Criticism of the ECB is in vogue – especially as the monetary perpetual motion machine in Europe has started moving increasingly quickly, and the rationale behind government bond purchases has attracted growing criticism from academics and professionals alike. If a government does not repay its debts, the towers of banking start to topple around the world. When banks start rocking, politicians actively seek to rescue them, which can jeopardise the solvency of the state itself. A classic vicious circle? Are risks still correctly priced? Where do future systemic risks lie? Were fundamental mistakes made in the introduction of the Euro? We discussed these and related issues with Jürgen Stark, Chief Economist and member of the Directorate at the European Central Bank (ECB) from 2006 to 2012.
You played a significant role in the introduction of the Euro. Did the architects of the Euro system make significant mistakes, or did they fail to pay enough attention to compliance with the rules? What would you do differently today as an architect of the Euro?
Jürgen Stark: I don't want to talk about "mistakes" here, as European integration has always been and remains an open process. What was and is flawed is the implementation and enforcement of the inherently consistent and stringent Maastricht concept of economic and currency union, which is based on certain principles and rules. This began with how the so-called convergence criteria, which member states had to meet to qualify for the currency union, were actually applied. The introduction of the Euro was ultimately a political decision. So it started with countries for which a single currency was too demanding and where the Euro was introduced too early. The addition of subsequent members also tended to be based on political reasons and was too early. Afterwards there was a technical and bureaucratic insistence on compliance with the rules, but this was not matched politically. Specifically, this means that the Maastricht concept has never been fully implemented. However, it was known that the economic and currency union was not supplemented and underpinned by a political union.
The Maastricht Treaty should have been supplemented by the Treaty of Amsterdam on this issue. But there was no support for the German demands. Then, as now, there is a lack of political will for more far-reaching integration. As things stand today, it would require stronger political integration, starting the currency union with only a "hard core" of members and, if this were not possible, the addition of insolvency regulations for states.
In a 2012 interview, you referred to the vicious circle that the ECB got into as a result of crisis management and state financing. Has the ECB now managed to escape from this vicious circle? Or is the opposite true?
Jürgen Stark: The ECB has been the critical crisis manager in the Euro zone since 2010. Back then, it began buying government bonds from certain Euro member states and by doing this turned itself into a lender of last resort for states. It now plays an even more active role and has become an important political player that governments and the financial markets fully include in their calculations. An escape from this role is extremely difficult to devise and manage.
What are the aims of the ECB's quantitative easing programme? Do you believe that these aims have been achieved?
Jürgen Stark: For around a year the ECB has been pursuing quantitative easing (QE) in monetary policy, after the base rate reached the nominal zero line. The balance sheet in the Euro system is to be expanded from 60 billion to 4,500 billion by March 2017 through monthly purchases of government bonds, ABSs and other bonds. The ECB council hopes that this will bring the currently very low inflation rate – which I call price stability – towards two percent to counter any deflationary risks. It is also intended to fix inflation expectations at a level corresponding to the ECB definition of price stability. The very low inflation rate is primarily due to the collapse in the oil price. The aim is to promote lending and nominal economic growth. The ECB believes that the expected effects are taking place. I would call this into question.
First of all, the ECB has a very narrow definition of "price stability" as a point target and is pushing the boundaries of its mandate. From a current perspective, there is absolutely no risk of deflation in the sense of a self-sustaining downward spiral in the price level. In terms of the effects, it is important to state that an improvement in credit conditions and lending was already apparent before these operations began. The ECB quantifies the growth effects of QE from 2015 to 2017 at a total of one percentage point. This is hardly a staggering effect when we set it against the dramatic expansion of the balance sheet. Effects had already been recorded in share prices and the Euro exchange rate, but these have now been overlaid with other effects. What the ECB totally hides are the unintentional medium to longer-term consequences of its policy.
Is the ECB going beyond its mandate to reach these objectives?
Jürgen Stark: Yes. For me that is clear. The ECB claims to be acting within the framework of its mandate, but in reality it is engaging in economic and fiscal policy. One effect is that the returns on government bonds from highly-indebted Euro countries are negative in some cases in the short to medium-term range. The risk premiums are approaching zero, giving completely false signals to the responsible politicians.
Can a sluggish economy be stimulated with a lax monetary policy?
Jürgen Stark: The ECB's policy has reassured financial markets in the short term. They have "bought themselves some time" so that governments can do their homework and tackle the true causes of economic weakness. These are structural in nature. But at the same time the ECB is suggesting that it can contribute to solving the problem. It is overestimating and overextending itself. A central bank cannot enforce productivity, its policy is not a substitute for consolidation of public finances and debt reduction (deleveraging), and it is not responsible for clearing bank and company balance sheets of bad loans. These are all a matter for governments and parliaments.
Jens Weidmann never grows tired of saying that the ECB becomes a "prisoner of politics" when it buys government bonds. Do you agree?
Jürgen Stark: The ECB is a prisoner both of its own policy and of politics per se. The mutual dependencies of the central bank, governments and financial markets have become so well-defined that a withdrawal from ECB operations in the foreseeable future is impossible unless you want to provoke a new crisis. The Federal Reserve's experience with withdrawal from QE3 and the reactions to the announcement of a first interest rise for a long time should give food for thought.
Do you think there is a moral hazard risk, in other words are potential risks in the Euro zone socialised?
