The European Central Bank in a State of Crisis: Policies, Effects and Downsides

The following text was originally written in German and has been translated by the Exploring Economics team. You can find the original text here. 

Activist Monetary Policy in Crisis

Since 2008, central banks in industrialised countries have adopted unconventional monetary policy strategies, evolving from passive-accommodating actors into proactive economic policy institutions. As a result, monetary policy has gained prominence and, in some cases, has even become more influential than fiscal policy.

Even the European Central Bank, which—due to its primary mandate of ensuring price stability—should theoretically be highly constrained in its actions, has proven to be a remarkably flexible, innovative, and discretionary institution throughout the crises of recent years. This is also linked to economic disparities within the European Union (broadly, the North-South divide) and the resulting differences in economic policy, which hindered the implementation of activist fiscal measures. While the EU largely adhered to fiscal austerity, which only softened slightly in recent years, monetary policy remained agile and effective from the outset. As a result, the ECB became the central actor in crisis management. Some even argue that the ECB, through its massive expansion of central bank balance sheets, took on the fiscal policy role traditionally held by finance ministries (De Grauwe/Yuemei 2023, Brunnermeier 2020). Over time, the scope of its interventions has expanded — initially focused on stabilising the banking sector, they have gradually extended into the real economy.

At first, during the 2008 financial crisis, the ECB focused on stabilizing the banking sector. Since banks are the key transmission mechanism for monetary policy in Europe, their collapse in 2008 posed a major risk to economic development. Starting in July 2009, the ECB provided additional liquidity to European banks under simplified conditions through tender operations labelled 'enhanced credit support'. This allowed banks to quickly and extensively access central bank funds, preventing liquidity crises. Additionally, the ECB introduced long-term refinancing operations (LTROs)—money auctions where banks could borrow from the central bank for extended periods. The first three-year LTROs, held in 2011 and 2012, allocated €1 trillion to credit institutions. These liquidity expansions were accompanied by the hope that the additional funds would flow into the real economy via increased lending.

It was only later that the ECB intervened beyond the banking sector. In 2010, the eurozone crisis intensified as risk premiums (i.e., interest rates) on 10-year government bonds of some eurozone countries, particularly Greece, surged. Through the Securities Markets Programme (SMP), the ECB began intervening in public and private debt markets within the eurozone to improve the depth and liquidity of sovereign bond trading. These bond-buying programmes succeeded in significantly lowering borrowing costs for peripheral eurozone countries. Since the ECB is prohibited from financing governments directly, it purchased sovereign bonds on secondary markets or from banks. This, in turn, incentivised banks to invest in government debt—especially in Italy and Spain, where banks bought large volumes of their governments’ bonds, driving down yields and temporarily easing refinancing difficulties. In turn, the ECB — despite strong opposition from the German Bundesbank — provided weakening banks in peripheral countries with longer-term liquidity while accepting lower-quality collateral. This occurred amid an increasingly intertwined banking and sovereign debt crisis linked to concerns about a credit crunch.

This bond-buying programme was accompanied by a viral speech given by ECB President Mario Draghi in September 2012, in which he pledged to do 'whatever it takes' to preserve the euro, including making unlimited bond purchases. However, these purchases were conditional on countries seeking assistance from the European Stability Mechanism (ESM) [1], which imposed strict austerity measures. Thus, monetary flexibility was exchanged for fiscal rigidity — a compromise that balanced the interests of northern and southern eurozone countries. A more ‘traditional’ step came in July 2012, when the ECB cut its key interest rate by 25 basis points to 0.75%, bringing it below 1% for the first time.

The monetary response to this first crisis phase, both in Europe and the U.S., consisted primarily of massive monetary expansion aimed at supplying liquidity that seemed lost due to the banking system’s collapse. A side effect of these easing measures was a dramatic increase in central bank balance sheets. Both the ECB and the U.S. Federal Reserve saw their balance sheets triple in the years following the financial crisis—a situation that persists today. Consequently, central banks have become some of the largest creditors to governments and other economic entities, especially corporations, thereby taking on substantial risks.

