Roundtable: Monetary Policy in the EU
The ECB, the climate and the interpretation of “price stability”

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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.