Updated: Mar 7, 2019
The European Central Bank should take into account the distributive effects of its monetary policy - at least when this policy results in a large increase in the bank’s balance sheet, as is the case with quantitative easing (i.e. the wholesale buying up of government bonds to boost liquidity).
Peter Dietsch argues that the European Central Bank’s (ECB) monetary policy of ultra-low interest rates and high levels of liquidity exacerbates inequalities in income and wealth. This is reason enough for the ECB’s mandate to be supplemented by a mandate to address inequalities.
“The recent economic recovery [in the eurozone] has improved real average incomes, but more rapid growth of top incomes and weaker improvement at the bottom meant that overall income inequality did not reduce.” So says the Organisation for Economic Co-operation and Development (OECD) in its 2017 report on “The Social Divide in Europe”. With respect to wealth, the gap is widening even more rapidly. How come the privileged benefit more from the recovery? Several causes are at work here, but the policies of the European Central Bank (ECB) stand out as one important factor. I shall argue that the ECB both should and could pursue a less inegalitarian monetary policy.
In the wake of the 2008 crisis, lowering interest rates was not enough to revive credit markets. When interest rates hit zero percent, central banks introduced new measures. In the case of the ECB, this “unconventional monetary policy” came in two stages. First, in 2011, the ECB started its so-called Long-Term Refinancing Operations (LTROs). Under this programme, commercial banks had access to credit for up to three years at an interest rate of only one percent. Second, in 2015, and thus a few years later than its UK and US counterparts, the ECB launched what is called quantitative easing (QE). This amounts to buying up financial assets, such as government or corporate bonds, held by banks or other financial firms. Both LTROs and QE were intended and indeed worked to inject substantial amounts of liquidity into the economy in order to avoid a crippling credit crunch. For example, between March 2015 and March 2017, the ECB bought between 60 and 80 billion euros’ worth of assets per month under its QE programme. In one sense, those unconventional measures were a success: They were certainly better than doing nothing, which would likely have resulted in a collapse of the financial system, bringing the real economy to a disastrous standstill.
However, the medicine the ECB prescribed came with serious and quite foreseeable side-effects. In particular, the liquidity injected ended up widening economic inequalities. Now, how do you react when your doctor prescribes you a drug with foreseeable, serious side-effects? Before taking the drug, you urge her to make sure that there are no policy alternatives available that offer a better balance of achieving objectives while avoiding negative side-effects.
I urge the ECB to do the same. Central banks, including the ECB, should take into account the effects on the distribution of income and wealth when making monetary policy. The standard line of response by central bank officials to such demands is that “to address rising inequalities or to steer the distribution of income […] is not the mandate of the ECB or of any modern central bank.” This is how ECB Executive Board member Benoît Coeuré expressed it in 2013. This response is perfectly correct given the current mandates of central banks. The question I raise, however, is whether central banks should be sensitive to distributive issues and how this could be done.
My argument proceeds in four steps. First, I will briefly explain how the post-crisis monetary policy of the ECB has exacerbated economic inequalities. Second, we will consider a menu of policy responses to this fact. Third, I shall defend one item on this menu, namely, the idea that the ECB’s mandate should include a certain level of sensitivity to distributive concerns. Finally, I will consider objections to this proposal raised in the Twelve Stars online debate.
The double-edged sword of expansive monetary policy
In the wake of the 2008 financial crisis, the ECB and other central banks injected substantial amounts of liquidity into the economy. In the immediate aftermath of the crisis, the primary goal of these policies was to revive credit markets; with time, the goal of stimulating the economy became more and more prominent.
The basic mechanism through which these policies have negative side-effects is the following: When you inject liquidity into the economy, economic agents will use this liquidity in one of two ways. Either they will invest it into productive activities, thus stimulating the economy (in this sense, QE “could” indeed lead to higher employment and less inequality, as one discussant in the online debate pointed out); or economic agents will use it to buy existing assets, which not only fails to stimulate the economy, but leads to asset price bubbles on stock markets, in real estate, and on other markets.
The evidence shows that the latter phenomenon was substantial. In the case of LTROs, the ECB even admitted that the programme did not achieve its declared aim of stimulating investment. When launching its third round of LTROs in June 2014, the ECB imposed conditions on commercial banks to pass on a certain share of the credit volume to productive activity precisely because the liquidity from the first two rounds of LTROs had by and large been used to buy existing assets. In its annual report for 2016, the ECB also acknowledges the significant wealth effects of its policies, and this assessment does not even take into account the impact of QE yet. Studies from other countries suggest that the distributive impact of QE is significant.
So, while one might at first sight think that the distributive effect of a low interest rate environment is to disadvantage savers (see objection raised in the online debate), once we take into account that wealthy people tend to hold their wealth not in cash, but in the form of assets, the dominant distributive effect of unconventional monetary policy has been to boost their wealth. During the years since the financial crisis, a period that has hardly been characterised by a booming economy, real estate and stock markets across the eurozone have shot up. To cite just one example, consider the rise of the German stock market index DAX from under 3,700 points in March 2009 to above 13,000 points in June 2018.
