On 13 September 2019, Germany’s bestselling newspaper Bild published an article accusing Mario Draghi, President of the European Central Bank (ECB) of ‘sucking dry’ the accounts of German savers (Esslinger, 2019).
The article, which appeared following the announcement of a further rate cut and the restarting of the ECB’s asset purchase programme (APP), was indicative of the growing public discontent with ECB policy, particularly in Germany. To many Germans and others across the continent, the ECB was punishing savers through its policy of negative interest rates while also inflating asset prices and creating dangerous incentives through its vast asset purchase programme. These and other unconventional policies were instituted following the failure of conventional monetary policy tools to lift Europe’s persistently low inflation towards the ECB’s inflation target of below, but close to, 2 percent. As Europe has lurched from crisis to crisis, dissatisfaction has been growing with political elites and European institutions, leading to gains for populist and nationalist political parties in local and European elections.
Central banks are powerful institutions run by a technocratic elite and as their powers have expanded in response to the crisis, fundamental questions about central bank independence and the need for democratic accountability have been raised. The argument for central bank independence is based on the need to be able to act to control inflation without political interference. Richard Nixon’s pressure on Arthur Burns, then Chairman of the Federal Reserve to engage in expansionary monetary policy despite high inflation prior to the 1972 presidential election is often cited an example of political interference that resulted in suboptimal monetary policy decisions (Abrams, 2006). From the 1980s onwards, a body of research emerged which slowed a strong empirical relationship between lower inflation and central bank independence and today institutional and operational independence is the norm for central banks across the developed world. However, the consensus on central bank independence that emerged has weakened with the expansion of central bank powers and the sustained use of unconventional measures.
Starting in 2012, the Governing Council began expanding its monetary policy toolkit, first to reduce borrowing costs of member states and later to counter the threat of deflation and raise inflation closer to target. The first of these policies was the ECB’s Outright Monetary Transaction (OMT) programme, it was also the first ECB programme to be challenged in the German Constitutional Court who later referred it to the European Court of Justice. When the programme was ruled constitutional as long as it met six conditions, the deputy head of Germany’s CSU party described the ruling as ‘not a good day for democracy in Europe’ (Khan, 2016). Over the next few years, as inflation fell consistently below target (and the ECB’s own projections), the Governing Council began purchasing assets [popularly known as quantitative easing (QE)], instituted negative interest rate policy and provided cheap funding to European banks.
One of the most common criticisms levelled at central banks is that they are run by an unelected elite that wield enormous power with little accountability. When the economy is growing, the work of central banks tends to go largely unnoticed. However, with the faltering Eurozone recovery and the introduction of new powerful tools, questions of legitimacy and accountability have arisen. Should democratic societies delegate power to unelected technocrats? On what basis are they making their decisions? How do they balance financial stability effects with the use of unconventional measures and what are the effects of these policies on ordinary people?
Attention has tended to focus on the aggregate effect of unconventional measures on the economy, however in the years since the financial crisis, the transmission channels of these unconventional measures and their distributional effects have become better understood. When the Bank of England (Bunn, 2018) examined the distributional effect of accommodative polices, they found that younger people benefited from increased job prospects and wages and lower interest rates on debt. Older households benefited the most from gains to asset prices (equities and property). Younger and less educated people saw larger falls in the wages relative to older and more educated people. It follows then that older professionals benefitted most from the unconventional monetary policy support provided as are the most likely to have accumulated the most assets. Central bankers would argue that they only target a particular inflation rate as part of their price stability mandate and use the tools required to achieve this objective but this does not change the fact that there are winners and losers from unconventional policy, more so than conventional monetary policy.
Unconventional measures are also having financial stability effects. The low interest rate environment is exerting substantial pressure on bank profitability and is affecting bank’s risk-taking behaviour through their search for yield. Research from the BIS showed that low interest rates induce banks to shift their activities from interest-generating to fee-related and trading activities (Brei et al, 2019). This shift is an attempt to offset losses from depressed interest margins. This can have implications for financial stability if banks take on riskier assets or reduce their lending requirements.
One of the most noticeable, and some might say alarming, effects of unconventional policy has been the expansion of central bank balance sheets. The ECB’s balance sheet has expanded to over €4.6tn and is growing again with the restarting of the APP in November 2019. Similarly, the Federal Reserve’s balance sheet expanded to $4.5tn at its peak before shrinking by about $1tn between early 2018 to mid-2019. This reduction was seen as a good thing by many who were looking forward to the normalisation of monetary policy. However, the recent spike in overnight repo rates has shown that disposing on the assets on the Fed’s balance sheet will be harder than was previously thought (Petrou, 2019). This will also have implications for the ECB and other large central banks when and if they begin reducing the size of their balance sheets.
