In the present debate on the European Central Bank’s expansionary policy stance, the focus is mostly on its quantitative easing programme. In January, the monthly volume of purchases was Those who interpret this as a step towards monetary tightening forget that QE is only one of two important policies that determine the euro area’s monetary base. The second, namely the full allotment policy to banks, is still in place. Under the policy, banks can borrow unlimited amounts from their central banks at a fixed rate against eligible collateral.

In practice these policies are quite similar. Under QE, the central banks buy bonds using central bank money. Under full allotment, they lend central bank money against bonds as collateral. A true exit from the ultra-expansionary policy of recent years would reduce the sum of the two; the composition would be of secondary importance.

Experience shows, however, that an exit strategy that controls the monetary base is not possible in the presence of capital flight. When the ECB last tried to implement such a strategy in a state of financial fragility, it failed spectacularly. In the spring of 2011, it raised interest rates to 1.25% from 1%, and then later to 1.5%. This was accompanied by a tightening of collateral standards and the explicit announcement of a gradual raising of interest rates.

The result was a wave of capital flight that nearly broke apart the Eurosystem. It was visible in the system of Target-2 balances, which measures the share of central bank liquidity that is wire-transferred across countries in net terms – after the announcements, they skyrocketed to €750bn from €300bn in only a few months. This pattern is highly reminiscent of speculative attacks in emerging markets just prior to the break-up of an exchange rate peg.

In Europe, the speculative attack was fuelled by investors’ flight to safety. As central banks in the crisis-affected countries provided liquidity by buying bonds or by lending against bonds as collateral, they indirectly absorbed risky assets from markets. Conversely, the Bundesbank’s absorption of liquidity put safe assets in circulation that previously were used to collateralise central bank credit. This made capital flight attractive, as safe assets could be bought without the price increase that would have been inevitable with fixed quantities.

A limit on the monetary base in this period would have implied a limit on the amount of capital flight through the Eurosystem, as well as a maximum of Target-2 balances that national central banks can accumulate. This follows from the fact that the national central bank of one country can only increase its credit to banks, while keeping the monetary base stable, if another country reduces its credit. This reduction is a natural reaction in the countries receiving net capital inflows – banks pay back their loans to the central banks, because they receive plenty of liquidity from abroad. But this reaction reaches a limit when the credit by the receiving central bank has fallen to zero. At this point, the ECB runs into a trilemma that is familiar from the literature on monetary policy in emerging markets: it cannot simultaneously secure the existence of a common currency, allow for unlimited capital flight, and control the monetary base. One of the three objectives must be given up.

While in most emerging markets the central banks opted to abandon their exchange rate pegs, the ECB made a different decision. On 8 December 2011, it gave up the third objective by abolishing its exit strategy and implementing an unprecedented monetary expansion, the ‘big bazooka’. Half a year later, ECB President Mario Draghi’s statement that the bank would do ‘whatever it takes to preserve the euro’, combined with the promise of unlimited capital flight, and that it would place no upper limit on Target-2 balances, implied that losing full control over the monetary base would be the consequence.

Policy-makers at the ECB are likely to have this episode in mind when refusing to interpret the latest reduction of bond purchases as a sign of a new policy stance.

Frank Westermann is Professor of Economics at Osnabrück University.