Peter Praet: Have unconventional policies overstretched central
bank independence? Challenges for accountability and
transparency in the wake of the crisis
Keynote address by Mr Peter Praet, Member of the Executive Board of the European Central
Bank, at the "Symposium on Building the Financial System of the 21st Century: An Agenda for
Europe and the United States", Frankfurt am Main, 29 March 2017.
* * *
I would like to thank Claus Brand for his contribution to this speech.
Evolution in consensus on the role of central banks and central bank independence
In the course of monetary history, consensus on the role of monetary policy and on the
appropriate degree of independence of the central bank has fluctuated considerably. During
major crises, the pendulum has tended to swing from one extreme to the other.
In the heyday of the gold standard, i.e. the decades preceding World War I, there was a
commonly accepted understanding of how to preserve monetary and financial stability. The gold
standard provided what we call a "nominal anchor". It effectively ensured central bank
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independence from other public policies by subjecting monetary policy to an automatic rule. At
the same time, there was a clear understanding of the role of central banks as a lender of last
resort. Under that regime, central banks enjoyed sufficient discretion to take effective action in
the event of banking panics. Adherence to the oft-quoted Bagehot principle ("lend freely at a high
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rate against good collateral" to solvent, but illiquid institutions ) ensured that lender of last resort
activities did not threaten monetary stability.
The pendulum began to swing away from this pre-war consensus when World War I prompted
many countries to subordinate monetary policy to financing war and to suspend the gold
standard. Countries returning to the gold standard after World War I, however, turned to overly
rigid management of monetary affairs. Lacking the necessary discretion, following the Wall
Street crash and the global recession in 1929, and the subsequent banking crisis, monetary
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policy prompted a precipitous collapse in money and prices. This spawned the greatest loss in
jobs and output on record in what came to be remembered as the Great Depression.
In a fateful irony of monetary history, the role of monetary policy in precipitating these calamitous
events did not usher in monetary reform. On the contrary, notions hardened that monetary policy
was powerless and that macroeconomic stability needed to be safeguarded through other
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policies. This shift in emphasis culminated in fiscal dominance, which contributed to the
monetary mismanagement of the 1960s and 70s, paving the way for the "Great Inflation". Only a
few countries that preserved central bank independence, such as Germany, were able to
maintain low inflation rates throughout these years.
The Great Inflation was eventually overcome as monetary policy once again gained centre stage
and was recognised as a powerful factor in macroeconomic stability. Economists, irrespective of
their scholarly persuasion, and policymakers alike became convinced of Milton Friedman's
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famous dictum that "inflation is always and everywhere a monetary phenomenon". This return to
old wisdom helped to rebuild a consensus that central banks need to be granted sufficient
independence to pursue monetary stability without political interference. The pendulum had
swung back, and central bank independence became the mainstay of inflation targeting
frameworks. In the European Union, the independence granted to the ECB for the pursuit of price
stability is a central plank of the Treaty on the Functioning of the EU and has thereby attained a
unique institutional and legal status.
Challenges for central bank communication and accountability in times of crisis
We have been going through the biggest financial crisis in two generations, which has now
lasted nearly a decade. Prior to it, monetary policy operated predominantly through adjustments
to short-term interest rates. But the crisis has upended traditional patterns in finance and
economics, and monetary policy is no exception. In its response to the crisis, the ECB has
deployed a novel and complex range of instruments. The novelty and complexity of these
unconventional measures have created challenges for accountability and transparency.
The financial crisis has evolved in three main phases, each of which has required different
monetary policy responses and has brought about particular challenges for central bank
communication and accountability.
The first phase was the abrupt liquidity crisis triggered by the turning of the global financial cycle
and the subsequent collapse of Lehman Brothers. It provoked a systemic failure of funding
markets and prompted global central banks to step in with forceful and coordinated interventions
to provide essential liquidity to the banking sector. Without this response, the financial system
would have collapsed and a far deeper recession would have ensued.
Owing to the funding freeze, the classical interest rate instrument ceased to be the main
signalling device of the monetary policy stance. The deployment of the central bank balance
sheet as a stabilising instrument was a novelty, and immediately met substantial scepticism.
First, there were concerns about moral hazard, given the unprecedented expansion of ECB
credit to banks at a time when banks were under scrutiny for their mismanagement of risk in the
pre-crisis period and for having precipitated the crisis in the first place. Second, there were also
concerns about these liquidity injections paving the way for inflation.
Owing to the incompleteness of the institutional structure of Economic and Monetary Union
(EMU), the profound effects of the banking crisis were not addressed as swiftly in the euro area
as in other jurisdictions. This paved the way for the second phase of the crisis, the sovereign
debt crisis, which was amplified by the fact that banks predominantly hold debt securities of their
own national governments. As the cost of borrowing increased for certain governments, banks
with exposures to this debt came under intense market pressure, ultimately leading to entire
national banking systems losing market access. This in turn resulted in financial fragmentation
and a serious disruption of the monetary policy transmission mechanism. As a consequence,
cuts in key ECB interest rates were not being passed on to firms and households to the same
extent in every euro area country.
