1

Current Scholarship
Central Banks

Author: Jens van ’t Klooster

This chapter provides an overview of the state of the art in constitutional theory with regard to the topic of central banks. It challenges accounts of central bank independence as involving limited discretion and distributional choices, as well as the narrow range of normative questions that such accounts raise. It also provides a roadmap for a vast range of procedural and substantive issues raised by independent central banks.

This chapter is due to appear The Cambridge Handbook of Constitutional Theory (3 vols.), edited by Richard Bellamy and Jeff King for Cambridge University Press.

Jens van ‘t Klooster, “Central Banks,” OSF Preprints (September 12, 2020), doi:10.31219/osf.io/4t2fr, available at https://osf.io/4t2fr/. 




Monetary Policy in the European Union

Monetary Policy in the European Union

 

Prompt for Discussion

Contributors:  Annelise Riles, Marco Goldoni, Joana Mendes, Jens van’t  Klooster,  Brigitte Young, Jamee  Moudud, Jeremy Leaman, Sebastian Diessner, Agnieszka Smolenska and Will Bateman

The European Central Bank played an important and powerful role in the management of the eurocrisis. Today, in the midst of the COVID-19 pandemic, the ECB once more emerges as a crucial actor. With its Pandemic Emergency Purchase Programme it is taking decisive steps to address the fallout from the crisis – not only attempting to safeguard financial stability, but also to prevent massive unemployment. As the ECB becomes an indispensable actor in crisis management, as its private and public sector bond purchase programmes become ever more far-reaching and larger in volume, it attracts more and more attention. A vibrant debate amongst legal and economic experts and with civil society actors confronts ECB practice with important questions of legality, democracy and policy.

Questions of legality include the following: Is the ECB still acting within its mandate? Can quantitative easing programmes – such as the public sector purchase programme or the pandemic emergency purchase programme – be qualified as monetary policy measures; or are they really economic policy measures that remain within the competence of member states? Is the ECB acting in violation of the prohibition of monetary financing (Art. 123 TFEU) when it purchases public sector bonds in such large quantities and with the aim of ameliorating refinancing conditions of member states?  Is the ECB pursuing with its crisis measures the primary objective of price stability (as mandated by Art. 127 TFEU) or are the ECB’s policy decisions not only informed, but guided by other – secondary – objectives? These questions have been at the heart of two constitutional complaints before the German Federal Constitutional Court (FCC) against two ECB quantitative easing programmes (OMT and PSPP) which triggered a confrontation between the FCC (doubting the legality of the programmes) and the Court of Justice of the European Union (adopting a quite lenient standard of review and confirming their legality).

Apart from debates of legality, questions of legitimacy, democracy and social justice take center stage: Given that the ECB is such a powerful actor and given the distributive consequences of its policy measures, shouldn’t it be subject to greater democratic control? Should monetary policy be democratized? What would it mean to democratize ECB policy? Here, too, views are divided. They are divided as concerns the empirics – the effects of QE programmes on social inequality, the actions of corporations and capital concentration. They are also divided as concerns democracy and democratization: Should central bank independence from politics be safeguarded and in return monetary policy powers be reined in and subjected to strict judicial review (this appears to be the view of the FCC)? Or should the conduct of monetary policy – in recognition that monetary policy cannot be neatly separated from non-monetary economic policy – be “politicized” and become more transparent and inclusive.

Finally, policy considerations are heatedly debated: If the ECB has such powerful policy instruments at its disposal, might it/must it employ them to address pressing public concerns such as climate change, social inequality and structural imbalances between member states?  Suggestions for the (re-)deployment of monetary policy abound: to selectively support green industry; to engage in more outright monetary financing to support the budgets of member states; to start a programme of peoples’ QE, inter alia to promote social cohesion. Yet, can monetary policy make up for the “design flaws” of European monetary union with its separation of monetary policy (as an exclusive EU competence) from fiscal/economic policy (remaining largely a competence of the member states)? Can “more money” – even if directed with precision towards social objectives – be a solution to the current existential crises or does it fuel a growth spiral that is co-responsible for the social and ecological crises we are in?

