Quel bilan tirer de l’ère Draghi à la présidence de la BCE ?

Key points:

  • Draghi found his success in unleashing the central bank’s full power. In a form of “institutional judo”, Lagarde may find hers in playing up the central bank’s powerlessness
  • Brexit: beyond the vagaries of British parliamentary life, the protection of European interests is key to the deal

 

(Tough) life after Draghi

Mario Draghi will preside over his last Governing Council meeting this week. After last month’s fireworks, nothing of substance is expected. But on this occasion we take stock of a very momentous 8 years at the European Central Bank.

Mario Draghi’s legacy as the “saviour of the Euro area” from 2012 onward will endure. He inherited a European Central Bank in 2011 which was still mightily influenced by the disciplinarian approach of the 1980s and 1990s and brought it closer to the Fed model. This provided the member states with the breathing space they needed to stop the deflationary spiral in 2012 and beyond.

The issue now is that this growth-friendly Fed model is finding, at least in Europe, its practical and institutional limits. Christine Lagarde is likely to be continuously gauged against a “Draghi benchmark”. Her problem is that her predecessor by the end of his tenure had used up all the policy space that he had created.

To summarize in too few words two complicated decades, once it had managed to finally anchor long term inflation expectations with a massive pro-cyclical tightening in 1980, the Fed moved towards a “neo-Keynesian” model in which cyclical stabilisation AND delivering on price stability could complement each other. It helps that the Fed formally pursues a dual mandate (price stability and full employment) but it is not crucial. In a nutshell, if inflation is below target it normally reflects a deficit of demand in the real economy. Cutting rates will bring the economy back to potential, taking inflation back to target at the same time.

In Europe the process took longer and monetary policy was “polluted” by an accumulation of objectives. The convergence to the Bundesbank model of the national central banks which would ultimately form the Eurosystem in 1999 was gradual, leaving inflation expectations high until the mid-1990s in some member states. In addition, monetary policy was throughout the 1990s encumbered by the need to deliver convergence to the qualification criteria for monetary union, such as foreign exchange stability and a reduction in the sovereign spread relative to Germany.

This plurality of objectives explains why in the 1990s monetary policy did not easily engage in cyclical stabilisation. Here we can take the example of France. In Exhibit 1 we show that in 1992 and 1993 French monetary policy embarked on a particularly ill-timed pro-cyclical tightening following on the Bundesbank’s fight against inflation in post-reunification Germany – a result of the way the European exchange rate system worked at the time – and provided only limited relief in the following years although the fiscal policy stance has turned clearly restrictive (Exhibit 2). In 1995, the short term rates were still close to 6%.

Exhibit 1 – The 1990s pro-cyclical monetary stance


 

Exhibit 2 – Stubborn commitment to pro-cyclical fiscal policy is not new


 

This was widely seen at the time as an unpleasant phase which was ultimately necessary to re-create a more “growth friendly” space for monetary policy. The idea was that once the single currency was established, the ECB would be able to more easily engage in cyclical stabilisation. And to be fair, by and large it did. The central bank maintained its policy rate at a very low level after 2001. The ECB managed to keep inflation on average at 2% over Wim Duisenberg’s and Jean-Claude Trichet’s tenures. If they had been overly hawkish, inflation would have missed the target.

Still, until Draghi took the helm, the ECB’s intellectual software remained quite different from the Fed’s, and this cost a lot at the beginning of the Great Recession. 

It took until 2003 for the ECB to change its definition of price stability from “below 2%” to “below but close to 2%”. The central bank had a hard time giving up on old monetarist indicators such as money aggregates, although it had been obvious for years that their information content was poor. The ECB also maintained a fondness for looking at headline inflation, long after the Fed had chosen to focus on “core” to avoid being led astray by transitory supply-side shocks. The policy-makers at the ECB had also been shaped by years of fighting at the national level against fiscally profligate governments and were profoundly suspicious of the capacity of fiscal policy to affect the cycle. Their long-held view was that the “Ricardian equivalence” was a fact of life, so that a fiscal tightening could ultimately lift growth by restoring confidence.

All these quirks, legacy of the 1980s and 1990s, were innocuous as long as the economy was not facing massive turbulences. But ultimately the disciplinarian stance took hold of the Governing Council at very bad moments twice: first in 2008 when the ECB continued to tighten monetary policy in spite of the growing evidence a global recession was coming, and in 2011 when it chose to start normalising policy rates on the back of a transitory acceleration in headline inflation and completely under-estimated the recessive impact of the general conversion to fiscal austerity after 2010.

