The next act for the ECB

Early last month, financial markets were taken by surprise when French lawyer and politician Ms Christine Lagarde was nominated to step into the shoes of the outgoing President of the European Central Bank (“ECB”) Mr Mario Draghi. The move cheered investors as prior to her nomination as ECB President, when she was still occupying the position of managing director of the International Monetary Fund (“IMF”), Ms Lagarde encouraged the world’s major central banks on various occasions to step up their concerted efforts towards supporting the growth outlook of the world’s economy through looser monetary policy. In fact, on 11 April 2019, Ms Lagarde pleaded with central banks to “stay accommodating” in order to “facilitate the fiscal measures that need to be taken.”

The responsibilities that Ms Lagarde will be taking on as ECB President following formal appointment by EU leaders in October 2019 are critical for the prospects of the euro area. She will have to fill in the space of Mr Draghi who, over the past eight years since assuming office on 1 November 2011, was instrumental in keeping the very existence of the euro project intact. Apart from his most famous signature moves in extending ECB monetary policy into unchartered territories and save the economic as well as the financial fate of entire countries including the notorious ‘PIIGS’ (namely Portugal, Italy, Ireland, Greece and Spain), the outgoing President also played a very important role in embracing the remit of the Single Supervisory Mechanism (“SSM”) which, in turn, is a central component of the European Banking Union and the framework that grants the ECB authority over all banks in participating EU member states.

Although it is unlikely for Ms Lagarde to receive the baptism of fire that Draghi had when he took over the realms of the ECB at the height of the euro debt crisis, the challenges for her going forward are surely no less daunting. It is true that Ms Lagarde will be inheriting a much healthier economy than Mr Draghi did in 2011, but on the other hand, she will kick-start her term wedged between a slowing global economy on the one side coupled with an outsized ECB balance sheet and with limited space for further downward potential in interest rates. Indeed, many financial analysts and economists have already opined that amid the various risks posed by the protracting trade dispute between the US and China as well as other geopolitical uncertainties including the possibility of a ‘hard’ Brexit in two months’ time, the ECB could well be in an awkward position where its competencies are already at their limit, and if this limit is stretched further, its independence and mandate would become subject to greater scrutiny and questioning. In fact, should economic conditions in the euro area deteriorate further, the ECB may have to respond again with greater force than it already did over the past few years, only this time having much less room for manoeuvring assuming no introduction of new unconventional monetary policy tools like ‘helicopter money’ – a term coined by economist Milton Friedman in 1969 and described as “very interesting” by Mr Draghi in 2016. This concept essentially involves the printing of new money to fund government spending or to distribute to the public at large.

As the unconventional aspect of modern monetary policymaking is exploited further and possibly extended beyond the tools in use today by the ECB – namely negative interest rates, quantitative easing and forward guidance – risks become more pronounced. These include those that challenge the same fundamentals that underpin financial stability that monetary policy itself is meant to safeguard. Indeed, as persistently very low to negative yields encourage moral hazard and fuel excessive risk-taking by investors, the incoming President Ms Lagarde might have to deal with circumstances that are already pointing to the creation of financial vulnerabilities including debt overhangs. As a result, a rather imminent task for Ms Lagarde might possibly well be the prioritisation between financial stability and price stability – a situation that puts to the test her atypical profile as a central banker. Furthermore, the new ECB President might also have to consider whether to follow the example of the US Federal Reserve and initiate a process of a ‘review of monetary policy strategy, tools and communication’. This would be particularly worthwhile in view of the ECB’s monetary policy target of an inflation rate of ‘below, but close to, 2% over the medium term’ which was first adopted by the ECB Governing Council in 1998 and slightly amended five years later in 2003, and which many economists are now considering to be no longer suitable.

The political and diplomatic background of Ms Lagarde provides confidence that the ECB will likely play a more active part in building consensus and determining how the process of economic integration within the euro area is conducted. As the euro sovereign debt crisis clearly showed, a major vulnerability of the EU is the incompleteness of the Economic and Monetary Union (“EMU”) which manifests itself in disjointed coordination of fiscal policy (which is largely shaped at national level) and monetary policy (which is conducted at supranational level by the ECB). Over the years, this imperfection increased the ‘burden’ of the economic success of the euro area on monetary policy which has now exhausted most, if not all, of its space for manoeuvring with the tools currently available. Against this background, it would not turn out as surprising if, in the months ahead, the ECB were to step up its voice in advocating the implementation of certain reforms at national level, even though this would risk impairing some of its independence.

Similarly, Ms Lagarde may also prove to be a key figure for the completion of the Banking Union going forward. In one of his remarks earlier this year, the Chairperson of the ECB Supervisory Board, Mr Andrea Enria, clearly acknowledged that Europe’s banking sector “remains largely segmented along national lines.” Although the improvement in economic conditions in the euro area over the past few years has helped to strengthen the resilience of European banks, issues related to low profitability, legacy non-performing exposures and digitalisation remain of paramount importance as they represent a challenge to long-term sustainability. In parallel, the incoming ECB President must also deal with the possibility of reinvigorating the establishment of the European Deposit Insurance Scheme which, in turn, would be an important building block for more cross-border bank mergers and the ‘defragmentation’ of the European banking sector.

Last month, European leaders opted for an unconventional candidate to take the helm of the ECB during unconventional times. The challenges for Ms Lagarde are significant. Nonetheless, her political prowess, negotiating skills and extensive international experience might turn out to be key elements for her to induce flexibility and quick response from the ECB and the other main institutions within the EMU aimed at improving the economic and financial prospects upon which the livelihood of millions of people are dependent on.

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