With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising a number of concerns. Not all are justified.
The main concern is that sooner or later the increase in central bank money will lead to inflation. However, there is no empirical evidence – across countries and over time – that the size of the central bank balance sheet in advanced economies is related to inflation. Even though inflation is ultimately a monetary phenomenon, the quantity of money circulating in the economy also depends on the motives underlying the demand for money by the private sector, in particular by the banking system. If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.
With the LTRO, the ECB has helped to reduce systemic risk and avoided a credit crunch. To minimise the inefficiencies and perverse incentives that may result from the increase in its balance sheet, and to reduce counter-party risk, the ECB should be given a greater role in co-ordinating and overseeing supervision of the eurozone banking system. The euro area needs a supervisory and regulatory compact, as much as – if not more than – a fiscal compact. Read more