Lagarde as ECB chief – independent but integrated?

7 minute read

The nomination of Christine Lagarde to head the European Central Bank (ECB) when Mario Draghi steps down later this year caught many by surprise, not least because we will now have twenty years of the ECB without a German president – a quite extraordinary turn of events.

Until recently, Bundesbank President Jens Weidmann seemed a shoo-in for the role, not only due to his nationality, but also because of his status as one of Europe’s heavyweight central bankers. Yet on reflection he may not have been such a natural fit, particularly with the change in mood over the last twelve months. After the recent elections, less clear-cut lines between political groups influenced the ‘horse-trading’ around nominations and the decision moved away from Weidmann. There were also worries, perhaps not in Germany but certainly in other parts of Europe, about appointing a supposed hardliner at a time when fragility in the region’s economy was beginning to show. Indeed, things have changed quite drastically in the last six to twelve months. Decision-makers were looking for a respectable and steady pair of hands, someone with stature and credibility. In that respect, Lagarde clearly fits the bill.

One year ago, everyone was preparing for the ECB’s exit from the extreme policy stimulus of the last ten years and, while the ECB was cautious, it had clearly painted guidelines hinting it was moving towards the end of ultra-loose monetary policy. In particular, it wanted to return interest rates to positive territory.

Then everything changed. Trade tensions flared up, economic weakness returned, and the ECB had to do a complete turnaround. It now seems more likely than not it will provide additional policy stimulus in the coming months.

Keeping policy loose is the right thing to do in the current environment and, despite Lagarde being neither a central banker nor an economist, her nomination is unlikely to exacerbate the risks of a policy mistake. Warning signs are flashing around Europe, suggesting additional stimulus, or at the very least the maintenance of existing stimulus, should be provided, and Lagarde is likely to maintain this direction. It may have unintended or unwanted consequences in terms of encouraging borrowing in some areas, but that is a price that must be borne. 

Safe pair of hands

Although some commentators have voiced concerns over Lagarde’s economic credentials, it is not essential for a central banker to be an economist. Going back over the history of the Bank of England, for example, a number of past central bankers like Edward George were political operators rather than economists, dealing with different parties demanding different things.

There are also numerous technical staff able to support Largarde. And while some have implied that the economics function has weakened since Peter Praet has stepped back, Philip Lane has filled his post as chief economist. Lane is highly-regarded and has a strong pedigree for the role; his experience at the Bank of Ireland as well as an education at Harvard and Columbia should stand him in good stead.  Additional support comes in the form of a large team of economists.

Furthermore, given the way the bank is organised, Lagarde will only be one voice on a governing council of 25. While Draghi and some other past central bankers made the ECB more synonymous with their identities, Lagarde is likely to be much more collegiate. Having been used to this approach as a politician in France and later at the International Monetary Fund (IMF), she is likely to focus on consensus-building, and on making sure any debate happens in private, after which all members of the bank present a united view, something at which Jean-Claude Trichet was adept.

Lagarde is a shrewd choice as she offers an array of experience and skills which are far more likely to matter to investors in the coming months and years. Not only does she have stature and credibility, but in her roles, first as minister of finance in France and then as managing director at the IMF, she has had to deal with all manner of people and differing opinions. She is a seasoned veteran at negotiation and consensus-building. She is confident, a strong communicator, and is used to dealing with polarised factions and parties.

Speculating on what may happen at the ECB under Lagarde, there could be a review of the inflation target. While the ECB is technically given its mandate by the European Parliament, Lagarde may be privy to discussions on the topic. The ECB is, after all, in danger of looking slightly foolish when it mentions a “close to but below two per cent” target it never gets close to, and it may be time to change it.

First impressions

Two important elements will be at play when she takes on her role. One is that Draghi has done his utmost to make the upcoming transition a smooth one. He has already signalled additional policy stimulus ahead of his departure at the end of October. By then, we may have had a small reduction in interest rates, and maybe an introduction of other measures such as tiering – meaning part of banks’ excess reserves held at the ECB would be exempt from negative interest rates, which should support banks’ profitability – or a restart to quantitative easing (QE). All of these will be Draghi’s initiatives, so if anything were to go wrong, it should fall at his feet rather than Lagarde’s. In this sense, he has cleverly given her a ‘clean run’ for her first year or so in office.

However, and this is the second element, she still needs to make her mark. Mark Carney’s nervousness at his first press conference as head of the Bank of England at the inflation forum in the UK drew a lot of negative press and questioning comments, but within a few months he had made the transition. Despite having no central banking experience, Lagarde should make the transition more easily as she is used to being in the spotlight.

