FEU is created by the European Liberal Forum (ELF)



European monetary integration has from the outset faced a potential ‘free rider problem’. The essence of the problem is that one or more member states may be tempted to borrow heavily from the European Central Bank (ECB) regardless of the impact on inflation for the entire Eurozone. Inflation for the whole area depends of course on the behaviour of all member states. The 1992 Maastricht Treaty – which reflected the monetary orthodoxy of the German Bundesbank – tried to pre-empt the free rider problem, with the key clauses 121 to 126 including both a prohibition on overdraft finance to national governments and a no bailout provision. The article shows how the ECB’s responses to three crises – the Great Financial Crisis of 2007 and 2008, the recession of the early 2010s, and the COVID-19 medical emergency – have led to enormous expansion of its balance sheet. The Bundesbank’s monetary orthodoxy has been abandoned and the constraints on the ECB balance sheet in the Maastricht Treaty have been disregarded, while inflation has risen to the highest levels since the introduction of the single currency. 

Keywords: ECB, free rider problem, Bundesbank, inflation  

1. Introduction: the free rider problem in a multi-government monetary union 

European monetary integration has, from its outset, had to confront a ‘free rider’ problem. This problem has been variously defined, but its essence is that agents can secure a benefit without paying anything towards it.[1] The danger is that, without a pre-emptive agreement between all the parties affected, the benefit will be under-provided or not provided at all. The argument of this article can be quickly stated: in its early years the key players in European economic and monetary union (EMU) – that is, its member nation states and the European Central Bank (ECB) – respected the free rider problem and behaved prudently, but more recently they have either forgotten about it or decided to disregard it. Already the annual increase in the consumer price index at the time of writing (March 2022) has reached 5.1 per cent, the highest figure since the European single currency was introduced in 1999. In important respects, the ECB and the nation states have become financially and monetarily irresponsible. Unless these irresponsible tendencies are reversed, the future viability of EMU will come into question.

In the single currency context, the free rider problem is readily described.[2] The objectives of EMU have been to provide the European Union not just with a shared currency and medium of exchange, but also with a money that is stable in value, and hence a reliable unit of account and standard of deferred payment. As is well known, excessive growth of the quantity of money – a rate of money growth far above the rate of growth of output – leads to inflation and undermines currency stability. Since money growth is determined by banks’ extension of new credit to the private sector and the state, restrictions of some sort are needed on the state’s ability to borrow from the banking system. A traditional monetary jurisdiction has only one government and one central bank, which together constitute the monetary authorities. In such a jurisdiction, which is normally a sovereign nation state, the blame for inflation mistakes falls unequivocally on the nation’s monetary authorities.[3] But, in a multi-government monetary union such as the Eurozone, a special difficulty arises. All the Eurozone member nations may benefit from price stability, but the link between the fiscal and monetary conduct of any one nation and the desired area-wide price stability may be elusive and unclear.

Indeed, the lack of clarity may be such that one government comes to believe that it can borrow, with impunity, on an enormous scale from the banks. If so, it may be tempted to act as a free rider at the expense of other nations. The perverse incentive is most obvious for small nations. The Eurozone contains, for example, Portugal and Greece, which both produce under 2 per cent of Eurozone gross domestic product (GDP). (In 2019 they accounted respectively for 1.8 per cent and 1.6 per cent of Eurozone GDP, according to the International Monetary Fund’s database.) If they run large budget deficits relative to GDP and finance these deficits entirely from banks, the impact on the Eurozone’s aggregate growth of credit and money is likely to be minor. The impact should be small enough that it does not endanger price stability for the Eurozone as a whole. But the outcome would be patently unfair on other larger Eurozone member states, if they maintained strong public finances with the associated high taxation and incurred debt in the capital markets at consequent extra cost (relative to bank finance). 

2. Institutional safeguards against free riders

The discussion so far is not original. It was well understood by EMU’s architects in the late 1980s and 1990s, and the founding documents tried to anticipate the free rider problem by specific provisions. The Maastricht Treaty of 1992 contained the ‘no bailout clause’ (Article 125) and a prohibition on overdraft finance from the Euro system (that is, the Eurozone’s central banks, under the aegis of the ECB) to national governments (Article 123).[4] Moreover, Articles 121 and 126 envisaged a newly centralised role for the European Commission and the Council of Ministers. The Commission and Council were to monitor member nations’ fiscal imbalances and assess their compatibility with the integrity of EMU.

