The European Central Bank

In short:

Considerations about the European Central Bank (ECB) provoke firstly some basic questions: Why is money needed in our economic system? What does a bank do? What’s the role of a central bank? What about the tasks, the structure, the particular challenges of the European Central Bank? How to balance the different economies in the North, South, Centre and West of Europe in ONE monetary union? Does the ECB policy reflect diverse macroeconomic theories / „ideologies“? What about the political influence taken on ECB decision-makers? Or is the ECB politically independent? Which are controversial points regarding the current crisis of the Euro zone and the whole financal sector? Is „quantitative easing“ the right answer to the problems? And what does it mean? Why and how creates the ECB money? Why and how produce private banks money, too?

Money is a mystery. In simple words, it is an equivalent amount of a product. It shows its value, but in a quantitative dimension, as a number. In terms of an economy as a whole, money represents the value of all the goods produced in a monetary area.

Life means moving, life is dynamic. For that reason, money is a matter of time, of future. If an entrepreneur aims to produce goods or/and services, he or she needs to buy some products (a hairdresser scissors, a dentist burrs, etc). It is therefore necessary to borrow money for starting a business and / or creating innovations. Thus, money allows to take out a loan in order to make investments. It is not only something which indicates a „have“, even loans and debts are money.

A bank was thought as a „medium“ between a lender and a borrower. It is not necessary that both meet each other directly like perhaps in medivial times. A bank provides the possiblity to place funds on one side and to lend money on the other. That makes the „money flow“ much easier. But a direct connection between saving and lending does not exist anymore. A private bank creates money when awarding a loan. The security to get this money „back“ depends on the creditworthiness of the borrower and is not linked to the bank’s deposits. Private banks are therefore often called „credit institutes“.

A central bank acts as „bank of the banks“. It has the monopoly of issuing the legal tender in a currency area. With its power to organise, manage and regulate the whole money supply it guarantees the value of a currency and therefore its acceptance. The countervalue of money is not gold anymore, its the confidence that for example a sheet of paper representing 50 € is accepted as a value paper or so-called bond which corresponds to this value of 50 €. Money is therefore not only private, it is a public good.

What was the idea of the ECB? See aspects of its history produced by the ECB from April 2014. (The recent crises is not mentioned.)

The overall aim of a central bank is to make economy running (and growing) from its money point of view. To do so, the total money supply has to be controlled and regulated to arrange that the amount of money corresponds to the value of all goods existing in a monetary area. That’s the task of the ECB, too. More concrete, it should prevent both inflation and deflation / economic crisis. Referring to the last, it stimulates investments by for example reducing the key interest rates. This point is controversial. It shows a conflict of aims between the intention a) to ensure price stability and b) to boost growth and thus employment. (The mission of the ECB and of the Federal Reserve/Fed in the USA differs in this regard. While the ECB has to focus on price stability only, the Fed seeks to achieve both objectives.) However, the ECB like other central banks is facing a problem raised by the financial sector (banks, shadow banks, pension funds, investment funds, corporates with banking function, etc.). The volume of money circulating all over the world is several times higher than the world’s growth domestic product / GDP. (Exact statistical data do not exist.) The financial sphere generates its own dynamics, it seems to be a reality for its own sake. But nevertheless, there are links to the so-called real economy at the same time. The ECB has to take it into account when its representatives decide on and implement the EU monetary policy. Moreover, since November 2014 a European banking union was established with a) a Single Supervisory Mechanism to invigilate big banks in the euro zone and b) a Single Resolution Mechanism for the case that a big bank is going bankruptcy.

What about the instruments of the ECB to maintain price stability?

a) managing the key interest rates by increasing or lowering them,

b) open market operations (purchase or selling of bonds from private banks),

c) exchange market intervention to influence currence exchange rates (for example between Euro and Dollar),

d) reserve requirements,

e) permanent facilities.

All instruments are intended to regulate the total supply of money. It can be expanded to combat unemployment in a recession by lowering the key interest rates. This is motivated by the hope to stimulate banks giving loans for investments. It can be reduced in order to prevent economy’s „overheating“, to avoid inflation and thus to save asset values.

