Following the European Central Bank’s announcement in September that it will restart its bond-buying program, several national central bank governors voiced unprecedented public criticism of the decision. “In my view, [outgoing ECB president Mario Draghi] has gone too far,” Bundesbank chief Jens Weidmann told German tabloid BILD. A group of former central bankers quickly followed with similar complaints.

All this comes on the back of strong condemnation in recent years of the eurozone central bank’s monetary policy from parliamentarians and other officials, particularly in countries such as Germany and the Netherlands.

The issue is not just that this damages public trust in the independence of the ECB. Such objections also tend to ignore the source of the current low-rate environment. For example, the ECB is constantly under fire in Germany, even though the German government’s unwillingness to spend and invest more has played a role in forcing Europe’s central bank to intervene and in keeping interest rates low. Criticism of the ECB coming from those in charge of fiscal policy is particularly galling because, over the last decade, the eurozone has relied almost completely on support from the ECB to stimulate its economy.

Too Much Saving

The ECB’s critics complain that it keeps interest rates artificially low, causing savers to lose out, distorting markets, reducing pressure on governments to reform, and putting pressure on banks’ business models and on pension funds’ funding positions. However, they tend to ignore the causes of the low interest rate environment and overstate the power of the ECB to control financial conditions. This critique also disregards the fact that interest rates have been on a downward trend since the 1980s. In fact, this trend in rates continued largely unchanged after the start of the ECB’s bond-buying program in 2015. Nevertheless, critics tend to blame this practice, which they often incorrectly describe as “money printing,” for the current state of financial conditions.

The bottom line is that too many people, and countries, are trying to save more than they invest. And as the demand for borrowing is lower than the supply, the price of borrowing, i.e. the interest rate, is falling. This is clearly visible in the eurozone, which as a whole consumes and invests significantly less than it produces, with the gap at about 3 percent of its gross domestic product. Ageing populations are often assumed to be a driving factor of this; a relatively larger group has to save more for their retirement. The fact that so many investors are searching for safe assets, often government bonds, pushes up their prices and thereby reduces their yields. On top of these private sector savings, many European governments are now running fiscal surpluses, further decreasing the supply of safe assets and pushing up their prices.

Counterproductive Fiscal Policy

While the ECB will never acknowledge that it has run out of tools to stimulate the eurozone economy, its repeated calls for government spending highlight that it cannot do the job alone. For several years now the ECB has been pointing out to governments that it needs support from fiscal policy to boost economic growth in the eurozone. But many governments have responded by doing the opposite: tightening fiscal policy, and in many cases running large fiscal surpluses for several years, often by increasing tax burdens and cutting back on public investment.

In spite of repeated calls for Germany to loosen the purse strings, including from the IMF, both governing German parties remain committed to the so-called “schwarze Null policy” of making no new debt. Olaf Scholz, the finance minister, recently indicated that Germany would be willing to increase spending in the event of a crisis comparable to that in 2008, but this sets an absurdly high bar—that was, we hope, a once-in-a-generation global economic crisis.

Germany did engage in fiscal stimulus during the global financial crisis in 2009-10, but this turned out to be a short-lived experiment. By 2011, it was already tightening again. That fiscal stimulus helped the German industrial sector through the slump, and Berlin might repeat the trick now to cushion the impact of the current industrial downturn, for instance through state support for reduced working hours. This would be welcome in the short term, but it runs the risk of crowding out the types of spending and investment needed for the medium to long term. Under the schwarze Null, every euro spent paying factory workers to stay at home is a euro not spent renovating schools, or improving low-carbon transport.

How to Kick the ECB Habit

Unemployment may be approaching historically low levels in the eurozone, but the persistence of low inflation points to a continued demand deficit. The ECB under Draghi has responded to this, but governments have barely contributed to these efforts. Through increasing spending, particularly investment, they could help create the conditions that would allow interest rates to be increased. Instead, some are calling on the ECB to tighten policy now in the same disastrous way it did in the past, unnecessarily cutting short economic recoveries.

There have been some tentative calls even from influential voices within Germany to increase spending, with the idea usually being to invest more in areas such as green technology. While this would be a good step, Germany and other countries in comfortable fiscal positions need a change in thinking, need to increase investment on a wider scale. Due to the current healthy state of its public finances, for Germany this would not even necessarily mean going beyond the headline budget targets set out in the European rules or violating its constitutional debt brake, which—unlike the schwarze Null—allows limited debt spending.

Beyond the modest positive economic spillovers to the rest of the eurozone, doing so could also encourage the bloc to rethink its fiscal rules. These could be made more accommodating to public investment in order to avoid situations in which governments cut down on this to reach headline budget targets. Such a shift in attitudes towards fiscal policy would be difficult to achieve, not least because the opposition to spending is not just driven by ideological considerations but also simply resonates well with many electorates. However, taking a new approach could help ease relations between the member states and could be achieved without letting go of prudent fiscal management altogether.

Europe needs investment in infrastructure, education, digital technology, and research to get it ready for the future and to boost the competitiveness of some economies, particularly peripheral ones. Public investment fell from 3.3 percent of eurozone GDP in 2008 to 2.7 percent in 2018. This is partly the result of secular spending pressures, as ageing populations pushed up healthcare and pension spending, but also of deliberate prioritization by policymakers.

