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The end of central banking as we know it

The severest crisis the European Central Bank (ECB) ever faced coincided with the early days of a new Executive Board. Over the past year and a half, the board’s six members, including the ECB’s president and vice president, have all been replaced, either because they resigned, or because their eight-year mandate expired.

New team

By order of appointment, the new board consists of:

  • Luis de Guindos, who replaced Vitor Constancio as vice president in June 2018
  • Philip Lane, who took Peter Praet’s place as chief economist in June 2019
  • Christine Lagarde, who became president on November 1, 2019, after Mario Draghi retired
  •  Isabel Schnabel and Fabio Panetta, who succeeded Sabine Lautenschlager and Benoit Coeure, respectively, in January 2020
  • Frank Elderson, who in December 2020 took over Yves Mersch’s seat on the Executive Board, and his position as vice chair of the ECB Supervisory Board

Six new people – four economists, two jurists – some of whom were heretofore unknown to the general public, are now assigned greater and more far-reaching responsibilities than any other top officials in the European Union. Some were nominated shortly before the health crisis hit. Crucial decisions, such as launching the Pandemic Emergency Purchase Programme (PEPP), had to be taken hurriedly while most ECB staff and the Executive Board worked from home.

Economists on the rise

When the name of Christine Lagarde, a former managing director of the International Monetary Fund (2011-2019), first came up in the race for the ECB presidency, some feared she might lack the technical expertise of her predecessor. Mario Draghi, a seasoned MIT economist, led Italy’s central bank before he took the position in 2011. Unlike him, Ms. Lagarde, a French lawyer and politician, had never devised monetary policy before joining the ECB. This is also the case of Vice President Luis de Guindos. Even though he is an economist by training, the former Spanish Minister of Economy appears to be more of a political figure on the ECB’s top table.

However, there are three high-profile economists on Ms. Lagarde’s new team. Two previously managed national central banks. Philip Lane served as governor of Ireland’s central bank (2015-2019). In this capacity, he was an ex officio member of the ECB’s Governing Council. Fabio Panetta was a senior deputy governor of the Bank of Italy in 2019.

Isabel Schnabel has an essentially academic background. She was a professor of financial economics at the University of Bonn and an advisor for the German government. Widely respected as an expert in financial markets and banking regulation, she quickly became one of the most active board members. Responsible for market operations, she oversees the bond-buying programs, including the PEPP, which is one of the ECB’s most critical tasks in the current context.

Polyphonic management

Since the coronavirus outbreak, Ms. Schnabel has also played a primary role in announcing, explaining and defending the ECB’s strategic decisions, notably with its no-limit monetary stimulus. Her main aim is to keep financial markets calm.

Over the past year, her Executive Board colleagues considerably expanded their media presence as well, each of them revealing their own vision of financial crisis management.

From the start, reaching out to the general public has been one of President Lagarde’s priorities. Before launching major new initiatives, her team seeks feedback from stakeholders – be they firms, financial sector representatives, industry associations, civil society organizations, academics or ordinary citizens. Public consultations have recently been held on the creation of a “digital euro,” for example. A series of “ECB Listens” events invites citizens to participate in a collective reflection on the institution’s first strategy review in almost 18 years.

At the same time, Ms. Lagarde’s leadership team displays a unity that had not been seen at the ECB in a long time. Mr. Draghi had left her a deeply divided institution. Especially toward the end of his mandate, his legendary “I decide, you follow” attitude was much contested, including in the small circle of Executive Board officials. In record time, Ms. Lagarde built a cohesive board of directors with strong personalities whose voices count equally. This eventually resulted in more tempered debates at the ECB.

The downside of a powerful corps of economic advisors is that the chief might get pushed aside. Ms. Lagarde no longer appears to be “the one that shows the force in terms of where the ECB is heading,” an investment analyst argued. At times, “it is difficult to tell who to listen to, whereas with Draghi it was clear,” another added. The constant talking of six board members makes it more difficult for market participants to form an opinion about the scope (and effectiveness) of the ECB’s decisions – a new source of uncertainty that can put markets under stress.

Model builders

Much of the Executive Board’s credibility rests on a staff of around 400 economists, gathered within the walls of the ECB’s headquarters in Frankfurt-am-Main. The work of these highly qualified researchers consists in building and improving macroeconomic models that should be of use to decision makers. For years, they have been at the forefront of developing econometric models to help policymakers assess the consequences and possible side effects of alternative policy scenarios.

A recurrent research theme is the nature of the shocks repeatedly hitting our economies. The bank also encourages analysts to “take a step back” and think about issues such as: How did we end up in a persistently low-growth world, and what could be the way out? After years of quantitative easing, why did inflation not take off? What are the factors that impair the transmission (and hence the efficiency) of monetary policy? How do market actors form their expectations about key variables such as inflation, credit risk, or even the central bank’s future action plans? How can we better understand the cause and effects of economic interactions?

A rock and a hard place

“Ultimately, the success of policy will depend on the quality of our models,” French economist Benoit Coeure said to doctoral students at the Paris School of Economics, less than a month before his term at the ECB Executive Board was due to end. He also cautioned the future economists not to fall into the trap of taking macroeconomic models for absolute truths and overstep the boundary “where science ends and ideology begins.” We owe this lucidity “to ourselves as policymakers” and “to society as a whole,” he added.

