More courtroom drama

As central banks and governments around the world battle to put in place measures to mitigate the worst of the Covid-19 economic fallout, the euro zone once again finds itself in an extremely difficult position. Whilst EU governments have done much to provide a range of packages to support workers who would otherwise lose their jobs, the only pan-Emu institution capable of looking at the regional picture is the ECB which is, to use the English cricketing parlance, batting on a sticky wicket.

Yesterday’s ruling by the German Constitutional Court (GCC) ordering the German government to ensure the ECB carries out a “proportionality assessment” of its debt purchases threatens to open a new front in the dispute between northern and southern members of Emu. The GCC is concerned that the “economic and fiscal policy effects” of the bond purchases should not impinge upon the ECB’s policy objectives and it has threatened to block Bundesbank purchases unless the ECB completes a review within three months. Having watched the UK Supreme Court intervene in Brexit-related issues, rightly in my view, it is difficult for me to say that the GCC is wrong. It is, after all, merely acting in what it perceives to be Germany’s national interest according to domestic law.

But this is not the first time that the GCC has become embroiled in the euro zone debate, having generally taken a dim view of Mario Draghi’s “whatever it takes” policy to keep the euro zone together. A case was first brought to the GCC in 2015 when a group of concerned citizens claimed that the ECB was engaged in monetary deficit financing which runs contrary to the Maastricht Treaty. This was subsequently referred to the European Court of Justice in 2018 which ruled in favour of the ECB. However, the GCC has now ruled that the ECJ’s earlier ruling is “untenable from a methodological perspective” which is a much stronger tone than anything it has delivered previously.

Had the ECB not recently ramped up asset purchases, the GCC would not have had to reopen the debate. But it did, and we could now be looking at a major constitutional problem. In effect the GCC has questioned the primacy of EU law, which takes precedence over national law and was such a bone of contention for Brexit supporters in the UK. Panos Koutrakos, professor of European law at City University in London is quoted in the FT as suggesting this represents “the first case where a German court says the European court has no jurisdiction.” One does not have to be a lawyer to realise that if the court has no jurisdiction, the legal basis of the single currency is under threat. It could get a lot worse for the EU if this encourages other governments to ignore ECJ rulings. For example, it has raised fears that the Polish government, which is engaged in a dispute with Brussels over the independence of the judiciary, could continue to defy the ECJ which would undermine the basis of the EU itself.

The GCC’s actions serve further to underscore the notion that there is one law for the prosperous north and another for the highly indebted southern Emu economies. If Germany is going to chafe at the actions of the ECB, the likes of Italy are less likely to accept lectures from other Emu members regarding fiscal policy. German politicians are likely to argue that both the actions of the ECB and the Italian government are in breach of the legal foundations of the euro zone. They may even be right. But that is not how the episode will be seen in Rome which is already disgruntled by the apparent lack of solidarity regarding support for those economies hardest hit by Covid-19.

As it happens, I find it hard to believe that the GCC really wants to cause the single currency project to unravel. Consequently I expect that the ECB will come back with a justification for its actions which satisfies all parties and the single currency will remain intact. But this is perhaps the most serious illustration yet of the flaws of the project. There are no instances of a single currency project holding together in the long run without some form of fiscal union. It is precisely because no such fiscal body exists within Emu that the ECB has to act as it does. History records that the Gold Standard lasted for almost a century whilst the Latin Monetary Union endured for 50 years. But the Bretton Woods System fell apart after 26 years. The common factor in the demise of each of these systems were the strains inherent in maintaining fixed exchange rate parities without any instruments other than monetary policy. Moreover, Bretton Woods fell apart because the US, as the biggest economy, was no longer prepared to subordinate its domestic policy to maintain the international order. The lesson from history is that the longer term future of the European single currency remains in doubt unless reforms are made to the institutional architecture.

But are the German critics right in their view that the buying of assets represents monetary deficit financing? The ECB has always been careful to emphasise that its balance sheet expansion has been driven by the need to raise inflation to meet the 2% target. If we accept this as true, then it is acting in accordance with its monetary mandate and not out of any fiscal concerns. Furthermore, the ECB buys in accordance with the capital key which means that it has bought more German Bunds than corresponding securities from other Emu members.

