Beginners Handbook

So what is the European Central Bank doing today for the economy?

Today, the European Central Bank is providing ample liquidity to the financial system and forcing banks to lend at very low interest rates, aiming to ensure banks continue to lend to companies and individuals.

The 2008 global financial crisis and the Covid-19 pandemic crisis have forced central banks across the world to intervene in an unprecedented manner. 

As the economy fell into a recession in response to government lockdown measures, the ECB repeatedly tried to support the economy further by lowering the interest rates that banks pay for borrowing or depositing money at the ECB. In 2014, the ECB has even taken the unprecedented step of pushing interest rates below zero into negative territory! Today, interest rates are negative (-0.5%). 

The effect of this policy is ambiguous. On the one hand, it means banks can earn additional money by borrowing from the ECB. On the other hand, negative rates also apply to money that banks deposit at the ECB (so called “reserves”). So banks only make profits from negative rates if they borrow more money than the amount they deposit in the ECB. There is also a risk that banks also charge a negative rate to their customers’ savings, although this is not a common practice so far.

Since 2015, the European Central Bank also introduced “quantitative easing” (also shortened to “QE”). This is a confusing term, but it means the ECB is directly purchasing financial assets (such as government debt, or debt from corporations) in the financial markets, instead of merely lending money to banks. The intended result is that financial investors will be incentivized to lend more to riskier projects, as low-risk assets are becoming financially unattractive, although in practice critics argue QE has resulted in higher inequality by pushing up the prices of assets, and has failed to help the real economy recover.

The Covid-19 crisis has justified more extraordinary measures by the ECB. Today, the ECB lends about 1.8 trillions euros to banks at a negative rate, and owns about 3 trillions euros of debt from EU governments. 

Controversially, the ECB is also purchasing about 600 billions euros from private banks and corporations. The ECB claims to be “market neutral” when doing so, which means they buy bonds from companies in proportion to the amount of bonds that that company has on the market. But many NGOs have denounced the ECB for supporting polluting companies when it makes these purchases.

Ultimately, the effectiveness of the ECB’s monetary policy is being questioned. On the one hand, the ECB policy has worked to ensure banks keep the economy afloat. At the same time, despite those impressive measures, inflation has remained too low during the last decade. Many have questioned whether the ECB has the right tools to help the economy, and argue that governments must take the lead by increasing their budgetary spending, which would help the real economy recover.