by Economist Paul De Grauwe and economist Yumei Ji defend an alternative path for the European Central Bank (ECB) to fight inflation. A route that would stop the current transfer of billions of euros from taxpayers to commercial banks and from which banks in Portugal also benefit
The European Central Bank (ECB) and most central banks are raising benchmark interest rates to fight inflation. But the way they do it ends up transferring billions of euros from taxpayers to commercial banks. As? As long as the banks don’t do anything.
The critique is made by economist Paul De Grauwe and economist Yumei Ji, who advocate (here and here) an alternative path to that followed by the ECB and most other central banks to fight inflation. A path that would allow central banks to continue to generate profits, with those profits paying dividends to their respective states and thereby benefiting all taxpayers.
But with the ECB’s current policy, the result is different. The billions of euros that will make profits for the central banks are transferred to the commercial banks as a fee for the deposits made with the central banks themselves.
How does this happen? It is necessary to go back to July 2022, more precisely on July 27, when the ECB began the process of raising interest rates, increasing its three reference rates by half a percentage point. Interest rates have not stopped rising and in less than a year they have already increased by three percentage points.
The goal is to withdraw money from the economy. On the one hand, to make more expensive the loans that commercial banks might take out with the ECB to finance the economy, and on the other hand, to encourage those same banks to deposit any excess liquidity they have with central banks instead of pumping it into the economy. Without the flow of credit to households and companies, the ECB expects consumption and investment to fall and thus reduce pressure on prices, controlling an inflation that is still far from control.
And today, when Christine Lagarde and other members of the ECB’s Governing Council meet in Frankfurt, despite economic instability emanating from the United States and Switzerland, the story should not be too different. The expectation is for a further rise in the ECB’s three reference rates, including the rate at which commercial bank deposits are paid (see note 1 at the end of the text).
And by increasing the remuneration paid to commercial banks, the monetary authority will once again, according to the authors, transfer to these banks profits that should belong to the taxpayers.
Thousands of millions of euros
According to studies published by Paul De Grauwe and Yumei Ji, in February, commercial banks had deposited more than 4.3 trillion euros with the ECB and euro zone central banks, at an interest rate of 2.5%. In other words, the commercial banks have a potential income of more than 100 billion euros from interest. Something like 0.75% of Eurozone Gross Domestic Product (GDP).
And with rising interest rates, that amount will be even higher. Funds that are no longer flowing into the coffers of their respective eurozone countries at a time when, the authors note, economies are slowing on the way to a possible recession.
There is, however, another path the ECB could take. And interest rates could even continue to rise.
What the authors argue is that the required minimum reserve ratio (see note 2 at the end of the text) that banks must create should be increased to an amount equivalent to the amount currently deposited by commercial banks with central banks, and that these amounts are not paid or only a part is paid, for example 25% of the total.
If this happened, money would still not be flowing into the economy because it would be in required reserves, central banks would not have to pay so much interest and would continue to show profits and thus pay dividends to the respective states, protecting the taxpayers.
But wouldn’t putting the brakes on transfers from central banks to commercial banks put financial stability at risk, especially at a time of market volatility? “If this is the motivation of central banks, it is certainly reckless. the banks [comerciais] forced to increase their capital ratios after the financial crisis. They have the necessary buffers to deal with earnings losses when interest rates rise. Large transfers of money from taxpayers to banks primarily protect their shareholders, not the banks themselves. And this should not be part of the objectives of central banks,” the authors respond in one of the published works.
Data on ECB deposits of banks operating in Portugal also make it possible to calculate the profits of Portuguese banks with the policy of increasing interest rates. According to data from the Bank of Portugal, at the end of February, more than 40 billion euros were deposited in the central bank, an amount which, with an interest rate of 2.5%, allows revenues exceeding one billion euros.
The results of the largest banks operating in Portugal in 2022 actually show this. CGD, BCP, Santander and BPI had profits of more than two billion euros last year. It was 5.5 million a day. And interest income brought in five billion with the help of the central bank.
Central banks have been arrested
Paul De Grauwe, speaking to CNN Portugal, says he has no doubts that his proposal will allow inflation to be controlled. “It would probably be even better,” the economist underlines, explaining that commercial banks already have guaranteed income from the ECB, which acts as a disincentive to improve the financial margin and pass on the rise in interest rates to the economy.
The London School of Economics professor finds only two explanations for the ECB and other central banks maintaining a fee on commercial bank deposits: the fact that they are bound by the commercial banks themselves. and the inertia of wanting to use the same system they have been using for over ten years.
“Yes they do [bancos centrais] they are captured by the banks,” the economist assures, adding that commercial banks are telling supervisors that if their deposits are not compensated it will be bad “for financial stability. And so they may have convinced the central bank that this is necessary.”
The second reason has to do with inactivity. “About 10-15 years ago, central banks switched to this system. They have a new operating procedure which consists of raising and lowering the interest rate, manipulating the interest rate on bank deposits. And they believe this is the only way. But in the past they didn’t do that,” De Grauwe explains, stressing that this central bank policy makes the shareholders of “the commercial banks” “very satisfied.”
De Grauwe also explains that central bank profits should be returned to taxpayers because central banks only make profits because governments have given them a monopoly on issuing money.
“And now they say: this profit we have is thanks to the governments, but we will not return it to the government. No, we will give it to private banks”, laments the economist.
“This is amazing. They tell us a story that says, this is the only way we can do it. And too many people believe that. Well, I say no, there are other ways we can do it,” concludes De Grauwe.
Note 1:
The ECB has three reference rates:
– The interest rate on large refinancing operations. The rate at which banks can borrow from the ECB over a one-week period: is currently at 3%, but was set at zero between March 2016 and July last year;
– The deposit fee, which determines the interest that banks receive on deposits made with the ECB: it is currently at 2.5%. But between July 2012 and June 2013 it was zero. And between June 2013 and July last year it was negative, forcing banks to pay for the deposits they made with the ECB.
– AND the liquidity supply rate, which sets the interest that banks pay when they borrow from the ECB for a one-day (overnight) period. It is currently at 3.25%.
Note 2:
In addition to ECB reference rates, there is another rate necessary for the alternative advocated by Paul De Grauwe and Yumei Ji. In the minimum bookings required to which eurozone banks are subject. Commercial banks are required to maintain a certain amount of funds in reserve in their current accounts with the respective national central bank. Currently, this amount is equivalent to 1% of total customer deposits. And these reserves are also paid by the central banks at the ECB deposit rate, which is currently at 2.5%.