To arrest and reverse this development, two policies were introduced. First, to ensure banks
could rely on longer-term funding, central bank liquidity was made available for up to three years,
and the collateral that could be used to access central bank money was expanded. Second, the
announcement of Outright Monetary Transactions (OMTs) in 2012 removed the euro area
breakup risk that was being priced into government borrowing costs.
Notwithstanding the success of OMTs in alleviating redenomination risk, the sovereign debt crisis
set back the recovery and laid the ground for the third phase of the crisis. Banks in large parts of
the euro area became less willing and less capable of keeping credit flowing to the real economy,
producing a vicious circle of contracting credit growth and weak demand dynamics. Accordingly,
headline inflation began to drift downwards, owing both to global energy and commodity price
developments and to ongoing weakness in the core components.
In June 2014 monetary policy in the euro area embarked on a phase of renewed expansion,
aimed both at enhancing monetary policy transmission, in a context of continued bank
deleveraging, and increasing policy accommodation in view of persistently weak inflation. Having
limited room for manoeuvre on the main refinancing rate, the ECB initiated a series of new
unconventional measures. These consisted of our targeted longer-term refinancing operations
(TLTROs), our asset purchase programme for public and private sector securities (APP), and
our policy of charging a zero interest rate on main refinancing operations and a negative rate on
excess reserves. As the floor of our monetary policy corridor - which by then had become the
key instrument steering monetary conditions in the money market - was reduced to negative
levels, other short to medium-term market yields dipped below the zero line as well.
Given the novelty, scope and size of the measures taken, and given their potential interaction
with other public policies, communication of these measures proved to be much more difficult
than before the crisis, when we only had to explain how changes in the main policy interest rates
affect the economy and ultimately the price level.
Likewise, holding the ECB accountable for its monetary policy has also become more difficult.
Let me illustrate this difficulty by considering how observers have been using Taylor rules to
compare our policy interest rates with rule-based benchmarks. In a Taylor rule, such
benchmarks are pinned down mainly by the deviation of inflation from target and by a measure of
economic slack. On this basis, observers held central banks accountable for monetary policy
decisions, as the relation between policy objective and instrument is transparent and not
equivocal. In a nutshell, empirical regularities lay the ground for a prescriptive monetary policy
rule - even though oversimplified - against which central bank actions can be evaluated.
In crisis times, it turned out to be nearly impossible to track the monetary policy stance using a
Taylor rule. First, with the interest rate having ceased to be the main instrument, incorporating
balance sheet measures into the rule is not straightforward at all.. Second, as the transmission
of policy interest rates to the economy has been impaired, their comparison with Taylor rule
benchmarks has become much less informative. Third, in view of persistently weak and low
inflation and a high degree of economic slack, Taylor rules might well prescribe the setting of
interest rates below their effective lower bound, wrongly indicating a tight policy stance, as the
easing effects of unconventional measures cannot be accounted for. Developing other
comparatively simple monitoring tools has not been possible. Overall, the ability of observers to
use policy rules to hold the ECB accountable has been severely hindered.
How can we then be sure that the measures taken fall within the ECB's narrowly defined price
stability mandate?
The precise scope of our price stability mandate has been the subject of some debate in recent
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times. Some have argued that central banks, by engaging in a systematic expansion of their
balance sheets, are in effect venturing into the realm of fiscal policy. Such views could be paving
the way for another turnaround in the public perception and institutional status of central banks,
which could result in less financial and, ultimately, less statutory independence. This threat may
be even more pronounced in a world in which, virtually everywhere, public debt has surged to
high levels, making political pressure on central banks to alleviate debt servicing costs through
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higher inflation more likely. Another swing of the pendulum?
Central banks are ultimately judged on their success or failure in ensuring low and stable
inflation. Central bank independence gives them the freedom to pursue their mandate.
Independence does not mean that they can act in a completely unfettered way. In modern
democratic societies, independent institutions are accountable. They need to explain the reasons
for their actions and why these are appropriate for fulfilling the mandate that has been assigned
to them as the result of a democratic process. For central banks, one of the challenges is to
communicate their internal deliberations in a transparent manner to their external stakeholders.
Safeguarding accountability
The Treaty sets out an accountability framework for the ECB, which requires regular
appearances by ECB officials before the European Parliament and the publishing of the Annual
Report. Let me remind you that the ECB was the first major central bank to hold press
conferences on its monetary policy decisions. The Economic Bulletin provides a comprehensive
account of the economic and monetary analyses supporting the Governing Council's
assessments. In 2015, we took another important step: we started publishing accounts of the
monetary policy meetings of the Governing Council, as an additional means to explain the
deliberation process that leads to our actions.
