Everything in proportion

A couple of weeks ago I wrote a piece looking at the ruling by the German Constitutional Court (GCC) which suggested that the ECB should demonstrate proportionality in the conduct of its asset purchases. It is worth revisiting the question to focus on the legal issue of proportionality, which is not well understood by non-lawyers in the Anglo Saxon world (including me). The reason for doing so is that the objections raised can be applied to the conduct of monetary policy around the world, not just in the euro zone, and goes to the heart of my criticisms about the overly lax monetary policy followed by central banks over the past decade.

Proportionality is not a concept which is enshrined directly into English law, which instead leans more heavily on the principle of (un)reasonableness. English law uses a standard known as Wednesbury unreasonableness to determine whether an action is such that “no reasonable person acting reasonably could have made it.” In case you are wondering, it gets its name from a 1948 legal ruling on a case between Associated Provincial Picture Houses and Wednesbury Corporation. Proportionality, on the other hand, is designed to check the infringement of citizens rights by legislative, administrative or judicial authorities and is enshrined in German law as far back as the 1880s. Without being an expert on law, my understanding is that reasonableness is concerned with the process by which outcomes are derived whereas proportionality is concerned with the outcome itself.

The GCC made the point in its ruling that the ECB’s Public Sector Purchase Programme (PSPP) has a number of economic side effects to which the ECB has not apparently given sufficient consideration. Asset purchases result in low interest rates which produce “considerable losses for private savings” and allow “economically unviable companies to stay on the market.” I would not contest these views but the complainants who brought the case argue that the ECB has not provided evidence to suggest that these costs are outweighed by the benefits of its actions. With the ECB having held policy rates in negative territory since 2014 and buying assets since 2015 in a bid to hold down bond yields, the extent and duration of monetary easing is increasingly a cause for concern because it magnifies the adverse consequences of the policy.

This goes to the heart of my own criticisms of central bank actions over the past decade. Indeed, I have made the point repeatedly that once the economy started its recovery from the 2008-09 recession, there was a case for central banks to take back some of the emergency monetary easing, if for no other reason that they would have more scope for policy easing when the next downturn hit. I have also argued that low interest rates have side effects which central banks have studiously ignored, particularly when it comes to their impact on future pension income. I once raised this question directly with the central bank governor of one of the smaller European nations, who admitted that he was aware of the problem but had come to the conclusion that the short-term considerations were more important. Arguably, the current generation of central bankers has displayed a lack of proportionality in their approach to monetary policy and we may only be aware of the impact of recent actions in the long-term. Admittedly, the Covid-19 outbreak has changed the calculus as central bankers are forced to take unprecedented action but it does not excuse their actions over the past decade.

The complacency in this regard was highlighted in Mark Carney’s last speech as BoE Governor when he suggested that society as a whole has not lost out from low interest rates because “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus, since only 2% of UK households have material deposit holdings without material financial assets or property wealth.” As I have pointed out before, a large part of society may indeed have seen an increase in the value of their wealth holdings, but since a significant part of it accrues in the form of housing, it is not easily realisable. Nor does it benefit those at the lower end of the income scale who are unlikely to have a large stock of assets. Carney’s post-hoc justification for the actions taken during his time as Governor would fail the GCC’s proportionality text.

When it comes to central bank decisions to ramp up asset purchases, it is not just the ECB which shows a lack of proportionality. Central banks argue that their inflation mandate gives them scope to boost asset purchases in a bid to return inflation to the target. But the evidence suggests that the policy has not worked because the likes of the ECB and the BoJ, which pioneered the policy almost 20 years ago, have singularly failed to boost inflation back towards 2%. Monetary theories of inflation have simply not worked over the last two decades – there has been no evidence that increasing the volume of liquidity in the economy has boosted prices (other than for financial assets), as the chart below indicates for the euro zone. If that remains the case, the good news is that central banks can continue creating liquidity without any adverse consequences for their inflation mandate. The bad news is that it undermines the case for the policy.

Nor should we necessarily buy the argument that central bank actions do not represent deficit financing simply because asset purchases are not taking place at the behest of the government. It would be naïve in the extreme to think that central banks and finance ministries do not coordinate their policies, particularly when in the UK the Treasury indemnifies the BoE’s bond purchases. None of this is to say that central banks should not buy bonds. However, the excuse that this being conducted for inflationary purposes is starting to wear a bit thin. It is really about creating space in the bond market to allow them to digest the huge flow of debt issuance which, as I argued here, does not have to constitute monetary deficit financing.

But if you believe that central banks have no other mandate than controlling inflation, this is a difficult case to make. Indeed, in the euro zone it is legally impossible. However, if central banks can argue that their actions are designed to prevent a breakdown of the sovereign debt market, which would have significant implications for the operation of economic policy, this would be a more proportionate response than hiding behind the inflation smokescreen. It would also be more honest.