Meetings of the Council of Ministers in 1997 resulted in further regulations based particularly on Articles 121 and 126. These amounted to a ‘Stability and Growth Pact’ (SGP), which laid down limits on the maximum permitted levels of a member nation’s budget deficit and public debt relative to its GDP. The SGP also specified an ‘excessive deficits procedure’ whereby governments that breached the limits would be subject to fines. In the first decade of the single currency the Maastricht Treaty provisions and the SGP were thought to be a sufficient remedy for the free rider problem. In a 2010 analysis by Wyplosz, the no bailout clause, the prohibition on overdraft finance, and the excessive deficits procedure were identified as three vital ‘safeguards’ of the single currency’s long-run sustainability.[5]

However, the three safeguards identified by Wyplosz had two serious weaknesses. Firstly, the Maastricht Treaty allowed large-scale transactions in government securities by central banks as part of monetary policy. It was understood that substantial asset purchases might be needed to boost the quantity of money and thereby to halt a recession (Issing, 2008: 124). The inconsistency here was definitely an issue, even if its implications were only latent. Government finance from the Eurozone’s national central banks by means of overdraft is unacceptable in normal conditions, according to an international treaty. But government finance from those central banks by means of open market purchases of government securities, in order to forestall recessions, is quite alright in practice. Is the distinction robust? Crucially, who is to decide when a recession is imminent? The point cannot be escaped: open market purchases of securities issued by governments – just like overdraft finance to them – expand the central bank balance sheet. Indeed, when the central bank finances its open market purchases from commercial banks (by the emission of cash reserves to them) and makes the purchases from non-banks, the effects are to increase both the monetary base and the quantity of money.[6]

Secondly, an acknowledged task for any central bank is to help commercial banks in the management of their cash. According to a well-recognised argument dating back at least to Bagehot’s 1873 classic text on Lombard Street, the central bank should provide ‘lender-of-last-resort’ loans to solvent banks when they are subject to a run on their deposits. This task can be problematic in a traditional one-government monetary jurisdiction, as the central bank can be criticised for being too soft on badly managed banks. It may be accused of ‘bailing out’ profit-seeking organisations in private ownership with highly paid senior executives.[7] But the central bank’s job is much harder in a multi-government monetary union such as the Eurozone. Most banks have their headquarters in a particular nation where they are registered and supervised, while their shareholders, depositors, and other stakeholders are mostly located in and belong to that nation.[8] The risk in the Eurozone is that runs on banks’ cash are concentrated in certain member states, while most member states are unaffected. Last-resort loans may then be extended, on a differential basis, to particular countries. Of course, last-resort loans have in one respect the same result as asset purchases: they expand the central bank balance sheet. 

The three institutional safeguards noticed by Wyplosz in his 2010 analysis were important, not least because they put down a marker for central bank strategy. All the same, from the start of the single currency the understood constraints on the ECB’s asset acquisition could be bypassed by the methods outlined in the last two paragraphs. The size of the ECB balance sheet, and the monetary consequences of its operations, might prove far more elastic – and potentially more inflationary – than envisaged when the Maastricht Treaty was signed.

2. Evolution of the ECB’s balance sheet: the early years, 1999–2007

In its early years the ECB’s behaviour could be said to resemble that of the Bundesbank. Since its establishment in 1957 the German central bank had forged a reputation as a staunch fighter of inflation. The ECB’s first two chief economists – Otmar Issing and Jurgen Stark – had Bundesbank backgrounds. Part of their thinking was that the quantity of money was influenced by the monetary base, a concept usually understood to include both notes and coin held by the public, and commercial banks’ cash reserves with the central bank. The monetary base does not constitute all of a central bank’s liabilities, but it normally moves in tandem with the central bank balance sheet as a whole. A familiar claim in thinking of this sort –commonly associated with the University of Chicago’s monetarism, but also blessed in numerous textbooks – was that the quantity of money could be viewed as a stable multiple of the base. Even if they did not believe in a rigid connection between the base and money, Bundesbank officials were concerned to limit the growth of the ECB’s own balance sheet; they tended to see rapid increases in the size of that balance sheet as potentially inflationary. One well-regarded book on monetarism said that ‘monetarists favour some measure of [banks’ cash] reserves’ as the best indicator of monetary policy, because they are ‘clearly under the control of the central bank’ and ‘have a powerful effect on the money stock, the monetarists’ target variable’ (Mayer, 1978: 26–27). The argument that central bank expansion was unwise because of its inflationary repercussions was important in its own right, but it also acted as a bulwark against free riding – with undue monetary financing of budget deficits – by Eurozone member states.

A prohibition on overdraft finance to the government had been spelt out in the national legislation that founded the Bundesbank in 1957. German hostility to such finance stemmed from the catastrophe of the Weimar hyperinflation in 1923, when the printing of new notes had been on an inordinate scale to cover the expenditure of the German state.[9] Although some national central banks under the ECB umbrella did hold government securities from the introduction of the euro in 1999, these were very small relative to the Eurozone’s economy.[10] More fundamentally, changes in its holdings were modest from month to month, and even from year to year, and allowed no scope for free riding by insubordinate member states.

