What’s Wrong with the European Central Bank?

As Mario Draghi’s term as president comes to an end, the battle over who will succeed him has brought all of the flaws that plague the European Central Bank to the fore.

“The Eurozone will endure, but it will not prosper,” writes London School of Economics professor John Ryan. With growth sluggish, interest rates kept at near-zero per cent for years, bonds at negative yield levels, the Eurozone economy grinds on, never losing, but never really winning.

So what’s wrong with the ECB? It’s inelastic: it can’t change policies easily. It has put so much money and effort into strategies that have not changed for years, that it now has very little left in its arsenal to effect more change, and Europe needs more without delay.

The two most likely candidates to replace Draghi, the moderate Finnish Central Bank Governor Olli Rehn, and Germany’s central bank governor, the rabid hawk Jens Weidmann of Germany, both want radical changes in the way the ECB works, a move sharply away from current ECB President Mario Draghi’s policies.

Draghi’s “whatever it takes to save the euro” speech in 2012 held the Eurozone together through several crises. “This speech was followed in 2015 by a EUR 2.5 trillion expansion of the ECB’s balance sheet with bond purchases, a policy critical to re-establishing the convergence of interest rates and control over monetary policy across the eurozone,” writes the consultancy Edison Investment Research. This is the controversial policy referred to as Quantitative Easing (QE).

Ineffective policies that have not changed

But Draghi’s policies have not lifted inflation – in fact, the ECB’s forecasts calling for a rise have been wrong, again and again, as research from the Brussels-based Bruegel think tank has shown. And while the European economy is recovering from the 2008-2009 crisis, it cannot be called dynamic.

And balance sheet expansion with bond purchases is likely to continue. Despite its having been formally closed by Draghi in December 2018, he announced in March that it is likely to start up again. He also announced a programme of cheap, long-term loans for banks.

The question is whether, under these conditions, balance sheet expansion can be effective? “QE is not quite the God that failed, but it is the solution that fell at the very least well-short of where people had imagined it would have come” explains Laureate economist Paul Krugman.

QE is not a substitute for economic growth; what the ECB hoped for, that QE would spur real economic growth, has not happened beyond a very limited degree. An expansion of the monetary base, coupled with easy credit, are a kick-start, not a long-term solution.

Need for new Solutions

Weidemann has advocated for this view for a long time. He has persistently called to put an end to QE, to reduce the size of the ECB’s balance sheet, warning that it poses a danger to economic stability in the Eurozone.

Rehn, on the other hand, calls for a rethink, an overall review of strategy, to consider what new strategies are available to the ECB. There is considerable support for this moderate approach; in fact, the US Fed is considering just the same thing.

“I dare say it is important for market observers, lawmakers, and the public to become more comfortable with the benefits of central banks using their balance sheet tools to pursue the public interest,” Boston Federal Reserve Bank President Eric Rosengren recently observed. “In my view, monetary policymakers should give more consideration to structuring the balance sheet to provide more leeway for policy measures to be taken when the next economic downturn occurs.”

Rehn points out that a full-scale review of the ECB’s monetary policy has not taken place since 2003. He called for “a re-examination of the principles, key assumptions and instruments underlying (the ECB’s) monetary policy.”

“The deviation of inflation expectations from the ECB’s target is worrisome in terms of the effectiveness of, and strategy for, monetary policy,” Rehn wrote in an editorial published by the Bank of Finland.

Vast power, far too much power

Then, as always, there are the issues generated by politics. “ECB policymaking has become problematically controversial and politicised,” writes Ryan, who points out that the ECB’s vast power is far too much unchecked power.

“It is, however, not just the vast power with which the ECB holds sway over Europe’s economies that is cause for mounting concern, it is the complete lack of transparency and accountability with which it wields that power,” Ryan continues.

“The ECB is far more independent than the US Federal Reserve, whose legal status is far weaker and which is directly accountable to Congress and the US government. The ECB was supposed to be like the German central bank, the Bundesbank. It has, however, failed to emulate the distinctive attributes that made the Bundesbank successful, such as accountability and interdependence with other democratic institutions.”