Daniela Gabor is professor of economics and macrofinance at UWE Bristol.
Zugzwang is the German word for a situation in chess (and life) where a move must be made, but any possible move will make the situation worse. It also perfectly reflects the predicament facing central banks in Europe.
Take the ECB, the banner of zugzwang’s central banking system. It has four possible moves: raise rates, QT, hold rates, and admit regime defeat.
Raising interest rates, as most expect Thursday (and by 75 basis points), may appease uberhawks in Frankfurt and elsewhere, but this is a calculated gamble to cause suffering – lower 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 that openly gives in just a year after its Strategic assessmentthat the only piece of its inflation targeting models it still trusts is the expectation fairy, now rearranged as financially literate people whose expectations of higher inflation will not abate, even when inflation begins to slow, because they remember being let down by a skeptical ECB.
This may be the diplomatic code name for (German) monetarist, who finally seem to have succeeded in intimidating the ECB into administering the drug intended for an overheated economy to eurozone countries already reeling from (chain) shocks , a dysfunctional energy market and declining real salaries.
Quantitative tightening is also looming, under political pressure from monetarist and other uberhawks. Their reasoning is fond of passing correlation for causality, and their reasoning is that the ECB needs to phase out its pandemic-era support for eurozone government bonds that have “blown up” its balance sheet and fueled concerns with fiscal dominance. But this one is financially illiterate.
Premature reduction of the ECB’s government bond portfolio is a decidedly bad move for two reasons.
First, the eurozone’s macro-financial architecture is connected to: strengthen volatility in government bond spreads to the German Bund, via the €9 trillion repo market. This wholesale money market forms the basis 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 government bonds as repo collateral. By making European states collateral factory for private financing, the founders did not take into account the financial stability implications for the ECB. Yet we know from the eurozone sovereign debt crisis that the valuation of repurchase collateral leads to cyclical market liquidity in eurozone government bonds, except in Germany, threatening liquidity spirals that only the ECB can prevent.
Liquidity spirals, it’s worth remembering, if not only bad for eurozone governments, but also for private institutions that use these bonds as collateral. It is this macro-financial role of government bonds that makes Mario Draghi’s “whatever it takes” speech, Lagarde’s spreading comments and the Transmission protection instrument. The ECB cannot wish it away in a high inflation environment and threatens to cause serious disruptions to the repo market by panicking into “quantitative tightening”.
Second, panic QT would also put pressure on sovereign markets that have already seen some tightening of monetary conditions. Italy’s 10-year yield is now hovering around 4 percent, a spread of 2 percentage points to the German Bund, at a time when eurozone countries need aggressive fiscal and structural policies to contain the possibility of future sustained supply shocks.
Keeping interest rates stable may be the right technocratic choice, but it entails institutional costs that the ECB is no longer willing to bear. Over the past year, the ECB has repeatedly made that choice, hoping that supply shocks it cannot control would disappear and inflation would return to the way its models predict. Putin’s invasion of Ukraine, coupled with European governments’ unwillingness to act decisively on energy price caps, have made the ECB an easy scapegoat.
Scapegoats invariably turn deaf central bankers into hawks, especially when their colleagues elsewhere act as obedient vassals of the dollar hegemon. Monetary historians will indeed marvel at that brief period when European politicians believed so strongly in the euro’s potential to deprive the US dollar that they put Jean-Claude Trichet in charge of the ECB. He pioneered the policy mix that the uberhawks are now pushing for: walking in crisis and reduce macro-financial support for sovereign collateral.
© Bloomberg
With that illusion behind us and the euro below par, the ECB is just another central bank caught up in the dollar’s global financial cycle, preying on facilitating comparisons with other central bank interest rates.
The fourth step – asking whether the inflation target has run its course – has even higher institutional costs. What if Zugzwang is that final stage of a central banking paradigm, when it implodes under the contradictions of its class politics? Under financial capitalism super cycle In recent decades, inflation-driven central banks have been outposts of (financial) capital in the state, guardians of a distributive status quo that destroyed the collective power of workers as they built shadow banking safety nets.
The limits of this institutional arrangement that concentrates (price) power and profit in (a few) corporate hands are now clearly visible. If the climate and geopolitics of 2022 are signs of Isabel Schnabel High volatility As most central banks and experts expect for the foreseeable future, macro-financial stability requires a new framework for coordination 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 central banks have had in the macrofinancial architecture and in our macroeconomic models.
The history of central banking teaches us that policy paradigms die when they fail to provide a useful framework for stabilizing macroeconomic conditions, but never at the hands of central bankers themselves.