Until the Great Financial Crisis, which began in 2007, the ECB’s most important activity was setting the short-term interest rate by repurchase operations. As implied by their name, repurchase operations involved the sale (or purchase) of securities, which would be followed at a later date by a matching purchase (or sale). They mattered because the terms of the repo set a price (that is, an interest rate), not because any change in the size of the ECB balance sheet was intended. Meanwhile, the opening years of the single currency were ones of reasonable prosperity, with banks generally profitable or very profitable and readily able to fund their assets in the wholesale markets. Lender-of-last-resort assistance was not needed anywhere in the Eurozone. With ECB holdings of government securities stable, and no last-resort lending, the ECB’s balance sheet was insignificant relative to that of the entire European banking system. In this period European monetary integration seemed to be going well, and worries about the free rider problem were not only unjustified but appeared to be hypothetical and remote from reality.

3. During and after the Great Financial Crisis, 2007–2011

The situation changed radically from the start of the Great Financial Crisis, usually dated as 9 August 2007, when BNP Paribas blocked withdrawals from three of its money market funds, citing such ‘a complete evaporation of liquidity’ in the wholesale money markets that the valuation of the assets inside the funds had become impossible. All banks which owed money on a short-term basis to other banks (and to some extent even to non-bank financial institutions) might find themselves unable to finance their assets. The strains symptomised a modern form of the cash run discussed by Bagehot in the late nineteenth century. Lender-of-last-resort lending – or ‘emergency liquidity assistance’, as it tended to be labelled in the early twenty-first century – was needed.

On 3 August 2007, just before the crisis, the ECB’s ‘lending to Euro area credit institutions related to monetary policy operations’ came to €448 billion. The ECB made borrowing facilities available on a potentially immense scale to its member banks, with the amounts at stake – by means of so-called fine-tuning operations – being €95 billion on 9 August, €110 billion on 10 August, and €310 billion on 13 August. Happily, the speed and scale with which the facilities were granted had the effect of restoring confidence, and for much of the following year the Eurozone seemed unaffected by the much worse banking crises in the United States and the United Kingdom. The ECB’s assets in August 2008 (at the 29 August make-up day, to be precise) were €1,451 billion, up on the immediate pre-crisis figure (on 3 August 2007) of €1,195 billion, but not dramatically so. ‘Lending to Euro area credit institutions’ on the same date was €467 billion. 

However, in September 2008 the difficulties in the wholesale markets intensified and regulatory officialdom let it be known that banks would in future have to maintain much higher capital to asset ratios. Under the planned Basel III regulatory regime, equity capital per unit of risk assets would rise by over 60 per cent.[11] By now banks in several Euro area countries were having trouble rolling over liabilities in the inter-bank market. The ECB helped them by its willingness to extend loans with what it termed ‘non-standard measures’. By the last make-up day that year (on 19 December), ‘lending to Euro area credit institutions’ was €843 billion and the ECB’s total assets were €2,022 billion. The loans were probably mostly to non-German banks, although data on the destination of the loans are not readily available.

As chief economist, Jurgen Stark was unhappy about the non-standard measures and believed that the resulting expansion of the ECB’s balance sheet might cause upward pressures on inflation. On 15 April 2010, he gave a speech in Washington which warned that ‘keeping our non-standard measures in place for longer than necessary would entail the danger of harmful distortions’. He noted, moreover, that ‘we have started gradually to phase out some of them’ (Stark, 2010). Unfortunately, as banks lost their ECB funding, they were obliged to sell assets, and the easiest assets to sell included government securities issued by the less creditworthy Eurozone governments. The prices of these securities declined and yields rose sharply. For example, the yield of ten-year Greek government bonds, which had been under 5 per cent in November 2009, had climbed to almost 8 per cent by April 2010. Further increases in bond yields implied ever-mounting interest bills on Greek government debt and, ultimately, might result in state bankruptcy. Over the weekend of 8–9 May 2010, European leaders agreed that the ECB should buy nation states’ government securities in sufficient volume to keep yields down to levels consistent with long-run fiscal solvency. On 10 May the ECB announced the Securities Markets Programme, which gave it authority to buy large quantities of government bonds. Purchase of Greek government paper came first.

On the ECB Governing Council, Stark and Axel Weber, the latter attending as the President of the Bundesbank, voted against the Securities Markets Programme, but they were outmanoeuvred and outvoted (Sinn, 2014: 261–265). So the attempt to limit the ECB’s balance sheet (and hence the monetary base) by reducing loans to banks was frustrated by the consequent pressure on the ECB to increase holdings of government securities. The ECB was split between, on the one hand, representatives of Bundesbank analysis and the German sound money tradition, and, on the other, representatives from most of the other countries with more pragmatic and flexible views. The tensions between the two kinds of thinking increased during 2010 and 2011, while in the background many Eurozone government bonds suffered from severe selling and large yield increases. (The yield on the ten-year Greek government bond went through 10 per cent in July 2010 and continued to rise in the following months, despite the ECB purchases.)