Monetary Policy Fizzles Amid Persistently Weak Economic Growth

Although the European Central Bank’s responses, coupled with new banking regulations, helped stabilise Europe’s banking system, these measures had a limited real-world economic impact. The expansion of credit and the substantial injection of central bank liquidity into banks — and subsequently into governments — failed to deliver the desired economic recovery within the European Union. Banks hoarded the cheap ECB funds or redeposited them with the ECB instead of providing loans to businesses and households. A key reason for this was weak demand for investment and consumer credit, as firms and households alike anticipated a bleak economic outlook (Kader, 2018).

This weak growth potential has deeper roots. Some economists argue that the 2008 financial crisis and the subsequent sluggish GDP growth reflect a more fundamental crisis in Western industrialised economies, rather than being merely the result of a sudden, speculation-driven financial collapse.

Analysis of long-term economic trends in Western industrialised nations reveals that the vulnerability of capitalist economies is not limited to recurring boom-and-bust cycles, which are considered typical of market economies. Rather, these long-term data show that advanced economies are marked by a secular decline in growth. Diminishing—or persistently weak—growth and profitability rates have been observable over the past 150 years (Piketty 2014). While growth rates historically rebounded after crises, they almost always settled at lower levels than before. This points to a long-term secular trend of declining economic growth, particularly in advanced economies. Even global GDP growth has slowed in recent decades and is now heavily dependent on China’s expansion (IMF 2017).

OECD data indicate that the EU’s potential growth rate[2] has weakened by one percentage point annually since the 1990s (Ollivaud et al. 2016). Similarly, profitability has seen a long-term decline in recent decades, with structural—not just cyclical—causes (ibid.).

For the U.S., economists like Robert Gordon and Lawrence H. Summers have documented (persistent) economic stagnation (Gordon 2012, 2016; Summers 2016). In his comprehensive work on U.S. economic history since 1870, The Rise and Fall of American Growth, Gordon (2012) traces productivity growth, demonstrating that—apart from a brief post-war period up to the 1970s—it has steadily declined. Meanwhile, former U.S. Treasury Secretary Lawrence H. Summers revived the concept of 'secular stagnation'[3], highlighting a fundamental stagnation trend in advanced industrial nations. He cited several causes, including weak corporate investment due to saturation in physical capital, a lack of productivity-boosting technological innovation, subdued household demand due to wealth and income inequality, and ageing populations.

If this structural growth weakness is real—and possibly even underpins recent crises—it is unlikely that loose monetary policy or central bank interventions are the right tools to counter it. At the very least, Summers argues that monetary solutions are inadequate: "Monetary expansion cannot eliminate a secular stagnation and may have beggar-thy-neighbor effects" (Eggertsson et al. 2016, 506).

Pandemic: The Floodgates Reopen

Despite these insights, the ECB deployed its monetary toolkit just as aggressively in subsequent crises. The EU’s more recent crises again triggered immediate and rapid stabilization measures from the ECB. Public health policies, particularly lockdowns to combat COVID-19, brought large swaths of the economy to a standstill. In 2020, the first year of the pandemic, the EU’s GDP plummeted. This time, policymakers responded with massive fiscal and monetary stimulus.

The ECB reopened its monetary floodgates: as during the financial crisis, access to central bank liquidity was eased for banks, governments, and corporations. New programs rolled out under acronyms like TLTRO[4] and PELTRO[5]. Once again, European banks were offered liquidity at highly favourable terms through tender operations to spur lending to the economy. For the first time, central bank loans to banks carried a negative interest rate of -1%, meaning banks earned interest for borrowing from the ECB. Simultaneously, the ECB purchased public and private sector securities under the PEPP[6] programme to stimulate investment. The banking sector also received regulatory relief, including looser accounting rules for non-performing loans, loan guarantees, and moratoria. These measures shielded banks from risks and averted another financial crisis.

