- The ECB has (naturally) changed substantially throughout its brief existence.
- But the current changes are more fundamental, affecting the core of the Bank’s behaviour.
- Once the question was how Italy would be able to live with a German currency. Now it looks the other way around, how will Germany live with an Italian currency?
In our article last week (Unhappy ECB) we noted that the European Central Bank (ECB) appears to be undergoing a process of transition, and evolving into a rather different organisation from the ECB of 1999, the start of the single currency.
In one sense this is both self-evident – the ECB is clearly both thinking and acting very differently from how it did when it started – and entirely unsurprising, as the world itself has changed in the intervening nearly quarter-century. It would be more of a surprise if the ECB of 2022 was exactly the same as the ECB of 1999, despite the pandemic, despite the eurocrises of the 2010s, despite the Global Financial Crisis of 2007-09 and despite all the other changes in the world economy since it was founded such as the rise of China and the rise of Tech. All central banks have changed in the last 20 years – changed their rule books, changed their operations, changed their styles, even changed their public profile – and the ECB is no exception.
But it is our contention that the ECB has changed and is changing more than most major central banks, and that having been established as the very epitome of a rules-based, inflation-fighting central bank it will in future be more flexible, less single-minded and perhaps less easy to understand or predict. Or, as one might summarise the move, “less Teutonic rules and more Latin flair”.
To understand this change, let us briefly go back to the ECB’s foundation. At the start it was both designed to be and set out to be a true successor to the Bundesbank – a hard-nosed, rules-based independent central bank who put the control of inflation first. The ECB’s founding fathers may have genuinely believed that this was the best way to run a central bank, or they may have more cynically believed that this was the best, if not only, way to get the German people to support the single currency project, but it does not matter much which: that was the blueprint.
And it worked very well indeed for 10 years. But it proved inadequate to handle the twin challenges of firstly the Global Financial Crisis, then the euro crisis. Indeed, doubling down on being a hard-nosed rules-based central bank was threatening to collapse the weaker economies of the Euro Area, even perhaps collapse the single currency itself. In the early 2010s it was by no means certain that Greece would be able to remain in the euro, and by no means certain that if they departed, the euro itself would survive. Indeed if a Greek departure had led to an Italian one, then the euro would have almost certainly not survived.
It took Mario Draghi (an Italian) and his comment in 2012 that the ECB would do “whatever it takes” to save the euro to turn the situation round. It is worth pausing a moment to consider what that phrase means – it is the total antithesis of the rules-based central bank, the orderly organisation doing what it knows is right and proper. Instead Draghi led it to do what was necessary, whether or not it was orthodoxy. And it worked.
By the end of the 2010s though the ECB was facing a dilemma. It was still at heart (and in its own estimation) a rules-based organisation, an orthodox inflation-fighting central bank, but it was increasingly finding that this was difficult in practice, and it was therefore adopting the “whatever it takes” approach more and more often. And then came the pandemic, and “whatever it takes” became even more the norm: asset purchases and minimal interest rates dominate and German-style rules have gone out of the window. And, latterly, German-style inflation numbers with them. And still it does not raise interest rates, or even rein in its money creation.
The contrast with above all the Federal Reserve is by now stark, following the release last week of the minutes from the December meeting of the FOMC. These made it clear that not only is the Fed prepared to raise interest rates much more aggressively in 2022 than previously thought (about time, in our view); it is also prepared to actively start shrinking its balance sheet. The latter point is more important than is usually realised. At no stage in history has a major central bank acted to shrink its balance sheet in nominal terms to any significant extent. We do not know the impact it will have; but if we posit that QE had the effect of lowering bond yields and keeping them low, then it makes sense to assume that QT (Quantitative Tightening) will have the opposite effect.
When one sees a central bank presiding over high inflation and still not acting according to received orthodoxy to bring it down, there are basically three main possibilities. The first is that the senior central bankers there do not want low inflation; but while there may be countries where this is the case, they are few and far between, even in less developed economies. Preservation of the value of the currency – a.k.a. delivering low inflation – is the essence of central banking, and almost anyone who reaches a senior position at a central bank will buy into this, however limited the central bank is in other ambitions. We can rule out that the ECB does not want low inflation.
A second possibility is that the central bank does want low inflation but those in charge do not know how to achieve it. But again, there will be few countries where senior central bankers do not have – or cannot find – the theory of how to control inflation. Central bankers meet continually, and are always sharing information and comparing notes. We can also therefore rule out that the ECB does not understand the theory of how to generate low inflation.