As Stark was perhaps the most prominent advocate of the Bundesbank position, his statements became increasingly important. In a contribution to the 13th Euro Finance Week event in Frankfurt on 16 November 2010, he emphasised in his concluding line that the ‘non-standard measures were the exceptional response to exceptional circumstances’. On 21 February 2011 Reuters reported that, in remarks again given in Frankfurt, Stark had expressed concern that ‘risks to the medium-term outlook for price developments … could move to the upside’ (Master and Jones, 2011). In a speech on 10 June 2011, also given in Frankfurt, he reiterated that ‘we see risks to price stability on the upside’, which demanded ‘strong vigilance’, including ‘further steps to phase out the non-standard measures’ (Stark, 2011). In this speech he also referred to the ECB’s ‘two-pillar’ framework for forecasting inflation, in which analysis of money and credit (the monetary pillar) accompanied analysis of the economy (the economic pillar). The mention of the two pillars was surprising, as the ECB Governing Council had decided over eight years earlier – in May 2003 – to stop publishing a reference value for M3 broad money. Many observers thought that the ECB could no longer defend the focus on money and inflation that had been such a feature of the Bundesbank’s intellectual framework in the late twentieth century.[12]

Stark’s grumbling about rising inflation may have made sense relative to a long-standing and successful approach to monetary policymaking in his own country. However, in the circumstances of late 2011 it had an overriding defect as far as the Eurozone was concerned. In forecasting terms, it was totally wrong. True enough, the annual increase in the Eurozone consumer price index did reach 3.0 per cent in October 2011. But from then on inflation declined relentlessly in depressed economic conditions. Eurozone real GDP fell for six consecutive quarters from the final quarter of 2011. Indeed, the prevalent concern in 2012 and 2013 became not inflation, but deflation. On 9 September 2011, Reuters reported that Stark would leave the ECB due to disagreement with the Securities Markets Programme, although the official announcement was that his resignation was for ‘personal reasons’ (Framke and Hübner, 2011).[13] (Stark’s term had been due to end in May 2014.) 

Stark’s resignation marked the end of German monetary orthodoxy as a powerful conceptual influence on ECB policymaking. While this orthodoxy prevailed, monetary and fiscal free riding faced a strong obstacle. Quite simply, because any expansion of the central bank balance sheet was regarded as suspect, debt and deficit monetisation by high-spending countries could not be tolerated, and cash-deficient banks were deterred from seeking emergency liquidity assistance. But in truth Stark had lost the argument. During 2010 and 2011 his pronouncements reflected concern that the Eurozone would suffer rising inflation over the medium term. Even within the Bundesbank framework, this was strange. In the two years from December 2009 M3 growth was negligible, a mere 1.5 per cent. (In other words, the annual rate of increase was under 1 per cent.) Anyhow, the recession of 2012 made his forecasts look ridiculous and discredited his position. 

Figure 1 shows the size and composition of the ECB’s assets from the start of 1999 to the end of 2011. At the start of the single currency the ECB’s assets were dominated by ‘other assets’, mostly gold and foreign exchange, with tiny holdings of securities and only modest lending to credit institutions. This pattern continued to hold until the Great Financial Crisis, when in late 2008 lending to credit institutions (that is, banks) jumped sharply in a few weeks. Such lending then fell, particularly in 2011, in line with Stark’s comments. A key message of the chart is that, even at the end of this period, in December 2011, the ECB’s ‘other assets’ were much larger than either securities held or lending to credit institutions.

4. The Draghi presidency, 2011–2019

Soon after Stark’s resignation, another crucial change occurred in the ECB’s top management. Mario Draghi of Italy took over from the French Jean-Claude Trichet as President of the ECB. Draghi’s interpretation of the Eurozone’s problems was utterly different from Stark’s. In Draghi’s view, the closure of the inter-bank market in 2007 had crippled the banking systems of several Eurozone member states, particularly where these systems had become reliant on the international wholesale markets for financing their expansion. These states included not just small members such as Greece, Portugal, and Ireland, but also Spain and to a lesser degree Italy.[14] Banks in these countries were under pressure to shrink their loan portfolios, largely because of the Basel III capital regime, but also to some extent because of heavy loan losses. Economic analysis argued that the shrinkage of banks would have adverse repercussions on economic activity.[15] Here indeed was a persuasive explanation of the deflationary forces which seemed to have become entrenched in the Eurozone. Further, the less robust banks were sometimes forced sellers of government securities, which pushed up yields. When Draghi assumed the ECB presidency, the yield on Greek ten-year government bonds was approaching 20 per cent. It was at these levels even though the previous months had seen a large default by Greece, in which private holders of Greek government bonds had been forced to accept a write-down of over 50 per cent on the supposed redemption value.[16]

Draghi and his colleagues decided that the answer was not to limit the non-standard measures, but to expand them enormously. In December he announced that €500 billion of new low-cost financing facilities would be made available to banks, with a term of up to three years. In February the figure was doubled to over €1,000 billion. The programme was called the ‘Draghi bazooka’ by the media, but in fact it was just a revamped and much enlarged version of the non-standard measures.[17] The ECB’s lending to credit institutions touched a low of €580 billion on 4 November 2011, just as Draghi took over. Three months later the number had climbed to €795 billion and three months after that to €1,117 billion. (The peak for this episode, of €1,261 billion, was on 29 June 2012.)