While the ECB currently addresses some of these questions in its Strategy Review 2020, we wish to join the debate with this roundtable. Our aim is, ideally, to forge a transatlantic debate. We hope to address common concerns raised by central bank monetary policy and in particular quantitative easing – once considered unconventional monetary policy and today widely used by the ECB, the Fed and other central banks around the world. We also want to identify the specificities of ECB monetary policy that result from the particular institutional design of the European monetary union when compared, for example, to the United States system of government.

Contributions

February 26, 2021
The Hegemony of Central Bankism and Authoritarian Neoliberalism as Obstacles to Human Progress and Survival
Jeremy Leaman, Loughborough University

February 18, 2021
Opening up ECB’s Black Box and Painting it Green- the Monetary Policy Mandate in the Age of New Challenges and Uncertainty
Agnieszka Smoleńska, European Banking Institute

February 10, 2021
The Distributive Impact of Central Banks’ Quantitative Easing Program
Brigitte Young, University of Münster

February 3, 2021
Money and the Debunking of Myths
Jamee K. Moudud, Sarah Lawrence College

January 25, 2021
Post-Crisis Central Banking and the Struggle for Democratic Oversight in Europe – a Trilemma and a Paradox
Sebastian Diessner, European University Institute and London School of Economics

January 18, 2021
The ECB, the climate, and the interpretation of “price stability”
Jens van’t Klooster, KU Leuven

January 12, 2021
Beneath the Spurious Legality of the ECB’s Monetary Policy
Marco Dani, University of Trento, Edoardo Chiti, Sant’Anna Scuola Universitaria Superiore Pisa, Joana Mendes, University du Luxembourg, Agustín José Menéndez, Universidad Autónoma de Madrid, Harm Schepel, University of Kent, Michael A. Wilkinson, London School of Economics

January 4, 2021
Rekindling Public Trust in Central Bankers in an Era of Populism
Annelise Riles, Northwestern University

December 28, 2020
Quantitative Easing, Quasi-Fiscal Power and Constitutionalism
Will Bateman, Australian National University

 

Date
Link to Article
Name
Affiliation

 

 




The ECB, the climate and the interpretation of “price stability”

January 18, 2021

Jens van’t Klooster, KU Leuven

The European Central Bank is not in an easy spot. It is expected to do much more than before 2008, but also stay within a mandate conceived in the 1980s. This has led the ECB to increasingly broaden its understanding of the price stability objective – recently also analysing climate change as a potential threat. It is a strategy that undermines its legitimacy and hinders its effectiveness.

In a recent article, Nik de Boer and I analysed the ECB’s conundrum in terms of authorization gaps: the ECB makes choices with far-reaching consequences for which there is no clear basis in its mandate. As a consequence of such gaps, the ECB’s actions lack clear democratic authorization. I will build on that article for my contribution to this roundtable but focus on recent efforts to define climate change as a threat to price stability. As I argue, to help avert 21st century environmental catastrophe the central bank needs better democratic authorization.

When the European community initiated the process of monetary unification, the task of the central bank was meant to be simple. At the time, sometimes referred to as “Eurofed”, it was meant to pursue price stability by setting short term interest rates. The economic effects of monetary policy were widely deemed benign – price stability, in the words of the ECB’s first chief economist Otmar Issing, was not merely “one of a long list of political and economic objectives”, but rather “a pre-condition for the successful pursuit of other objectives”. Importantly, what counts as “price stability” is not explained in the treaty. Instead, it explicitly states that the task of the ECB is not just to “implement”, but also “define” its monetary policy. In the 1990s and early 2000s, the ECB set out a simple and quantitative definition: consumer price inflation of below, but close to, 2% over a two to five-year horizon.

That simple definition of price stability came from a world where financial markets were deemed efficient and high wages a threat to economic stability. A lot has changed since then. After a decade of crises, few still believe that financial markets can be left to their own devices. Hence, central banks receive much closer scrutiny.

Since monetary policy is the most important economic competence entirely delegated to the EU-level, it is not surprising that the ECB is time and again expected to act. In response to new challenges, the ECB has sought to broaden its objectives in part by redefining its understanding of price stability. The interpretation of the term “price stability” is now the prism through which its Governing Council members decide, and outsiders are expected to debate, monetary policy.