This time, fiscal policy also reacted decisively. Across Europe, governments introduced COVID-19 aid to mitigate lockdown impacts on businesses and households. While EU budget policy during the financial crisis had been constrained by the austerity paradigm of the Maastricht criteria, the pandemic resulted in fiscal loosening. The strict budget rules of the Stability and Growth Pact were relaxed in favour of the Next Generation EU programme. State aid was streamlined, budget rules were eased and joint EU debt issuance was enabled. "Faced with the pandemic crisis, discretion trumped rules, and the European Commission took it upon itself to borrow in the open markets to finance the programme" (Lapavitsas/Cutillas 2021, 445). Combined with monetary measures and substantial fiscal support (especially for firms), European economies emerged from the COVID crisis relatively unscathed.

Short-Term Stabilization Without Long-Term Revival

Although these measures were effective in the short term, they once again caused central bank balance sheets to expand and public debt to rise. Furthermore, they failed to deliver the desired long-term boost to sustainable growth. This became evident when the ECB shifted its monetary policy in response to the war in Ukraine. Disruptions to energy supplies from the war sent prices soaring in Europe, triggering eurozone inflation. To restore price stability, the ECB raised key interest rates incrementally to 4.5% starting in July 2022 and began winding down its corporate bond-buying programs. The unsustainability of this support became clear as aid expired, particularly in the corporate sector: bankruptcies have risen sharply since the end of relief measures, and the eurozone economy—led by Germany—remains weak. Consistent with the earlier argument, this reflects growth weakness with structural underpinnings.

Record Profits in the Banking Sector

What the ECB initially did not halt during the rise in inflation, however, was the provision of cheap liquidity to banks. Assuming this would ensure banks had sufficient liquidity to lend to the real economy despite higher interest rates, the TLTROs were extended. As mentioned earlier, the ECB charged a negative interest rate of -1% on TLTRO funds. This meant that banks borrowing from the ECB not only paid no interest but received 1% interest from the ECB. Simultaneously, banks could park their excess liquidity with the ECB, earning -0.5% on these deposits.

With weak credit demand due to the economic downturn following the Ukraine crisis, banks exploited this opportunity: they borrowed funds from the ECB only to redeposit them immediately. The interest rate differential worked in their favour—earning 1% on borrowings while paying only 0.5% on deposits—yielding a 0.5-percentage-point profit. Additionally, banks benefited from rising interest rates: they promptly increased lending rates but not deposit rates, widening their interest margins. This drove record profits in 2023 and likely 2024. The ECB only ended these tender operations after criticism that the TLTRO terms amounted to "excess profits" and unjustified subsidies for banks (De Grauwe/Yuemei 2023).

Expansive Monetary Policy Endangers Financial Stability

Against this backdrop, central banks’ unconventional measures have reignited debates about the optimal size of their balance sheets. Bloated central bank balance sheets not only failed to deliver the hoped-for economic growth—they may have backfired. Even if monetary easing temporarily stimulated growth (which is dubious), it could mid-term undermine financial stability, potentially triggering new economic crises (Adrian et al. 2020, Grimm et al. 2023). Low interest rates encourage banks, households, and firms to take excessive risks. If these risks materialise amid economic weakness, bad loans can destabilise banks and precipitate another growth collapse. "Excessive" lending—where credit exceeds borrowers’ income-based repayment capacity—leads to particularly severe GDP contractions.

Moreover, low rates incentivise banks and investors to borrow cheaply and speculate in financial markets. This demand drives up asset prices (asset price inflation), enriching security holders (institutional investors and wealthy households)—i.e., creditors[7]. This is economically inefficient, as wealthier households have a lower marginal propensity to consume.

Thus, monetary policy redistributes wealth upward. The affluent benefit not only from central bank policies but also from state-backed bailouts that socialise losses onto public budgets rather than creditors. These creditor rescues are funded by taxpayers and higher public debt, necessitating austerity measures—especially in welfare sectors—under EU fiscal rules.