The Draghi bazooka saved the Eurozone banking system and in that respect helped the economy. The pressures on banks to shrink their balance sheets eased, as they had time to make new capital issues and to retain operating profits, and so to rebuild equity. They no longer had to sell government bonds on such a large scale, and most Eurozone government bond yields fell in 2012 and 2013. However, money growth remained low. Cash-strained banks could take advantage of the borrowing facilities for a generous period of three years, but that still meant that the loans had to be repaid within the deadline. In the years to December 2012 and 2013 M3 broad money increased by 3.0 per cent and 1.0 per cent respectively. In 2014 consumer inflation dropped to negligible levels. By December 2014 the annual increase in the consumer price index fell into negative territory and it stayed there in the opening months of 2015.

In these circumstances another upheaval in Eurozone policymaking was discussed and endorsed. In both the United States and the United Kingdom, the central banks had reacted to the Great Recession by purchasing assets from the non-bank private sector in operations usually labelled ‘quantitative easing’ (QE). Given the apparent success of QE in boosting demand, output, and employment, a case could be made that a similar approach should be adopted in the Eurozone. Admittedly, open market purchases of government securities might be construed as government finance from the ECB, which would be contrary to the spirit of Article 123 of the Maastricht Treaty. But – as discussed earlier – stimulatory open market operations had always been regarded as a legitimate response to recession. By early 2015 the ECB’s Governing Council was committed to a major programme of asset purchases. According to a Reuters story in December 2018:

<EXT>The asset purchase program, a monetary experiment known as quantitative easing (QE), was launched in March 2015 to prevent sub-zero inflation from further hitting an economy still reeling from the euro zone debt crisis. The ECB has spent €2.6 trillion euros (€2,600 billion) over almost four years, buying up mostly government but also corporate debt, asset-backed securities and covered bonds – at a pace of €1.3 million a minute. That equates to roughly €7,600 for every person in the currency bloc. As intended, QE has lifted economic growth while wages and lending have risen. (Carvalho, Ranasinghe, and Wilkes, 2018)</EXT>

The benign effects of QE were inescapable and impressive, with the Eurozone recording positive growth of real GDP in all five years to 2019, while inflation stayed down. However, the ECB had moved far from the Bundesbank philosophy of restricting central bank assets. To recall, the Bundesbank’s approach to central banking was intended both to counter inflation and to curb the free rider problem. The increase in the ECB’s holdings of government securities in the four years to end-2018 was enormous relative to the amounts involved in the Securities Markets Programme that had caused so much friction between Stark and other ECB officials in 2010 and 2011. By the end of 2018 these holdings had exceeded €2,900 billion. They levelled out in 2019, with the ECB’s leadership increasingly hopeful that the Eurozone banking system was again in good shape and that the economy could move forward without the artificial support of its asset purchases.

Draghi stood down from the ECB presidency at the end of October 2019. He was widely admired as having ‘saved the euro’ by his astute decisions and, especially, by a speech on 26 July 2012 where he said that the authorities would do ‘whatever it takes’ to keep the Eurozone in being. However, one assessment was that the intellectual debates on European economic policy had become confused and fractious, and that Draghi left the ECB ‘more divided than ever’ (Amaro, 2019). Many economists had started to prescribe actively expansionary fiscal policy to boost demand, even though the implied large budget deficits would breach the SGP.[18]

An analyst at the consultancy firm TS Lombard, Constantine Fraser, judged that ‘[i]t’s hard to overstate just how important Draghi’s tenure has been, even if you’re generally sceptical about individuals’ ability to shape historical events. Not only did he play the single most important role in – essentially – saving the euro zone, but since autumn 2011 he has de-facto rewritten the ECB’s mandate’ (Amaro, 2019). The significance of this rewriting is evident in Figure 2, which again shows the size and composition of the ECB’s balance sheet, but now from the inception of the single currency until Draghi’s departure. A salient feature of Figure 2 is the dramatic surge in the ECB’s holdings of securities – meaning mostly government securities – beginning particularly in 2015.

5. The COVID-19 emergency, 2019

Christine Lagarde assumed the presidency of the ECB in November 2019. She had worked for over 20 years as a lawyer at Baker & McKenzie, a large Chicago-based international law firm. Unlike her predecessor, she had no serious background as an economist. Her speeches did not indicate deep knowledge of monetary economics, and she had no meaningful scholarly papers on economics to her name. The academic counterweight to Lagarde at the ECB since 2019 has been Philip Lane, an Irish economist who has specialised in international monetary economics. From 1 January 2020 the most senior German figure on the ECB Executive Board – apart from the Bundesbank’s own representative (Jens Weidman) – was Isabel Schnabel, who was seen as a ‘moderate’ in the various doctrinal disputes that afflict modern macroeconomics (Arnold and Buck, 2019). 

