Ten years on from the outbreak of the Great Financial Crisis Fran Boait and Stan Jourdan evaluate the policy of central banks since then and propose reforms of the European Central Bank that are necessary in the future if they are to serve the needs of the great majority of Europeans.
Fran Boait is Director of Positive Money and Stan Jourdan is Head of Positive Money Europe. Positive Money is a movement for a money and banking system that works for society and not against it
Ten year after the outbreak of the Great Financial Crisis Fran Boait (Director of Positive Money) and Stan Jourdan (Head of Positive Money Europe) evaluate the policy of central banks since then and propose reforms of the European Central Bank that are necessary for the future if they are to serve the needs of the great majority of Europeans.
The financial crisis has exposed how powerful central banks are. Yet, they have been subject to very little public scrutiny, and at the same time their interventions are being criticized for their lack of impact. Is it time that we thought about reforming central banks?
10 years after the crash and we are still facing high unemployment, almost 10%, across Europe, most economies are still reliant on high levels of private debt to keep them afloat, and inequality is soaring.
But not only did the financial crisis cause massive damage to many people’s lives through job losses, bankruptcies, losing homes and livelihoods but it also has sent reverberations around the political landscape, that have manifested in many different ways. There has been a radicalising and polarising within countries and across Europe. We are almost certainly witnessing the breakdown of the social-political consensus that has dominated Western democracies over the last 40 years, and what is going to emerge is far from clear.
Throughout history discussions around the role and tasks of central banks have been confined within a very few circles of financiers and technocrats. Under the influence of the so-called “Washington consensus”, all western central banks were gradually reformed to adopt new regimes of independence and price stability mandates. The Bank of England was thus granted independence in 1997, while the European Central Bank’s independence was seen by some countries as a precondition for its very existence.
There are some valid justifications for this development. The main rationale was that central banks would do a better job if they were institutionally separated from fiscal decision makers and therefore from political cycles interference on monetary policy. In practice, central bank independence also meant that central banks weren’t allowed to finance governments. This prohibition would force governments to borrow from the markets instead, and in turn manage their budget with greater care than in the past.
For some time, the transformation of the central banks’ institutional arrangements was perceived to be a success. Virtually all mainstream economists have praised ‘the great moderation’, referencing the fact that inflation has been ‘under control’ for the past 30 years. But in fact, what was actually going on in economies was laying the foundations for the largest financial crisis in modern history.
Central banks didn’t see the crisis coming, nor did they find sufficient responses to it. In spite of their independence, central banks role have been heavily embarking on policies with political implications and their powerful tools have both been misused and ineffective.
Against this background, we hope to shed light on some of the key lessons which should be drawn from the financial crisis.
Lesson 1: No more independence without accountability
The first lesson is that central banks’ independence does not mean their decisions do not have political implications. Despite decisions being made under narrowly technical considerations and parameters, they can have huge political consequences, and therefore central banks should be subject to scrutiny by and be accountable to political institutions.
In the peak of the financial crash, the crisis-management in the euro area did not go well, and decisions made had disastrous results for the economies most struggling in the eurozone. Alongside the series ‘last chance” summits in Brussels, the European Central Bank (ECB) has emerged as perhaps the most decisive institution in tackling the crisis, but also the most controversial one.
One of the most illustrative cases where the ECB overstepped its technical role was during the Irish banking crisis in 2010. Under the presidency of Jean Claude Trichet, the ECB, under the growing fear of a possible collapse of the Irish banking sector, sent secret letters to the Irish government which eventually led to the country requesting a bailout programme to the Troika. The content of the letters, which were leaked to the press after years of unsuccessful pressure for public disclosure, indicated indeed that the ECB pressured the Irish government to ask for a “voluntary bailout”… without which the ECB would let the Irish banking system collapse. Further reports indicated that Trichet himself had a phone call with Finance Minister Lehinan, where the ECB’s chief alluded to a “financial bomb” exploding in Dublin in case the government did not act upon the ECB’s will.
After the Irish government gave in, the ECB went further in making sure that only Irish taxpayers would pay the price of the rescue plan through austerity measures, while investors who had funded the banking bubble, were repaid in full by the government.
Whatever justifications the ECB could provide on this unfair treatment, what is clear is that under the name of political independence, the ECB took decision which in turn, had dramatic political consequences, including the picking of winners and losers between citizens and investors and the arm twisting of elected officials.
Hence, the idea that central banks could be entirely isolated from political dynamics have been proven wrong during the euro crisis. By contrast, it seems political interactions between central banks and political institutions are unavoidable if not desirable during crisis times.
Isolating them only fuels chaos and absence of coordination. Lastly, what this reveals is that independence can only be made democratically legitimate if central banks are being held accountable for their acts.
In the euro crisis case however, never has the ECB been held to account on its management of the Irish crisis. The ECB refused to published the ‘secret letters’ and repeatedly prevented the Irish government from applying some debt relief towards the Irish banks’ private investors (contrary to what happened in Cyprus few years later).
Lesson 2: Central banks should support their governments in times of crisis
The euro crisis also provides ample evidence that a too strict prohibition of monetary financing of governments such as the one enshrined in the EU Treaty is neither desirable nor sustainable.