In the 2010-12 Eurozone crisis, the price stability objective became the rationale for buying sovereign bonds of individual member states – most notoriously in the ECB’s Outright Monetary Transactions (OMT) Programme. At the time, buying sovereign bonds was widely deemed to go beyond the ECB mandate, which explicitly prohibits lending directly to governments.  The mandate, however, does not rule out buying them indirectly – from primary dealers, sometimes just days after issuance. To justify its 2012 OMT-programme, the ECB conceptualized the sovereign debt crisis as a threat to price stability. It argued that large divergences between bond markets for individual member states undermined its ability to set financial market conditions across the euro area. Buying bonds was part of its efforts to maintain price stability.

The legal basis for the OMT programme is an example of what we in our article describe as an authorization gap, because the ECB could equally well have argued that it should not implement the programme. The German lawyers who sued the ECB in the 2015 Gauweiler case argued that OMT constitutes a “suspension of the market mechanisms which violates the Treaties”; a view also supported by Bundesbankpresident Jens Weidmann. However, neither the ECB nor the German litigants have a clear-cut case. The ECB mandate simply does not contain provisions for whether, and if so how, the ECB should deal with sovereign bond yields.

Since the OMT programme, authorization gaps have popped up left and right, leading the ECB to ever broaden its account of price stability. After the Eurozone crisis ended, European economies remained in a deep recession. Youth unemployment topped 40% in Greece and Spain. Absent a coordinated fiscal expansion, the ECB decided to embark on a quantitative easing (QE) bond buying programme. By far the largest programme, the multi-trillion euro Public Sector Purchase Programme (PSPP) again targetedsovereign bonds. The side-effects of low interest rates have become pervasive, raising the question at the heart of the May 2020 Bundesverfassunsgericht ruling: is the pursuit of the self-imposed 2% target still proportionate? Can the ECB simply continue to pursue it even if that has massive repercussions for the general trajectory of European capitalism? Again, there is a clear gap in the PSPP’s democratic authorization.With the 2020 Pandemic Emergency Purchase Programme (PEPP), the ECB has moved even further into uncharted constitutional territory – as earlier contributions to this Roundtable have already shown.

 The ECB has acted forcefully in providing massive fiscal support to the Member States to fight the Pandemic, but remains more timid in its efforts to green the EU’s financial system. The central bank has tentatively started to consider whether climate change may be a threat to price stability. This connection is not as far-fetched as it may initially sound. Investors currently fail to adequately price financial risk that result from climate change. Decarbonizing the economy will require ditching carbon intensive infrastructure, productive capacity and even whole sectors of the economy. Extreme weather events threaten coastal real estate and can damage the economy’s productive capacity. Droughts and biodiversity loss threaten agriculture. Economically, the effects of climate change could be both deflationary and inflationary.

Climate change, accordingly, will have consequences for the central bank’s ability to achieve its medium-term inflation target. Moreover, climate change fits the general rationale for the price stability objective; to make sure nominal price developments track real economy growth. Since Mark Carney’s 2015 ‘tragedy of the horizon’ speech, central bankers have published volumes on environmental threats to monetary stability. At the ECB, Isabel Schnabel and Christine Lagarde have both linked climate change to the ECB’s primary mandate (here and here).

Central banks are sure to take some actions to manage the climate transition. The political questions today concern what they do, how much is left to financial markets and where the public gets a say over the actions of central banks.

Against that background, there are major concerns with the ECB’s recent efforts to conceptualize climate change as a threat to price stability. Although an activist trajectory can be justified in terms of the legal mandate, the past decades have made clear that almost anything can be. This is the real problem with the ECB’s authorization gaps; law has lost much of its role in constraining monetary policy. Authorization gaps make the democratic basis of any actions – activist or not – thin. Acting to green the financial system would arguably be less political than doing nothing, but that itself does not legitimize any particular ECB policy. The Karlsruhe judges have already signalled their willingness to weigh in on green bond purchase programmes.

Treating climate change as a threat to price stability makes democratic debate on the proper ECB response all but impossible. The considerations at stake in defining price stability are too technical for inclusive deliberation. What good is a multi-lingual ‘ECB listens’ campaign when you need an Economics PhD to formulate your opinion in the right vocabulary?

The imperative to subsume ECB action under the price stability mandate will also undermine its effectiveness. What should ultimately matter is that the global climate does not enter a trajectory where catastrophic outcomes can no longer be averted. Policies that target consumer prices in 2035 are unlikely to be the best way to achieve that.