Not often do ECB top officials speak so frankly about the challenges decision makers face on a day-to-day basis while trying to bridge the gap between the “science” and the “practice” of monetary policy. In his December 2019 speech, Mr. Coeure shed light on the professional dilemmas of Executive Board members during existential crises, like the current pandemic.

The case for monetary stimulus is a perfect illustration of such policy predicaments. If the stimulus is not big enough, the pandemic may cause long-lasting scars to the economy and living standards. If there is too much of it, other risks could materialize, including excessive debt and – even though this seems unlikely right now – uncontrollable inflation.

For the ECB’s elite economists, the second option is preferable to the first. The ECB should “err in doing too much rather than too little,” Mr. Panetta said in an interview last September.

This remark reflects the current team’s trial-and-error approach to central banking. Striking a “balance between prudence and pragmatism” was chief economist Philip Lane’s way of putting it.

Pushing the limits

When the ECB was founded in 1998, experimental central banking would have been considered an oxymoron. The EU treaties had assigned it a clear and narrow mandate: to preserve the single currency’s purchasing power. The strategy was to target inflation through interest rates. For the old guard of central bankers, the institution’s key mission was to conduct monetary policy, and by no means fiscal policy.

The ECB’s full independence from political interference was at the heart of the eurozone project. It was seen as a foundation of the trust citizens could have in the institution. To avoid fiscal dominance over monetary policy, treaties explicitly forbid monetary financing by the ECB.

Since the 2008 financial crisis, a lot of water has gone under the bridge. The ECB’s scope of action was significantly enlarged during President Draghi’s reign, despite concerns this would lead to greater politicization of the central bank. At the time, several of Mr. Draghi’s monetary policy decisions were contested in court. They were seen by some as an illegitimate overstepping of the ECB’s original mandate. However, the European Court of Justice ruled in 2018 that the bank does not infringe EU law when implementing its ever more ambitious quantitative easing programs.

With Covid-19 and the extreme financial measures it requires, the ECB’s job is getting trickier, while its scope of action is continuously expanding. The upcoming strategy review, promised by Ms. Lagarde as soon as she took office, was postponed to September 2021 because of the pandemic. It is expected to outline a range of new ECB missions, which on the bank’s website are summed up by the motto: “We will leave no stone unturned.”

Moving the target

As far as the ECB’s price stability mandate is concerned, the target inflation rate of “below but close to 2 percent over the medium term,” defined by the strategy review of 2003, seems to have outlived its usefulness. There are many speculations on how the target might evolve in the 2021 review.

In the current low-inflation context, a rise of the target seems unlikely. After years of ultra-expansionary monetary policy, the 2 percent rate was already unreachable. Increasing the gap between real and targeted inflation would only further undermine the ECB’s reputation.

Some Governing Council members have called for cutting the target rate to between 1 to 2 percent. That too carries risks, let alone because inflation measures are often overstated.

What if, all of a sudden, inflation shoots up as a result of massive economic stimulus? Should the target be more “flexible” (applicable over a longer time horizon, for example), as others suggest?

The only hint Ms. Lagarde gave so far is that the target should be revisited in “a way the public can easily understand.”

New battles

The intertwining of monetary and fiscal policy can be expected to continue. Faced with an unpredictable macroeconomic environment and limited monetary policy space, the ECB might increasingly turn to fiscal policy.

Its greatest challenge will be to achieve the “right fiscal-monetary policy mix,” macroeconomist Olivier Blanchard writes in a recent memo addressed to Ms. Lagarde. In times of severe recession, too little fiscal support is risky – not only financially, but politically as well; too much of it creates other problems, the economist warns. High spreads and volatile asset markets are but a few.

The fact that the ECB is facing not one, but 19 (mostly different-minded) fiscal partners in the euro area is not making things any easier. In the coming months, the postponed debate on the creation of a fiscal union might flare up again.

While implementing a fiscal policy agenda of its own, Ms. Lagarde’s ECB might be seduced by ethical combats such as inequality. Income redistribution, to be addressed by new policy tools under discussion, such as “helicopter money,” is becoming a concern. As a good “listener” to stakeholders, the ECB is now even talking about “gender equality.”

Its other grand cause will be the fight against climate change. Since the beginning of her term, Ms. Lagarde opened the door to using the bank’s colossal asset purchase schemes to pursue climate-friendly objectives. Executive Board member Frank Elderson – who made a name for himself by cocreating the Network for Greening the Financial System – will certainly play a key role in “greening” the ECB as well.

Showing a preference for low-carbon investments is not incompatible with the ECB’s role as financial market supervisor. Systematically buying green bonds under the ECB’s asset purchase programs is, however, another story. The institution can, and should, have at best a “marginal effect” on the fight against global warming, Mr. Blanchard believes.

Going too far on the green and distributional side could prove problematic for the institution. Mr. Blanchard has a point: if it is pulled in too many directions, the ECB runs the risk of “not fulfilling its primary mandate as best as it can.”

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