However, the lingering suspicion remains that there is a gulf between what the central bank says in public and the underlying motivation for its actions. But as Gertjan Vlieghe of the Bank of England pointed out recently, looking merely at the balance sheet transactions is not a good guide as to what a central bank is doing because “when a central bank issues reserves, the main counterpart asset on the central bank balance sheet is generally some form of government financing … in a strict sense some part of government spending is always financed with central bank money.”  The crucial determinant of the action is “who makes the decision and with what objective.” Given the separation of powers between Emu governments and the central bank, it is hard to make the case that the ECB is directly engaged in monetary financing. However much the judges sitting on the GCC may know about the law and however much they may suspect the actions of the ECB, they cannot prove anything beyond reasonable doubt. This may be an instance where the court has bitten off more than it can chew.

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.

A negative view of negative rates

My views on the disadvantages of low interest rates have been set out on this blog over recent years and increasingly there are indications that this view is moving into the mainstream. Indeed, across large parts of Europe the debate is not about low rates but rather negative rates. The theory of negative rates is simple enough: Banks are penalised for holding excess liquidity on deposit at the central bank and therefore have an incentive to lend it out. Whilst this policy may work for a limited period of time, it is now more than five years since the ECB lowered the deposit rate into negative territory. 

Today’s move to reduce it further to -0.5% may well be counterproductive although the ECB has finally recognised that forcing rates lower will simply impact on the bottom line of the banking sector and have introduced a system of tiering to provide some form of relief. Nonetheless, the negative interest rate policy is not having the desired effect and rather than continue with more of the same, it is time to reconsider our monetary options.

It is ironic that on the same day the ECB announced changes to monetary policy, the Swiss Bankers Association issued a strong statement decrying the SNB’s negative interest rate policy, arguing that “the societal, structural and long-term damages will become even greater the longer we find ourselves in this ‘lower forever’ environment.” SBA Chairman Herbert Scheidt argued that “negative interest rates are causing massive structural damage to the Swiss economy and disadvantages for the country’s citizens. They result in bubbles and damage the competitiveness of the Swiss economy long term because they keep unprofitable companies alive artificially. Negative interest rates also put the pensions of Swiss citizens at risk. A further lowering of interest rates would further exacerbate this issue. The longer negative interest rates remain in place and the greater the structural damage for Switzerland, the more urgent it becomes to ask from which point onwards countermeasures must be taken against negative interest rates.”

There are a lot of strong arguments there which deserve to be taken seriously. The idea that zombie companies are kept alive artificially is of short-term benefit to those who would otherwise be put out of work, but in the longer-term it hampers the efficient allocation of resources throughout the economy to areas where returns are higher. I have long argued that pension fund returns will be dampened by excessively low interest rates and a report this week highlighted that annuity rates in the UK have fallen to historic lows. Every £10,000 in the pot yields just £410 – down 12.3% from the start of the year – compared to between £900 and £1100 in the 1990s. In effect, buying an annuity to generate a guaranteed lifetime income will, in the words of pension expert Ros Altmann, “mean poorer pensioners for the rest of their lives.”

The impact of loose monetary policy on boosting financial markets to levels which look way out of line with fundamentals has been well documented. Although conventional P/E measures suggest that equities look extremely expensive in a historical context, the fact that the dividend yield on stocks is significantly higher than bond yields for the first time in almost 60 years means that investors are unlikely to dump equities any time soon (chart). By raising the net present value of housing services, low interest rates have also boosted house prices above fundamentally justified levels (a subject to which I will return). 

 

There is, of course, a risk that if markets have been inflated so much by low interest rates, any attempt to raise them will cause the bubble to deflate quickly. Central banks concerned with maintaining the stability of the financial system will be keen to avoid such an outcome. On this reading of events, the lower rates go and the longer they are maintained, the more difficult it becomes to raise them. The US may provide a counterfactual where markets continued to perform strongly despite the fact that the Fed was raising rates, but this was partially owed to the Trump Administration’s corporate tax cuts so the jury is still out.

We should not overlook the fact that central banks can only impact on the supply of credit and its price, but not demand, and we are increasingly at the point where reducing interest rates is akin to pushing on a string (to use the phrase attributed to Keynes). But I had an interesting discussion with a colleague who suggested there is nothing special about negative rates per se – the main problem is that positive rates have been baked into so much contract law that we struggle to deal with negative rates. He described a case of two identical derivative contracts where one receives a floating rate payment over the period of an EONIA contract whereas the other defines a fixed payment calculated on the reference (EONIA) rate. Both are essentially the same instrument in a world where interest rates are above zero but they are treated differently in a negative rate world because interest payments “cannot be negative” whereas the fixed payment can.