If tweaking the price stability objective is not the right way to fight climate change, what is? In our article, we outline a range of democratic tools that could be used to give new ECB policies adequate democratic authorization. Many of these do not require ratification of a new treaty – a process involving an intergovernmental conference, queens, dukes and dozens of other political bodies. Rather, these proposals can rely on tools available within the existing constitutional framework.

For one, the ECB is already subject to a secondary mandate for supporting the EU’s broader economic policy objectives (where this does not hinder its pursuit of price stability), which are spelled out in Article 3 TEU. The objectives include “the sustainable development of the Earth”. Article 121 (2) TFEU allows the Council to articulate how it sees the role of environmental and climate-related objectives in that secondary mandate. Moreover, Article 129 (3) TFEU allows the Council and European Parliament to amend the instruments assigned to the ECB in its statutes.

The ECB could itself also do more to incorporate existing EU positions on the contours of its mitigation trajectory into the design of operations. For example, the ECB can draw on the so-called Green Taxonomy for economic activities that contribute to the EU’s environmental objectives. One way to do that is a proposal I made for Green TLTROs, which would make ECB open market lending rates conditional on lending in accordance with the Green Taxonomy (as far as I know, a similar proposal has not yet been written for the Federal Reserve – hint hint!).

For now, treating climate change as a threat to price stability may be the best way to navigate the ECB’s new challenges. Over time, however, Europe’s central bank needs better constitutional arrangements. The interpretation of decades old treaty provisions is not a good basis for running the world’s largest economy.




Special Edition: Money in the Time of Coronavirus

Special Edition: Money in the Time of Coronavirus

Prompt for Discussion

Contributors: Katharina Pistor, James McAndrews, Saule Omarova, Mark Blyth, Jamee Moudud, Elham Saeidinezhad, Dan Awrey, Fadhel Kaboub, Leah Downey, Virginia France, Lev Menand, Nadav Orian Peer, Robert Hockett, Carolyn Sissoko, Jens van ‘t Klooster, Oscar Perry Abello, and Gerald Epstein

Download PDF

The financial strains brought by the coronavirus outbreak feel strangely reminiscent of 2008, and yet, markedly different. In the United States, at the writing of this prompt, the S&P 500 has crashed 25%, and the federal funds target rate is once again moving towards the zero bound. The treasury securities market is in disarray, and the Federal Reserve is set to increase its repo lending by over one trillion. In Washington, the administration’s insistence that concerns were overblown is now replaced with negotiations over the size and shape of a stimulus package. “I don’t want to use the b-word”, said a senior administration official about plans to support distressed industries, like airlines. The b-word is, of course, bailout. 

So far, so 2008. But the monetary dynamics we are witnessing in the time of corona also take us into new territory.  The proximate cause of the crisis past came from within the financial system itself: the housing credit bubble and abuses in subprime lending. The corona crisis, on the other hand, emerges from a material threat to human health.   Where the 2008 crisis revealed the vulnerabilities of financial globalization, the corona crisis is disrupting the global production system, upending supply chains, and threatening shortages in essential inventories.  

We wonder about the extent to which the policy arsenal of 2008 can contain the dislocations currently occurring, and what, exactly, stimulating consumer demand means when the consumer herself is in quarantine.  Moreover, the crisis response to the corona crisis is taking place within an institutional setting that was itself reshaped by the 2008 crisis reforms. As corona strains unfold, it remains to be seen whether the promise of financial resilience will be borne out, or whether fundamental design flaws left in place will frustrate reformers’ efforts. 

In this Special Edition Roundtable, JM invites contributors to provide live analysis of money in the time of corona, here in the U.S., and around the world.