Very early in the Lagarde presidency, concern was expressed about the economic implications of COVID-19. The global pandemic was announced in March 2020. Restrictions on personal contact were imposed, with devastating negative impacts on the travel and hospitality sectors everywhere, and a loss of output that year of up to 10 per cent in major economies. This loss of output was viewed by economists as ‘a recession’, a word which usually denotes a reduction in output and employment due to a deficiency of aggregate demand. The policy response in the leading Western economies was therefore to boost demand, both by widening budget deficits and by resuming central bank asset purchases (or QE).

The return of QE was justified – according to Lane, Schnabel, and others – by the very low level of central bank interest rates, which meant that stimulus could not come from a big cut in such rates. The effect of the asset purchases on the quantity of money was a matter of little or no interest at the ECB, as at other top central banks, because the quantity of money was not believed to matter to the determination of any important macroeconomic variables. In the four months to June 2020 the M3 measure of broad money increased by 5.6 per cent or at an annualised rate of 17.8 per cent. This was the fastest M3 increase in a four-month period in the history of the single currency. The annual rate of increase reached 12.5 per cent in January 2021, again the fastest pace of expansion in a period of this length since the euro had come into existence.

A case can be made that attributing 2020’s output loss to demand deficiency was a serious misinterpretation. The output loss could instead be understood as an interruption of supply, imposed for medical reasons, and hence as an adverse supply-side shock. If so, increasing aggregate demand by deliberate policy would lead to excess demand and rising inflation. This line of discussion could proceed in the sort of framework set out in naïve Keynesian textbooks, without any reference to money aggregates. In the event the short-term impact of the collapse of output was particularly on energy prices since oil was of course used particularly in travel and transport. The fall in oil prices was so large as to prompt forecasts of persistent deflation. On 2 July 2020, as the money explosion was at its peak, Schnabel gave a presentation to the Berlin Economic Roundtable which described the ECB’s response to the medical emergency as ‘necessary, suitable and proportionate’. One slide was titled ‘Marked weakening of inflation over the medium term’ and envisaged that the annual increase in Eurozone consumer prices would be close to 1.0 per cent at the end of 2021 and to 1.2 per cent at the end of 2022.

Given the intellectual background of the ECB’s executives, it is perhaps unsurprising that the size of the ECB’s balance sheet ballooned. Early in the pandemic the ECB embarked on a new pandemic emergency purchase programme (PEPP). At the time of writing (March 2022) this is described on the ECB’s website as ‘a non-standard monetary policy measure … to counter the serious risks to the monetary policy transmission mechanism and the [economic] outlook for the euro area. The PEPP is a temporary asset purchase programme of private and public sector securities.’ The initial setting was for a ‘€750 billion envelope for the PEPP’, but the Governing Council decided to enlarge this ‘by €600 billion on 4 June 2020 and by €500 billion on 10 December, for a new total of €1,850 billion’. In 2019 the ECB’s holdings of government securities had been stable. From 13 March 2020 to 4 March 2022 holdings of all securities – with government bonds preponderant – rose from €2,879 billion to €5,018 billion. (So the increase in the period was €2,139 billion, somewhat above the €1,850 billion ‘envelope’. The explanation is that the PEPP complemented an existing and ongoing asset purchase scheme.)

Some Eurozone banks had trouble funding their assets in the COVID-19 period, but media reports did not suggest these were particularly serious after mid-2020, once the hubbub about COVID-19 had begun to abate. Nevertheless, the ECB made available immense borrowing facilities to the banks under the label ‘targeted long-term refinancing operations’, where the word ‘targeted’ made the exercise more respectable. The ECB’s loans to credit institutions were €618 billion on 13 March 2020, but no less than €2,201 billion on 4 March 2022. According to Lagarde, in a statement to the ECON committee of the European Parliament on 19 November 2020, ‘[t]he key role of monetary policy in [the current] situation is to preserve favourable financing conditions for all sectors and jurisdictions … [P]reserving favourable conditions for as long as needed is key to support people’s spending, to keep credit flowing and to discourage mass lay-offs.’

In summary, the Lagarde presidency has so far been accompanied by an extraordinary indifference to the constraints on the ECB balance sheet – the three safeguards noticed by Wyplosz in 2010 – that were discussed and formulated in the 1990s. When she took over from Draghi, the ECB’s total assets were €4,676 billion, whereas on 4 March 2022 (the latest numbers at the time of writing) they were over 85 per cent higher at €8,673 billion. The increase in this period of less than two and a half years was therefore almost exactly €4,000 billion. By contrast, in the first eight years of the euro’s existence, when the constraints in the Maastricht Treaty still meant something, the ECB’s assets rose by less than €500 billion and the assets that expanded most were the ECB’s claims on the rest of the world. In a remarkable speech called ‘Escaping Low Inflation’ on 3 July 2021, Schnabel nevertheless worried that ‘medium-term inflation’ would be ‘likely to remain below the Governing Council’s aim’. She wanted the ECB’s monetary policy decisions, in concert with active fiscal support from Eurozone governments, ‘to set in motion a virtuous circle of rising underlying inflation and wages’ (Schnabel, 2021). In other words, Schnabel supported more inflation.

