Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.

The ECB’s Changing of the Guard

LONDON – This month, the European Central Bank hosted a colloquium in honor of Peter Praet, its departing chief economist. Having worked closely with ECB President Mario Draghi through the years after the 2008 financial crisis and subsequent euro crisis, Praet, more than anyone else, has been the one to steer the bank’s governing council toward a common decision in difficult situations. His departure comes after that of Vice President Vítor Constâncio last summer, and he will be followed out by Draghi in October and Benoit Coeuré of the ECB executive board in December.

These important changes in the ECB leadership offer a chance to reflect on the challenges the Bank will face in the coming years. As the eurozone’s only truly federal institution, the ECB has found itself acting as the “institution of last resort” during past crises, picking up the pieces when national governments fail to reach agreement. It has managed this despite its complex governance structure. The ECB governing council comprises 19 national central-bank governors, each representing countries with different interests, as well as the executive board, whose six members are appointed by the European Council following an intense bargaining process.

Though Draghi tends to get most of the attention, he made sure to point out at the colloquium that it was Praet whose recommendations have consistently been accepted by the governing council these past eight years. The departing leadership’s success in building a consensus within such a diverse group should not be taken for granted.

Over the past decade, the ECB, like other central banks, has vastly expanded its monetary-policy toolkit. This process started with Draghi’s predecessor, Jean-Claude Trichet, but it deepened under the current leadership with the launch of long-term refinancingoperations for banks, quantitative easing (QE), forward guidance, and negative interest rates on deposits.

It was much more difficult for the ECB to these pursue unconventional measures than it was for the US Federal Reserve, the Bank of England, and the Bank of Japan. These policies have distributional implications well beyond those of traditional interest-rate policies, and in the eurozone this often takes on a geographical dimension, which can intensify disagreement. Nonetheless, the ECB has capably defended the principle that these implications less important than the necessity (and economic advantage for all) of preserving the euro and fighting deflation.

Now, a new leadership team will have to face new challenges. Appointees to the ECB must be technically competent, well regarded in the economic community, and politically unencumbered, so that they can resist pressure from national governments. Their job is to devise a policy strategy that makes sense for the eurozone as a whole, while at the same time engaging with all stakeholders in a constructive manner. These are demanding requirements. If the ECB’s next leaders do not meet them, the euro itself will be at risk.

Complicating matters further, by 2020, the European Commission and the European Council will each have a new president and leadership teams of their own, and the European Parliament will have seated a new generation of politicians who have not taken part in the past decade’s compromises and reforms. On the contrary, many of them will have been elected in a political environment of anger, diminished trust, and intra-EU fragmentation.

Still, there is a broad consensus that the eurozone will need more than monetary policy to ensure continued growth and stability. Obviously, with interest rates at the zero lower bound, more monetary/fiscal-policy coordination is a must. The eurozone would also benefit substantially from macroprudential policies and better bank-resolution tools, as well as the development of a common capital market. Yet there is little political consensus for the expanded federal competencies and increased level of risk sharing such policies would require. As a result, holding the eurozone together will continue to fall to the ECB.

The task will not be easy. In the event of another slowdown, limited fiscal capacity in some countries, combined with the absence of common stabilization tools, suggests that the ECB will have to push the boundary of unconventional policies even further than it has. That might mean expanding its asset-purchase program and the size and composition of its balance sheet. Yet without progress toward deeper financial integration and a common capital market, private risk sharing will remain limited, impairing the effectiveness of the ECB’s efforts.

More broadly, the ECB should take stock of the past year and revise its strategy accordingly. It needs to improve the transparency of its decision-making process by clarifying the roles of economic and monetary analysis in its “two-pillar approach” to maintaining price stability. Its inflation target – currently defined as “below, but close to, 2% over the medium term” – must be made more precise, with a correction for its downward bias.

This process will be controversial. As is already happening elsewhere, the ECB’s independence will be challenged. But, unlike the Fed and the BOJ, the ECB will have to navigate the interests of separate countries across a deeply divided union.

Looking back, it is clear that a political agreement to create a common European currency would have been impossible but for the emergence of a worldwide consensus around central-bank independence in the 1990s. That new consensus turned out to be so strong that the ECB’s independence was actually established by treaty (as the condition for Germany’s buy-in). Independence is thus the eurozone’s key governing principle. It must be defended at all costs, particularly in circumstances under which the ECB is forced to evolve and assume a larger role to make up for divisions among national governments.

The battle over central-bank independence will define the ECB’s next decade. As national governments reflect on Praet’s departure and look ahead to the selection of a new president and executive board, one hopes they will take seriously the task of picking the right women and men for the job.

Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.

Copyright: Project Syndicate, 2019.