Usefulness of the article: Understanding the transmission channels of monetary policy in the eurozone provides insight into how the European Central Bank affects the distribution of income and wealth. The emergence of side effects, which are sometimes undesirable, shows that monetary policy alone cannot do everything. The coordinated use of various levers (monetary, budgetary, fiscal) is the means of linking economic efficiency and the social contract.
Summary:
- By stimulating activity and accelerating job creation, the accommodative monetary policy pursued in the euro area could significantly reduce income inequality.
- The increase in financial asset prices caused by unconventional monetary policies would have an ambiguous effect on wealth distribution, although the deleterious effect of increasing inequality seems to prevail.
- Inequality is not something that should be managed by monetary policymakers, but by political decision-makers using fiscal and budgetary levers.
- Only the coordination of different policies (policy mix) can bridge the gap between economic efficiency and the social contract.
The growing interventionism of central banks since the Great Financial Crisis of 2008 raises questions about externalities, in particular the inequalities generated by such aggressive monetary policy. While the debate on inequality has become central as unconventional monetary policies have become widespread, it often proves fruitless due to overly fragmented analysis of the transmission channels through which monetary policy alters the distribution of wealth or income. To clarify the debate, it is necessary to distinguish between the different types of inequality under discussion. Despite their multiplicity, two main types are often mentioned: those relating to the distribution of income and those relating to the distribution of wealth.
1) The impact of monetary policy on income inequality
The first factor generating inequality in income distribution is that between insiders and outsidersin the labor market. The accommodative nature of monetary policy has helped to combat income inequality (Lenza and Slacalek 2018) by supporting economic activity and employment(Ampudia et al. 2018). More specifically, the conventional aspect of monetary policy (keeping short-term rates at a minimum) and the unconventional aspect (in particular, the implementation of a large-scale asset purchase program to lower long-term rates, coupled with forward guidance setting the time horizon for this policy) have played a very strong countercyclical role in economic activity (Peersman 2011, Sahuc and Mouabbi, 2019), thereby containing income inequality by stimulating employment.
To reduce income inequality, monetary policy influences not only the unemployment rate but also the labor force participation rate (Campolmi and Gnocchi 2016). As the latter can be weakened for a long time during a persistent negative shock, monetary policy can (as was the case during the last Great Recession) positively influence the labor force participation rate, providing massive support to economic activity in order to limit the impact of the negative shock (Erceg and Levin 2013).
Furthermore, low interest rates since 2008 have been favorable to borrowers by reducing interest payments on their debt and unfavorable to savers, who receive lower interest income than in the past (Aucler 2017). Many low-income households have more debt than assets, while net savers are mainly concentrated in the first deciles of the income distribution. As a result, this policy reduces the flow of money from the poorest to the wealthiest and helps to reduce income inequality.
In addition to its direct effect on employment, which combats the widening of income distribution, monetary policy indirectly shifts the budgetary constraints of eurozone countries, allowing them to be more proactive in their public spending. The maintenance of an accommodative policy, which offers states[4]the possibility of refinancing at zero or even negative rates, has significantly reduced the burden of interest payments on public debt.
As a reminder, in the early 2000s, France devoted the equivalent of 3 percentage points of GDP to paying interest on its public debt; In 2019, the interest burden represents just over 1% of GDP, despite the sharp increase in the public debt-to-GDP ratio (58.9% at the end of 2000 compared with 98.1% at the end of 2019). This frees up fiscal space in times of calm and allows governments to play a countercyclical role in crises. The case of France during Covid-19 illustrates this perfectly. The public deficit, expected to be around 9% of GDP in 2020 and made possible by flexible monetary conditions, has, among other things, limited income losses for employees thanks to the partial activity scheme and supported the most modest households[5]thanks to the exceptional measures (solidarity aid, increase in the back-to-school allowance, RSA/ARS aid) put in place by the government.
The ECB, as a player in preserving the solvency of eurozone countries, enables fiscal policy to be fully effective and combats the exacerbating effect of crises on income inequality. And as the St. Louis Fed recently pointed out, the increase in public debt linked to greater use of fiscal leverage should not be a major concern given the macroeconomic environment. The combination of several structural factors (including demographics, weak technology-related productivity gains, and rising inequality (Furman and Summers 2020)) is leading to a sustained weakness in the natural interest rate, which is shifting the fiscal constraint to levels that no one has ever seen before.
