Zugzwang Central Bank (ECB edition)
Daniela Gabor is Professor of Economics and Macrofinance at UWE Bristol.
Zugzwang is the German word for a situation in chess (and in life) in which a move must be made, but every possible move will make the situation worse. It also perfectly reflects the difficult situation facing central banks in Europe.
Take the ECB, the emblem of the central bank zugzwang. He has four possible moves: Raise Rates, QT, Maintain Rates, and Admit Regime Defeat.
Rising interest rates, as most expect on Thursday (and by 75 basis points), may appease uberhawks in Frankfurt and elsewhere, but it’s a calculated gamble to inflict pain – weaker growth and higher unemployment – to quote Isabel Schnabel.
The ECB claims to act with “determination”, a curious choice of words to describe a rudderless central bank which openly admits, just a year after its Strategic reviewthat the only element of its inflation targeting models that it continues to trust is the expectation fairy, now recast as financial literacy people whose higher inflation expectations won’t subside even when inflation starts to ease because they remember being let down by a dovish ECB.
It may be the diplomatic code name of the (German) monetarists, who seem to have finally succeeded in bullying the ECB into administering the medicine for an overheating economy to eurozone countries already reeling from the shocks of the (chain) supply shocks, a dysfunctional energy market and falling real wages.
Quantitative tightening is also in order, under political pressure from monetarists and other uberhawks. Keen on passing correlation for causation, their reasoning is that the ECB must undo its pandemic-era support for eurozone sovereigns that has “bloated” its balance sheet and stoked concerns about fiscal dominance. But this is financially illiterate.
The premature reduction of the ECB’s sovereign bond portfolio is a bad decision, for two reasons.
First, the macro-financial architecture of the euro area is anchored on amplify volatility of sovereign spreads to the German Bund, via the €9bn repo market. This wholesale money market provides the plumbing for the creation of private credit, both on bank balance sheets and through securities markets.
It was designed – by the ECB and the European Commission – to rely primarily on eurozone sovereign bonds as pension collateral. By making European states a guarantee factory for private finance, the founding fathers did not take into account the implications for the financial stability of the ECB. Yet we know from the Eurozone sovereign debt crisis that the valuation of repo collateral means cyclical liquidity in the Eurozone sovereign market except for Germany, threatening liquidity spirals that only the BCE can prevent.
Liquidity spirals, it should be remembered, are not just bad for eurozone governments, but also for the private institutions that use these bonds as collateral. It is this macro-financial role of sovereign bonds that connects Mario Draghi’s “whatever the cost” discourse, that of Lagarde closing comments and the Transmission protection instrument. The ECB cannot wish this in a context of high inflation and risks triggering serious disruptions in the repo market by panicking towards “quantitative tightening”.
Second, panic-QT would also put pressure on sovereign markets which have already tightened monetary conditions. Italy’s 10-year yield is now hovering around 4%, a 2 percentage point spread against the German Bund, at a time when eurozone countries need aggressive fiscal and structural to contain the possibility of future persistent supply shocks.
Keeping rates fixed may be the right technocratic choice, but it comes with institutional costs that the ECB is no longer prepared to bear. Over the past year, the ECB has made this choice several times, in the hope that the supply shocks that it cannot control would dissipate and that inflation would once again behave as predicted by its models. Putin’s invasion of Ukraine, coupled with the reluctance of European governments to act decisively with energy price caps, has made the ECB a convenient scapegoat.
The scapegoat invariably turns dovish central bankers into hawks, especially when their peers elsewhere act as obedient vassals to dollar hegemony. Indeed, monetary historians will marvel at this brief period when European politicians so believed in the potential of the euro to topple the US dollar that they appointed Jean-Claude Trichet as head of the ECB. He pioneered the combination of policies that uberhawks are now advocating: a hike in a crisis and reduce macro-financial support for sovereign guarantees.
With this illusion behind us and the Euro below parity, the ECB is just another central bank trapped in the global dollar financial cycle, plagued by easy comparisons with other central banks’ interest rates.
The fourth move – asking whether inflation targeting has run its course – has even higher institutional costs. What if Zugzwang was that final stage of a central banking paradigm, when it implodes under the contradictions of its class politics? Under financial capitalism great cycle Over the past few decades, inflation-targeting central banks have been outposts of (financial) capital in the state, guardians of a distributive status quo that has destroyed the collective power of working people while creating security for the shadow banking system.
The limits of this institutional arrangement which concentrates (pricing) power and profit in (a few) corporate hands are now evident. If the climate and geopolitics of 2022 are omens of Isabel Schnabel High volatility that most central banks and experts expect in the near future, then macro-financial stability requires a new coordination framework between central banks and treasuries that can support a state that is more willing and able to discipline capital.
But such a framework would threaten the privileged position that central banks have had in the macro-financial architecture and in our macroeconomic models.
Central banking history teaches us that policy paradigms die when they cannot provide a useful framework for stabilizing macroeconomic conditions, but never in the hands of central bankers themselves.