Cometh the hour, cometh the woman

• Christine Lagarde’s nomination as ECB President faces scepticism from economists concerned about central bank independence
• Monetary policy and the economy are entering uncharted territory that will require skilful navigation
• Lagarde’s political experience and open mind make her uniquely equipped to handle the coming challenges

The nomination of IMF Managing Director Christine Lagarde as the next European Central Bank President has not met with universal acclaim among economists. Because she used to be the French finance minister and is not an economist, critics believe that her appointment could reduce the degree of European central bank independence. We do not agree with these criticisms. In our view, Christine Lagarde may be exactly the leader that the ECB needs.

Even though central bank independence (CBI) should certainly be preserved, an excessive degree of it could impede coordination between fiscal and monetary policy, which we think will be vital during the next recession. What’s more, protecting CBI will require substantial political skills, which Lagarde demonstrably possesses. Finally, it could be advantageous to have an ECB president who is not strongly intellectually invested in a certain school of economic thinking, but rather has an open mind and is willing to learn about an ever-changing environment.

CBI helped conquer the high inflation of the 1980s…

The economic problems facing the world 40 years ago can be summarized as a massive overreach by the public sector that resulted in a large increase in the supply of sovereign bonds. In an effort to control sovereign borrowing costs, central bank policy rates were kept far too low, causing inflation to accelerate sharply. This reduced the public’s appetite for sovereign bonds, which prompted a rise in real borrowing costs, driven by an increase in the term premium.

There is a very important lesson to be drawn from this: the government may be able to manipulate borrowing costs to its advantage in the near term, but in the long term market forces will always punish irresponsible policies. In the early 1980s, policymakers made two crucial decisions that laid the foundation for a strong recovery led by private investment. First, a severe dose of fiscal austerity sharply reduced the supply of sovereign bonds, putting downward pressure on real yields. Second, control over short-term interest rates was delegated to an independent central bank with a price stability mandate.

…but today’s problems are of a very different order

The current situation in DM space is more or less the opposite of the situation 40 years ago. In the 1970s there was a persistent excess supply of safe Treasury bonds and money, whereas now both are characterized by persistent excess demand. As a result, real rates are extremely low and inflation remains stubbornly below target. The solution is to supply sufficient sovereign bonds and money to eliminate this excess demand. Over the past 10 years this has happened, but in a very unbalanced way. Central banks have increased the supply of money, but only by decreasing the supply of bonds available to the private sector. Meanwhile, fiscal authorities have been focused on limiting additional bond supply as much as possible.

The ECB and the BoJ now face a very low and flat yield curve, because of which further monetary easing is running into strongly diminishing returns. The way to increase these returns is to increase the supply of sovereign bonds, which will require larger government deficits. This would not only satisfy the private sector’s elevated demand for safe assets but would also enable the private sector to run a similar or larger financial surplus as a higher level of output. This will hold especially if fiscal easing is used to improve the supply side of the economy. To the extent that a high degree of CBI has impeded explicit coordination with fiscal policy, it has arguably contributed to this imbalanced policy mix. This imbalanced mix also raises financial instability risks because it forces central banks further into “lower for longer” territory, raising the risk that the concomitant search for yield will blow asset price bubbles.

Incomplete institutions create additional difficulties in Europe

From a legal perspective the ECB may be among the most independent central banks globally, but over the past 10 years it has been drawn deeply into political waters. The inadequate institutional structure underpinning the Economic and Monetary Union means that the ECB is the only European institution with deep enough pockets to act as a saviour of last resort for the euro.

This is always a case of “damned if you do, damned if you don’t”. Not intervening may well mean the end of the euro. However, if the ECB is too proactive in bailing out politicians, they will be less motivated to implement a lasting solution. As a result, the ECB will be forced to go further into unconventional territory than it would otherwise have done, which could exacerbate the region’s secular stagnation/lowflation problem.

In this respect, the criticism of the core hawks regarding the ECB’s unconventional measures is not unfounded. But there is also another side, as the key policy responses had a monetary justification in their own right. The Outright Monetary Transactions program improved monetary policy effectiveness by reducing the unwarrantedly high degree of redenomination risk priced into peripheral spreads. Quantitative easing effectively diminished deflation risks by pushing EMU sovereign yield curves lower and flatter and by signalling the ECB’s strong determination to do “whatever it takes” to achieve inflation convergence. In the end, monetary policy should be fully focused on achieving the goals of price stability and full employment. If there are other policy goals, policymakers need additional instruments to achieve them.

During the first 10 years of the ECB’s existence, the economic and political environment was very calm, so it was easy to keep monetary policy strictly separated from fiscal policy and political considerations. In a way, the core hawks want to return to this situation by urging sovereigns to reduce debt ratios and implement structural reforms.

We believe this recipe completely ignores the economic environment in which these sovereigns operate. Instead of being a source of discipline, markets have proved to be an amplifier of shocks. Before 2008 they hardly priced an additional risk premium for highly indebted sovereigns; since then, they have priced excessive risk premiums that threatened to create their own reality. Core sovereign bonds are perceived as safe by investors, giving these governments the advantage of a sharp fall in borrowing costs when a negative shock hits. The flip side is a sharp rise in peripheral borrowing costs, which impedes the ability of these governments to stabilise their economies.

The ECB must deal with politics whether it wants to or not

This feature is not a sustainable political equilibrium. Because its monetary policy objectives were aligned with the need to correct diverging sovereign yields, the ECB has been able to provide some fiscal risk-sharing by stealth. However, such an alignment of objectives is not always guaranteed. Thus, to allow the ECB to remain focused on price stability, the region will need some degree of actual fiscal risk-sharing. What’s more, removing the aforementioned asymmetry in sovereign yields will require the creation of a region-wide safe asset for which the ECB is willing to act as a lender of last resort. If all this were not enough, the Eurozone economy has probably ventured so far into secular stagnation territory that monetary policy will need help from fiscal policy to get out of this.

The next ECB president may well be forced to get her hands politically dirtier than her predecessor Mario Draghi did. At the same time, she needs to be strong enough to stand up to politicians seeking to reduce the independence of the ECB for their own purposes. President Trump’s recent attempts to undermine the Federal Reserve show that this threat is not imaginary.

We believe Christine Lagarde is uniquely qualified to manage this difficult balance. She is very well connected and highly skilled in politics. At the same time, she is demonstrably determined to protect the interests of the IMF. In the process of doing this, she has also shown that her lack of training as an economist is not an insurmountable problem. During her IMF tenure she has relied on the advice of highly skilled economists, and the ECB has no shortage of these. What’s more, she is not afraid to admit when she was wrong in the past and is open to new ideas. This is a highly desirable feature at a time when monetary policy and the economy are in uncharted territory.