The European Central Bank faces an uncomfortable dilemma that goes to the heart of its political and economic viability. Although headline inflation has fallen in recent months thanks to softer energy prices, ‘core’ inflation is rising. So fulfilling the ECB’s medium-term 2% target is highly unlikely unless the bank tightens policies further.
If it does, longer-term interest rates would probably go up in tandem – which would extend already high book losses on the Eurosystem’s bloated holdings of euro-denominated securities. The ECB will have to choose between two unpalatable options. Either it must prepare European public opinion for long-term inflation rates of well over 2%. Or it will face losses that could eventually force recapitalisation, with serious consequences for its shareholders, the European Union’s national central banks.
As Jacques de Larosière, a former governor of the Banque de France and managing director of the International Monetary Fund, pointed out on 3 May, the aftermath of excessive quantitative easing has weakened central banks’ balance sheets, reputation and independence.
In view of the inflationary threat, the ECB should be considering a bold move to reduce its balance sheet and lower the overhang of excess euro area liquidity by selling a significant part of its euro-denominated bond portfolio. Such action would be a logical move signalling that the anti-inflation battle is vigorous and unconditional. But we are highly unlikely to see this enacted, because it would crystallise heavy central bank losses and immediately open the question of whether the ECB needs recapitalisation.
Euro-denominated bonds valued at acquisition cost – not at depreciated market value
We need to scrutinise the ECB’s accounting conventions. In its statement to end-2022, the bank takes into account the depreciation of the market value for bonds in non-euro currencies. The bulk of its portfolio is however in euro-denominated bonds. They are valued in the balance sheet at historical acquisition cost, contrary to their significantly depreciated market value. This can be justified only on the argument that these bonds will be held until maturity.
There is a contradiction here. The ECB’s legal obligation is to fight inflation. But as a result of its discretionary accounting methodology, the ECB is blocking a route to fulfilment of its mandate by presupposing an unconditional refusal to sell these securities.
In 2022 the ECB released a €1.6bn provision for financial risks to offset losses incurred in the year, bringing the provision down to €6.6bn. This is an unrealistically low amount. The ECB and its member NCBs face additional running losses owing to the gap between the low interest rate on bonds held in its portfolio and the increasing interest rates paid on funding deposits from banks.
Quixotically, these losses are higher for the NCBs from countries like Germany and the Netherlands with the lowest public debts and highest-rated bonds. This is because the Bundesbank and De Nederlandsche Bank mainly own bonds from their own governments – with much lower yields than those of more indebted countries like Italy or Spain.
In view of the ECB’s limited equity and insufficient risk provisions, the losses on Eurosystem bond portfolios of several hundred billion euros last year will eventually attract the attention of politicians and financial markets – especially if these loses are exacerbated by even modest interest hikes in coming months. In the event of NCB losses, the ECB would be financially liable under article 32.4 of its statutes, which states that the governing council may decide that NCBs shall be indemnified against costs incurred ‘in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ECB.’
The markets would find it hard to accept a possible need for the ECB to recapitalise NCBs, when the ECB is itself fighting against large losses.
Bundesbank case underlines Eurosystem vulnerability.
The Bundesbank’s case underlines the Eurosystem’s vulnerability. On its roughly €1tn of bonds purchased through Eurosystem quantitative easing, the Bundesbank as of end-2022 recognised a fall in market value of €108bn.
Joachim Nagel, the Bundesbank president, has been seeking to lower the ECB’s balance sheet by ending its unnecessary policy of reinvesting the proceeds of bonds held under QE purchases.
The ECB decided on 4 May to stop (as of end-June) reinvestment of bonds under its ‘asset purchase programme’, but it will continue reinvesting maturing bonds under the ‘pandemic emergency purchase programme’ at least until end-2024. In fact, there is no longer a pandemic emergency. The inflationary threat requires an immediate stop to PEPP reinvestment.
The question of losses by central banks and whether central banks can become insolvent has long occupied economists and policy-makers. The question extends well beyond the European Union – but the unique position of the ECB as a multinational central bank without a European government behind it makes the European issues particularly fraught.
Willem Buiter, a former member of the Bank of England’s monetary policy committee, 15 years ago concluded that the ECB or the NCBs which own it could be recapitalised only if national treasuries agreed a fiscal back up. In a paper for the Centre for Economic Policy Research, he pointed out this could cause great political complications: ‘Who stands behind the ECB as recapitaliser of last resort?’
Losses at Bundesbank and elsewhere in Eurosystem may have political impact
The Bundesbank’s potential or declared losses might add impetus to a lawsuit against PEPP at the German constitutional court. The case was launched in March 2021 by a group including Europolis, a Berlin think tank, of which I am the founder. The action refers to an earlier constitutional court ruling on the ECB’s 2012 ‘outright monetary transactions’ programme that prohibits Bundesbank participation in asset purchase programmes that expose it to the risk of losses endangering its credibility.
The case will look additionally at whether PEPP was proportionate and whether a prohibition of monetary financing has been violated. In his submission to the pending case, Bruno Schönfelder, an economist aligned with the plaintiffs, argues that continued losses could make markets doubt the Eurosystem’s ability to fulfil its price stability mandate.
The capital losses at the Bundesbank and other members of the Eurosystem may have a political impact. Isabel Schnabel, the German ECB board member responsible for market operations, admitted in November 2021 that raising ECB interest rates might lower market values of bonds in its portfolio – meaning that ‘central banks would be willingly accepting losses on their balance sheets that would ultimately lead to losses for the average taxpayer’.
Christine Lagarde, ECB president, and her fellow board members like Schnabel and Philip Lane, responsible for economics, would argue that there is no danger and that monetary union is impregnable and irreversible. However, they and the shareholder NCBs would be wise to consider unfavourable scenarios – and to have plans at hand for dealing with them.
Markus Kerber is an attorney and professor of public finance and political economy at the Technical University of Berlin. Together with plaintiffs from academia and corporate Germany he has over the past 15 years launched eight lawsuits at the German constitutional court over EU and ECB actions.