Changing of Lagarde

Arrivederci Signor Draghi

The changing of the guard at the ECB has been well documented recently with numerous articles looking back over Mario Draghi's tenure as President. Opinions are mixed, depending on where one stands on the question of QE. A large part of the German economics profession believes he has followed an unsound monetary policy, with QE serving only to swell asset values whilst having little overall impact on the economy. A more sympathetic view is that Draghi is the man who saved the euro zone following his 2012 promise to "do whatever it takes" to support the single currency.

For my own part, I give him great credit for his actions in 2012. Without his decisiveness, in the face of significant internal opposition, there is a serious risk that the single currency could have collapsed. Odd though it may seem now, given the relatively small size of its economy, the raging Greek debt crisis laid bare the fault lines underpinning the euro zone. Draghi was able to put a sticking plaster over the gaping wound and prevent a bad situation from becoming worse. Had he listened to other voices which argued against taking action, things could have been very different. Indeed, many have pointed out that Draghi is a very adroit politician. He did not have the policy tools to back up his 2012 promise and who knows what would have happened had markets tested him out. Indeed, it took almost three years before the ECB embarked on a policy of asset purchases.

The fact that the euro zone remains stuck in low gear reflects a combination of political intransigence on the part of euro zone governments and changed economic circumstances which have put downward pressure on global inflation, and make the euro zone economy appear more sluggish than it really is. Governments have offered the ECB no real support. The fact that they continue to sit on their hands with regard to fiscal policy makes the ECB's job harder. And as the ECB's first President, Wim Duisenberg, pointed out almost 20 years ago, governments need to do more to restructure their economies in order to remove growth obstacles. In so doing this would remove the reliance on the central bank to support growth. But aside from Germany, whose Hartz IV policies in the mid-2000s proved to be a successful package of labour reform measures, most governments have done little or nothing.

That said, the ECB's policy stance of further cutting interest rates into negative territory and continuing to buy huge quantities of government bonds are the actions of an institution that has run out of ideas. Indeed, the September decision to resume QE caused huge dissent within the Governing Council and prompted the resignation of German representative Sabine Lautenschläger. It is not the first time a German representative has quit in protest. In 2011 both Axel Weber and Jürgen Stark walked the plank. However it is significant that the most recent dissent was not only confined to German board members with French, Dutch and Austrian members expressing doubts about the policy stance.

It is well known that QE has an increasingly smaller marginal impact - the greater the volume of asset purchases, the smaller the impact. A recent research paper suggested that asset purchases produced an average increase of 0.3 percentage points in annual GDP growth between 2015 and 2018 and 0.5 percentage points in CPI inflation, with a maximum impact in 2016. Interestingly, when the working paper version was published the impacts were assessed to be rather larger. Either way, with the central bank balance sheet already at 40% of GDP it is questionable whether the benefit of increasing asset purchases is worth the cost. But whilst this is a valid concern, the simple fact is that the euro zone is still afloat because of Draghi’s actions. He has expanded the ECB’s policy toolkit and given his successor a fighting chance of moving the economy along.

Bienvenue Madame Lagarde

The appointment of Christine Lagarde as Draghi's successor was initially a controversial choice and she faces a number of challenges going forward. I have no doubts about her ability to do the job but she was clearly a political appointee, as Emmanuel Macron sought to shoehorn a French candidate into one of Europe's top jobs. As the head of an independent central bank, Lagarde will have her work cut out to maintain the impression that it is not simply an institution designed to maintain the cohesion of the EU – a view prevalent in some quarters which judges the ECB's monetary policy as a way of keeping Italy afloat.

Lagarde probably has little choice initially but to continue with the policy initiated under Draghi, but her challenge will be to keep the representatives of northern countries onside. The last thing she needs are further damaging splits amongst council members. However the fact that she represents one of the powerhouse economies means her views may carry a bit more clout. Bigger challenges will come later. It is unlikely that a loosening of monetary policy will have any significant impact on growth, and the debate is increasing likely to turn to the damaging side effects of low interest rates.

Low rates work by shifting consumption and investment patterns across time. If consumers are spending today they are not saving for later. But if they are forward looking, as modern macro theory assumes, at some point they are going to change their behaviour in order to build up precautionary savings balances - perhaps for pension purposes. Moreover since interest rates are so low, the amount they will have to save to build up a decent pension pot is likely to be quite substantial. In other words, a policy of low rates forever could start to prove self-defeating. I would not be surprised if at some point in future, the debate starts to shift towards raising interest rates in order to boost long-term growth prospects. Of course, it will not be put in such terms; central bankers will simply talk about policy normalisation.

Recent comments by Lagarde suggest that she will continue to be outspoken on policy issues. In comments earlier this week, she suggested that “those that have the room for manoeuvre, those that have a budget surplus, that’s to say Germany, the Netherlands, why not use that budget surplus and invest in infrastructure? Why not invest in education? Why not invest in innovation, to allow for a better rebalancing?” and suggested that both “have not really made the necessary efforts.” This is pretty powerful stuff and although it is unusual to name individual governments, it chimes with the view I have held for a number of years that governments need to get involved on the fiscal front. There are those who say that central bankers should focus on monetary policy issues. Whilst I respect that view, it is also the case that when fiscal inaction impacts on monetary policy they have a duty to speak out.