6. Conclusion: the free rider problem remains

In the early years of the European single currency the ECB’s approach to monetary control owed much to the example of the Bundesbank. The aversion to both monetary financing of budget deficits and loan assistance to the commercial banking industry anticipated the free rider problem. As intended by Articles 121 to 126 of the Maastricht Treaty, there was limited scope for individual member nation states to run large budget deficits or for their banks to secure cheap central bank finance.

But since 2007 the Bundesbank model has been abandoned. Good reasons could be provided from 2007, when the global inter-bank market closed to new business, for the ample borrowing facilities (or ‘non-standard measures’) made available to banks to enable them to fund their assets. Moreover, an argument can be made that the two Draghi bazookas (of much expanded ‘non-standard measures’ from late 2011 and large-scale asset purchases from early 2015) were essential to keeping the single currency in being. All the same, certain nations benefited from the ECB’s actions in the Draghi presidency, while others lost out. The ECB’s purchases of government securities from the 2010 crisis were particularly of debt issued by the Greek, Portuguese, and Irish governments, while there can be little doubt that the loans to banks were directed mostly to banks with high levels of non-performing loans and hence little credibility in the inter-bank market. Many of these banks were – and still are – in Italy, Spain, Greece, and Portugal. Draghi may have saved the euro, but he had indeed rewritten the rule book. 

Respect for the Maastricht Treaty’s constraints on central bank balance sheet expansion vanished, almost completely, during the COVID-19 medical emergency. The ECB lent freely and on an enormous scale to Eurozone banks. Although the destination by country of these loans is not publicly disclosed, the remarks in the previous paragraph are still relevant. The banks with questionable solvency are predominantly in Italy, Spain, Greece, and Portugal. Further, the ECB’s purchases of government securities have been particularly helpful for countries with large budget deficits which might otherwise have had difficulty selling bonds in capital markets. By contrast, countries with budget surpluses have gained next to nothing from QE. One symptom of the unfairness of the ECB’s conduct is the large imbalance in the Eurozone’s Target2 settlement system. Germany (that is, the Bundesbank) has for several years had a large positive balance, on which it receives hardly any meaningful return. Meanwhile, Italy and Spain (via their central banks) have – again for several years – had large negative balances, in effect borrowed money on which they have to pay next to zero interest.[19]

So far the risk inherent in the Eurozone’s free rider problem – that all nations try to borrow heavily from the ECB and so cause excessive money growth – has not been unmanageable. Nevertheless, the highest rates of broad money growth in the Eurozone’s history – recorded, as shown above, in 2020 and early 2021 – have been followed by the highest inflation rates. Recent analysis of this topic by the ECB’s research department has to be characterised as short-sighted and inadequate. Far into 2021 the ECB’s leaders articulated concern about too low inflation, when the prospect was already for inflation far above desired levels. Sure enough, other central banks – notably the Federal Reserve and the Bank of England – also failed to anticipate the inflation dangers in the high money growth they had orchestrated from spring 2020. But the ECB had received a special intellectual legacy of sound-money ideas from the Bundesbank – and it might have been expected that this legacy would have checked undue ECB expansionism even in the stressful COVID-19 period.


Amaro, S. (2019). ‘Draghi “Saved the Euro”, but Leaves the ECB More Divided Than Ever’.

CNBC Europe News, 24 October.

Arnold, M. and Buck, T. (2019). ‘Germany Set to Appoint Isabel Schnabel to ECB Board’. Financial Times, 22 October.

Bernanke, B. (2015). The Courage to Act. New York: W. W. Norton & Co.

Bresciani-Turroni, C. (1953). The Economics of Inflation: A Study of Currency Depreciation in Post-War German

y, 1914–1923. Transl. Millicent Savers. London: George Allen & Unwin.

Carvalho, R., Ranasinghe, D., and Wilkes, T. (2018). ‘The Life and Times of ECB Quantitative Easing, 2015–18’. Reuters, 12 December.

Castañeda, J. and Congdon, T. (2017). ‘Have Central Banks Forgotten About Money? The Case of the European Central Bank, 1999–2014’. In T. Congdon (ed.), Money in the Great Recession, pp. 101–129. Cheltenham: Edward Elgar.

Congdon. T. (1992). ‘Analytical Foundations of the Medium-Term Financial Strategy’. In T. Congdon, Reflections on Monetarism, pp. 65–77.Aldershot: Edward Elgar, for the Institute of Economic Affairs.

Congdon, T. (1997). ‘Why the Euro Will Fail’. In P. Temperton (ed.), The Euro, pp. 77–95. Chichester: John Wiley & Sons.

