The ECB has one major disadvantage compared to the Fed

This applies not only to interest rate policy, but also to the strategy of “quantitative easing”, in other words above all the increased purchases of securities caused by the pandemic. Now the high value of independent central banks is particularly evident.

This is because science has extensively proven both theoretically and empirically that independent central banks are particularly effective in combating price increases. But how independent are the central banks today, especially when compared internationally?

The formal answer is clear: Central banks in Europe and the US enjoy legal independence. The perceived independence even goes beyond that. Hardly any politician dares to publicly question this status – otherwise a storm of public indignation threatens.

But beyond this reassuring insight, two dangers lurk. The first: fiscal dominance. If states enter into excessive debt and thus bear a very high interest burden, central banks could feel compelled to include the costs for this interest burden and thus for the financial policy freedom of the states in their decisions.

Not only Greece got into turmoil

You don’t want to risk countries getting into difficulties due to higher interest rates and a situation like the one in the European sovereign debt crisis ten years ago. At that time, it was not only Greece that was in turmoil. Rather, the yields for several European countries rose so strongly that only expensive rescue packages could prevent even more serious effects such as the collapse of the euro area.

From a certain point in time, fiscal policy threatens to dominate the monetary policy decisions of the central banks. The second danger: market dominance. On the international capital markets the expectation has arisen that the central banks would “fix it” if the worst came to the worst. Just think of the crash of the international stock markets in March 2020. At that time there were panic warnings that the corona pandemic would result in a global economic crisis.

Governments and central banks intervened rightly and massively to mitigate the consequences for the global economy. But there are cases in which government and central bank interventions are less or not at all helpful. If they intervene too often and according to unclear criteria, the expectation that central banks would “cram out” the increasingly careless capital markets if necessary anyway.

It will then become more and more difficult for central banks to take countermeasures and return to a “normal” course – any announcement of a withdrawal would ultimately worry the capital markets. Fear of violent market reactions threatens to dominate monetary policy. The central banks run the risk of being driven by the capital markets.

The difficult balancing act of the ECB

What does this mean for the current situation and the fight against inflation? Both the Fed and the European Central Bank (ECB) have announced that they want to tighten the reins. The US Federal Reserve is acting much more resolutely than the ECB because the Fed has already announced several rate hikes and wants to reduce its balance sheet more quickly.

There may be good and understandable reasons for the ECB’s rather wait-and-see attitude. These include, for example, lessons from previous crises such as in 2008 and 2011, when it raised interest rates too early and had to revise its decisions after a short period of time.

But the ECB has a structural disadvantage compared to the Fed – and thus a much more difficult balancing act to manage. Unlike the Fed, it is responsible for 19 states with different economic data and, above all, state financing conditions. One can easily imagine what would happen if highly indebted euro area countries had to pay higher interest rates on their debts again.

Because of the structure of the euro system, the risk of fiscal dominance is significantly higher for the ECB than for the Fed.

What are the consequences of this asymmetry? For the foreseeable future, the normalization of monetary policy is likely to proceed faster in the US than in the euro area. The weak development of the euro against the dollar reflects this expectation. This pleases companies in the euro area who sell their products in the USA, and especially the export-oriented German economy. However, this development has serious downsides.

First, we are importing further inflation due to the rising dollar exchange rate. The products imported from the USA or invoiced in dollars are becoming more expensive due to the strong dollar and are driving up prices for local consumers and producers in Europe. Second, even without imported inflation, the risk of fiscal dominance will make it more difficult for the ECB to effectively combat current inflation.

A unified capital market for the euro zone

For this it needs structural support from politics – the open flanks that still exist in the further development of the economic and monetary union must finally be closed, for example through the completion of the capital markets union.

The most problematic downside of the current development, however, is that the euro will find it increasingly difficult to compete with the dollar. The status of the dollar as the world’s reserve currency has traditionally made it easier for the USA to gain access to international capital markets, both in terms of government debt and in corporate financing.

The importance of the reserve currency also has geopolitical effects – companies in the euro area can become dependent on decisions by the US government. Iran and Nord Stream 2 are two illustrious examples.

Creating a unified capital market for the euro zone would not only mean more economic efficiency, but also more political sovereignty. The rise in inflation should therefore be a wake-up call for us.

The author: Jörg Rocholl is President of the European School of Management and Technology Berlin and Deputy Chairman of the Scientific Advisory Board at the Federal Ministry of Finance.

More: The ECB will not be able to please everyone