Reforming the Eurozone financial system: A system-dynamics approach

Abstract

In order to assess the effectiveness of the non-standard monetary policies of the European Central Bank (ECB) in maintaining (price-)stability in the Eurozone financial system, we have developed a system-dynamics model. It combines a neoclassical growth model with a stock-flow model of the Eurozone financial sector at a high level of aggregation. With endogenous money creation, the multidirectional relationship between asset prices and net income and the dual causality of both liquidity and investment relative to interest rates as key features of the model, the developments of the past 50 years can be made understandable and be extrapolated to 2050. The model results indicate that the non-standard policies of Quantitative Easing- and increased interest rate policy, which the ECB has at its disposal within its current mandate, are not up to the task of maintaining price stability within the Eurozone (2% targeted inflation). Inflation initially remained too low for a long period, after which it became so high that it then had to be controlled by interest rate policy. However, the application of this policy in the current pro-cyclic system with its many positive feed-backs, carries a significant risk of overshooting the inflation target and causing harmful economic side effects. The simulation experiments indicate that (price) stability of the (modeled) system requires a coordinated application of policy measures that countercyclically both ease and tighten the total amount of money in the system. The most obvious way to achieve this is to allocate money creation exclusively to the ECB in the form of 100% Central Bank Digital Currency (CBDC). With this high volume of countercyclical money creation, it becomes possible to control liquidity and inflation in an adequate dynamic way through money creation alone, making interest rate policies with potentially harmful effects for the economy as a whole unnecessary. In the shorter term, improvements can already be made through non-exclusive money creation by the ECB (as Central Bank Created Currency; CBCC), in addition to the current pro-cyclical money creation by commercial banks. However, less price stability is achieved in this partial transition. Although tailor-made, potentially damaging interest rate adjustments are still needed to offset the destabilizing pro-cyclical money creation. Both the CBCC- and CBDC-countercyclical approaches argue for an expansion of the ECB's mandate as the sole ‘money-authority’ to control the amount of money in the system, from a single and unambiguous objective. In both alternatives, the EU-governmental structure can channel the (public) share in the creation of money (respectively in the order of 200 and 500 bn € / year) to the real economy, including the repay of public debt, tax reductions and direct investments in physical and social infrastructure.

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