The ECB and the cost of independence: discovering a new “catastrophic loop” in the European Economic and Monetary Union

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The European Central Bank has frequently used unconventional monetary policy approaches, such as large-scale bond purchases, since the financial crisis. Armando Marozzi presents evidence of a new “catastrophic loop” in the European Economic and Monetary Union resulting from these measures. It shows that once the ECB adopts unconventional monetary policy approaches, it tends to take positions that promote conservative fiscal policies among member states. This fiscal conservatism in turn produces lower GDP and lower inflation, which increases the need for further large-scale bond purchases.

The notion of ‘catastrophic loop’ generally refers to the relationship between banks and euro area states that arises when a large amount of government bonds on banks’ balance sheets erodes the value of bank capital as interest rates rise. In a recent article, I extend this notion to uncover a fatal new loop between the institutional architecture of the European Central Bank (ECB), its unconventional monetary policy and the “fiscal position” of the ECB.

While central bank independence has been called a “free meal” because it lowers inflation at no cost to production, I show that defending independence during a financial crisis in Economic and Monetary Union (EMU) is macroeconomically expensive. As unconventional monetary policy exposes the ECB to the threat of fiscal dominance, the euro area monetary authority is responding by shifting its fiscal stance towards conservatism. In other words, to protect monetary dominance, the ECB asks governments to restrict fiscal policies, thus preventing them from profiting from monetary measures. This, in turn, outweighs the positive effects of unconventional measures and results in a lower level of GDP and inflation than it would have been if the fiscal stance had been constant. This new fatal loop is shown in Figure 1.

Figure 1: A new “catastrophic loop” in the European Economic and Monetary Union

To note: For more information, see accompanying author document.

The underlying assumption here is that an unconventional monetary policy can endogenously lead the ECB – to minimize the budgetary implications of these measures and therefore to protect its independence – to have a preference for budgetary conservatism. To provide supporting evidence, I first quantify the degree of accommodation of the ECB’s fiscal policy using the Wordscore approach (blue) and with an expert survey (red) in Figure 2 below. -below; then, I study how this and other macroeconomic variables behave in the face of an unconventional monetary policy shock. Figures 3 and 4 show some of these results.

Figure 2: Degree of accommodation of fiscal policy

To note: Wordscore is a method of extracting political positions from political texts. Using the approach to capture the degree of fiscal policy accommodation, I extract the political dimensions from normative fiscal policy paragraphs in the ECB’s introductory statements. I then validate the model results with an expert survey. The figure shows the estimated degree of fiscal policy accommodation for Wordscore (blue line) and the average of responses in the expert survey (red line). Above 0 indicates a budget accommodating score (i.e. encouraging governments to increase the deficit to finance significant public spending to support aggregate demand), while below 0 indicates a budget score. hawkishness (that is, encouraging governments to keep public budgets under control). The results of the expert survey have been rescaled to facilitate comparability.

Chart 3 shows that the purchases of government bonds generate considerable windfall gains for euro area countries, i.e. the public budget improves, the debt-to-GDP ratio and debt payments. Net interest decreases dramatically and income increases. In addition, governments internalize the positive fiscal effects of monetary measures and increase public spending and investment, proving that public spending reacts countercyclically. This result is important because the fiscal consequences of government bond purchases are what threatens the independence of the ECB via concerns about fiscal dominance.

Figure 3: Impulse response of fiscal variables to a large-scale bond purchase shock

To note: Budget responses at the euro zone level. The results are based on an autoregressive vector-increased factor (FAVAR) model identified with a proxy for large-scale bond buying shocks (LSBP). The LSBP surprises are derived from the exploitation of the Eurozone Monetary Policy Events Database (EA-MPD) of Altavilla et al. (2019) and originally adapting the methodology of Swanson (2017). The figure shows the response to a 0.25% drop in the policy indicator due to an LSBP shock, with 90% bands displayed.

Figure 4, on the other hand, shows the response of the communicated fiscal stance (degree of accommodation of fiscal policy) to an expansionary bond purchase surprise. The result supports the hypothesis that the ECB demands that fiscal consolidation be accompanied by massive purchases of government securities. In fact, the model shows that the degree of accommodation of fiscal policy plunges 1.6% on impact and remains significantly negative for 12 months after the shock. The ECB therefore calls on governments to restrict fiscal policies in a procyclical manner after unconventional monetary easing.

Figure 4: Impulse response of the degree of accommodation of fiscal policy to a large-scale bond purchase shock

To note: The figure shows the response to a 0.25% drop in the policy indicator due to a large-scale bond buying shock, with bands of 68% and 95% displayed.

The last assumption is that the inverse relationship between the communicated “fiscal position” and the unconventional measures found results in a level of GDP and inflation that would have been higher if the ECB had kept its fiscal position constant. Chart 5 shows the cumulative net effect of a Hawkish shock in the ECB’s communicated fiscal stance over sub-periods. Bars below zero indicate that the degree of fiscal policy accommodation surprises had a shrinking effect on the series and vice versa.

Between 2010 and 2013 – the period covering the sovereign debt crisis – GDP and inflation could have been around 0.2% and 0.1% higher, respectively. From 2014 to 2016, while the effect on GDP remained negative although slightly reduced in magnitude (around -0.1%), the impact on inflation became positive. Finally, over the 2017-19 period, the counterfactual for GDP and inflation was positive for one or the other variable. As a result, the contractionary effects of fiscal prudence messages were more pronounced during the period when the euro area economy was most in need of stimulus.

Figure 5: Cumulative historical counterfactuals by period

To note: The figure shows the cumulative counterfactual for GDP and inflation in 2010-13, 2014-16 and 2017-19.

The main results of this analysis are as follows. First, when an expansionary and unconventional monetary policy shock occurs, the degree of fiscal policy accommodation decreases significantly: that is, the ECB becomes more fiscal conservative. Second, I find empirical evidence that sending fiscally hawkish messages is macroeconomically expensive. In fact, both GDP and inflation are higher in the scenario where the degree of fiscal policy shock is off; especially during the sovereign debt crisis. Taken together, these results demonstrate the existence of a new “fatal loop” between large-scale government bond purchases and the degree of accommodation of the ECB’s fiscal policy in the euro area.


Note: This article gives the author’s point of view, not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: European Central Bank (CC BY-NC-ND 2.0)


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