Top of Lagarde’s ECB to-do list: stop QE and democratise monetary policy

If Christine Lagarde is serious about greening the European Central Bank, she must not hide behind its mandate.

The European Central Bank is at a crossroads. It finds it increasingly difficult to achieve its price-stability objective, yet its new, unconventional tools are having pernicious side-effects. The way forward is to give the challenge back to European citizens and their elected representatives. The ECB’s incoming president, Christine Lagarde, a former politician herself, is the ideal candidate to do so.

Under the current president, Mario Draghi, the ECB has sought to achieve its objective—defined as an inflation rate of below but close to 2 per cent—through quantitative easing (QE). Starting in 2014, this has led the bank to create €2.6 trillion in new euros to buy bonds (debt instruments traded in financial markets). Unsurprisingly, the programme has driven up the prices of financial assets. Perhaps more surprisingly, it has failed to achieve the ECB’s goal, with inflation hovering around just 1 per cent.

Largely unchanged

Regretfully, when Lagarde takes over on November 1st, it appears she will inherit and continue Draghi’s programmes largely unchanged. Despite its side-effects, the ECB has just recently decided to restart its QE programme. Some governing council members opposed that decision, but the bank’s internal debate is stuck between more QE and doing nothing.

QE does have many undesirable side-effects. A well-known consequence is that it increases wealth inequalities: QE drives up asset prices and financial assets are mostly owned by already well-off households. The Bank of England estimates that its QE programme provided the poorest 10 per cent of UK households with a wealth increase of around £3,000 but the wealthiest gained an average of £350,000. QE is also a driver of rising property prices in recent years.

Particularly controversial are the ECB’s purchases of corporate bonds. These have primarily benefited the large multinational companies which can afford to issue bonds. Even worse, they have had a disastrous environmental impact: a recent study shows that 63 per cent of the purchases have gone to carbon-intensive industrial sectors, such as fossil-fuel extraction, car-makers and electricity generation.

The QE programme has these side-effects because it works through financial markets, allowing the ECB ostensibly to avoid overt political choices. The ECB focuses its purchases on low-risk assets. It also seeks to minimise the effects of its programme on relative market prices, an objective Lagarde wants to uphold.

But such a market-based purchase programme will by its nature preserve the unsustainable status quo. Innovative green companies are risky and tend not to issue bonds, so will not be in a position to benefit from QE. Hence, as I show in a recent co-authored study, bond markets cannot be relied on to achieve a green transition.

Distributional choices

Central banks are extremely reluctant to make distributional choices. Because central bankers are not elected their legitimacy is tenuous—it is unclear what gives these men and (few) women the right to exercise so much power. To deflect such challenges, central bankers treat their mandates as if they held a clear set of instructions, which the bank merely implements.

In reality, the ECB’s mandate does not tell it what to do at all. As long as price stability is achieved, the bank is merely instructed to support the economic objectives of the European Union. How to understand those objectives is something the ECB itself decides.

Its statutes also place few limitations on what the ECB can do to achieve those objectives. It can create new money to buy any kind of financial assets in the market and, conditional on a two-thirds majority of its governing council, even use new money for completely different purposes.

The discretion that the ECB has within its mandate is underlined by its recent decision to introduce a tiered deposit rate. This means that banks receive a discount on the negative interest rate they pay at the ECB’s deposit facility. Deutsche Bank alone stands to benefit to the tune of €200 million from this measure. Could that money not have been spent better elsewhere?

Lagarde should end the pretence that the ECB mandate contains clear instructions. Replying to a member of the European Parliament on a European Green Deal, she acknowledged that global heating was ‘one of the existential threats of our times’. But she cautioned: ‘The most appropriate, first-best policy response and initiatives primarily fall outside the realm of central bank policies. While the ECB contributes to sustainability objectives within its mandate, it is up to the political authorities to […] address these challenges.’

But the ECB mandate does not stop the bank from enabling first-best green policies by coordinating its programmes with EU level institutions. The ECB should push for changes to monetary policy when political authorities fail to act. This may put the bank in an uncomfortable position, but Lagarde the politician can do a lot to give legitimacy to better programmes.

Democratic control

Her priority should be to abolish QE and to return responsibility for the distributional effects of monetary policy to the eurozone’s elected leaders.

In a democratic society, there is only one source of legitimacy—the citizenry via its elected representatives. On the EU level, citizens are represented by both the European Parliament and the national governments in the European Council. Their views should be brought to bear on the future of the ECB’s operations. This can be done through various direct forms of consultation and dialogue, as well as by targeting ECB purchases on financial institutions, such as the European Investment Bank, which are under democratic control.

What should happen with the money? In light of the climate crisis, there are enough infrastructure projects which could be funded. Anyone who has sought to travel through Europe by train will know that transcontinental high-speed lines are sorely needed. If all else fails, giving new money to citizens directly would still be better than using it to inflate financial-asset prices.

Whatever happens next, the decision should be as democratic as possible within the constraints of the ECB’s constitutional independence. Giving politicians a say on where the money is spent does not take away the ECB’s final authority over monetary policy, since it would still be up to its governing council to decide how many new euro to issue. And over time the bank should push for treaty changes which provide its decisions more solid democratic support.