Monetary Policy In America Is A Mess. Things Are Even Worse In Europe.

A look at the ECB balance sheet explains the hypothesized obduracy. By the end of 2021, this is headed to 80 percent of eurozone GDP, versus the Fed’s balance sheet at just under 40 percent. Whereas the Fed’s balance sheet is made up almost entirely of loans to the US government (mainly Treasuries) and government-sponsored mortgage debt, the ECB’s consists largely of junk or borderline junk, including vast holdings of weak sovereign debt (no. 1 Italy). Loans to a virtually bankrupt banking sector amount to a third of total ECB assets. On top of that, the Italian and Spanish central banks have borrowed over €1 trillion of debt within the so-called TARGET2 system with the Bundesbank, the chief creditor on the other side. 

Let’s go through the thought experiment of the ECB embarking on a monetary normalization course which would have as consequence market interest rates rising 200 basis points across the board and slimming down the balance sheet by, say, 25 percent as a first stage to reestablish monetary base as anchor to the system. The weak banks could simply not pay the added interest rate cost to the ECB on their vast indebtedness given their lack of scope to raise rates on their loans to weak sovereigns and corporates. One way or another they would have to get subsidies to pay the interest—but how can critically weak sovereigns afford this except via ECB money printing? Resentment from the “frugal north” and EU laws against state aid would impede action.

A Green-CDU (Christian Democratic Union) coalition in Berlin such as is likely to emerge from this autumn’s elections according to present polling would have no wish to break the European Economic and Monetary Union (EMU) up. Holding the status quo together means giving a nod to the ECB to keep rates down (at present subzero) and spare us all these traumas. In the same vein, just imagine the system stress if the Bundesbank demanded that the Banca d’Italia pay interest on its debit balance within TARGET2, or if the ECB toward restoring monetary base as anchor had to liquidate 20 percent of its Italian government debt holdings as part of a general cutback. Better just to allow inflation to rise.

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