In this regard, setting the right tone at the first two ECB press conferences in December and January will be key. One option to help assuage any fears and ensure a smooth delivery will be to involve chief economist Lane. While this has not been done at the ECB before, it is a regular occurrence at the Bank of England’s press conferences, and she might benefit from emulating it. She can share responsibility for some answers, while still giving her take on the governing council’s view.

Getting more political?

With two politicians at the top of the ECB, vice president Luis de Guindos and now Christine Lagarde, some have highlighted the risk of the bank becoming more political. Lagarde will be keen to allay those fears.

Yet because of her background, she will probably also want to push for closer integration, and to strengthen the institutional structure of the euro zone. She will likely put more stress than Draghi and his predecessors on working to complete both the banking union and the capital markets union and, eventually, setting up a single fiscal authority to make the region akin to a “united states of Europe”.

This will be a long and arduous task because of objections from certain members, primarily Germany. However, Lagarde may be helped by the nomination as head of the European Commission of Ursula von der Leyden, who is also ostensibly, and somewhat surprisingly for a German, pro-integration. There may be conflict at times in terms of their vision, but having a French person at the helm of the ECB and a German person as the head of the European Commission, both of whom are pro-integration, may finally provide a catalyst for progress.

Given the complexity of the task, it will remain a multi-year or perhaps even a multi-decade process but, to the extent they can stimulate initiatives, they could prioritise the banking union and single deposit insurance around the euro zone. The Five Presidents’ Report¹, which in 2015 outlined a path towards stronger economic and monetary union, painted the ambition but has stalled, and they may try to relaunch it. Though it could take decades, if the euro zone is going to survive as a single entity on a long-term basis it must set up a single fiscal authority that allows for some form of debt mutualisation. How they do it is more about political economy than economics. If someone can coordinate a step towards that it may well be Lagarde.

Fiscal policy and the Italian question

Because of Lagarde’s career as a politician, as finance minister and head of the IMF, she will have a good understanding of – and interest in – fiscal policy, so she probably won’t be shy of commenting once she joins the ECB. Indeed, while at the IMF, she has been quite vocal at times in pushing for fiscal stimulus to be provided “from those countries where there is room”. However, this will not necessarily mean fiscal and monetary policy are being coordinated or that the independence of the bank is undermined. Lagarde will certainly speak about fiscal policy, but likely in a nuanced manner, much in the way Draghi has.

Interestingly, without overstepping the bounds of her ECB role, the strict stance she has taken as head of the IMF when talking about those countries with no fiscal room indicates she could take a harder line with Italy, by implying a certain scepticism about some of the Italians’ fiscal ideas. Although she admitted to taking too hard a line with Greece over its struggles to emerge from the sovereign debt crisis, and some lessons have been learnt, the circumstances today are very different and Lagarde is unlikely to go easy on Italy.

While deficits around the EU are generally smaller and the euro zone seems somewhat more unified than during the Greek crisis, Italy does remain a vulnerable point. The government is rebelling against EU deficit rules and its unique public-sector numbers are a real risk. If Italy’s government doesn’t face up to it, the situation could spiral out of control.

In response, the EU will be wary of imposing greater austerity the way they did in Greece, but will want to find a sensible way of resolving the Italian deficit issue and steer nationalist leader and Deputy Prime Minister Matteo Salvini away from some of his populist initiatives. At the ECB, Lagarde is likely to be supportive of this.

Once she begins her new role, Lagarde’s priorities will be to make the transition from Draghi as smooth as possible and, on the assumption that he plans additional stimulus measures, to follow through on their execution. Before the ECB can restart bond purchases, however, it may have to change its holdings rule to increase maximum issuer limits.

Purchases of public debt instruments are guided by the ECB capital key, which specifies the share of the ECB’s capital attributable to national central banks.² If it wants to buy more French or Spanish bonds, for example, it also has to buy German bonds in proportion. The programme is close to reaching its allowed limit of holding 33 per cent of Germany’s outstanding government bonds, so any further purchases will require setting higher limits.

Although the limits are self-imposed, changing them would require careful consideration. Legally, the ECB cannot vote in favour of a bond restructuring of debt it holds, because it would equate to providing direct financing to that government, which is prohibited under EU treaties. Therefore, if the ECB holds a blocking minority of a country’s bonds, that country is effectively banned from restructuring its debt.³ This makes any increase in the ECB’s limits a sensitive issue.

Making the wrong decision or miscommunicating it could expose the bank to political or even legal difficulties. Even if the decision is made under Draghi, Lagarde will have to negotiate its implementation with skill.

Finally, Lagarde will want to keep financial markets on side – not in terms of doing what they want, but by putting on a strong performance in those first two or three public appearances. Her priority will be to make the transition a success, and hopefully be around when Europe begins to recover.

References

1. The Five Presidents' Report: Completing Europe's Economic and Monetary Union, 22 June 2015
2. ECB
3. Reuters