Congdon, T. (2011). Money in a Free Society. New York: Encounter Books.

Congdon, T. (ed.). (2017). Money in the Great Recession.Cheltenham: Edward Elgar.

Cukierman, A. (2021). ‘Reflections on the Shifting Consensus about Monetary and Fiscal Policies Following the GFC and COVID-19 Crises’. In G. Ferri and V. D’ Apice (eds.), A Modern Guide to Financial Shocks and Crises, pp. 180–198.Cheltenham: Edward Elgar.

EUChicago Research Team. (2016). ‘Europe’s Free Rider Problem’, 9 December, http://uchicagogate.com/articles/2016/12/9/europes-free-rider-problem-why-eu-states-do-not-pay-their-fair-share/.

Framke, A. and Hübner, A. (2011). ‘Top German Quits over Bond-Buying Row’. Reuters, 9 September.

Issing, O. (2008). The Birth of the Euro. Cambridge: Cambridge University Press.

Master, F. and Jones, M. (2011). ‘ECB Policy-Makers Ratchet Up Inflation Warnings’. Reuters, 21 February.

Mayer, T. (1978). The Structure of Monetarism. New York: W. W. Norton & Co.

Schnabel, I. (2021). ‘Escaping Low Inflation?’ Speech at the Petersberger Sommerdialog, Frankfurt am Main, 3 July, https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210703~f221554ff2.en.html.

Sinn, H.-W. (2014). The Euro Trap. Oxford: Oxford University Press.

Sinn, H.-W. (2020). The Economics of Target Balances (Cham: Palgrave Macmillan for Springer Nature.

Stark, J. (2010). ‘Taking Stock: Where Do We Stand in the Crisis?’ Speech at BMW Stiftung Herbert Quandt, Washington, DC, 15 April.

Stark, J. (2011). ‘Adjusting Monetary Policy in a Challenging Environment’. Speech at the ECB and its Watchers, no. XIII conference, 10 June.

Wyplosz, C. (2010). ‘European Stabilisation Mechanism: Promises, Realities and Principles’. VoxEU blog, 12 May.

[1] The literature is large. See, for example, EUChicago Research Team (2016). The problem of burden sharing in military alliances is similar.

[2] See also Congdon (1997), particularly p. 93.

[3] For a discussion of the relationship between the budget position and money growth, using the credit counterparts identity, see Congdon (1992).  

[4] The term ‘the Euro system’ is taken, for current purposes, to be equivalent to the European Central Bank.

[5] In this note Wyplosz (2010) said that the Stability and Growth Pact ‘never worked’, while the two remaining of the three safeguards had ‘been blown away’.

[6] The implications of different open market operations for the monetary base and the quantity of money are discussed in Congdon (2011), essay 4, particularly pp. 80–81.

[7] Numerous books in a bank-bashing vein have been published. In the American case, all loans made in the Great Financial Crisis by the Federal Reserve to the commercial banking system have been repaid. See Bernanke (2015: 469). Indeed, the federal government has made a profit on its GFC interventions in the banking system.

[8] People belong to a nation by some combination of birth, citizenship, and residence.

[9] The classic reference is Bresciani-Turroni (1953).

[10] The securities held by the ECB on the first make-up day in January 1999 were worth less than €21 billion, compared with a Eurozone GDP of over €6,000 billion.

[11] The new rules had several dimensions, but the summary in the text captures the gist of the changes. The changes required banks to shrink assets as demand and output were already weakening and arguably caused an intensification of the recession. See chapters 1 and 2 of Tim Congdon (2017: chapter 1–2) for further discussion. 

[12] For more on the ECB’s disillusionment with the monetary pillar see Castañeda and Congdon (2017).

[13] In the ECB internal debates of 2011 the Securities Markets Programme was likely to be replaced by a programme of Outright Monetary Transactions, which was even more unattractive to Stark and like-minded German economists. 

[14] The offending nations were sometimes grouped as the ‘GIPSIC’ nations (Greece, Italy, Portugal, Spain, Ireland, and Cyprus) and sometimes as the ‘PIGS’ (Portugal, Ireland, Greece, and Spain).

[15] Normally the repayment of bank loans results in the disappearance of money balances. Many discussions of the period focus on the credit side of the story, without mentioning money. 

[16] The Wikipedia entry on the crisis is the most useful known to the author.

[17] The media use of the phrase ‘Draghi bazooka’ has been erratic. Sometimes it is used to refer to the programme of long-term refinancing loans from December 2011 and sometimes to the ECB’s purchases of government securities from early 2015.

[18] The shift in policy fashion to a rather crude Keynesian fiscalism was not confined to Europe. See Cukierman (2021).

[19] Sinn (2020), in chapter 9, discusses the interest rates paid on Target2 balances. There is no question that Germany has been disadvantaged by the negligible return on its credit balance.

No data was found

Want to receive the whole journal online or in print?

* Required field