However, even though « the empirical data available for various countries suggest that lower interest rates […] and quantitative easing measures […] compress income distribution and reduce inequality […] these effects are not strong enough to stem the secular trend of rising income inequality » (Ampudia et al. 2018).
2) The impact of monetary policy on wealth inequality
While the impact of monetary policy on inequality has often been studied through the lens of income disparities, the decoupling of financial asset prices from economic activity overthe last decade has created a buzz around the effects of monetary policy on wealth inequality.
Several mechanisms are at work in the increase in financial asset prices driven by monetary policy.
The first channel is conventional. In the case of equity markets, by maintaining zero or even negative interest rates and anchoring rate expectations at a sustainably low level, the ECB modifies the discount rate at which the future profits of listed companies are discounted. Thus, even without a company increasing its profitability, its market capitalization increases because the future profits that the company is expected to generate are valued more highly in the present[7].
The second major channel through which monetary policy affects the price of financial assets is the unconventional channel. By massively filling its balance sheet with debt securities, the ECB creates money on its liabilities side, which it exchanges with investors (mainly institutional investors such as banks, insurers, and funds) in exchange for debt securities. This operation unbalances the composition of investors’ portfolios by creating excess liquidity, which they correct by reallocating this liquidity to movable or immovable assets. It could be said that this channel is not really unconventional in the second instance. Ultimately, the rebalancing of portfolios has an effect only because it implies a fall in (long-term) interest rates.
However, rising prices for different assets do not have the same effect in terms of increasing wealth inequality. Inflation in equities, which are almost entirely held by the top centiles of the wealth distribution, increases inequality more than rising prices for sovereign bonds, which are held by a much broader spectrum of the distribution. Indeed, capital gains from an increase in the price of government bonds are not correlated[8]with the net wealth of households (Adam and Tzamourani 2016, Domanski et al. 2016). As for real estate assets, rising housing prices lead to a hump-shaped distortion[9]in the wealth distribution. « The poorest and richest households benefit the least« (Adam and Tzamourani 2016). Wealth equity is therefore much more affected when monetary policy leads to a rise in the stock markets than in the sovereign bond or real estate markets.
Despite complex and uncertain effects depending on the type of financial asset, the ECB’s asset purchases appear on average to increase wealth inequality. Concluding that the ECB’s current policy reduces income inequality but tends to increase wealth inequality, the legitimacy of its intervention can be questioned. Should monetary authorities continue on their current course of action or take into account the side effects they are causing?
3) Legitimate and justified monetary intervention
The legitimacy of the ECB’s actions and those of many other central banks stems from their compliance with their mandate. Within the eurozone, inflation targeting[11]is the primary mission of the monetary authorities. Therefore, all unconventional measures designed to encourage employment and stimulate inflationary growth in order to achieve the objective of price stability must not be hindered. This is the real guarantee of the ECB’s credibility. Without it, the effectiveness of its interventions would be significantly reduced or even ineffective, and could even cause undesirable and lasting tensions on the exchange rate and on the financing of the economy.
Questioning monetary policy on the grounds that it amplifies wealth inequality is also a rather weak argument from a social welfare perspective, as households are less sensitive to the reduction of inequality during a recession than to the overall stabilization of the economy.
Questioning monetary policy on the grounds that it amplifies wealth inequality is also a rather weak argument from a social welfare perspective, as households are less sensitive to the reduction of inequality during a recession than to the overall stabilization of the economy[12]. In addition, monetary policies do not have a temporary effect on the economy, but a lasting one. They create the conditions for convergence in the longer term. Without their intervention, the impact of recent crises would have led to much deeper long-term inequalities. Economic stability is a necessary condition for reducing inequality. Former ECB Governor Mario Draghi put it this way: « While it is true that the richest are the first to benefit from the effects of quantitative easing, it is also the most powerful tool for reducing inequality in the longer term. »
Furthermore, in achieving its objectives, the Central Bank is under no obligation to internalize its externalities. In other words, its judgment and monetary decision-making must be based solely on its primary objective. The side effects of its policy must be studied and discussed, but without curtailing its power to act, which would undermine its ability to fulfill its mandate. The Covid-19 crisis is a perfect illustration of this scenario. The increase in the monetary base initiated by central banks and their massive purchases of debt securities have strongly supported stock prices, particularly in the equity markets (Cox et al. 2020), but have also enabled governments to finance their public deficits in order to support economic activity and counter the deflationary forces of the crisis. A number of other arguments can be put forward to justify central banks’ lack of response to asset prices:
(1) A credible monetary policy that is committed to the full and sole fulfillment of its mandate consists, in most cases, of not reacting to changes in asset prices.