There are not just calls for central banks to do less. Most recently, there have been appeals for central banks to purchase green asset under their QE programmes (Financial Times Editorial Board, 2019). Again, the question arises – should such potentially significant political decisions be made by unelected technocrats? Paul Tucker in Unelected Power (2018) calls for restricting the power of central banks to preserve their legitimacy. He argues that the delegated power and democratic legitimacy can only be insured through a narrow interpretation of central banks’ price stability mandate. Central bankers cannot be voted out in elections and so the ‘release valve’ that operates between politicians and the public does not apply so to retain their legitimacy central banks must stay sticky within their mandate. Tucker makes a strong case that the power of central banks has become too great and should be restricted. Independence however, allows central bankers to make decisions that may be deeply unpopular to safeguard financial stability over the long term.
Over the last number of years, the Central Bank of Ireland has come under pressure regarding its macroprudential mortgage measures, which limit the Loan-to-Value and Loan-to-Income levels (Kelly, 2019). The measures are credited with limiting house price growth and borrower indebtedness, but they have also had the effect making it more difficult for young people to get on the property ladder. There might be more widespread support for seeing the rules weakened or rolled back if the human and economic cost of the financial crisis was not still so vivid in the public’s mind. The mortgage measures do illustrate the difficult but necessary trade-offs from central bank decisions and how useful independence can be for shielding the central bank from political interference.
In an increasingly globalised world, relations between central banks have also changed. Monetary policy decision can have significant spill over effects across borders leading to significant capital movements and currency appreciation and depreciation. This effect can put added pressure on central banks to act to offset the actions of another central bank, as can be seen from Donald Trump’s comments following the recent announcement of further stimulus in the euro area (Fitzgerald, 2019). In these types of situations, central bank independence can provide useful political cover for national leaders.
The Treaty on the Functioning of the European Union guarantees central bank independence. It also mandates price stability as the primary objective of the ECB but the treaty does not specify how this objective is to be achieved. This gives the ECB broad leeway to accomplish its primary objective. There may be a temptation in the absence of a coordinated fiscal policy to try ever more elaborate ways to raise inflation and growth but the implications for financial stability must be carefully considered and then monitored going forward.
Despite central banks buying unprecedented numbers of bonds across the developed world, no advanced economy has seen high inflation in recent years. Some economists theorise that advanced economies have entered a new era of permanently low inflation and central banks can print money to finance government spending without undue concern. This is known as Modern Monetary Theory (MMT) and it is based on the belief that countries that print their own currency can never run out of money. As the issuing authority, countries with debts denominated in their own currency will always be able to print more money and therefore cannot default on their debts. MMT does sounds appealing, as it would allow politicians to unleash the power of government spending to create jobs, finance social spending and build infrastructure. However, it would I believe reach a tipping point where government spending and public consumption would lead to rising long-term interest rates and ultimately high inflation. Setting aside the economic arguments for MMT, the Eurozone crisis has exposed the fault line in Europe between the more frugal and conservative northern European countries and the poorer less productive southern countries, which are struggling with budget deficits and high debt. The Germany economic mind-set is deeply influenced by the hyperinflation of the 1930s and this cautious approach can been seen at the highest levels of policymaking in Germany. With the limits imposed by the Maastricht Treaty, it seems unlikely that the governments would be willing to allow theories like MMT to be tried in Europe in the near future.
The ECB has a perception problem, it is seen as an elitist institution. There have been some efforts to increase transparency in the ECB over the last number of years, but it is clear that there is still much work to be done. One of the most important and perhaps most difficult tasks for central bankers is explaining their decisions to the public. The public can find economics and monetary policy impenetrable and the minutia of policymaking tedious. Central banks must become better at explaining to the public their role in the economy and more importantly what they can and can’t do. One of the best ways to do this is through transparency at all levels. Certainly, the trade-off between independence and accountability is a complex one but to ensure continued central bank legitimacy in the eyes of the public we must become better at it.
- Abrams, B. A. (2006) ‘How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes’ Journal of Economic Perspectives – Volume 20, Number 4 – Fall 2006 – pp. 177–188.
- Ben-Ami, D. ‘The strangling of European democracy’ Spiked, 23 August 2019. Available at: https://www.spiked-online.com/2019/08/23/the-strangling-of-european-democracy/
- Brei, M, Borio, C. and Gambacorta, L (2019) ‘ Bank intermediation activity in a low interest rate environment’ BIS Working Papers No 807, August 2019.
