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Monetary policy isn’t a panacea

Published in Business Spectator (Melbourne), 24 March 2016

Who is the most important politician in Europe? If you think it was Germany’s Angela Merkel, Britain’s David Cameron or even Russia’s Vladimir Putin you might have good arguments on your side.

Unfortunately, you would still be wrong.

Europe’s most important politician is not a politician at all. In fact, the person in question never stood for election. And yet, whatever decisions he makes have a direct impact on entire European countries, businesses, and peoples.

Of course I am talking about Mario Draghi, the President of the European Central Bank.

The financial, fiscal, monetary and economic crisis that has been raging in Europe for the past eight years has elevated the position of its top central bankers. Where political institutions could no longer find answers to the challenges facing the continent, it was left to central bankers to clear out the mess.

There was no coup d’état of central bankers against elected representatives. The gradual shift of power from politics towards the ECB happened because the bank remained the only institution powerful enough to deal with the challenges. That it did not have to ask anyone for permission certainly helped. That it did not have to stand for re-election, did as well.

Thus over the course of the past years, monetary policy has taken over the role previously exercised by politicians. A banking system is struggling? Call in the ECB. A country is on the verge of default? Call in the ECB. The euro is under attack? Call in the ECB.

Because governments have proven so powerless, the ECB readily filled the power vacuum. It delivered when politicians could not.

But after all these years of growing central bank power, it is probably time to question whether this is how Europe should be run in the future. Sadly, even asking this important question now falls to a central banker.

In an interview with the newspapers of the Funke media group, Bundesbank President Jens Weidmann was his usual critical self.

The conflicts between Weidmann and Draghi are legend, with a clear allocation of roles: Weidmann as the orthodox defender of hawkish, hard currency values; Draghi as the embodiment of anything-goes, whatever-it-takes central bank activism. Weidmann’s latest interview did not disappoint in that respect since it delivered more broadsides against the ECB.

What Weidmann also did, was to put a big question mark over the role of central banks more generally. For example, he said: “I’ve stressed time and again that the longer the ultra-accommodative monetary policy is left in place, the more ineffective it becomes. And it’s also worth noting that the more you put the pedal to the metal, the more serious the risks and side-effects you face.”

When asked what he meant by that, Weidmann replied: “It is obvious that financial stability, say, is more at risk — bubbles can emerge in financial markets which, if they burst, can make life more difficult for central banks. Life insurers are also being pushed into choppier waters. Plus there’s a greater risk of the incentives for sound budgeting being undermined and of the central bank being misused for political purposes. Nor should we allow the non-standard policy measures to breed public uncertainty, since this could run counter to monetary policy objectives.”

Translated into plain English, Weidmann’s worries are clear: He believes that the emergency measures taken by central banks are not just dangerous in themselves. They are also invading into the territory of government policy. He sees the problem of central banks making decisions so that governments do not have to.

Later in the same interview, Weidmann gets even clearer: “Monetary policy isn’t a panacea — it can’t replace urgently needed reforms in individual countries, nor can it solve Europe’s growth problems. That would simply be too much of a tall order, and it would most certainly end in tears.”

Yes, sure, the head of the Bundesbank would say that, wouldn’t he? But does that make it wrong? Hardly.

What Weidmann points out, in very simple language, is an economic truism: Monetary policy can certainly help an economy recover in the short term. But it will never replace sound economic policy in the long term.

That stating such truisms also implies an attack on Weidmann’s nemesis Mario Draghi does not invalidate his claim. Because Weidmann is right.

What Europe needs more than anything else is a return to growth. Industrial production in Italy, Spain and France is still miles behind its pre-crisis levels. Unemployment is also well above anything one would expect to see in ordinary times.

Central bankers like Draghi may take credit for the fact that, despite the circumstances, no cataclysmic crisis has yet set in. Fair enough. But that is not the same as resolving the underlying crises.

Draghi and his central banking colleagues have effectively administered painkillers without curing the disease. How ironic that it is a central banker like Weidmann who is pointing this out?

The reliance of Europe’s political elites on the ECB is dangerous. So far, the ECB has willingly obliged to do what was in the interest of governments. But in doing so, it has reduced the urgency of structural reforms in many European countries. It has also prevented a necessary restructuring of the financial sector. Finally, it has allowed bubbles to grow on the back of its emergency measures.

Weidmann is correct in pointing out these central bank transgressions. It is indeed good to remind politicians that it is them, not central banks, that have been elected to make economic policy decisions. It was wrong all these years to hide behind the ECB and wait for the crisis to pass.

With every year that this crisis drags on, it becomes more obvious that the ECB cannot solve Europe’s problems. It can only put them on hold.

As Weidmann’s interview makes clear, central banking may be potent in the short term. But it cannot address the underlying causes of Europe’s malaise. It really is no panacea.

Europe’s economic crisis will only be over when the ECB President’s power no longer eclipses that of the continent’s elected leaders.

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