In a similar vein, the Finnish financial regulator is currently trying to assess whether it is legal for banks to pass on negative rates to retail depositors. Different countries have taken a different approach to this problem, with some refusing to levy the charge on retail customers. But this raises a question of whether depositors might simply withdraw their funds from one country and place them in another euro zone country where depositors are protected. To the extent that the period of negative rates has lasted longer than anyone initially anticipated, banks’ business models are going to have to change. Last month Jyske Bank in Denmark announced it would issue 10-year mortgages at a rate of -0.5%, although the bank will not lose money on the product since fees and other charges will be sufficiently high to ensure a profit. This may well be a template for the rest of Europe where fees and charges are likely to rise as banks struggle to make a profit in a world of negative rates.

It appears that ECB Council members were not unanimously in favour of the measures adopted today, with the central bank governors of France, Germany and the Netherlands reportedly opposed to a resumption of bond purchasing. Their views on negative rates are not known but this is an indication that northern European central bankers believe we are very near the limits of what an expansionary monetary policy can achieve. Mario Draghi may thus have delivered a poison pill to Christine Lagarde, who takes over as ECB President at the start of November. With Draghi having maxed out the credit card during his tenure, it will fall to Lagarde to deal with the consequences.

The limits of central banking

Prior to the great crash of 2008, investment bankers were – at least in their own minds – regarded as masters of the universe. No more. As their fancy clothes, woven from cloth so fine that the eye could not see it, were revealed to be non-existent, they were usurped by central bankers who used the muscle of zero interest rates and the power of their balance sheets to rescue the global economy from meltdown. More than a decade later and questions are increasingly being raised as to whether the tools which were deployed in 2009, and which are still in use today, are fit for purpose. Worse still, central bankers can be forgiven for wondering whether they have been hung out to dry by politicians who seem increasingly unwilling to provide the necessary degree of support to allow them to do their job effectively.

The BoE: A relative oasis of calm

The BoE finds itself in a slightly easier position than either the Fed or ECB although it has been sucked into the political fallout from Brexit, and with a new Governor set to take over from Mark Carney in just over seven months’ time, his successor may face an unenviable task in steering a post-Brexit course. One criticism that can be levelled at the BoE is that its forward guidance policy, which has often hinted at rate hikes which never materialise, may be about to miss the mark again. Indeed, recent hints that the next rate move will be upwards flies in the face of economic data, which point at below-target inflation in H2, and trends in the global monetary cycle. In common with many central banks, it has failed to create space to ease policy in the event that the economy cools. Central bankers dismissed this line of reasoning when conditions were propitious for a rate hike in 2014, and whilst Brexit has complicated the picture, it is hard to avoid the feeling that the BoE will go into the next economic slowdown with precious little ammunition.

The ECB: Taking flak from all sides

Across the channel, the ECB’s situation is even more desperate. Despite having cut the main refinancing rate to zero and the deposit rate to -0.4% whilst boosting its balance sheet to almost 40% of GDP, a meaningful economic recovery in the euro zone remains elusive and inflation continues to undershoot the ECB’s target. There are now expectations that the ECB will counter current economic conditions with even more monetary easing – a view that Mario Draghi reinforced this morning. The ECB is all that has stood between the integrity of the euro zone and disaster: It has done all the policy easing whilst governments have stood idly by without deploying any of the fiscal ammunition at their disposal. Draghi, who will leave his post as ECB President in October, deserves great credit for doing “whatever it takes” to keep the show on the road. Those who have criticised Draghi, including Bundesbank President Weidmann and various northern European politicians, should take some time to reflect on what might have happened in 2012 had the ECB not opened the taps.

However, the criticisms levelled by Weidmann at least come from someone with skin in the game. Draghi’s hints of further easing were met today by a Twitter blast from the self-styled stable genius in the White House accusing the ECB of weakening the euro against the dollar “making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.” This sends two messages: (i) Trump is a lobster short of a clambake and more seriously (ii) he threatens to open a new front in the war of economic nationalism, dragging the euro zone into a conflict which has hitherto been confined to the US and China.

