January 25, 2021

Sebastian Diessner, European University Institute and London School of Economics

The European Central Bank is in the process of reviewing its strategy, having vowed to ‘leave no stone unturned’ in a quest to render its monetary policy framework ‘fit for years to come’. The central bank is certainly right in doing so: as has become clear for all to see, the ECB’s strategy is reaching its limits in terms of both effectiveness and legitimacy. This roundtable contribution seeks to address both of these limitations in turn, thereby revealing a trilemma and a paradox.

After a deceptively calm first decade of EMU, the successive crises of the second decade and the ECB’s unconventional monetary policy response have resulted in a conundrum for the independent central bank – one which is thrown into sharp relief by the ongoing pandemic-induced recession: how can the ECB manage to achieve price stability (to fulfil its de jure primary mandate), maintain financial stability (to fulfil its de factopost-crisis mandate) and minimize risks on its balance sheet (to avoid threats to its de facto independence stemming from fiscal and/or financial dominance) all at the same time? While the ECB’s post-crisis conundrum is not dissimilar to the situation of other major central banks – all of which are stuck at the zero lower bound in a quest to revive inflation through quantitative easing ad infinitum –, it displays a couple of uniquely European features. The conundrum is probably best understood as a trilemma: the ECB can only comply with two of the three imperatives listed above.

 

(Source: Diessner 2020)

The rationale behind this is as follows. European monetary policy-makers can have either:

• Price stability and financial stability. To achieve both of these, the ECB would need to continue net asset purchases and provide cheap credit to the financial sector. Its balance sheet would be bound to remain large and subject to a variety of risks (including interest rate and default risk). A persistently large balance sheet raises the spectre of fiscal and/or financial dominance: that is, the central bank’s hand constantly being forced by market panic and/or the needs of government debt management, calling the ECB’s de facto independence into question. This scenario may be referred to as ‘QE infinity’.

Or

• Price stability and minimal (risks on) balance sheet. To achieve both of these, the ECB would need to end net asset purchases and unwind its balance sheet, and resort to interest rate-setting as the main monetary policy tool (including deeply negative interest rates where necessary). This would likely increase risks of instability in government bond markets and raise the spectre of fragmentation. This scenario may be referred to as ‘narrow central banking’.

Or

• Financial stability and minimal (risks on) balance sheet. To achieve both of these, the ECB would need to provide direct support to member state governments, households or firms, without pursuing net asset purchases. Whether this would risk an overshoot in the ECB’s inflation target depends on whether we are in an inflationary or a deflationary regime to begin with. This scenario may be referred to as ‘monetary finance’ or ‘helicopter money’.

 

This stylized trilemma entails two important qualifications. First, it should matter greatly whether the euro area finds itself in an inflationary or a deflationary regime. In the case of a deflationary spiral – which appears likely in light of the COVID-19 crisis – monetary finance of government deficits arguably provides a way to resolve the trilemma: a limited programme of monetization would help eliminate doubts about the sustainability of public debt (thus contributing to stability in bond markets) and provide an extraordinary boost to persistently sluggish inflation. Given that the effect of monetary finance would be permanent and amount to the respective government debt essentially being forgiven, interest and default risk on the ECB’s balance sheet would be minimized as well. Second, only the pursuit of price stability and financial stability should matter economically to the ECB, while the requirement to minimize (risks on) its balance sheet is of a more legalistic and Eurozone-specific nature.

The paradox of legitimacy-as-accountability post-crisis

While the ECB’s strategy review is predominantly concerned with the conduct of monetary policy, a thorough review of the central bank’s democratic oversight is equally urgent and pertinent, given that its powers and responsibilities have a tendency to expand from one crisis to the next. Despite these expansions, the independent central bank’s democratic legitimation remains decidedly ‘thin’. Its ‘input legitimacy’—that is, input participation by the people—is reduced to a narrow but ultimately vague mandate specified in the EU Treaties, and is crucially limited by the central bank’s far-reaching independence, which rules out to ‘seek or take instructions’ of any sort (Art. 130 TFEU). In turn, ‘output legitimacy’—that is, the effectiveness in achieving mandated policy outcomes—is diminishing fast, given the central bank’s mounting difficulties with achieving its inflation target over the years.

This essentially leaves the ECB with what Vivien Schmidt has termed ‘throughput legitimacy’, a procedural form of democratic legitimation that is mostly concerned with the quality of governance processes and revolves around efficacy, transparency, openness/inclusiveness of interest representation and, most importantly in the EMU context, accountability. Among the different channels of the ECB’s democratic accountability, its quarterly ‘Monetary Dialogue’ with the European Parliament’s Committee on Economic and Monetary Affairs (ECON) undoubtedly stands out as the most important. The Monetary Dialogue exemplifies how throughput legitimacy differs from input legitimacy in EMU: in effect, the ECB’s accountability amounts to answerability to the questions of Members of the European Parliament (MEPs) who do not, however, have substantive means to reward or sanction the central bank. This non-substantive form of democratic oversight renders the ECB’s legitimacy contingent on perceptions of accountability among MEPs – that is, whether MEPs deem their (written and oral) questions to have been answered adequately by the ECB or not.

This thin and contingent form of democratic legitimation gives rise to a paradox post-crisis: on the one hand, the central bank’s enlarged crisis-fighting roles require ever-broader scrutiny and parliamentary debate; on the other hand, the quality of accountability arguably hinges on the specialization and focus of those involved. One way to address the seemingly contradictory challenge of both wider and more specialized central bank oversight would lie in reshaping and formalizing the procedures of the Monetary Dialogue and in the creation of a parliamentary sub-committee of ECON dedicated to overseeing the ECB in particular.

Viewed in this light, the strategy review and the accompanying ‘ECB Listens’ events can be read as attempts to remedy some of the ECB’s missing input legitimacy and to recalibrate its monetary policy framework towards achieving mandated policy outputs. Both should be complemented by a serious attempt to enhance its throughput legitimacy as well, by means of strengthening democratic oversight.

Yet, whether the strategy review will provide a genuine opening to change the central bank’s modus operandiultimately remains to be seen. To be sure, a growing coalition of actors from diverse backgrounds appears poised to challenge the current path towards ‘QE infinity’ and demand more radically innovative instruments, including direct cash transfers. As so often, however, the ECB might well find itself caught in the middle between those who want it to do (even) more and those who want it to do (even) less, thereby allowing it to settle for the status quo with only a few minor tweaks. But the very recognition of the need for a strategy review implies that the status quo should not be an option this time.