The Hidden Costs of Monetary Policy

Lesen Sie die deutsche Version hier.

Throughout the 1990s and early 2000s, central banks focused on a single goal: controlling inflation. Their independence protected monetary policy from political influence. The global financial crisis of 2008 marked a turning point. Confronted with collapsing markets, central banks expanded their role. Alongside price stability, they sought to contain financial risk and keep sovereign borrowing costs under control. During the European sovereign debt crisis, countries such as Greece, Spain, and Italy struggled to repay government debt, raising fears of bankruptcy. Central banks intervened to reassure investors and keep financing costs manageable. Their main tool was quantitative easing (QE), involving large-scale purchases of long-term government bonds and selected corporate assets. Through these purchases, they pushed up prices for these securities and lowered long-term interest rates, making borrowing cheaper for governments, companies, and households.

The scale of these programs was unprecedented. The ECB’s balance sheet stands at roughly 6 trillion euros, up from about 1 trillion in 2006. This represents a sixfold increase in less than 20 years.

These interventions left central banks with much larger balance sheets and interest rates close to zero. Some expected the resulting liquidity to boost growth. Others feared it would trigger inflation. The first group believed cheaper credit would spur investment and consumption. The second pointed to historical cases of monetary excess. Neither outcome occurred.

Squandered opportunities

With hindsight, the explanation is clear: QE is not the same as printing money for fiscal spending. In countries like Venezuela or Argentina, central banks financed government deficits directly. QE, by contrast, injected liquidity into financial markets. Yet commercial banks, constrained by weak investment prospects and tighter regulation, did not pass on this liquidity to firms or households. As a result, QE failed to produce broad economic stimulus or sustained inflation while preventing any anxiety on sovereign (and corporate) bond markets for over a decade.

Unintended effects followed. Asset prices, especially real estate, rose sharply, fueling concerns about affordability and inequality. Investors, pushed by central bank purchases, searched for returns elsewhere, driving up the prices of houses, stocks, and other assets. Wealthier households benefited, while younger or poorer households struggled to buy homes or invest. Persistently low rates also kept many unproductive firms alive. These “zombie” firms survived only because borrowing was cheap, despite being unable to grow or innovate. Their survival tied up resources that could have been used more productively. At the same time, governments, under less pressure from markets, delayed reforms. Without high borrowing costs to discipline them, politicians postponed fiscal adjustment and structural change.

«Investors, pushed by central bank purchases, searched for returns elsewhere, driving up the prices of houses, stocks, and other assets. Wealthier households benefited, while younger or poorer households struggled to buy homes or invest.»

This combination of reform delays and weak productivity growth led to stagnation. Many commentators now refer to the 2010s as a “lost decade” for Europe, marked by low dynamism and persistent structural problems. QE created space for reform, but policymakers failed to use it. Rather than reforming labor markets, simplifying regulation, or investing in long-term growth, many governments increased spending and ran structural deficits. Imbalances persisted or worsened. Italy illustrates this trend. The reform agenda launched by Mario Monti in 2011 was quickly dropped after ECB actions eased bond market pressure.

The pandemic response followed a different model. This time, fiscal and monetary policy worked together. Governments introduced large stimulus programs, transferring funds directly to households and firms. Central banks again expanded their balance sheets to absorb the resulting debt. This approach prevented economic collapse. Incomes stabilized, firms survived, and unemployment stayed below early projections. However, strong demand met limited supply, creating inflationary pressure. When external shocks, such as energy price spikes and supply chain disruptions, followed, inflation surged. Central banks were then forced to reverse earlier policies.

Central banks cannot create growth

Where does this leave us? Central bank interventions can stabilize economies in the short term, but they come with costs. As Milton Friedman used to say, there is no such thing as a free lunch. Some costs, like inflation, appear quickly. Others, such as zombie firms and reduced pressure on governments to cut deficits, emerge gradually. Central banks can delay fiscal reckoning, but they cannot replace political decisions.

Long-term growth requires higher productivity, stronger competition, and credible fiscal policy. Productivity growth (i.e., producing more with the same resources) raises living standards. Monetary policy cannot create this. Only structural reforms and investments in education, infrastructure, and innovation can. The necessary measures are well known but politically difficult: simpler regulations, more flexible labor markets, stronger incentives for private investment. Monetary policy can buy time, but it cannot substitute for reform. It may even delay it by softening market discipline and fostering dependence on central banks.

The expanding role of central banks also threatens their independence. If they are expected to support fiscal policy or pursue political goals such as green investments or industrial strategies, the case for independence weakens. The boundary between monetary and fiscal authority is already less clear. The political careers of former central bankers like Janet Yellen that went from being governor of the Fed to treasury secretary for the Biden administration and Mario Draghi, who went from president of the ECB to prime minister of Italy, underscore this shift. The line between technocratic policy and political responsibility continues to blur.

«The expanding role of central banks also threatens their independence.»

Central banks are not all-powerful and should start to downsize before it is too late. Concretely, this means leaving governments to face markets without monetary support, pruning initiatives that do not concern their core mandate, and allowing risks to exist, as there is no growth without creative destruction. The fewer responsibilities central banks take on, the better they can safeguard independence and focus on their core task: stabilizing prices and keeping inflation under control. Over time, protecting that independence serves everyone’s interest.