You couldn’t inflate, even if you wanted to

By Warren Mosler

With the tools currently at their immediate disposal, including providing unlimited member bank liquidity, lowering the interbank rate, and buying euro national government debt, the ECB has no chance of causing any monetary inflation, no matter how hard it might try. There just are no known channels, direct or indirect, in theory or practice, that connect those policies to the real economy. (Note that this is not to say that removing bank liquidity and national government credit support wouldn’t be catastrophic. It’s a bit like engine oil. You need a gallon or two for the engine to run correctly, but further increasing the oil in the sump isn’t going to alter the engine’s performance.)

Lower rates sure don’t do the trick. Just look to Japan for going on two decades, the US going on 3 years, and the ECB’s low rate policies of recent years. There’s not a hint of monetary inflation/excess aggregate demand or inflationary currency weakness from low rates. If anything, it seems to me that the depressing effect on savers indicates low rates from the CB might even, ironically, promote deflation through the interest income channels, as the non government sector is necessarily a net receiver of interest income when the government is a net payer. (See Bernanke, Reinhart, and Sacks 2004 Fed paper on the fiscal effect of changes in interest rates.)

And if what’s called quantitative easing were inflationary, Japan would be hyperinflating by now, with the US not far behind. Nor is there any sign that the ECB’s buying of euro government bonds has resulted in any kind of monetary inflation, as nothing but deflationary pressures continue to mount in that ongoing debt implosion. The reason there is no inflation from ECB bond buying is because all it does is shift investor holdings from national government debt to ECB balances, which changes nothing in the real economy.

Nor does bank liquidity provision have anything to do with monetary inflation, currency depreciation, or bank lending. As all monetary insiders know, bank lending is never reserve constrained. Constraints on banking come from regulation, including capital requirements and lending standards, and, of course credit worthy entities looking to borrow. With the ECB providing unlimited liquidity for the last several years, wouldn’t you think if there was going to be some kind of monetary problem it would have happened by now?

So the grand irony of the day is, that while there’s nothing the ECB can do to cause monetary inflation, even if it wanted to, the ECB, fearing inflation, holds back on the bond buying that would eliminate the national government solvency risk but not halt the deflationary monetary forces currently in place.

So where does monetary inflation come from? Fiscal policy. The Weimar inflation was caused by deficit spending on the order of something like 50% of GDP to buy the foreign currencies demanded for war reparations. It was no surprise that selling that many German marks for foreign currencies in the market place drove the mark down as it did. In fact, when that policy finally ended, so did the inflation. And there was nothing the central bank could do with interest rates or buying and selling securities or anything else to stop the inflation caused by the massive deficit spending, just like today there is nothing the ECB can do to reverse the deflationary forces in place from the austerity measures.

So here we are, with the ECB demanding deflationary austerity from the member nations in return for the limited bond buying that has been sustaining some semblance of national government solvency, not seeming to realize it can’t inflate with its monetary policy tools, even if it wanted to.

Post script:

The only way the ECB could inflate would be to buy dollars or other foreign currency outright, which it doesn’t do even when it might want a weaker euro, as, ideologically, they want the euro to be the reserve currency, and not themselves build foreign currency reserves that give the appearance of the euro being backed by foreign currency.