ISET Economist Blog

Europe’s Dramatic Monetary Failure
Sunday, 14 February, 2016

This week, another crazy idea haunted economically faltering Europe. According to the plans of European politicians, the 500 euro note will disappear and cash payments above 5,000 euro will be made illegal. Officially a measure against money laundering, the pretext was correctly debunked by Hans-Werner Sinn in the Frankfurter Allgemeine Zeitung: the true reason for this step is to push interest rates further down. Big notes allow to store wealth in cash, and if that is not possible anymore, interest rates can be brought even further into the negative, depriving banks of the opportunity to just set up safes to store their money. 

For many years, the European Central Bank (ECB) is failing to fight deflation. The official ECB target inflation rate is 2%, but for 2015, the provisionally estimated inflation rate was 0%, and in 2013 and 2014 it was 1.5% and 0.5%, respectively. To spur price increases, the president of the ECB, Mario Draghi, regularly fires his “bazooka”, the central banker’s slang term for bringing huge amounts of money into circulation. For example, throughout the year 2015, the ECB injected 1.1 trillion euros into the economy through buying bonds from private and public issuers. This was one of many similar measures of “quantitative easing”, of which there are so many that it is difficult not to get confused about all the bazookas fired by Draghi in the last years.

The amount of euros circulating in the Eurozone, as measured by the broad money aggregate M3, has gone up from a bit more than 7 trillion in 2006 to almost 11 trillion at the beginning of 2016. This is an increase by about 57% in the last 10 years, far exceeding the GDP growth in the 19 countries that now form the Eurozone. In the last decade, the economic output of these countries grew by a meager 8%. The supply of money was ballooning, and the number of goods that could be purchased for this money did not keep up with this development. 

Why the hell are European companies not increasing their prices? As it turns out, nothing is wrong with Europe. It is just the colossal failure of Mr. Draghi and his ECB to think outside of the box.


All the bazookas that Draghi fires do not lead to additional consumption or investment, because the money does not end up in the pockets of consumers. 

Currently, the only channel through which the ECB injects money into the economy is by reducing interest rates. This is done directly through the rates at which banks can deposit money at the ECB, which are already negative, and through buying bonds of companies and governments (the so-called open market operations). According to classical pre-Keynesian theory, low-interest rates will stimulate investment activities, as they make it cheaper for companies and governments to finance investments through debt.

However, already in 1936, Keynes put away this idea. In his seminal book The General Theory of Employment, Interest, and Money, he demolished the classical, harmonious view on investment. According to Keynes, the interest rate is not alone what determines the investment activities. Rather, what drives the investment of private entrepreneurs is the anticipated demand for their products, without which investment would not be profitable. If demand is lacking and so-called “animal spirits” take over, low-interest rates will not bring the economy out of the slump.  

What we observe right now fits very well with Keynesian thinking. Europe is in a Keynesian liquidity trap, as was repeatedly suggested in the last years (cf., for example, “The Euro Zone: Falling into a Liquidity Trap?”, Société Générale Econote 22, December 2013), a situation where additional money does not reduce the interest rate further, as the additional liquidity is absorbed by economic agents, hoarding money and not lending it to companies for investments (in his General Theory, Keynes names eight reasons why people are hoarding money, ranging from greed to, more importantly, they wish to remain flexible and not commit one’s money in investments). Yet, the situation is even more severe than envisioned by Keynes, as hoarding (closely related to the animal spirits) is arguably not the primary cause why prices do not pick up. Most people do simply not have the opportunity to hoard because the newly generated money does not make it to their wallets! 

There is no channel how Draghi’s bazooka money makes its way to the pockets of ordinary people who would like to consume. As low-interest rates do not increase investment activity, these low-interest rates do not translate into additional income for consumers. Public borrowers could in principle make a difference by using low-interest rates for increased spending, but most European countries are already overindebted. Their main concern is to contain their overboarding debt, and they cannot expand their deficits even if interest rates are low.


Is there an alternative way to inject money into the economy that does not go through low-interest rates? In his famous 1969 paper “The Optimum Quantity of Money”, Milton Friedman writes: “Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community.” Helicopter money would be money the ECB would just transfer to every European, say, 1,000 euro to each of the 340 million inhabitants of the Eurozone. This would lead to an impulse of 340 billion euro. A part of this money would be consumed, and this would affect prices. The marginal propensity to consume (the share of additional income that is used for consumption) was estimated to be 12% in Europe (cf. Carroll, Slacalec, and Tokuoka: “The Distribution of Wealth and the MPC: Implications of New European Data”, ECB Working Paper 1648, 2014), so that if one would give an extra 1,000 euro to each European, they would on average consume 120 euros more.  And if this is not enough, give them another 1000 euro, and another 1000, so long until they start consuming sufficiently and drive prices upwards! 

Helicopter money is often mistaken as government financing through the central bank. This is not what Milton Friedman had in mind. If the ECB buys government debt, it is just reducing the interest rate governments have to pay, but, as argued above, this is not translating into higher government spending. The ECB is therefore not bringing money directly into the pockets of those who want to spend.

Draghi’s useless squeezing of interest rates comes at enormous costs. Firstly, providing banks and “investors” with cheap money (instead of giving it to consumers) may fuel bubbles in the real estate and financial sectors. Some people argue that the 2008 economic crisis started with quantitative easing, which was practiced already in the early 2000s and provided ample money for speculation and unsound business models. Secondly, the extremely low-interest rates make it difficult for ordinary Europeans to save for their retirements and other purposes.

Also, future bazookas will not have the desired effect, because they will not increase the money in the pocket of those people who would like to spend. Instead of asking what is the structural problem of European monetary policy, Draghi repeats the same monetary policy measures again and again. Like so many EU bureaucrats, also the ECB president is a failure. And this is a problem for all of us, as the Eurozone is the second-largest economy in the world, and if Europe coughs, Georgia gets a cold.

The views and analysis in this article belong solely to the author(s) and do not necessarily reflect the views of the international School of Economics at TSU (ISET) or ISET Policty Institute.