Mario Draghi very quickly eliminated those intellectual “quirks” and brought clarity to policy-making. If demand is weak and the output gap is widening, for instance as a result of a fiscal tightening brought about by the need to keep the “bond vigilantes” at bay, then monetary policy needs to be more accommodative, even if oil prices are transitorily pushing headline inflation up. If the required quantum of accommodation cannot be delivered by conventional means because policy rates cannot be taken further down, then quantitative easing must be unleashed. If that is not enough, very explicit forward guidance can be used to anchor market rates.

Obviously it did not hurt that this neo-keynesian model came very handy at a time when the monetary union was fighting for survival. The ECB’s commitment to “whatever it takes” magnified the impact of the new institutions set up by the member states, in particular the European Stability Mechanism. But this crucial support was fully justified by the macroeconomic situation, in particular the deflation risk which the fragmentation of the Euro was triggering, for instance via the self-defeating fiscal tightening forced onto the periphery.

It took incredible determination and courage to get there, and without some measure of “personal power” instead of the collegial and consensual approach normally found in decision-making at the European level, it is likely that this intellectual and operational conversion would never have happened. 

The “September 2019 package” is probably the epitome of monetary “Draghism”. All the ingredients are there. The central bank is explicitly calling on fiscal policy to help. Forward guidance explicitly mentions the need to see a re-acceleration in core inflation, and there is now no time limit to QE.

But all the same the “September 2019 package” probably marks the very limit of “Draghism”. We have already commented at length in Macrocast on the defects of the current ECB stance. Unlimited QE is credible only if down the line the Europeans are ready to go “full Japanese” and accept a de facto merger of the government’s and the central bank’s balance sheet where nothing – institutionally or politically – can put a cap on the central bank’s purchases of government bonds. The very fact that the ECB chose a monthly quantum which allows (just) not to reach the limit of 33% is an interesting indication that even Draghi could not easily force another big political leap in the Euro area.

Monetary union is uncontroversial again, but not the ECB. Mario Draghi can be legitimately proud of having made the euro popular again. According to the European Commission “Eurobarometer”, support for the Euro is now as high or higher among European citizens than before the Great Recession in core as well as in the periphery, fully offsetting the concerning decline observed at the time of the sovereign crisis (Exhibit 3 and 4). However, this is not benefitting the ECB. Less than 50% of German and Italian citizens trust the central bank, significantly less than in 2007. All European institutions have suffered, but the ECB lost more ground than the Commission or the parliament. It seems  that the central bank has been too hawkish for Italy and too dovish for Germany.

Exhibit 3 – Support for the Euro does not extend to the ECB…


 

Exhibit 4 – …In Germany as well as in Italy


 

A central bank should not seek popularity, but this lack of trust remains an issue. Dissent within the Governing Council against the latest package cannot be ignored, especially since it is no longer coming exclusively from the same core countries. Quite paradoxically, Christine Lagarde may spend a good part of her tenure convincing governments that there is not much she can do herself, that monetary policy has indeed met its limits and can no longer bail the Euro area out of every cyclical shock if fiscal policy remains on hold.

Draghi found his success in unleashing the central bank’s full power. In a form of “institutional judo”, Lagarde may find hers in playing up the central bank’s powerlessness.

Brexit: Protecting European interests

Attention is currently focused on the politicking around the endorsement of the last-minute deal struck between the UK and the EU. At the time of finishing this note on Sunday night it is unclear what parliament, or the British government, or any new government arising from any new elections, would actually do with an extension that the EU may or may not grant (we expect the former). Beyond the unlimited joy of delving into British constitutional law, we want here to explore the actual nature of what has been negotiated. While Brexit in itself is a net loss for both parties, we think the deal under consideration is one of the best possible ones the EU could dream of. We also think it is probably one of the worst possible ones from the point of view of the UK’s economic interests, although we acknowledge it may maximise the UK’s sovereignty at the not inconsiderable cost of loosening the union with Northern Ireland (and possibly Scotland down the line).

The EU had three main interests to defend, in no particular order: first, safeguarding the integrity of the single market without jeopardizing the interests of its member State with the most at stake in case of erection of a hard border – Ireland. Second, avoiding the short term negative economic shock a “no-deal” situation would have on the EU given the size of the British market. Third, making sure post-Brexit the UK would not be in position to take advantage of unlimited access to the European market by pursuing aggressive competitive policies. The deal secures all three.