In pursuit of these targets, European governments ignored investment in the long-term strength of their economies. Now that government bonds carry negative interest rates, and governments are thus effectively being paid to borrow, there is no excuse to continue to do so. Only by letting go of the arbitrary fiscal targets and stimulating investment and consumption demand in the eurozone can governments get Europe’s economies to a position where the ECB is able to withdraw its monetary policy support over time.

The post Red Herring & Black Swan: Rally Behind the ECB appeared first on Berlin Policy Journal - Blog.

Artwork © Dominik Herrmann

Christine Lagarde is not making any public statements at the moment. She doesn’t want to risk any controversies in the run up to the EU summit in October, at which she is to be finally appointed president of the European Central Bank. Every word would be scrutinized and also interfere with the work of the current ECB president, Mario Draghi, who remains in office until the end of October.

Lagarde had been expected to attend the largest French economics conference in Aix-en-Provence shortly after the European heads of state and government agreed on nominating her at the beginning of July. She cancelled her conference appearance, though she still went to Aix-en-Provence but only to attend the opera, which she loves. Her younger brother Olivier, who is a well-known baritone, often accompanies her on such visits.

The 63-year-old Frenchwoman did, however, send a message to the disappointed conference organizers—it’s the only statement she has made since her appointment. Referring to the conference topic of “regaining trust,” she wrote: “With trust, the child takes its first steps, the lovers exchange rings, the entrepreneur invests, the banker gives credit, the citizen gets involved. I am convinced that your conference theme is the first condition for the world to meet the challenges it faces.”

At the ECB, too, her first task will be to build trust—in her own leadership and in the ability of the central bank to set the right framework conditions for the economy and thus prepare the European Monetary Union for the future.

Expectations are especially high in Germany, where there is the most hostility to the ECB’ low interest rate policy. The opening of the monetary policy floodgates was met with harsh criticism here because it harms savers, burdens banks, and thus triggers the feeling that Germans are paying for others. Can the former managing director of the International Monetary Fund (IMF) smooth the troubled relationship and successfully guide the ECB through the next eight years, years that may become turbulent?

A Well-Liked Dove

Lagarde is certainly well liked among the main players of the financial markets. Experts like to divide central bankers into “doves,” advocates of a loose monetary policy, and “hawks,” advocates of a restrictive monetary strategy. While Jens Weidmann, for example, the president of the Bundesbank and defeated candidate for the ECB job, is seen as a hawk, Lagarde is regarded as a dove. “She’s probably even more of a dove than Draghi,” bond manager Ben Lord of the British finance company M&G Investments told the Financial Times. While that may not be the consensus view on the financial markets, many do see Lagarde as at least being in line with Draghi.

Lagarde expressly welcomed the ECB president’s announcement in July 2012 that he would defend the euro with “whatever it takes,” thus creating a protective wall around the common currency. As a result of this guarantee, the ECB massively bought up government bonds issued by European governments. Lagarde was even “an early supporter” of this “quantitative easing,” says Andrew Benito of Goldman Sachs.

The ECB hopes that this will bring the stubbornly low inflation rate in Europe closer to the prescribed target of “close to two percent.” The glut of money is therefore likely to continue under Lagarde for some time. She recently warned that the global economy was entering rough waters and recommended that the central banks maintain their loose monetary policy. On the day of her nomination in early July, European government and corporate bond prices jumped. Investors continue to expect high prices for the bonds which implies low interest rates.

A Keynesian Worldview

Lagarde’s time at the helm of the IMF would seem to indicate that she is not an “ultra-liberal,” the derogatory term used in her native France to describe economic liberals. Traditionally, the fund has dealt with topics such as currency issues, imbalances in international trade, and major macroeconomic indicators such as public debt and growth. Lagarde expanded the spectrum to include social inequality, gender discrimination, climate change, energy policy, anti-corruption, and financial stability.

As a result the IMF no longer has shed some of its image as a hard-hearted neo-liberal institution. There has always been a range of thinking among the well over 1,000 IMF economists, but under Lagarde the focus changed: countries with fiscal leeway were advised more strongly than before to increase public investment. Savings programs should not be too harsh, capital market controls, which had previously been taboo, became socially acceptable, while privatization was no longer regarded as a panacea. Under Lagarde, the Keynesian worldview has to some extent become the norm at the IMF.

While the anti-Keynesians at the fund may blame her for this change, overall there is no doubt about her popularity with the staff there. Lagarde is considered capable of compromise and a team player. She includes rather than excludes. “Building consensus is one of her outstanding skills. She listens to the opinions of everyone involved, even a young economist who joined the IMF just six months ago,” Bruno Silvestre, who worked for many years as her spokesman in Paris and Washington, told the Frankfurter Allgemeine Zeitung.

Team Player with Charisma

She gained respect because she increased the fund’s financial resources and thus its firepower. This also reflects her negotiating skills with the 189 governments represented in the IMF. Her charm has also been good for the IMF. Lagarde, who loves jewelry and is always elegantly dressed, has a winning charisma that is effective. The fact that she is also known to be “as tough as nails” doesn’t have to be a contradiction.