***

 

Contributions

June 29, 2020
Roundtable Wrap-up
Sannoy Das, Harvard Law School

May 21, 2020
Human Capital Bonds and Federal Reserve Support for Public Education: The Public Education Emergency Finance Facility (PEEFF)
Gerald Epstein, University of Massachusetts 
Amherst

May 12, 2020
The Fed Should Bail Out Low-Income Tenants and Not Just Banks and Landlords
Duncan Kennedy, Harvard Law School

April 29, 2020
Getting to Know a Brave New Fed
Oscar Perry Abello
, Next City

April 10, 2020
The Problem with Shareholder Bailouts isn’t Moral Hazard, but Undermining State Capacity
Carolyn Sissoko, University of the West of England

April 2, 2020
Crises, Bailouts, and the Case for a National Investment Authority
Saule Omarova
, Cornell Law School

March 31, 2020
Why the US Congress Gives Dollars to the Fed
Jens van ‘t Klooster, KU Leuven and University of Amsterdam

March 26, 2020
A Fire Sale in the US Treasury Market: What the Coronavirus Crisis Teaches us About the Fundamental Instability of our Current Financial Structure
Carolyn Sissoko, University of the West of England

March 25, 2020
The Democratic Digital Dollar: A ‘Treasury Direct’ Option
Robert Hockett, Cornell Law School

March 22, 2020
Derivative Failures
James McAndrews, TNB USA Inc. and Wharton Financial Institutions Center

March 20, 2020
The Case for Free Money (a real Libra)
Katharina Pistor, Columbia Law School

March 19, 2020
The Monetary/Fiscal Divide is Still Getting in Our Way
Leah Downey, Edmond J. Safra Center for Ethics
at Harvard University

March 18, 2020
Is Monetary System as Systemic and International as Coronavirus?
Elham Saeidinezad, UCLA Department of Economics

March 17, 2020
Here We Go Again? Not Really
Dan Awrey, Cornell Law School

March 16, 2020
Repo in the Time of Corona
Nadav Orian Peer, Colorado Law

March 16, 2020
Beyond Pathogenic Politics
Jamee K. Moudud, Sarah Lawrence College

March 15, 2020
Economic and Financial Responses to the Coronavirus
James McAndrews, TNB USA Inc. and Wharton Financial Institutions Center

 




J. van ‘t Klooster, Why the US Congress Gives Dollars to the Fed

March 31, 2020

Jens van ‘t Klooster, KU Leuven and University of Amsterdam

Commentators have raised various concerns over provisions in the $2 trillion US stimulus bill that assign $454 billion to protecting the Federal Reserve against losses. The most basic worry is that losses should not matter to a central bank. Although I agree that a lot ultimately rests on conventions, that is true for many things. This fear of losses, rather than the Federal Reserve Act itself, may ultimately be what stops it from doing what Dan Awrey, Leah Downey and Robert Hockett have rightly said it should: provide at least some of the support now available to Wall Street to the US’s struggling real economy.

In this blog, I will first say something about why it makes (some) sense to spend this money to protect the Federal Reserve against technical insolvency. I then contrast the Federal Reserve’s attitude with what is happening in Europe, where the European Central Bank has historically also been immensely concerned about losses. For now, in launching its Pandemic Emergency Purchase Programme (PEPP), it has given up a lot of its earlier risk aversion.

Let me start with some philosophy: does it even make sense to think about financial risk in relation to central banks? Central banks report on their activities and design their operations assuming the reality of their accounting framework. From this balance sheet perspective, central banks are exposed to financial risk because they hold financial assets. Accounting is crucial for private sector agents because they face budget constraints. If central banks operate on an analogous logic, they face a risk of insolvency in this accounting sense. If the value of their assets drops below the value of their liabilities, they are insolvent.

Central bank budget constraints, however, are not at all like those of the private sector. They are not enforceable through the legal system in the way that budget constraints of economic agents are. Where it comes to obligations to pay in in its own currency, central banks can always just print the money. For this reason, the consequences of insolvency are limited. Indeed, the central banks of Chile, the Czech Republic, Israel and Mexico have operated with negative equity, holding assets valued less than their liabilities, for years. It is true that central banks often have strict legal requirements for controlling and reporting the value of their assets and liabilities.12F Calls to “Audit the Fed,” as critics have rightly pointed out, falsely suggest that the Federal Reserve is currently not audited by an outside accounting firm. Central banks, however, often decide on their own accounting framework. The Fed, in fact, used this power in 2013 to create a new way to avoid net negative equity. A central bank is, hence, somewhat like a firm under historical socialism, where, even if accounting practices were in place, bankruptcy remained a political decision and losses per se would not result in the dissolution of the firm.