While ironing out the technical details of the actual implementation of the complex solutions found to the customs conundrum on the island or Ireland would likely be very challenging, in principle the deal means that the integrity of the single market should be protected even in the absence of a hard border. Legally, Northern Ireland would remain within the UK’s customs territory – and would benefit from any more advantageous trade deal negotiated between the UK and third parties – but when it comes to “intra-Ireland” trade, de facto it would remain within the EU’s customs union. In practical terms the actual border would be between Northern Ireland and the rest of the UK.

At the beginning of the negotiations the EU wanted to secure this via a “backstop”: as long as no alternative mutually acceptable arrangement could be found within the post-Brexit “long term relationship”, Northern Ireland would remain in the customs union. In a way, we have now “jumped” one step and what has been negotiated in a hurry in the last few days could actually end up being permanent. Initially, London wanted to subject the Irish customs solution to a regular mechanism of political consent which would have given the Northern Irish unionists a de facto veto. Finally, the deal makes it sufficient for a simple majority of the Northern Irish parliament to support the arrangement for it to continue.

Unless a political earthquake occurs in Northern Ireland, between the Republican (Irish nationalist) parties and the pro-European non-sectarian groups, there should always be a majority to support the continuation of this rather bizarre arrangement. No wonder the pro-Brexit Democratic Unionist Party supported the pro-remain opposition’s efforts to thwart the deal on Saturday in the Commons.

Does this mean that the deal would irresistibly bring about Irish unification, in the long run? From a political point of view the unionists have suffered a heavy blow. From a purely economic point of view though, the population of Northern Ireland, across sectarian lines, may decide that cumulating the advantages of two customs unions, one with the EU and another one with the UK, would be a good enough status quo. But Scotland would probably quickly request a similar treatment, adding to the tension with London.

Outside the island, in our view, the indefectible support provided to Ireland by the European institutions and the other member states – would make the Union much stronger down the line. A common criticism of the EU is that it is in reality a Franco-German condominium fairly oblivious of the interests of the smaller countries. To a large extent this is something on which the Brexiters were counting in their negotiations with the Union, often expressing surprise at why Brussels would support Dublin’s position against a more powerful partner such as the UK. But neither Berlin nor Paris chose to “by-pass the Irish” to secure an easy deal with London. This is an important message for the consistency of the EU.

The second point – avoiding the shock of “no deal” – is obvious. The UK buys 13% of the Euro area exports. Given the prominence of many external risks at the moment, the EU could do with avoiding another adverse shock on foreign demand. The story is a bit different at longer horizons. Indeed, if as we believe the deal would impair the UK’s long term growth prospects, this wouldn’t be in the interest of the EU. But we started with this: Brexit is a net loss. The question is how to minimize its cost, and for whom.

Finally, we mentioned last week concerns in European capitals around the possibility that a deregulated UK, pursuing an aggressive “Singapore on the Channel” approach, would turn into a proper competitor to the EU while still benefitting from easy access to its market. The notion of “level playing field” is no longer contained in the withdrawal agreement, but is pushed to the non-binding political declaration which broadly defines the future long term relationship between the two parties. Still, now that only a “free trade agreement” is the objective, as per Boris Johnson’s long held position, the Europeans maintain their leverage. They have been very clear that the scope of said free trade agreement – yet to be negotiated - would be dependent on the UK’s willingness not to diverge too much from the EU on social or environmental norms. The UK would thus free to pursue its “buccaneering” strategy on the edge of Europe and cut free trade deals with whoever it wants, but the quality of its access to the EU market would suffer. There won’t be any “free lunch”.

Assuming parliament ultimately allows Boris Johnson to have its way, what economic benefits could emerge for the UK from all this?

A free trade agreement is not the same thing as being a member of the customs union and/or the single market. A worse access than today to what is – and is likely to remain – the UK’s biggest export market is not going to help the UK’s global attractiveness. More profoundly, and it is a point we have already made in Macrocast, we do not think there is deep political support for the “buccaneering” strategy in the British electorate. Years of austerity have triggered a yearning for a more protective state.

True, Boris Johnson may be lucky and benefit from the combination of a weak left-wing opposition now that Jeremy Corbyn has lost his shine with the “first past the post” electoral system which can generate strong absolute majorities in parliament with less than 40% of the votes. He may have a window of opportunity to pursue his strategy. But it would be a very, very risky gamble.

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