This was demonstrated by the fact that the ECB has taken a series of measures to circumvent its prohibition from financing governments. In 2010, while Greece, Portugal and Italy’s debts were facing speculative attacks by financial markets, the ECB did eventually step in and purchase Southern European government’s bonds, in order to calm down market turbulence. But many felt that the market interventions were too little, too late. Had the ECB announced the programme earlier when the crisis started, much of the market panic would never have occurred, therefore avoiding unnecessary damages on the economy which ended up having a damaging effect on citizens.
Learning from the ECB mistakes, the new president Mario Draghi, appointed in November 2014, made a famous pledge to do “whatever it takes” to save the euro. Subsequently, the ECB announced the setup of the Outright Monetary Transactions (OMT) programme, a bailout scheme where the ECB would provide unlimited liquidity under conditions of austerity programmes agreed with the Troika.
Finally, the ECB committed to the most conventional unconventional monetary policy stimulus, already being undertaken by the Bank of England, Federal Reserve, and Bank of Japan: quantitative easing (QE).
The fact that those decisions were overseen by the European Court of Justice proves that the ECB decisions were legitimate. The fact that Draghi’s “whatever it takes” speech succeeded in calming down market immediately proved that some kind of support by the ECB towards government’s’ debt is a reasonable thing to do during crisis. No other central bank in the world did or would have hesitated to implement such programme in similar circumstances. Yet despite it being technically feasible, such a move was at the time deemed unfeasible by the ECB due to political and legal restrictions. Alas, the ECB’s hesitations only fuelled political and market uncertainties.
What the Euro crisis history shows is that monetary financing prohibition is a huge disability for central banks in times of crisis. The ECB has managed to find a way to circumvent this prohibition under QE, however we should ensure central banks do not doubt their own capacity to relieve governments from illegitimate and irrational market pressures.
Lesson 3: Central banks need new tools to achieve their mandates
Since March 2015 the ECB, under its quantitative easing programme, has injected more than 2,000 trillion euros into financial markets by purchasing government and corporate bonds. In addition, many central banks including the ECB and the BoE have adopted very low – or even negative interest rates. The combination of both policies is historically unprecedented and demonstrates by themselves the gravity of the situation. But their effectiveness should be questioned.
QE is supposed to incentivise banks to make loans to the economy and thereby spur an economic recovery. In practice, QE programmes (combined with record low interest rates) have reduced the cost of credit, but they have done little to boost the real economy, especially when considering the size of these money printing schemes.
Despite this massive-scale money creation programme, most central banks are failing in achieving their primary objective: to maintain inflation close but below 2%. Inflation in the Eurozone has been super-low for the past 5 years. And its recent rise is mainly due to external factors such as energy prices, not so much the ECB’s policies.
This failure reveals a major problem in the transmission mechanism of monetary policy. All central banks tools only indirectly influence financial intermediaries, and then rely entirely upon the goodwill of banks and investors to spend or invest this money into the economy by creating more debt. Additionally the process also relies on households and businesses wanting to take on more debt.
This last point is a paradox in the entire strategy of central banks: while we are still recovering from a spectacular crash 10 years ago caused by a build-up in private debt, how can higher levels of private debt be a solution?
QE is better than the ECB doing nothing as it prevents self-fulfilling market panics and it can provide some leeway against austerity policies. It is however not enough to actually stimulate a sustainable recovery in the economy.
It’s clear that central banks are out of ammunition, and if there was a downturn tomorrow, they would not know how to respond. This is why there is growing support for central banks to consider more ‘radical’ tools such as monetary financing, where money is created like the QE scheme but channelled towards public investments, for example linked with the Green transition (Strategic QE or Green QE). Another alternative to QE would be to distribute modest amounts of money directly to all citizens in order to boost spending.
The merits of all those proposals would be to circumvent the banking sector as the only channel for monetary policies. They would increase the ability of central banks to achieve their mandates.
Time for central banking reform
It is now clear that central banks’ will never go back to their pre-crisis role. The financial crisis led policymakers to task central banks with new roles such as the banking supervision and macroprudential policies. More recently, the Swedish central bank has announced a change of its price stability objective. Central banks are evolving, and not before time.
European policymakers should open their eyes to these live discussions and question how the ECB can best serve economies in the Eurozone. While the economy slowly recovers, now is the best time to consolidate the learnings from the past crisis and to reform central banks.
While an overall review of central banks mandate and statutes would be ultimately necessary (especially if central banks’ keeps non-delivering on their primary goals), such reforms of the ECB could start with three concrete priorities.
First, we should re-establish central banks’ legitimacy by increasing their accountability towards elected parliaments and citizens. Building on the work of Transparency International’s recent report findings, this would involve making the European Parliament able to nominate or dismiss the ECB’s board of directors, instead of leaving those nominations to close-door negotiations between head of States. In addition, the EU Parliament could self-reinforce its democratic control of the ECB by making better use of the quarterly hearings of the ECB president in Brussels.
Secondly, policymakers should explicitly allow central banks to make use of direct quantitative easing in the future to abolish self-fulfilling market panics due to legal confusion around the ability for the ECB to purchase governments debts.
And finally, EU policy makers should explore and evaluate other innovative monetary policy instruments; to make sure central banks dare use the tools they have at their disposal in the future to ensure they have a positive impact on the health of economies.
The future is far from certain. However what is clear is the most powerful economic institutions, central banks, are not being adequately scrutinised to ensure they serve society over and above financial markets. If what emerges from the breakdown of the socioeconomic consensus does not seek to democratise central banks, and the financial sector at large, then it is unlikely that a truly fairer, more democratic, and more equal society will emerge.