The absence of a default risk, however, does not mean that central bank accounting has no practical significance, as central bankers are keen to point out. A central bank with net negative equity may change its behaviour to a more profit-oriented strategy, which may hinder its macroeconomic and financial market roles. Financial market participants and governments may have less confidence in the central bank, threatening its independence and ability to achieve its objectives. Citizens may think all sorts of things. As is the case for all institutions at the pinnacle of the financial system, as Katharina Pistor has argued, the financial constraints that central banks face are more discretionary and depend crucially on their own perceptions, those of other political institutions and those of market participants.

We should not underestimate how serious central bankers take their budget constraints. Risk management informs an important part of the day-to-day operations of a central bank. Many of the key operational decisions turn on whether risks are properly anticipated and mitigated. To give up on that approach in a crisis is difficult. This is illustrated by the Fed’s September 2008 decision to withhold credit from Lehman Brothers, which was based on concerns about losses. Fear of losses is also part of why central bank swap lines, which Elham Saeidinezhad already called attention to, have such a narrow geographic reach. For central bankers, taking on financial risk requires an immense psychological transformation. This, and the $4 trillion in loans that it is meant to unlock, is ultimately what Congress pays for. Eligibility criteria for these programmes may still be way too strict.

To illustrate central bank reluctance and draw some comparisons, consider a European perspective. Here too, central bankers tend to be immensely preoccupied by financial risk. In the past weeks, however, the European Central Bank has made some dramatic moves  that side-line a host of preoccupations that were decisive in its response to the previous crisis (for more detail see my blogs on this here and here).

The ECB’s legal mandate does not say much about risk management beyond a provision that says that credit should be secured by “adequate” collateral. The main issues are for the ECB itself to decide, which initially gives rise to considerable internal fighting over how to deal with risk. In 2005, the ECB resolved most of these debates by committing itself to a strict market-based approach. From then on, the ECB’s collateral policy, also with regard to government bonds, had served to protect it against losses. Moreover, its risk management strategy is meant to follow, rather than shape, market practices. To this end, the ECB makes the collateral eligibility of government bonds conditional on a sufficiently high credit rating issued by Moody’s, S&P and Fitch. In the 2010-12 Eurozone Crisis, this risk management strategy shaped the ECB’s actions and stopped it from taking up a role as lender of last resort to the member states.

The ECB gave up its narrow focus on risk management only partially after Mario Draghi in July 2012 committed to do “whatever it takes.” When in 2014 the ECB started its Quantitative Easing programme, the ECB imposed a range of constraints on purchases to protect itself against losses. For one, government bonds are bought by the national central banks (e.g. the Bundesbank and the Banque de France) to ensure that any default would not impose losses on the ECB itself. Purchases strictly followed the ECB’s capital key, which is determined by population and GDP of individual member states. The ECB also takes various measures to ensure that secondary markets continue to shape risk premia paid by individual member states. Finally, the programme remained burdened by the ECB’s minimum credit rating, which led to the exclusion of Greece and the inclusion of highly-rated corporate bonds issued by Royal Dutch Shell and other fossil fuel companies.

Although the ECB has thus historically been very preoccupied with financial risk in designing its crisis-fighting measures, the recent Pandemic Emergency Purchase Programme constituted a radical break. The key passage from the ECB press release comes at the end:

To the extent that some self-imposed limits might hamper action that the ECB is required to take in order to fulfil its mandate, the [Governing Council of the ECB] will consider revising them to the extent necessary to make its action proportionate to the risks that we face.

Although less pithy than “whatever it takes,” the PEPP’s key provision is more compelling in its implicit philosophy and certainly more powerful. It admits that most limits hitherto applied to ECB tools were self-imposed. Therefore, they can be revised in light of the risk (i.e., the economic dangers from the pandemic) that the Eurozone faces. This kind of recognition at the ECB opens the door to giving up the capital key and other restrictions on the PEPP. For now, it is noteworthy that Greece is already explicitly part of the programme. The ECB also expanded the already uniquely generous eligibility requirements of its collateral framework. It is striking that all these things become possible under its new president Christine Lagarde, who may very well lack the central banker’s intuitive risk aversion. 

Are the Federal Reserve and the European Central Bank on different trajectories with regard to risk? Let’s see when the dust settles.