By Mathis Richtmann and Max Krahé
Translated by Marc Beckmann
In a landmark ruling in May this year, the Federal Constitutional Court in Germany questioned whether the purchase programs of the European Central Bank (ECB) were proportionate and therefore legal. In addition to its crucial consequences for European policy, the ruling launched a debate about the appropriate relationship between independent central banks and parliamentary democracy. One outcome of that debate was German parliamentarians informally committing to regularly invite the President of the German Bundesbank, Jens Weidmann, to sessions of the parliament’s finance committee. The first of these sessions is held on Wednesday (16 September).
Together with Positive Money Europe, Dezernat Zukunft is following this process. In this article, we first outline two topics we consider worthy of discussion, loosely linked to the primary and secondary mandate of the European System of Central Banks. We then ask what significance this new format has for the relationship between parliament and central bank, and what overarching questions it raises.
The scope around the primary objective
The primary objective of the European System of Central Banks – and thus of both the Bundesbank and the ECB – is to ensure price stability. However, it is not legally defined how central banks should fulfill that objective, which means the choice of what economic analysis to use and what instruments to employ is up to them.
The resulting scope for action is considerable, and its use by the ECB and Bundesbank can be questioned. For example, in summer 2011 the ECB pulled the interest rate brakes very early on, contributing to the fact that the euro zone – in contrast to the United Kingdom and the USA – experienced a second and possibly avoidable recession.
In particular, the link between unemployment and price trends in central bank analysis is controversial. We briefly explain where this controversy comes from, and why this topic could and should be the subject of Weidmann’s hearing.
Prices, work, and “when to brake”?
The impacts of monetary policy unfold with a certain delay – it often takes twelve to eighteen months before interest rate increases, reductions or other measures take full effect. Central bankers therefore always try to predict where inflation will be in twelve to eighteen months time. If they have the impression that, at that point, inflation will be too high, they preemptively put on the brakes.
One indicator traditionally given a lot of weight is unemployment. If it is “too low”, the bargaining power of workers increases, workers fight for higher wages which leads to fears of inflation in the near future. This ratio – low unemployment equals high inflation, and vice versa – is known in economics as the Phillips curve.
Based on the Phillips curve, the rule up to now has been if unemployment falls below a certain level, then the central bank tends to apply the handbrake to increase interest rates and as such tame down inflationary pressures, even if no inflationary pressure is apparent today. This is to prevent inflation from occurring in twelve to eighteen months.
This analysis is both consequential and controversial. It is consequential because it justifies early braking, which directly increases unemployment. It is controversial because it is often unclear whether the slowing down inflation was premature, and the unemployment thereby created constitutes unnecessary suffering.
For example, in August the US Federal Reserve announced a departure from exactly this interpretation of unemployment as potentially inflationary. As Federal Reserve President Jerome Powell stated, the Fed will reassess the relationship between unemployment and inflation in the future. Given the declining bargaining power of employees in the gig-economy and the enormous supply of labor in globalized markets, there is no longer a threshold level of unemployment that constitutes the sole basis for the Fed to hit the monetary brakes. Only when acute inflationary pressure becomes apparent will the Fed apply the handbrake.
An appropriate topic for Wednesday’s hearing would therefore be whether the Bundesbank shares the Federal Reserve’s analysis. Does it see a threshold value above which “too low” unemployment becomes an inflation driver, or does it share the Fed’s view that the link between low unemployment and inflation is currently broken? If the existence of a threshold is affirmed, it would be interesting to ask further what justifies a different analysis of the US and the euro zone.
Last but not least, the committee could ask what contribution the Bundesbank could make to prevent a premature interest rate hike or premature austerity policy from stalling the recovery – such as in 2011. This applies all the more as Weidmann is already publicly warning that the debt ratio must again be reduced to 60%, even though debt reduction has an effectively deflationary, i.e. slowing, effect.
Secondary objective: Is the central bank acting in an ecologically proportionate manner?
In addition to the primary mandate, a secondary mandate obliges central banks to support the general economic policy of the European Union, as long as this does not endanger the fulfillment of the primary mandate. A prominent goal of the von der Leyen Commission is sustainability in general and the fight against climate change in particular.
A second topic of the hearing could therefore be the question of the extent to which monetary policy could support – or at least not hinder – this priority. Specifically, the committee could examine the bond purchases of the Bundesbank and the ECB. For example, since October 2014 the ECB and its subordinate national central banks have purchased various types of bonds with a volume of around €3.5 trillion, i.e. €3,500 billion. Positive Money Europe estimates that until 2018 alone, around €110 billion of this has been invested in bonds of particularly CO2-intensive industries.
Benoit Cœuré, then a member of the Governing Council of the ECB, acknowledged this and argued that the current policy of market neutrality was leading to the purchase of corporate bonds with an undesirable carbon footprint. The Pandemic Emergency Purchase Program (PEPP) launched in March is also likely to have further affected investment in these industries than would otherwise have been the case in a ‘business as usual’ context.
In addition to supporting CO2-intensive companies, this purchasing policy – which is erroneously described as “market neutral” – accumulates financial stability risks. The European Systemic Risk Board, which works on the premises of the ECB and therefore naturally maintains close contact with the central bank, has already established that the market misprices climate risks. Since the rating agencies on whose credit rating the Eurosystem relies have not yet reflected these risks, the bonds of unsustainable companies are subject to increased risk. To the extent that the purchases made by the ECB support the prices of these bonds, they increase the magnitude of the fall in the price of a possible correction.
Things could be different. In view of the secondary mandate, for example, the bonds of CO2-intensive companies could be excluded from the purchases of European central banks. This would support the general economic policy of the European Union without jeopardizing the primary mandate.
This topic, should it be raised on Wednesday, would provoke an intense discussion. As recently as December, Weidmann had spoken out against a reorientation of monetary policy along with the challenges of the climate crisis. He said that discriminating against specific industries on the basis of monetary policy would contradict the market neutrality laid down in European treaties. However, a detailed analysis of the market neutrality principle shows that it is by no means legally binding, and is in any case both practically and theoretically impossible.
Current member of the ECB’s Governing Council Isabel Schnabel also commented on this at the end of August, noting how climate change is now the greatest challenge for central banks – even greater than the ongoing pandemic. She also pointed out that with regard to the incorrect pricing of climate risks, “market neutrality might not be the right benchmark”.
The big picture: Democratic proportionality
In addition to economic analysis and the consideration of climate change, there are a number of other individual topics that could be discussed on Wednesday. One of which could be Weidmann’s austerity speech to the Übersee Club in Hamburg two weeks ago. But above these individual topics there is a larger question – what is the right relationship between the central bank and parliament in a democracy?
For example, should the exchange between parliament and the central bank take place in public, as on the European level, or in a closed session as planned for Wednesday in the Bundestag? If closed, to what extent should parliamentarians inform the public after the meeting? How often and in what framework should future hearings be held?
In addition to these process-oriented questions, there are also more fundamental issues. Should European central banks strategically support the role of the euro? Is it right that “the disciplining of fiscal policy should be done by market forces” and not by the voters? Could additional democratic oversight of the central bank even provide backing for more targeted specific strategic interventions?
Wednesday’s session will provide an opportunity to discuss these and other questions about the relationship between democracy and the central bank. Both the President of the Bundesbank and the parliamentarians are thus called upon to do justice to the increased public interest in monetary policy.