The network that she has built up over the years plays a central role here. During the financial crisis, she often exchanged ideas with Henry (“Hank”) Paulson, the then US treasury secretary, whom she knew from their Goldman Sachs days. She was and is personally known to numerous important CEOs because she advised them as a star lawyer. Since her time as French finance minister, she has also got on very well with her former German counterpart Wolfgang Schäuble.

This helped her when in 2010, against German resistance, she called for Greece to be helped out of its existential economic crisis. Later, she advocated a restructuring of Greece’s debt with easier conditions for the government in Athens. The relationship with Schäuble was not damaged. The same applies to her rapport with Angela Merkel. There’s a mutual respect there marked by the fact both have succeeded in what is still a male-dominated world.

The Spiral of Cheap Money

But does the ECB need someone quite so political at its helm at a time when the independence of central banks around the world is threatened? In the United States, President Donald Trump is putting pressure on the Federal Reserve, in Europe the ECB has fallen into a spiral of cheap money, which spares countries with lax financial management like Italy the necessary reforms. So far, the ECB has not been able to escape this spiral, because abandoning this policy could endanger the entire monetary union. The ECB has thus made itself vulnerable to blackmail.

Can Lagarde stand up to governments in this context? Some doubt it. Yet as IMF chief she proved her independence from the German government when she and the IMF withdrew from the third rescue package for Greece in 2017 against Berlin’s wishes. Behind the scenes, she fought fierce battles with Greek Prime Minister Alexis Tsipras over austerity programs and credit conditions. Recently, she also warned of the debt mountains piling up around the world.

Then again, she still has to prove her independence from the French government. Yet she is less embedded in the French establishment than it might first appear. Even as a young woman, Lagarde was more attracted to America. She failed the entrance test to get into the classical elite school, the ENA. Instead, she made her career with the American law firm Baker McKenzie, one of the largest in the world, where she stayed for 25 years.

She later joined the French government, appointed by French President Nicolas Sarkozy as finance minister. However, she has never been a politician who sought a popular mandate from the electorate, being more attracted to the wider world.

An episode as French finance minister also left a bitter aftertaste: an affair involving French entrepreneur Bernard Tapie. On her watch, the French state paid more than €400 million as compensation to Tapie in connection with the opaque sale of Adidas in the 1990s. It’s still not clear exactly who gave the instructions for the payment of such a huge sum; a French court found her guilty of “neglecting” her official duties, but imposed no punishment.

The Eternal First

Throughout her life she’s been something of a pioneer—in terms of her gender, her nationality, and her education. She was the first woman and the first non-American to head Baker McKenzie, as well as the first woman to serve as French finance minister, head of the IMF, and now president of the ECB. All of that demands a lot of assertiveness.

As the eldest of four siblings, she grew up with her three brothers in a middle-class family in the port city of Le Havre. Her father was a professor of English, her mother a teacher. Politics was always present in her family; her parents knew leading politicians like Pierre Mendès France or the later President of the EU Commission, Jacques Delors, who were visitors to the family home.

When she was 12 years old, she took up synchronized swimming. Three years later she was on the national team and a silver medal winner in her age category. She has displayed both discipline and the ability to integrate ever since. But when she was 16, her father suddenly died. The family had less money and Lagarde had to go to work as well as attend school.

When she was 18, she spent a year in the US on a scholarship, attending a high school in Maryland, and she also interned on Capitol Hill as a parliamentary assistant to William S. Cohen, later secretary of defense in the Bill Clinton administration.

Christine Lagarde, the eternal first. She will also be the first ECB president not to have a degree in economics. Her economic background had already been an issue when she was at the IMF. “I can understand what  people talk about,” she told The Guardian in 2012, “I have enough common sense for that, and I’ve studied a bit of economics, but I am not a super-duper economist.” At the ECB, of course, this could become a problem, because the job is more technically challenging than at the IMF.

Fishing in a Larger Pond

In times of crisis, central bankers often have to react quickly. They  need not only the right instinct, but also the technical knowledge. At the same time, Lagarde is not a novice. Anyone who headed the IMF for eight years and was French finance minister for four years has enough knowledge of the economic context. Nevertheless, many observers believe that Lagarde must draw on the ECB’s expertise more than her predecessors. The top expert there will be Philip Lane, the bank’s chief economist, who comes from Ireland.

Decision-making at the ECB should in any case have a broader basis. Draghi took decisions with a small group of his closest confidants or even alone. Lagarde is likely to fish in a larger pond and at the same time change the ECB’s external image. Her proven communication skills, which Draghi lacks, are one of her greatest assets.

After spending the last eight years in Washington, the first lady of the financial world is returning to Europe. When it comes to her private life, the move to Frankfurt will be far more convenient: She can now see her partner, a French entrepreneur from Marseille, and her two adult sons living in France without needing to take a transatlantic flight.  

The post Close-Up: Christine Lagarde appeared first on Berlin Policy Journal - Blog.