And the third possibility is that the central bank in question wants low inflation, knows how to achieve it but is somehow unable to execute the required strategy. That could be because of political interference and override: Turkey and Venezuela are the most obvious cases of this at the moment. Or it could be because of other circumstances, such as the weakness of the economy or a national unwillingness to endure the cost of controlling inflation.
This was the case for the “100 Club” – those countries where there were more than 100 of the local unit to the euro when they joined the single currency. Five countries were members of this club: Spain, Greece, Italy, Portugal and Slovenia, with a mention-in-despatches for France which would also have been a member were it not for their redenomination in 1960.
In every case except Slovenia’s, the 100 Club’s small-value currencies reflected years, in some cases decades of failing to control inflation in the period after the Second World War (Slovenia is an exception because the Tolar was only introduced in 1991, and had a very low value right from its introduction). But in every case the country concerned had a highly competent central bank, and central bankers who wanted to control inflation and were no less well versed in the theory of how to do so. Rather, they presided over high inflation not because they wanted to, not because they did not know any better but because they knew that, however much they may have liked to run a low inflation, hard central banking regime, they risked breaking their countries if they did. In short, they were the servant of their citizens, not their master, and had to cut their cloth according to society’s preferences.
And the ECB is now discovering that it too is the servant of its citizens not their master, and if the Latin part of the EU wish to run a high debt, low productivity society, the central bank’s job is to accept that and run with it the best they can, not ignore it and plough on with rules-based central banking regardless.
The ECB must play the hand it has been dealt. It is the central bank of a range of economies, some of which are weaker than others, and some of which, due to their debt dynamics and the structure of their societies, are less able to withstand the hard medicine of the sort of interest rate regime more usually associated with 5% inflation. It is perhaps not entirely a coincidence that of its 4 presidents, one was uninspiring (and dismissed after half the standard 8-year term), and the other three have been from Latin countries (two from France and one from Italy), where experience of such matters and of operating in such circumstances is higher. And (despite Herr Weidmann’s excellent credentials in the last decade) none at all have been from Germany.
The latter point is perhaps more significant than is often realised. For a long time, there has been a perception that the EMU was, in the words of the late British Cabinet Minister Nicholas Ridley “a German racket designed to take over the whole of Europe”. In fact, this was never the case. EMU was forced on Germany as the price for German reunification and to reinforce French control over the EU, threatened by a Germany that hitherto had meekly accepted a junior position in the Franco-German alliance, but now suddenly increased in population by a quarter (although GDP rose by much less). Similarly, the British debate both before and after Brexit was very much conditioned on the idea that if the UK could simply get Germany (in the shape of Chancellor Merkel) on board, then everything would somehow be all right. It never worked like that and a series of British Prime Ministers were disappointed.
The problem here is that two principles are in collision: On the one hand, there is the Golden Rule, i.e., “he who has the gold, makes the rules”. But on the other hand, we hear the words of the Athenian emissaries to Melos during the Peloponnesian War, “the strong do what they can and the weak suffer what they must”. Germany may be the EU’s paymaster, but it is only one of 19 EA members, and its allies in matters economic are small (the Netherlands, Finland, a few others) while on the other side are three of the four largest EU members, France, Italy and Spain (plus again smaller allies). Germany certainly has the gold; but it does not have the strength.
Hence, it is more and more looking as though, rather than being the son of the Bundesbank, the ECB will end up through necessity being the son of Banca d’Italia and Banque de France. Instead of wondering (as many did in 2000) whether Italy will be able to live with Germany’s hard currency, it is looking increasingly as if Germany is going to have to learn to live with Italy’s.
To understand the true essence of a rules-based central bank, a personal anecdote from 1992 may help. This was the time of the ERM crisis, when Bundesbank interest rate rises were creating havoc in the ERM and real hardship in other EU countries. One of the authors of this Comment remembers observing this to his opposite number at Bundesbank, and the conversation went like this:
“You are destroying Europe with your interest rate policy“
“Yes I know, but we must follow the rules”
“But Europe will never let you get away with this – they will destroy the Bank”
“This also we know. But even the continued existence of the Bank is secondary to following the rules”
We accept this is perhaps a little unkind; France’s large inflation was well and truly over by the mid-1950s, whereas the other members of the 100 Club saw ongoing high inflation well into the 1970s or even later.