(2) Central banks do not have an informational advantage that allows them to reliably detect bubbles in financial markets and do not have a fixed definition of normal asset prices (Bernanke and Gertler 1999, Mishkin and White 2002).
(3) The involvement of monetary authorities in stabilizing asset prices would create moral hazard.
If the ECB plays its role to the full and allows financial asset valuations to rise, should citizens then be left to bear the brunt of wealth inequality?
4) Fiscal leverage as an appropriate response to inequality
The problem posed by the effectiveness of monetary policies in their unequal distribution of overall economic gains should not be the concern of monetary policymakers, who are by definition unelected, but rather that of elected politicians. As Ben Bernanke argued in response to criticism of the Fed when he was its chairman, « the right response [to inequality] is rather to rely on other types of policies to directly address distribution concerns, such as fiscal policy (taxes and public spending programs).« It is coordinated action, or the policy mix, that must enable the achievement of optimal societal objectives.
In response to the Covid-19 crisis, monetary policy has enabled governments to finance public deficits and go as far as necessary in their fiscal stimulus. The ball is now in the courts of governments, which must take responsibility for addressing wealth inequality, because monetary policy cannot do everything. Those who are concerned about the harmful effects of unconventional measures on inequality should generally advocate for more proactive fiscal policy in order to accelerate economic recovery and job creation and allow monetary policy to be less aggressive. This is especially true since fiscal leverage becomes more effective when interest rates are at rock bottom.
More specifically, it is the structure of compulsory levies used to finance fiscal policy that is best suited to correcting excessive distortions in wealth distribution. Public spending is already highly redistributive. Although unpopular, taxes such as inheritance tax will have to be the subject of public debate again if the public wants greater wealth equality. Its low distortionary and disincentive nature is perfectly in line with greater equality in the distribution of wealth. These instruments are all the more attractive given that, in periods of low growth and excess savings, the redistributive effects of fiscal policy stimulate aggregate demand and investment.
Conclusion
The redistributive effects of monetary policy in the eurozone are only clear and discernible when inequalities are studied at a very detailed level. While there is a fairly clear consensus on the effectiveness of monetary policy in reducing income inequality, its effect on wealth inequality is more complex and uncertain due to the heterogeneous distribution of financial assets in the distribution of wealth.
Overall, asset purchases appear to increase wealth inequality, but the ECB should not seek to correct the side effects of its actions. On the one hand, the multiplicity of its objectives would hinder it in fully achieving its mandate of price stability and would undermine its credibility. On the other hand, the issue of income and wealth distribution should not be left to monetary policymakers but to political decision-makers through budgetary and fiscal levers.
Advocates of greater wealth equality should call for more monetary and fiscal coordination. Strengthening the policy mix couldhelp bridge the gap between monetary policy effectiveness and the social contract. Finally, strengtheningmacroprudential policy could also be an effective tool for limiting the side effects of monetary policy on financial markets.
In any case, each objective has its own tool. Multiplying the ECB’s objectives would only lead to inefficiency and undermine the institution’s credibility.
Bibliography:
Ampudia, Miguel & Georgarakos, Dimitris & Slacalek, Jiri & Tristani, Oreste & Vermeulen, Philip & Violante, Giovanni L., 2018. « Monetary policy and household inequality, » Working Paper Series 2170, European Central Bank.
Adam K. and P. Tzamourani (2016), Distributional consequences of asset price inflation in the euro area, European Economic Review, Vol (89), 172-192.
Auclert, Adrien (2017). “Monetary Policy and the Redistribution Channel”, Working Paper, No 23451, NBER.
Ben S. Bernanke & Mark Gertler, 1999. « Monetary policy and asset price volatility, » Proceedings – Economic Policy Symposium – Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
Ben S. Bernanke & Mark Gertler, 2001. « Should Central Banks Respond to Movements in Asset Prices?, » American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
Ben S. Bernanke 2015 “Monetary policy and inequality” Brookings Blog.