The Fed: Managing in the presence of a stable genius

Imagine, therefore, what it must be like to be in Jay Powell’s shoes. The Fed has done what the textbooks recommend by taking away some of the excessive stimulus as the economy recovered. Unfortunately, Trump has determined that the Fed is the main obstacle to the ongoing US upswing and has been excoriating the FOMC for not cutting rates. Worse still, a story surfaced today suggesting that in February the White House explored the possibility of stripping Powell of his chairmanship and leaving him as a Fed governor. This is an unprecedented attack on the independence of the central bank. Not that politicians have refrained from dictating to the Fed in the past. One story, recounted by Reuters journalist Andy Bruce, recalls instructions from the White House to former Fed Chairman Paul Volcker ordering him not to raise interest rates during an election campaign. “Volcker, knowing the command was illegal, left the room without saying anything.” But the attacks on Powell are far worse – and lest we forget, he was appointed by Trump in 2018 with the endorsement that “He’s strong, he’s committed, he’s smart.”

The FOMC has recently revised down its assessment of the need for future rate hikes and it is increasingly likely that the next move will be a cut. It is not clear whether this is a direct response to the President’s attacks or whether the Fed has misread the economic outlook so badly that it feels the need to ease policy rather than tighten, as it believed necessary at the start of the year. However, to the extent that the Fed may be trying to head off further attempts by Trump to impose his own candidates on the FOMC, following the failed attempts to appoint Stephen Moore and Herman Cain, it is likely that the Fed is acceding to the pressure. Perhaps the Fed’s view is that by throwing a few small scraps in Trump’s direction, it will be better placed to maintain its independence in the longer run. But whilst it has long been evident that the Fed is not as free from political influence as it portrays, selling out in such an obvious manner could have the reverse effect by undermining its perception of independence in the market.

Dealing with the lower bound

The common themes across the central banking universe are that they are running out of tools to deal with the low-inflation world which we inhabit today, whilst also coming under much greater pressure to deliver on politicians’ objectives. With regard to instruments at the central banks’ disposal once interest rates reach the lower bound, there are essentially just three: QE, forward guidance and driving interest rates into negative territory as the ECB has done. At a recent Fed monetary policy conference (a so-called “Fed Listens Event” which deserves more in-depth coverage another time), a paper by Sims and Wu highlighted that QE is the most useful tool of the three; forward guidance depends on a central bank’s credibility (cf. the Fed’s position) and that negative rates become less effective the larger is the balance sheet (cf. the ECB’s position).

With central banks having tried all of these instruments to a greater or lesser degree, it is difficult to avoid the conclusion that we are near the end of the road with regard to monetary policy. After all, central banks have largely failed to stimulate inflation and there are serious concerns that if the floodgates are opened even further, this will serve only to store up greater problems in the future. Indeed, I have long argued that we will only know the full impact of low interest rates in the very long term once we see what our pensions are worth. What this does suggest is that much more of the burden of managing the economy will have to fall on fiscal policy in future – an issue I will deal with in my next post. The good news is that this will at least take central bankers out of the firing line and make politicians take some responsibility for what they should have been doing all along.

The market for central bank governors

The search for a successor to BoE Governor Carney kicked off last week, ahead of his contract expiry next January, whilst jockeying for the top job at the ECB has also got underway with Mario Draghi due to stand down in November. Naturally the press has had a field day looking at the possible candidates for both positions. But less attention has been paid to the qualities necessary to be an effective central bank governor.

Over the last 30 years there has been a tendency to appoint economists to the top job. It has not always been the case, of course. Whilst former ECB President Trichet and BoE Governor Eddie George both had academic qualifications in the subject, neither would be regarded as front-line economists. But compare them to contemporaries such as Alan Greenspan, Ben Bernanke, Janet Yellen, Wim Duisenberg, Mervyn King and Draghi it is clear that a strong economics background has been viewed as an advantage. The reason for this is simple enough: Over recent years, central banks have been given a mandate to target inflation which means that they have a much closer focus on economic issues than has historically been the case.

However, I do wonder whether the unwillingness to raise interest rates – particularly in Europe – reflects the overly cautious nature of a policy-making body in which economists hold the upper hand. It was not for nothing that President Harry Truman reputedly demanded a one-handed economist in order to eliminate their tendency to say “on the one hand … but on the other.” More seriously, since the financial crisis central banks have acquired additional responsibility to manage the stability of the financial system which means that a macroeconomic background may not be the advantage that it once was.