- Bunn, P., Pugh, A., Yeates, C., ‘The distributional impact of monetary policy easing in the UK between 2008 and 2014’ Bank of England Staff Working Paper No. 720, March 2018.
- Butler, J. ‘Quantitative easing has pernicious effects that favour the wealthy’ The Guardian, 28 September 2018. Available at: https://www.theguardian.com/business/economics-blog/2016/sep/28/quantitative-easing-qe-pernicious-effects-favour-wealthy-tax-middle-class
- Elliott, L. ‘Central banks were always political – so their ‘independence’ doesn’t mean much’ The Guardian, 12 September 2019. Available at: https://www.theguardian.com/commentisfree/2019/sep/12/central-banks-political-independence-monetary-fiscal-policy
- Esslinger, L (2019) ‘So saugt GRAF DRAGHILA unsere Konten leer’, Bild, 13 September 2019. Available at: https://www.bild.de/bild-plus/geld/wirtschaft/politik-inland/ezb-leitzins-schlecht-fuer-sparer-frau-merkel-stoppen-sie-endlich-den-minus-zins-64669942,view=conversionToLogin.bild.html
- Financial Times Editorial Board (2019) ‘How central banks can tackle climate change’, Financial Times, 31 October 2019. Available at: https://www.ft.com/content/1eacda7e-fbd1-11e9-a354-36acbbb0d9b6
- Fitzgerald, M., ‘Trump says the ECB is ‘succeeding’ at depreciating the euro against the dollar while the Fed ‘sits’ CNBC, 12 September 2019. Available at: https://www.cnbc.com/2019/09/12/trump-says-the-ecb-is-succeeding-at-depreciating-the-euro-against-the-dollar-while-the-fed-sits.html
- Foa, R.S., Wilmont, J. ‘The West has a resentment epidemic’ Foreign Policy, 18 September 2019. Available at: https://foreignpolicy.com/2019/09/18/the-west-has-a-resentment-epidemic-populism/
- Gharleghi, B. ‘Central bank independence and economic growth’ DOC Research Institute, 4 March 2019. Available at: https://doc-research.org/2019/03/central-bank-independence-economic-growth/
- Kelly, F., ‘ Taoisearch raises prospect of changes to rules on mortgage lending’ Irish Times, 26 July 2019. Available at: https://www.irishtimes.com/news/politics/taoiseach-raises-prospect-of-changes-to-rules-on-mortgage-lending-1.3968813
- Khan, M. ‘‘Not a good day for democracy’ – German critics attack ECB court ruling’ Financial Times, 21 June 2016. Available at: https://www.ft.com/content/23aa92d1-a15a-3892-bc2c-00159f80dab9
- Hartmann, P., Smets, F., (2018) ‘The first twenty years of the European Central Bank: monetary policy’, European Central Bank Working Paper Series, No. 2219 December 2018. Available at: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2219.en.pdf
- Honohan, P. (2019) ‘Should Monetary Policy Take Inequality and Climate Change into Account?’ Peterson Institute for International Economics, October 2019. Available at: https://www.piie.com/publications/working-papers/should-monetary-policy-take-inequality-and-climate-change-account
- Kedward, K. ‘Why it’s time to abandon the myth of central bank independence’ Open Democracy, 1 April 2019. Available at: https://www.opendemocracy.net/en/oureconomy/central-bank-independence-myth-its-time-abandon-it/
- Matthews, D. ‘Modern monetary theory, explained’ Vox, 16 April 2019. Available at: https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained
- McCarthy, C. ‘Analysing rise and fall of populist forces’ Irish Independent, 14 January 2019. Available at: https://www.independent.ie/entertainment/books/book-reviews/analysing-rise-and-fall-of-populist-forces-37703106.html
- Petrou, K., ‘Repo ruction highlight failure of post-crisis policymaking’ Financial Times, 6 November 2019. Available at: https://www.ft.com/content/fe562cbe-feee-11e9-b7bc-f3fa4e77dd47
- Rabbitte, P. ‘Our democracy is facing new challenges’ Magill Summer School. Available at: http://www.macgillsummerschool.com/pat-rabbitte-2/
- Rogoff, K. ‘How central bank independence dies’ Project Syndicate, 31 May 2019. Available at: https://www.project-syndicate.org/onpoint/how-central-bank-independence-dies-by-kenneth-rogoff-2019-05?barrier=accesspaylog
- Transparency International EU (2017) ‘Two sides of the same coin – Independence and accountability of the European Central Bank. Available at: https://transparency.eu/wp-content/uploads/2017/03/TI-EU_ECB_Report_DIGITAL.pdf