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The Crisis of Central-Bank Governance

The European Central Bank may enjoy stronger protection against political pressure than other central banks do, but it also faces unique constraints. The more the ECB is forced to expand its policy remit to meet new economic challenges, the more likely it is to trigger destabilizing political conflicts within the eurozone.

LONDON – The relationship between monetary authorities and governments differs in important ways between the United States and the eurozone. The US invariably falls into a traditional pattern whereby governing politicians, with an eye toward the electoral cycle, tend to favor expansionary fiscal policies and looser monetary conditions, while the Federal Reserve, wary of political pressure, endeavors to assert its independence. If the Fed’s autonomy were called into question, domestic – and, by extension, global – macroeconomic stability would be jeopardized.

The pattern in the eurozone is the opposite of this. On the whole, fiscal policymakers are hesitant to pursue stimulus even in the face of an economic slowdown (as is the case today), and it is the European Central Bank that ends up trying to pressure others to act. This inversion of roles between governments and monetary policymakers has no historical precedent. It has occurred as an unexpected result of the eurozone’s design, and it now threatens to pose a persistent challenge to the bloc’s stability.

More broadly, both the US and the eurozone are experiencing symptoms of a crisis of economic governance that has been building for more than 30 years. In the US, the Fed’s independence is granted by Congress and could in principle be withdrawn, whereas the ECB’s independence is protected by the Maastricht Treaty. But this is of little comfort to Europeans, considering that the tension between European monetary authorities and member-state governments could ultimately undermine the consensus in favor of the single currency itself.

As a stateless central bank within a bloc where national governments retain fiscal sovereignty, the ECB has few tools with which to pressure governments to pursue economic policies that are consistent with its inflation target. At most, the ECB can send a message that when interest rates are zero or negative, fiscal policy is more important than monetary policy for boosting aggregate demand or influencing inflation.

But sovereign states are unlikely to respond to this message unless it happens to be compatible with their own national objectives, which inevitably take precedence over eurozone-wide priorities. The upshot is that the ECB will continue to be the economic institution of last resort. During the euro crisis nearly a decade ago, it was forced to assume ultimate responsibility for financial stability, regardless of whether the problem was one of liquidity or of solvency. And now, it will be ultimately responsible for stabilizing eurozone output, regardless of what national governments do (or fail to do).

In principle, there is a lot more that could be accomplished through monetary policy within the eurozone. But in practice, for the ECB to do more than it already has would require expanding its remit in controversial and divisive ways. Its policymaking scope would quickly reach a political, if not an economic, limit.

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Because the top economic-policy priority in the 1980s and 1990s was to keep inflation in check, central banks were given a mandate that focused squarely on price stability. It was widely agreed that such a narrow mandate would ensure central-bank independence in the face of political pressure for potentially inflationary policies. Moreover, the Maastricht Treaty included fiscal rules to prevent member states from accumulating excessive debt, thereby alleviating concerns of a sovereign crisis that could destabilize the entire bloc.

Yet under today’s conditions of low interest rates, tepid growth, and high risk aversion among investors, the most important “externality” for the eurozone is weak internal demand from larger members such as Germany. Neither the existing fiscal rules nor the EU’s framework for coordinating macroeconomic policies can adequately address this problem.

Hence, while the ECB and the European Commission can exercise moral suasion, they cannot actually force a member-state government to pursue fiscal expansion. And while the Maastricht Treaty protects the ECB from the type of pressure that US President Donald Trump has brought to bear on the Fed, it cannot protect the eurozone from the political divisions that would emerge if the ECB broadened its remit.

The Maastricht Treaty has turned out to be a powerful embodiment of “historical determinism.” When it was signed in 1992, the prevailing economic challenges were quite different from those of today. The intellectual consensus back then was that fiscal rules and an independent central bank with a narrow mandate were sufficient for macroeconomic stability. In fact, these factors explain why Northern Europeans – particularly the Germans – accepted the idea of the common currency in the first place.

This could not have happened today, when new challenges are leading to a new consensus on both fiscal and monetary policy. On both sides of the Atlantic, central banks have developed large balance sheets and become “market makers,” and there is a growing need for closer coordination between monetary and fiscal policymaking. Fiscal policy, on the other hand, needs to be used more actively for demand management. This calls for an entirely new governance framework, the creation of which will be exceedingly difficult, especially for the eurozone. Still, there is no other choice, given that ECB independence, although it must be protected, will be insufficient for guaranteeing macroeconomic stability.

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