By Lucas Blasius
After eight years as President of the European Central Bank, Mario Draghi stepped down on 31 October. His successor is Christine Lagarde, former chairwoman of the International Monetary Fund, who takes office at a time of great macroeconomic uncertainty. Lagarde inherits an arsenal of monetary policy that is lacking ammunition, as well as an ECB governing council that is perhaps more divided than ever before over its most recent decision to lower already negative rates and restart quantitative easing.
Mario Draghi is widely known for having strengthened confidence in the Euro in times of great scepticism and uncertainty, and there is no doubt that the ECB has significantly contributed to overcoming the sovereign-debt crisis under his auspices. He has also led the bank into a new era of monetary policy by introducing innovative and unconventional instruments. These measures were necessary as changes in the interest rate were not passed on by commercial banks to the private sector. In response to such disturbances in the monetary transmission mechanism, the ECB has supported banks with subsidised long-term loans. In addition, Mr Draghi caused a stir with the introduction of negative interest rates and with quantitative easing, the massive purchase of government bonds, which aimed at reducing market interest rates of the countries hardest hit by the economic crisis. As a result, the ECB accumulated €2.6tn euros in assets, including nearly a quarter of the outstanding bonds of eurozone countries.
The use of unconventional instruments has indeed not been unsuccessful: This can be seen from a look at the development of credit spreads for government bonds in the euro zone. Credit spreads quantify a credit risk premium are calculated as the difference in yield between German sovereign bonds, the lowest-risk investment, and another sovereign bond. Thus, the greater the risk that a state will not service its debt (as it might, for instance, leave the eurozone), the larger the credit spread of the respective bond. In the course of the European debt crisis, spreads of southern member states shot to record heights because there was great uncertainty as to whether the states would be able to recover from their desolate economic situation and could finance their growing debt ratios. Since commercial banks are among the largest creditors to governments, the sovereign debt crisis turned into a banking crisis, which in turn affected the real economy and households. Many economists attribute the trend of converging spreads in the years after 2012 to the success of Mr Draghi’s unconventional monetary policy. His promise to do “whatever it takes” to preserve the Euro, and the ECB’s commitment to the bond market vis-à-vis crisis-ridden states through its enormous asset purchase program, were decisive factors in containing the euro crisis.
The ECB’s loose monetary policy had another important consequence in the real economy. When lending to companies and households rose again in 2015, this was also reflected in the following years in economic growth and the well-being of labour markets. Whereas unemployment rates averaged 12 percent across the euro zone in 2013, the number of employees grew by 11 million in the following years. Since then, the improvement in the labour market has driven the overall economic recovery of the bloc and has boosted private spending and investment. A solid European labour market is all the more important in times of great uncertainty due to Brexit, global trade wars and a protectionist attitude of the US President towards the EU.
Mr Draghi’s actions have provoked criticism for quite some time, especially in Northern Europe. But now of all times, at the end of his term in office, the controversy seems to be culminating: Only in September did the ECB announce that it would cut the deposit rate to an all-time low of -0.5 percent and resume its quantitative easing programme. Shortly thereafter, former central bankers from four European countries sent an open letter opposing Mr Draghi’s low-interest policy. The critics suspect an intention to protect highly indebted governments from a rise in interest rates. Moreover, they claim that the current, ultra-loose monetary policy is based on unfounded concerns about a deflationary spiral. Opposing the ECB’s loose monetary policy, by implication they therefore accept the current inflation rate, which is indeed far from the targeted 2 percent. However, lowering the inflation target would not only be economically hazardous, but would also strengthen populism especially in the south. That is because a change in the inflation target implies a change in the income distribution between debtors and creditors since the real debt burden is a result of the nominal interest rate and the inflation rate. A consequence of decreasing the inflation target would therefore be the redistribution of (interest) income from, broadly speaking, southern debtor countries towards northern creditors.
However, despite all the efforts, the ECB clearly missed its primary mandate of maintaining price stability defined as an annual inflation rate of below, but close to, 2 percent. Only last month inflation fell to a three-year low of 0.8 percent. Against this backdrop, the most recent measures seem almost like a last, desperate attempt to turn the tide. The announcement that the ECB would not have to stop at the 2 percent mark, but could instead allow higher price pressure in the sense of a symmetrical inflation target (instead of an upper limit) for a certain period of time, undoubtedly belongs to Mr Draghi’s most extreme choice of words.
In the face of the already very low and self-imposed restrictions on quantitative easing, the ECB has hardly any ammunition left. It is therefore not surprising that Mr Draghi appeals to the fiscal policy of the member states, arguing that the central bank alone cannot handle the great task of countercyclical economic policy. However, coordinated fiscal policy action between states to strengthen investment seems to be unlikely. While Italy lacks the funds, German politicians are reluctant to touch the schwarze Null (i.e., a balanced budget), even though the German economy has been on the verge of a downturn for months now and the government could go into debt on unprecedented terms.
This is where Christine Lagarde enters the stage. Granted, the ECB’s monetary policy is unlikely to change much under her auspices. There is no doubt that in a world in which growth is slowing in all major economic blocs and there is hardly any perceptible inflationary pressure, interest rates will remain very low for the foreseeable future. Although Ms Lagarde does not have the typical CV of a central banker, this could indeed make her just the right candidate for the job. As head of the International Monetary Fund, she has been valued for listening to a variety of opinions and building consensus between different shareholders. And her experience as French finance minister may give her the political tact that she needs to persuade eurozone governments to assume their fiscal responsibilities. In fact, Ms Lagarde already drew public attention to herself in August by calling for a reform of European budgetary rules. She argued that eurozone members should be given additional room for manoeuvre in the use of fiscal policy instruments during times of economic downturn. On a different note, she announced to put climate change on the macroeconomic agenda, suggesting that the ECB could steer its asset purchase program towards green bonds.
Ms Lagarde will indeed have to demonstrate her political skills right at the beginning of her term of office. She has the historic chance to bridge the deep divide in European monetary policy between North and South, between – so to say – monetary hawks and doves.