Jürgen Stark: Moral hazard is omnipresent whenever governments or central banks intervene in the market. It is always a question of degree. The huge volume of government bonds bought by the ECB has put a brake on the pace of reforms in many countries. It has led to incentives to actually increase state debt. Without the ECB's interventions, and the market distortions they have caused, some countries would be close to insolvency again. The political guarantee to keep all current Euro member states in the single currency ultimately means that other member states are liable for the risks taken, which leads to more financial transfers.
For a long time, this has been nothing to do with the Maastricht concept, which included a "no bail-out clause" to make member states individually responsible for their government finances.
What side-effects and unintended consequences do you think a zero interest policy and liquidity glut has on the markets?
Jürgen Stark: During my time as a member of the ECB Directorate and council, I was constantly bothering my colleagues with the delayed consequences of an excessively long period of low interest rates and abundant liquidity. For several years, the Bank for International Settlements in Basel has also been warning of "unintended consequences". In view of the new "mainstream central banking", I think this is very brave of them. With zero interest, the interest rate loses its indicator and control function as one of the key relative prices in an economy. Risks are no longer priced correctly. This results in market distorting effects and misallocation of resources. The hunt for returns is in full swing, which increases the risk of new market exaggeration and crisis. The behaviour of market participants changes, including their saving and precautionary behaviour, and traditional business models are called into question. Deleveraging and structural adaptations are delayed. "Zombie" banks and companies remain in the market and dampen any gains in productivity. And we must not forget the regional and international spillover effects on non-Euro countries and emerging nations.
In recent months, the Euro zone has been the darling of the capital markets. Is the Euro still in crisis mode?
Jürgen Stark: The crisis in the Euro zone is a long way from being overcome. This would only be the case if the ECB had returned to the path of normality. Many of the unresolved problems are currently being overlaid by other phenomena, such as the significant growth in geopolitical uncertainty, the collapse of the oil price and the economic problems in China. Europe's problems have not diminished either – on the contrary. The wave of refugees, the widespread enmity to reform, the anti-European mood that is apparent in some countries from the results of recent elections, and the possible exit of the United Kingdom from the EU are just a few examples.
Do the new powers and the addition of new tasks (see bank supervision) lead to conflicts of goals and interests? Has the ECB's self-perception in terms of crisis management changed?
Jürgen Stark: Both governments and the financial markets were expecting the ECB to take on a more active role. And it has indeed done so. In crisis management, it saw itself as the only realistic European federal institution with the necessary flexibility, rapid decision-making processes and – critically – unlimited financial resources. This role brought with it additional functions, such as bank supervision and shared responsibility for financial stability. This inevitably leads to conflicts of objectives and interests, particularly as the ECB council is the final decision-making authority on bank supervision issues and monetary policy. It is to be expected that these conflicts will be resolved at the expense of price stability.
What proposals would you submit to the ECB to reform itself?
Jürgen Stark: A return to its core mandate. Our paper money system – the "Fiat money" regime – requires the public to have complete trust in the central bank as a guardian of the currency and to keep the value of money stable. This is a huge and extremely responsible task. The ECB needs to move away from its current role in state financing. There need to be new treaty provisions to transfer bank supervision to a separate, newly established institution. A central bank can essentially only have a limited impact with the instruments available to it. Any expectations beyond this overburden it.
Taking a historical view, flooding of money markets inevitably leads to exaggerations. Do you see the signs of a new crisis on the horizon?
Jürgen Stark: There have been and still are exaggerations in some asset prices, for example property and government bonds. For shares, we have now experienced a correction process. Markets will remain nervous and volatile. This is partly due to geopolitical reasons, but is also driven by the monetary policy differences between the large Western central banks. I would not rule out sudden market corrections. These can quickly escalate into a new crisis. And how will central banks respond then?
What is your assessment of the recent interest rate decisions by the Fed?
Jürgen Stark: It was a step that was overdue. But the Fed has delayed for a long time because it was not certain of the reaction of financial markets and wanted to avoid friction. It was also being warned by the IMF and academics about taking this step now. It is therefore moving very gradually away from the zero line, but there is still a long way to go to get back to "normality".
You appear as a speaker in front of different audiences – for example undergraduate and PhD students at Munich Technical University in November 2015. What drives you to keep the issue of monetary policy to the forefront of public perception?
Jürgen Stark: It involves issues that are relevant to the public and that exercise them. Nevertheless, there is no historical experience of the consequences of such a long period of low interest and liquidity glut. People certainly feel that something completely unusual is going on. Their concerns will keep increasing, particularly those who are more risk-averse, and their doubts about whether they can still trust the central bank will grow. A key aspect is how the ECB has gone beyond the restrictions of the Maastricht Treaty and moved away from the German Bundesbank model that it was initially based on.
[The interview was conducted by Prof. Matthias Scherer / TU Munich and Frank Romeike / editor in chief of RISK MANAGER and FIRM board member]
Jürgen Stark was Chief Economist and a member of the Directorate at the European Central Bank (ECB) from 2006 to 2012. From September 1998 he was Vice-President of the German Bundesbank. On 1st May 2002, Jürgen Stark joined the board of the German Bundesbank with responsibility for international relations and auditing. Between 1993 and 1994 Jürgen Stark was the head of International Currency and Financial Relations & European Community Financial Relationships at the German Ministry of Finance. From 1995 to 1998 he was Secretary of State in the German Ministry of Finance, where he played a key role in the introduction of the Euro.
Between 1968 and 1973, Jürgen Stark studied economics at the University of Hohenheim and Eberhard Karls University in Tübingen. He gained his doctorate in economics in 1975.