buiter37_Frank Rumpenhorstpicture alliance via Getty Images_ecb Frank Rumpenhorst/picture alliance via Getty Images

Fiscal Capture at the ECB

By using all the means at its disposal to support potentially debt-distressed member states, the European Central Bank is not merely serving as a market maker of last resort. Rather, it is engaged in fiscal-support operations, potentially to the detriment of its mandated objectives.

LONDON – Since the second quarter of 2021, inflation in the United Kingdom, the United States, and the eurozone has far exceeded their central banks’ 2% target. This surge could well be explained by the unexpected severity and duration of the COVID-19 pandemic, the fallout from Russia’s war in Ukraine, and repeated errors of judgment by the Bank of England, the US Federal Reserve, and the European Central Bank.

But another possible explanation is that monetary policy has been subject to fiscal dominance or fiscal capture. In this interpretation, major central banks have engaged in aggressive low-interest-rate and asset-purchase policies to support their governments’ expansionary fiscal policies, even though they knew such policies were likely to run counter to their price-stability mandates and were not necessary to preserve financial stability.

The “fiscal capture” interpretation is particularly convincing for the ECB, which must deal with several sovereigns that are facing debt-sustainability issues. Greece, Italy, Portugal, and Spain are all fiscally fragile. And France, Belgium, and Cyprus could also face sovereign-funding problems when the next cyclical downturn hits, or when risk-free interest rates normalize from the past decade’s extraordinarily low levels, or when sovereign risk is priced more realistically.