How to react to the distributive impact of monetary policy? If one accepts that, as a society, we should be concerned about rising inequality, and that monetary policy has inegalitarian side-effects, a menu of three basic types of response opens up.
First, one might think that the issue is more fundamental than the choice between different policy instruments. According to some observers, the fact that central banks, in order to implement monetary policy, have to rely on the cooperation of commercial banks to either expand or reduce credit of the right kind (namely, geared towards productive investment) represents the real source of the problem. Even at this more fundamental institutional level, alternatives do exist: A system of full reserve banking (see the proposal to separate money-creation from credit put forward in the online debate), for instance, would take away the capacity to create credit from commercial banks; they would be mere intermediaries between savers and investors. Even if there were a consensus that full reserve banking was desirable – which there is not – it represents such a radical departure from the status quo that it hardly seems feasible in the short term. Incidentally, a referendum for such a radical reform recently was rejected by the Swiss electorate.
Second, many observers, including central bankers, will point out that it is the job of fiscal policy, rather than monetary policy, to redistribute income and wealth. In other words, if monetary policy happens to boost inequalities in an unjust way, then governments should adopt a more progressive tax structure to correct for that. Two things need to be said in response to this argument. First, in the current context of capital mobility and tax competition, the ability of governments to react in this way is severely constrained. Second, even if that constraint could be overcome, economists rightly underscore the fact that redistribution always comes with inefficiencies attached because it changes the incentives of people. Therefore, it is more efficient to prevent inequalities from occurring in the first place rather than correct for them after the fact.
This leads us to the third response. What I propose is that the negative distributive side-effects of monetary policy be taken into account in monetary policymaking. This idea could be implemented at the institutional level in two different ways. One way would be to address the trade-offs between monetary and fiscal objectives through a bilateral coordination of the two policy areas in a joint committee of the treasuries of eurozone member countries and the ECB. The second option, defended here, is to modify the mandate of the ECB to make it sensitive to distributive issues.
Sensitivity to distributive concerns in practice At first sight, asking central banks to care about distribution might seem like a crazy idea. Given their capacity to print money, their power to reduce inequalities by printing money for the poor would be as unlimited as it would be destabilising for the inflation rate and potentially for the entire economy. Let me clarify right away: Turning the ECB into a modern-day Robin Hood is not the idea.
Instead of asking the ECB to use its powers to help >re<distribute income and wealth, the proposal here is more limited: When pursuing its aims of price stability and financial stability, the ECB should accord some weight to the foreseeable distributive side-effects of its policies and thus aim to avoid exacerbating inequalities further. Incorporating a sensitivity to distributive issues of this sort into the ECB’s mandate plausibly has three components. First, one needs to specify under which conditions the sensitivity should kick in. We need to define a threshold: When the distributive side-effects of an envisaged monetary policy intervention lie above a certain threshold, then the ECB should weigh the benefits of the policy in terms of price stability and financial stability against the costs in terms of distribution. One possible proxy for this threshold is the impact of the policy on the balance sheet of the ECB. For measures that significantly expand the ECB balance sheet – such as LTROs or QE – sensitivity to the distributive impact would be required. Second, one needs to specify how to deal with the trade-off between price and financial stability, on the one hand, and distributive concerns, on the other. To make a proposal as to the precise ponderation of these policy objectives would, however, go beyond the scope of this article. Let it suffice to say that central banks that manage to strike a balance between inflation targets and a general concern for growth can be reasonably expected to also have an eye on inequality if only they have a mandate to do so. Third, alternative policy instruments would have to be available to, and seriously considered by, the ECB. To name but one, the idea of “helicopter money” – that is, direct payouts to citizens in order to stimulate demand in times of crisis – should be given more serious consideration than was the case in the aftermath of the financial crisis.
Two objections Some will object that an independent body such as the ECB should not be given competences regarding distribution since it lacks political legitimacy (see the objection raised in the Twelve Stars online debate). In response, it should first be highlighted that the policies of this independent institution already have a profound distributive impact, as demonstrated above. Second, recall that my proposal is not to ask the ECB to make fiscal policy by proxy, but only to limit the inegalitarian consequences of its own policies.
Others might be worried that being sensitive to distributive issues will make for a less effective monetary policy. While it is in the nature of policy trade-offs that taking them seriously requires making compromises, there is no reason to think that sensitivity to distributive issues as such would undermine the traditional goals of monetary policy.
Further reading Fontan, Clément, François Claveau and Peter Dietsch. “Central banking and inequalities: Taking off the blinders.” Politics, Philosophy &Economics 15 (4): 319–357, 2016.
On 18 May 2018, Peter Dietsch defended his proposal in the Twelve Stars debate. The main objections are presented below. Rebuttals can be followed in the online debate.