Zugzwang central banking (ECB edition)

Daniela Gabor is a professor of economics and macrofinance at UWE Bristol.

Zugzwang is the German word for a situation in chess (and life) in which a move must be made, but each possible one will make the situation worse. It also captures perfectly the predicament facing central banks in Europe.

Take the ECB, the posterchild for zugzwang central banking. It has four possible moves: raising rates, QT, holding rates and admitting regime defeat.

Raising interest rates, as most expect it to do on Thursday (and by 75bp), may appease the uberhawks in Frankfurt and elsewhere, but this is a calculated bet to inflict 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 admits, just one year after its Strategic Review, that the only bit of its inflation targeting models it still trusts is the expectations fairy, now recast as financially literate people whose expectations of higher inflation will not subside even when inflation starts to decelerate because they remember being let down by a dovish ECB.

This may be the diplomatic code name for (German) monetarists, who seem to have finally managed to intimidate the ECB into administering the medicine intended for an overheating economy to eurozone countries already reeling from supply (chain) shocks, a dysfunctional energy market and falling real wages.

Quantitative tightening is also on the cards, under the political pressure of monetarists and other uberhawks. Fond of passing correlation for causality, their reasoning is that the ECB must unwind its pandemic-era support for eurozone sovereigns that “ballooned” its balance sheet and fuelled concerns with fiscal dominance. But this is financially illiterate.

Premature shrinking of the ECB’s portfolio of sovereign bonds is a distinctly bad move, for two reasons.

First, the eurozone’s macro-financial architecture is wired to amplify volatility in sovereign spreads to the German Bund, via the €9tn repo market. This wholesale money market provides the plumbing for private credit creation, both on bank balance sheets and through securities markets.

It was designed — by the ECB and the European Commission — to mainly rely on eurozone sovereign bonds as repo collateral. In turning European states into a collateral factory for private finance, the founding fathers did not consider the financial stability implications for the ECB. Yet we know from the eurozone sovereign debt crisis that repo collateral valuation means cyclical market liquidity in eurozone sovereigns except Germany, threatening liquidity spirals that only the ECB can prevent.

Liquidity spirals, it is worth remembering, or not just bad for eurozone governments, but also for private institutions that use those bonds as collateral. It is this macro-financial role of sovereign bonds that connects Mario Draghi’s “whatever it takes” speech, Lagarde’s spread-closing comments and the Transmission Protection Instrument. The ECB cannot wish it away in a high-inflation setting, and risks triggering severe repo market disruptions by panicking into “quantitative tightening”.

Second, panic-QT would also pile pressure on to sovereign markets that have already delivered some tightening of monetary conditions. Italy’s 10-year yield now hovers around 4 per cent, a 2 percentage points spread to the German Bund, at a time when eurozone countries need aggressive fiscal and structural policies to contain the possibility of future persistent supply shocks.

Holding rates steady may be the right technocratic choice, but it comes with institutional costs that the ECB is no longer prepared to bear. For the past year, the ECB has repeatedly made that choice, in the hope that supply shocks that it cannot control would dissipate, and inflation would once again behave as its models predict. Putin’s invasion of Ukraine, coupled with the reluctance of European governments to act decisively with energy price caps, have left the ECB as a convenient scapegoat.

Scapegoating invariably turns dovish central bankers into hawks, particularly when their peers elsewhere act as obedient vassals to the dollar hegemon. Indeed, monetary historians will marvel at that brief period when European politicians believed so much in the euro’s potential to unseat 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: hike in a crisis and reduce macro-financial support for sovereign collateral.

With that illusion behind us and the euro below parity, the ECB is just another central bank trapped in the global dollar financial cycle, prey to facile comparisons with other central bank interest rates.

The fourth move — ask if inflation targeting has run its course — has even higher institutional costs. What if Zugzwang is that last stage of a central banking paradigm, when it implodes under the contradictions of its class politics? Under the financial capitalism supercycle of the past decades, inflation-targeting central banks have been outposts of (financial) capital in the state, guardians of a distributional status-quo that destroyed workers’ collective power while building safety nets for shadow banking.

The limits of this institutional arrangement that concentrates (pricing) power and profit in (a few) corporate hands are now plain to see. If the climate and geopolitical of 2022 are omens of Isabel Schnabel’s Great Volatility that most central banks and pundits expect for the near future, then macro-financial stability requires new framework for co-ordination between central banks and Treasuries that can support a state more willing to, and capable of, disciplining capital.

But such a framework would threaten the privileged position that central banks have had in the macro-financial architecture and in our macroeconomic models.

The history of central banking teaches us that policy paradigms die when they cannot offer a useful framework for stabilising macroeconomic conditions, but never at the hands of central bankers themselves.