Perhaps the most important job of any CEO, whether of a central bank or a listed company, is institution building. Mark Carney promised to be the new broom at the BoE who would bring the bank into the 21st century, getting rid of many of the arcane practices which had become institutionalised over the years and improving diversity. I am not qualified to say whether he has succeeded in this goal but we hear good things about the working environment within the central bank. More importantly, perhaps, the BoE has taken on the regulation and supervision of around 1500 financial institutions over the past six years as the responsibilities of the central bank have evolved and the head of the Prudential Regulation Authority occupies one of the most senior jobs in the BoE.

One of those touted to succeed Carney is Andrew Bailey, head of the Financial Conduct Authority, an institution independent of the BoE which is charged with ensuring that “financial markets work well so that consumers get a fair deal.” Bailey is a former BoE official who has worked in an economics function, but crucially has a very strong background in regulation. It is an indication of the extent to which the BoE’s role has changed in recent years that Bailey is even in the running for the job.

The experience of the ECB President has been rather different since Mario Draghi took over in 2011. He is – probably rightly – credited with holding the European single currency bloc together during the Greek debt crisis by promising to do “whatever it takes,” despite opposition from representatives of other member states, notably Germany. Like the BoE, the ECB has also taken on greater responsibility for the regulation of financial institutions although unlike the BoE there is no suggestion that the potential successor to Draghi will need a background in financial regulation.

Interestingly, this paper by Prachi Mishra and Ariell Reshef makes the point that the personal characteristics and experience of central bank governors does affect financial regulation. “In particular, experience in the financial sector is associated with greater financial deregulation [whilst] experience in the United Nations and in the Bank of International Settlements is associated with less deregulation.” They go on to argue that their analysis “strengthen[s] the importance of considering the background and past work experience before appointing a governor.”

This is an important point. In 2012, when the BoE was looking for a successor to Mervyn King, the Chancellor of the Exchequer cast his net far and wide. Mark Carney got the gig because the government wanted an outsider to take over a central bank which was perceived to be too close to the institutions it was meant to regulate. Moreover, he had previous experience of running a central bank. But whilst Carney has done a good job over the past six years, I still believe it wrong to think (as the Chancellor George Osborne did during the hiring process) that filling this role is akin to finding a CEO of a multinational company, whose place can be filled by anyone from an (allegedly) small pool of international talent. They are an unelected official who holds a position of key strategic importance, enjoying unprecedented powers to influence both monetary policy and the shape of the banking system. In that sense it has never been clear to me that the interests of an outsider with no experience of UK policy issues are necessarily aligned with the UK's national interest.

Contrast this with the way the ECB process works. There are, in theory, 19 candidates for the top job amongst the central bank governors of EMU members, all of whose interests are aligned with those of the euro zone. In addition, there are another five potential candidates amongst the members of the Executive Board. Admittedly there is a lot of political horse-trading involved in the selection process, but there is no need to look for an outsider who may not necessarily be up to speed with the complexities of local issues, not to mention local politics which is increasingly a problem for central bankers (I will come back to this another time).

For the record, this is absolutely not an issue of economic nationalism – it is simply to remind those making hiring decisions that just because someone has done a similar job does not necessarily make them the best candidate for a position elsewhere. Indeed, if the evidence from the private sector is anything to go by, the continuity candidate may be the best person for the job: In the private sector, “firms relying on internal CEOs have on average higher profits than external-CEO firms”. And for anyone who doubts that the search for an external candidate will necessarily be an improvement over the local options, just ask the English Football Association about their experiences with Sven-Göran Eriksson and Fabio Capello.

Monetary policy: What's the alternative?

The news last week that the ECB will commit to keeping interest rates on hold for the remainder of this year and provide additional liquidity in the form of targeted longer-term refinancing operations (TLTROs) is an illustration of the central bank’s concern about the economic slowdown. But it also reflects the continued reliance on monetary policy to support the economy in the absence of any other options.

