In our last article (“Ever Closer Union? The state of the EU today” – 4.10.15) we considered the state of the European Union’s general political health. Even the most ardent supporter of the Union would be forced to admit that this is currently not good, though it is fair to say that the issues the EU has faced this year have been challenging indeed.
However, one part of the EU’s political architecture is usually spared such criticism. The European Central Bank and its President Mario Draghi are widely seen to be both competent and effective; it is the most powerful component of the Eurozone’s institutional infrastructure, and its actions and its monetary policy both define the single currency and arguably have at times single-handedly kept it sound. Indeed, for many people the ECB is the only effective institution in the Eurozone, if not the whole of the EU.
The Americans may emblazon their currency with the words “In God we trust”; it is not too much to say that for the Eurozone, the equivalent sentiment is “In Draghi we trust”.
And as a reflection of this trust, the political leadership of the Eurozone increasingly turns to the ECB whenever they have a difficult financial challenge. Rebuild Eurozone banking supervision? – give the ECB supervisory and regulatory powers. Complete the Banking Union? – call on the ECB to be in the lead. Keep the Greek banks alive while the politicians work out what to do? – again, the ECB obliges. Restart the economy? – the ECB’s Quantitative Easing (QE) programme, started earlier this year, has by narrowing the gap between monetary and fiscal activity helped the Eurozone post some slightly less dire economic statistics.
This trend looks set to continue. The ECB is sure to be called into play in the ambitious project to build a proper Capital Markets Union, the project that Lord Hill has been tasked with, and there are even calls (from Germany no less, in the form of Hans Eichel, federal finance minister in the last SPD government) for the ECB to direct its QE programme to provide funding for small and medium sized businesses and increase investment in infrastructure projects.
And so far, Draghi and his team have not let anyone down. But this concentration of power and duties at the central bank poses a number of questions.
Question 1: Are governments employing the ECB to ensure financial stability and a properly regulated and supervised banking system because it is the best institution available or simply because it is the easiest to press into service?
There has been very little debate in the Eurozone about whether banking supervision is best done at the central bank or by a standalone authority, yet (and despite the comparative lack of success of Britain’s FSA in the recent financial crisis) it is by no means certain that concentrating responsibility for financial stability at the central bank alongside its responsibilities for monetary stability is always the optimal arrangement.
Question 2: Since the ECB did not find it entirely straightforward to manage policy when it had just 1 main instrument (interest rates) and 1 main objective (low retail price inflation), how easy will it find it to optimise across at least 3 instruments (interest rates, balance sheet size, macro-prudential tools), perhaps as many as 4 or 5 objectives (RPI/CPI, asset price inflation, financial stability, functioning of the banking system, economic activity), and 19 countries, ranging from moderate growth to deep recession?
This is not just a question of choosing the right tool for each task and ensuring that objectives and instruments are correctly aligned. The possibility of unintended consequences, of policy decisions in one area of the ECB’s activities interacting with and perhaps conflicting with their activities in another increases dramatically with every new responsibility they take on.
Question 3: If the ECB is responsible for both monetary and financial stability (and much else besides), how does it resolve conflicts of interest between its multiple duties?
This is connected to the last question, in that the “conflicts of interest” can be at the operational level of the best policy to achieve one of the ECB’s objectives not being helpful to it in achieving another of its objectives. But increasingly, as the ECB moves into the political sphere and its decisions are more subject to political debate and disagreement, conflicts of interest may have a political dimension as well, and this is an area where the bank will have to tread carefully.
Question 4: Given that even the ECB has finite capacity, are governments sure that the extra tasks that it has been given such as those related to financial stability are the optimal use of that capacity?
This appears to be the question that no-one wants to ask. Like at any other central bank, decisions in the ECB are delegated to lower levels of the organisation where they can be. But also like at any other central bank, the more policy-orientated decisions have to be taken at or very near the top of the organisation, and this means an increasing workload for the Governing Council. Not a few national central bank governors have been heard to rue in private how much time they now spend flying to and meeting in Frankfurt.
Question 5: Given that one of the ECB’s most powerful assets is its reputation, is it optimal to put that at risk in so many new and difficult fields? One would for example not want mistakes in macro-prudential regulation (a new and difficult field where much is untried), or liquidity support for the Greek banking system (when the ECB came very close indeed to breaking the cardinal rule of “never lend to an insolvent bank”), to undermine the ECB’s reputation in the monetary or payment system spheres.
I was alerted to this concern by a good friend at a senior level in the ECB. But, with all due respect to his obvious regard for the ECB’s reputation, and while acknowledging that reputations take a lot of winning but can be lost in an instant, I think the Eurozone is probably justified in turning to their ace when they need to. Particularly this summer, when the fate of the Greek banks was literally determined in the boardroom in the Eurotower, it was I believe better to have tried to save the Eurozone, even at the cost of the ECB’s reputation, than to save the ECB’s reputation at the possible cost of Greece’s membership of the euro.
And the biggest question of them all –
Question 6: If the ECB is asked to do everything, what do the politicians do if Draghi fails?
It is this last question that haunts the ECB; indeed it haunts all central bankers, not just those in Frankfurt. The fear is that the authorities in a number of developed countries have put all their eggs into the one basket labelled “central bank”, and have simply no plan for what to do if the central bank does not or cannot deliver.
For the Federal Reserve, or the Bank of England, or the Bank of Japan, this is worrying enough. But these central banks are operating in established states with (by and large) stable political structures. For the ECB, this is not so reliably the case: neither the architecture and competences of the Eurozone nor even the political structure and nature of the Union it is part of are fully determined and settled, and for several of the ECB’s proposed actions there are almost as many political voices against as voices for.
More perhaps than for any other central bank at any time in history, the ECB today faces unfamiliar challenges with untried and unconventional tools and uncertain political support.