian. His low profile and relaxed demeanor can be deceptive. On taking over the leadership of the ECB he quickly delivered two very controversial decisions. He lowered the central banks’ interest rate and embarked on a controversial loan programme, giving cheap (1% interest ) three year loans to European banks.
Draghi’s cheap loans totaling over one trillion euros saved the Eurozone banks from a damaging liquidity crunch and introduced a breath of fresh air into financial markets, They also brought down the interest rates for the sovereign bonds of Spain and Italy. Prior to the Draghi measures these were at crisis levels and heading higher. These loans were probably the single most effective decision in bringing a period of relative calm to the Eurozone financial markets.
It soon became obvious Signor Draghi’s low interest loans to banks were a form of “quantitative easing”, not different in principle to the QE introduced earlier by Ben Bernanke of the US Federal Reserve. Both central bank leaders studied economics at the Massachusetts Institute of Technology (MIT) at about the same time. Both have run into considerable opposition regarding their policies, particularly quantitative easing.
Creating Money
QE occurs when the central bank uses its power of “creating money” to purchase bonds and other financial assets from banks. This injects new money into the economy, providing liquidity to banks and acting to lower interest rates.
In the U.S., Bernanke did this by using central bank funds to buy bonds from commercial banks. Draghi’s quantitative easing, sometime referred to as “quantitative easing by stealth”, was a variant on this. He loaned ECB money to banks against collateral (including mortgages, etc.) for a three year period. Both versions inject new money into the economy.
The practice is one widely condemned by many. In the USA, leaders within the Republican party have asked for Bernanke’s resignation. In Germany, the policy has been fiercely opposed by many of the country’s leading economists. Those opposed to Draghi’s “new money” policies reads like a “who’s who” of German economists, including at least three members either currently or previously on the ECB’s decision making Council (Juergen Stark who resigned from ECB council in protest, Alex Weber former ECB Council member, Jen Weidmann, president of Bundesbank). The German tabloid “Bild”, warned that the Euro risked becoming a “spaghetti currency”.
A Difference in Central Bank Roles
The main priority of the ECB since its inception has been the maintenance of price stability. The above austerity school economists are all staunch supporters of this aim and the more passive role it implies for the ECB. They are wary of the possible inflation risk posed by quantitative easing. Their policy prescriptions for the Eurozone countries currently in financial difficulty (Spain, Greece, Italy, Ireland, Portugal and, yes, Cyprus) focus on “fiscal consolidation”, i.e. reducing government debt by elimination of excessive government spending and increased taxes.
Both Bernanke and Draghi recognise that there is a risk of inflation associated with the injection of such new money but they believe that (a) they can control it and (b) the risk is one which is acceptable in a recession such as that which has recently afflicted the American economy and which characterises many Eurozone countries today. The austerity school disagrees.
Who is right?
Who is right? There is an ambivalence and uncertainty at the moment within the Eurozone on how far to support Draghi and his more proactive interpretation of the role of the ECB. As in most such economic disagreements, a clear answer will prove elusive. It is generally recognised that the infusion of funds by Draghi’s loans to European banks helped them at a time when they desperately needed it. While many of the policies of the austerity school are undoubtedly constructive and even necessary over the long term, the danger is that in the more immediate years the medicine may kill the patient. This too is a risk.
Decision on which policy to support may come sooner than we think. There are signs that the opposition within the ECB to Draghi’s policies is gathering strength. Jens Weidmann, a member of the ECB council and charter member of the austerity school, has given voice to his doubts concerning the side effects (inflation) of Draghi’s policies. As reported in the Financial Times, he has indicated that risks taken by the ECB in helping Eurozone banks should be under “continuous review”. He suggests thought should be given to an “exit strategy”.
All this comes at a time when economic recession and unemployment in the peripheral Eurozone countries seems to be getting worse with no improvement in sight. Interest rates, crucial to any growth and economic recovery, are once again rising, not least in Cyprus.