That the euro zone economy has lost momentum is not in doubt. But this to a large extent reflects a number of exogenous factors, such as the Chinese slowdown, which is at least partly the result of the trade dispute with the US. ECB President Draghi indicated as much in his prepared statement, telling the assembled journalists that the loss of economic momentum was primarily due to “the slowdown in external demand” and that “the risks surrounding the euro area growth outlook are still tilted to the downside, on account of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” Responding to this slowdown by committing to keep rates unchanged makes some sense. But what is less obvious to me is why, when factors beyond the control of the ECB are responsible for the loss of economic momentum, is the ECB prepared to activate monetary measures designed to target the domestic economy, particularly TLTROs which operate at one remove? Moreover, why wait until September to initiate them?

In the ECB’s words, TLTROs “provide financing to credit institutions … at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy.” And whilst it is true that in recent months the rate of loan growth to the euro zone private sector has slowed (chart), the most notable loss of momentum has been in corporate sector loans which is likely to be a consequence of global business conditions. Increasing liquidity supply is all very well, but there are serious questions as to whether demand for additional cheap credit exists. Indeed, unlike 2008-09 when the credit crunch was actively holding back economic recovery, today we are awash with liquidity. But the euro zone’s problem is magnified by the growing split between northern and southern states. For example, borrowing costs for Italian banks have risen since last summer as concerns grow regarding the government’s fiscal stance. The TLTROs are thus of more benefit to southern Europe than the north.

Draghi’s comments also repeated the long-standing message that “structural reforms in euro area countries need to be substantially stepped up to increase resilience, reduce structural unemployment and boost euro area productivity and growth potential.” This is a message which has been part of the ECB’s communications strategy since the days of Wim Duisenberg and in fairness has been heeded by the likes of Germany. But Italy’s growth performance remains by a considerable margin the worst in the G20 and recent efforts in France to broach the subject of reform were met with a wave of public protests which caused the government to back down. But the fact that the euro zone’s potential growth limit today stands at 1.5% compared to 2% at the start of monetary union does illustrate the necessity to heed Draghi’s call.

But the biggest failing across large parts of the industrialised world in recent years has been the unwillingness to use fiscal policy as a tool of economic management, which has thrown the burden of adjustment onto monetary policy. Draghi did point out that fiscal policy across EMU is mildly expansionary but “countries where government debt is high need to continue rebuilding fiscal buffers.” Whilst accepting that excessively high levels of debt have economic costs, notably the fact that they represent claims on future resources, Italy has consistently run a primary surplus over the last 20 years of around 1.5% of GDP. Requiring additional fiscal tightening in Italy is only going to prove counterproductive. The extent of fiscal tightening across many European countries is captured by the decline in cyclically-adjusted government spending (here, see Table 6A) which in Germany has fallen by 10 percentage points of potential GDP since the mid-1990s whilst in Ireland it is down by 15 percentage points (and nearly 40 points since mid-2010).

A lax monetary policy cannot offset a fiscal tightening of that magnitude. For one thing, monetary policy operates in an indirect route in which the benefits may get lost in the transmission process (e.g. if there is limited demand for credit). Moreover, a long period of low interest rates is likely to have adverse side effects. Our future incomes as represented by pension savings require us being able to generate a decent rate of return on the income we set aside to provide for tomorrow. The ECB’s policy of holding the short end of the yield curve deep in negative territory, whilst buying up to one-third of the euro zone debt stock, has resulted in German maturities up to nine years falling into negative territory. Following last week’s announcement by the ECB, even the nine-year segment fell below the line whilst the benchmark 10-year Bund yield at one point hit just 0.05%.

That is not going to help our future incomes. Nor does it help banks, which rely on a positively sloped yield curve in positive territory to generate income. With the ECB deposit rate at -0.4%, banks have no incentive to hold excess liquidity at the central bank. Even the BIS has pointed out that profitability is a crucial area of banking resilience since this determines the extent to which they can recover from losses resulting from economic shocks. Although much progress has been made to weather-proof bank balance sheets thanks to legislation implemented in the last decade, profitability – particularly in Europe – remains well below pre-2008 levels. With European bank price-to-book ratios still well below unity, this indicates that investors are not very optimistic with regard to a recovery in profits.

It is hard to avoid the conclusion that central banks, particularly the ECB, continue to operate a lax monetary policy because there are no other policy options. But the longer we operate policy consistent with economic conditions prevailing in 2009, the greater will be the potential adverse long-term consequences. Whilst this is all part of Draghi’s “doing whatever it takes” strategy outlined in 2012 to hold the euro zone together, we are now at the point where the ECB needs help from governments to get the economy back on its feet.