Campolmi, Alessia & Gnocchi, Stefano, 2016. « Labor market participation, unemployment and monetary policy, » Journal of Monetary Economics, Elsevier, vol. 79, pages 17-29.
Cox, Greenwald and Ludvigson, 2020. « What Explains the COVID-19 Stock Market?, » NBER Working Papers 27784, National Bureau of Economic Research, Inc.
Domanski, Dietrich, Scatigna, Michela and Zabai, Anna (2016). “Wealth inequality and monetary policy”, BIS Quarterly Review, March.
Erceg and Levin, 2013. « Labor Force Participation and Monetary Policy in the Wake of the Great Recession, » IMF Working Papers 2013/245, International Monetary Fund.
Furman and Summers 2020 “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates”, Havard Kenedy school, PIIE
Gornemann, Nils, Kuester, Keith, and Nakajima, Makoto (2016). “Doves for the Rich, Hawks for the Poor? Distributional Consequences of Monetary Policy,” International Finance Discussion Papers, No. 1167, Board of Governors of the Federal Reserve System (U.S.A).
Lenza, Michele and Slacalek, Jiri, 2018. « How does monetary policy affect income and wealth inequality? Evidence from quantitative easing in the euro area, » Working Paper Series 2190, European Central Bank.
Mishkin and White, 2002. « U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy, » NBER Working Papers 8992, National Bureau of Economic Research, Inc.
Peersman, Gert, 2011. « Macroeconomic Effects of Unconventional Monetary Policy in the Euro Area, » Cepr Discussion Papers 8348, C.E.P.R. Discussion Papers.
Sahuc and Mouabbi, 2019. « Evaluating the Macroeconomic Effects of the ECB’s Unconventional Monetary Policies, » EconomiX Working Papers 2019-2, University of Paris Nanterre, EconomiX.
[1]These are all workers with an employment contract and a stable income.
[2]These are all active individuals seeking employment and those whose situation in the labor market is too volatile to allow for stable income.
[3]Ampudia et al. 2018) show that households in the lowest income quintile benefit much more from monetary expansion in the eurozone four quarters after the impact of the QE shock. « Their income increases by around 3.5% on average, while for other households the increase is around 0.5%. »
[4]At the end of January 2021, France’s 10-year debt was at -0.30% and it benefited from negative rates for maturities of up to 15 years.
[5]A study by the Treasury Department showsthat this aid was indeed targeted at the lowest deciles. It increased the standard of living of the poorest 10% of households by an average of 2.4% and that of the next decile by 1%. Nearly two-thirds of this aid benefited the first two deciles.
[6]The St. Louis Fed study emphasizesthe sustained weakness of inflation and, like Blanchard, argues that as long as r<g, the government can run a structural primary deficit while keeping the public debt-to-GDP ratio unchanged.
[7]In an actuarial calculation, the interest rate is the price of time. If the interest rate were 5%, €100 invested today at that rate would be worth €163 in 10 years. With zero interest rates, €100 in 10 years has the same value today. In other words, the value of a future sum increases as the interest rate falls.
[8]Adam and Tzamourani (2016) show the absence of correlation for households in the euro area using data from the Household Finance and Consumption Survey (HFCS).
[9]This effect stems from the weight of real estate in the assets of each decile of the distribution. Proportional to their assets, real estate represents a negligible share in the first deciles of the distribution (households that cannot afford to buy property). This share peaks in the middle and upper-middle classes, as most households in these classes are homeowners but do not have the means to hold other financial assets. Finally, among the wealthiest households, the weight of real estate in wealth tends to decrease as they diversify their assets.
[10]However, there is heterogeneity between countries. The effect of real estate inflation on wealth distribution varies depending on the proportion of renters and homeowners in the country.
[11]While in 2003 the Governing Council stated that it aimed to keep inflation below, but close to, 2% over the medium term, the target now seems to be moving towards inflation close to, but below, 2% on average (this implies that inflation may exceed 2% without the central bank reacting if it has previously been below target).
[12]The INSEE’s monthly survey of household confidence (CAMME) shows that the decline in confidence during crises is mainly driven by the collapse in job prospects. Unemployment appears to be the main fear of households in the event of a negative shock to the economy.
[13]During a hearing before the European Parliament debating a report by the European Central Bank on the results of its actions in 2016.
[14]His response was published on his blog Brookinks.edu onJune 1, 2015.