ECB decisions of either an expansionary or a contradictionary monetary policy have to be done with regard to the differences of the European economies. The euro covers both boosting and shrinking economies in the same monetary area. For example, acting against recession in the Southern countries by lowering the interest rates may raise difficulties in the Northern ones. Otherwise, high interest rates might control the boom and ensure stability of private assets, but reinforce the economic slowdown at the same time. The ECB decision makers can only voter for the less damaging option.

In case of crisis, the ECB may act as a „lender of last resort“. If there is a lack of liquidity (due to bank runs, a thread of state bankruptsy or others) the ECB can provide additional central bank money. It has this „last authority“ as the ECB holds the monopoly to issue the legal money in the euro zone. It therefore can never become insolvent.

Example: In 2012, the ECB president Mario Draghi announced to purchase government bonds of countries facing difficulties, if necessary.

The ECB is located in Frankfurt / Germany. It holds basic capital of 5 billion Euro and currency reserves in a countervalue of 50 billion Euro.

The decision-making bodies are the Governing Council with its president Mario Draghi, the Executive Board and the General Council.

The ECB is part of the European System of Central Banks (ESCB) which is composed of the national central banks of all 28 EU member states and the ECB.

It is also member of the Bank for International Settlement (in French: Banque des règlements internationaux, in German: Bank für internationalen Zahlungsausgleich) which is called the „Central bank of the central banks“ based in Basel/Switzerland.

The ECB under discussion

The role of the ECB and its money policy are often a matter of argument.

Raised by the current crises of the financial sector and the euro zone with the results of high state deficits in some member states, the ECB has been criticised for expanding the money supply by lowering the key interest rates („quantitative easing“). Banks would have not increased their loaning and low key interest rates could only help the Southern states of Europe, it is said. More fundamentally, creating money by a central bank were a „never ending story“ and has the general risk of devaluating the currency. The real anchor value of financial assets would therefore be weaker and weaker. Another point deals with the idea of direct purchases of government bonds by the ECB. It would be much cheaper and easier for states in (debts) crisis to take a loan directly by the central bank. At the moment, private banks get money from the ECB for low interest rates (prices), but „sell“ money by purchasing government bonds to the states with much higher interest rates. In doing so, it has been argued that banks gain profit from the misery of societies including the tax payers. This perspective meets another crucial point of the ECB’s mission: the independence. A central bank shall not act as a direct money provider like for a king/queen in former times. It has to work independently of political influence including the power relations between all member states. However, there are different „schools“ or approaches in macroeconomic theory which shape decision makers’ opinion. And the approaches are linked with political preferences – nobody is neutral…

Last, but not least the ECB is part of a context. Critical voices claim for more transparency of the whole banking sector. A huge amount of bad loans shall exist. Is Europe prepared for the case of a new crisis? Moreover, labour unit costs which deeply correspond with prices and thus interest rates have been drifted apart significantly. The Southern countries like Spain and Greece had too high labour unit costs (wages), those of Germany too low (see the graph). Combating these economic imbalances in Europe would require a coordinated fiscal policy in Europe – which leads to question, what kind of Europe and how much Europe do we want?

Sources

+Bank for International Settlements, https://en.wikipedia.org/wiki/Bank_for_International_Settlements

+European Central Bank, http://www.ecb.europa.eu/home/html/index.en.html

+Illing, Gerhard / König, Philip, The European Central Bank as Lender of Last Resort, DIW Economic Bulletin 9.2014, http://www.diw.de/documents/publikationen/73/diw_01.c.488640.de/diw_econ_bull_2014-09-3.pdf

+Scheller, Hanspeter, The European Central Bank. History, Role and Function. European Central Bank, Frankfurt 2004. http://www.ecb.europa.eu/pub/pdf/other/ecbhistoryrolefunctions2004en.pdf

+Spiecker, Friederike, How should better governance of the EMU look like? Part I and II, 27th March 2015, http://www.flassbeck-economics.de/how-should-better-governance-of-the-emu-look-like-part-i-and-ii/?output=pdf

Films

Joost, Hans-Jörg, Was ist die EZB?

Müller, Alexander, Geldpolitische Instrumente der EZB

Geldschöpfung – Giralgeld (in German)

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