Posted by: Dirk | April 12, 2011

The ECB moves to end the ‘shell game’

Axel Leijonhufvud has called the transfer of wealth from savers to banks via market interest rates that are below natural rates a shell game. While savers collect meagre interest rates from their banks, these get a free lunch by investing in abundant government bonds from (supposedly) risk-free lenders. The spread is theirs to keep.

From this perspective the recent hike of the ECB’s interest rate is to be applauded. It is a small step, and I believe the forecast for the end of the year is 1.75%, but it is a start. However, this use of monetary policy might result in a shift of monetary problems into the fiscal dimension. As almost everybody agrees with, the investment binge in Spain and Ireland – among others – was caused by too low real interest rates, among other things. The inflows of foreign money led to a rise of the price level in those economies, pushing the real rate down. Now that the investment that turned sour – mostly housing – has been moved into the public sector by guaranteeing for all national banks, there is a fiscal problem resulting from misguided monetary policy.

You might get the impression that the ECB accidentally hit an economy in the stomach, and is now tip-toeing away to return to business as usual. However, this characterization would be unfair. The ECB has provided and promised to continue to provide credit to those countries in troubles. I wonder though, whether the fact that monetary policy can create fiscal problems has led to a change in thinking about economic policy at the ECB and at the European Commission, which would/should/could lead the effort to renegotiate the repayment of European sovereign debt.

I think that the ECB, while letting savers slowly of the hook, shifts the burden towards taxpayers, which would be the party responsible for paying any bill arising from the fallout of possible haircuts on sovereign debt. The ball would be back in the political field, which will prove difficult for politicians who have always argued that there are no costs to the tax payers. Countries like Ireland and Spain have no fiscal and no monetary policy at hand to deal with their respective economic crises. Renegotiating the repayment of sovereign debt seems like the only option they have when people start to voice their unhappiness with the current situation.

This is far from over.

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