Summary Evaluation of the Measures

In sum, monetary crisis responses must be judged as ambivalent at best. On the positive side, post-2008, the ECB proved agile and innovative, deploying new tools in each crisis phase. During the financial crisis, pandemic, and initial Ukraine war shock, it flooded markets with liquidity (expanding its balance sheet). Later, it reverted to traditional rate hikes to combat energy-driven inflation.

Monetary policy created economic manoeuvring room where fiscal policy was paralyzed by uneven development in the eurozone, strict fiscal rules and political disagreement over the direction and extent of economic policy interventions. These measures may have helped stabilise the financial markets and the economy in the short term. However, they did not achieve a sustainable revitalisation of economic growth. Consequently, they did nothing to combat long-term stagnation. Furthermore, the policy was accompanied by considerable regressive distributional effects, as evidenced by the socialisation of private risks, the banking sector's windfall profits, and financial gains for the wealthy.

Bibliography

Adrian, Tobias, Duarte, Fernando, Liang, Nellie, Zabczyk, Pawel (2020): Monetary Policy and Macroprudential Policy with Endogenous Risk, IMF Working Paper 20/236.

Brunnermeier, Markus (2023): Rethinking monetary policy in a changing world, in: Finance and Development: New Directions for Monetary Policy, Vol. 60, International Monetary Fund, Washington DC, March 2023, pp. 4-9.

De Grauwe, Paul/Ji, Yuemei (2023): Monetary policies that do not subsidise banks, VOXEU, Column, 9 Jan 2023. Online: https://cepr.org/voxeu/columns/monetary-policies-do-not-subsidise-banks (last accessed 15.08.2023).

Eggertsson, Gauti, Mehrotra, Neil, Summers, Lawrence (2016): Secular Stagnation in the Open Economy, in: American Economic Review, Vol. 106, No. 5, 503-507.

Goodhart, Charles A. (2017): A Central Bank’s optimal balance sheet size?, Discussion papers, DP 12272, Centre for Economic Policy Research, London, UK.

Gordon, Robert J. (2012): Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds, NBER Working Paper Series, No. 18315.

Gordon, Robert. J (2016): The Rise and Fall of American Growth, Princeton University Press.

Grimm, Maximilian, Jorda, Oscar, Schularick, Moritz, Taylor, Alan M. (2023): Loose Monetary Policy and Financial Instability, National Bureau of Economic Research (NBER), Working Paper No. 30958.

IMF (2017): World Economic Outlook, Washington.

Kader, M. (2018): Der erschöpfte Kapitalismus, in: Nuss, Sabine (Hrsg.), Der ganz normale Betriebsunfall, Berlin.

Lapavitsas, Costas, Cutillas, Sergi (2021): National States, transnational institutions, and hegemony in the EU, in: Evolutionary and Institutional Economics Review, 19, 429-448.

Ollivaud, Patrice, Guillemette, Y., Turner, David (2016): Links between weak investment and the slowdown in productivity and potential output growth across the OECD, OECD Economics Department Working Papers, No. 1304, Paris.

Piketty, T. (2014): Das Kapital im 21. Jahrhundert, München.

[1] The ESM was established by the euro member states and came into force in autumn 2012. It was initially endowed with EUR 700 billion in capital in order to grant emergency loans to eurozone countries at risk. However, the granting of these loans is linked to strict fiscal adjustment measures (Stützle 2014).

[2] Potential growth describes the development of gross domestic product with optimum utilisation of existing capacities, without any pressure on inflation rates. Potential growth is not a fixed figure, but must be estimated.

[3] The term was originally coined by the US economist Alvin Hansen.

[4] TLTRO: Targeted Longer Term Refinancing Operations

[5] PELTRO: Pandemic Emergency Longer Term Refinancing Operations

[6] PEPP: Pandemic Emergency Purchase Programme

[7] see: Bank of England 2012: The Distributional Effects of Asset Purchases, Quarterly Bulletin Q3, London.; Jon Frost / Ayako Saiki 2012: How does Unconventional Monetary Policy Affect Inequality? Evidence from Japan, De Nederlandsche Bank, Working Paper Series, No. 423.