Overall, the steps that the ECB took to enhance transparency have been acknowledged in a
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report released this week by Transparency International EU. Concerning monetary policy
communication, it notably commends our decision to publish regular accounts of the Governing
Council's monetary policy discussions. By explaining the rationale behind our policy decisions,
the accounts also show how the measures we take are aligned with our mandate of maintaining
price stability. This is important, because some unconventional monetary policy measures have
been challenged on the grounds that they could be serving other policy objectives.
To elaborate further on this, I will take a few examples of monetary policy measures that some
have perceived to be fiscal or quasi-fiscal measures. It is imperative to be fully transparent on
such measures and dispel any doubts about their motivation and their effect on price stability.
Safeguards against encroachment on the area of fiscal responsibilities are extremely important.
Conflicts with the price stability objective could emerge from monetary operations that support
unsustainable government finances or insolvent financial institutions.
There is no doubt that monetary policy has had beneficial effects on government finances;
monetary policy has unavoidable implications for public budgets. The same kind of indirect
support occurred during the easing cycle in the early 2000s, when our main refinancing rate was
reduced to 2% - a very low level at the time - and was maintained at that level for more than two
years. The fiscal ramifications of monetary policy that we see today (and in the early 2000s),
however, differ fundamentally from the deliberately coordinated strategy of monetary financing
that we observed in some countries in the 1970s. Today the use of any central bank instrument
has to be justified solely on the basis of the central bank's narrow price stability objective, and not
on any fiscal consequences thereof.
Borrowing from the theory of monetary regimes, it is the dominance of the central bank mandate
over the objective governing fiscal conduct that differentiates the setting of monetary policy today
from anything we saw prior to monetary union. The ECB continues to have the necessary
institutional independence, the financial resources and operational capacity to take all appropriate
measures, if and when needed, to counter upside or downside risks to price stability in a truly
symmetric fashion.
It could be argued that there are multiple channels through which the central bank could take on
tasks and obligations that pertain to the fiscal authority, and some of these channels are both
more subtle and less apparent than outright financing of public deficits. Extending liquidity
support to insolvent banks is a case in point.
But, even in this admittedly fuzzier terrain that separates liquidity provision from solvency
support, the ECB operates in a sound framework that has passed multiple resilience tests in
recent years. In the case of Greece, for instance, the choices of the Governing Council were
another example of strict adherence to this framework. In keeping with Article 123 of the Treaty,
which prohibits the ECB from monetary financing, the Governing Council imposed strict limits on
the use of government securities as collateral for loans that the Greek banks received from the
ECB.
We nevertheless continued to supply the necessary liquidity so as to ensure the functioning of
the Greek banking system and the continuation of lending to businesses and households. This
was in line with the principle by which the Eurosystem may lend to banks which are solvent and
have sufficient collateral. To sum up, the balance we achieved with our interventions during the
Greek crisis was fully within our mandate; it respected the political commitment to the single
currency contained in the Treaty, but at the same time we implemented that commitment within
the limits of our Statute.
The Treaty prohibition of monetary financing has been a key element in preserving the monetary
policy nature of OMTs and the public sector purchase programme (PSPP). The technical
features of OMTs imply that they would only be considered if warranted from a monetary policy
perspective. Moreover, the extra exposure to any single country that the Eurosystem might
acquire as a consequence of OMT activation would be secured by the country's strict obligations
arising from the European Stability Mechanism (ESM) macroeconomic adjustment programme
to which the country would have to submit as a precondition. It is worth noting that in June 2015
the European Court of Justice ruled that, given the strict modalities for activation, OMTs fall within
the scope of the ECB's mandate and include sufficient safeguards to avoid monetary financing.
A number of safeguards apply to public sector bond purchases under the PSPP too. Such
purchases have a monetary policy purpose which is different from the one that applies to OMTs
and are specifically aimed at bringing inflation back to our medium-term objective in a situation in
which our key interest rates are at levels that can hardly be reduced much further. The modalities
are exclusively governed by the primary objective of price stability and are decided in full
independence, irrespective of developments in other policy areas.
The size and duration of the PSPP are calculated to achieve progress towards the ECB's
inflation objective. The effectiveness of the tool is rooted in two important features of the financial
system. First, government bond yields are the benchmark indicator for pricing a large set of
private debt instruments. Second, government bond markets are deep and liquid. Interventions in
these markets can initiate a process of portfolio rebalancing with significant secondary effects on
broad financing conditions. Several safeguards are in place to minimise potential distortive
effects on market functioning and price formation (such as the issuer limit and the issue share
limit of 33%).
There has been a prominent financial stability dimension in all unconventional measures taken,
but the existing institutional framework ensures that monetary policy is the last line of defence
with respect to preserving financial stability. The establishment of the European banking union, in
particular the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism
(SRM), has taken monetary policy one step further away from financial stability issues. Progress
has been made to ensure that regulatory capture and forbearance are minimised and that
shareholders bear responsibility and face the consequences of failure. But we are not there yet.
These mechanisms need to be complemented by a common system of deposit protection,
which would further bolster financial stability by reducing the risk of bank runs in crisis times.
Conclusion
To conclude, unconventional policies have been complicated to implement and to communicate.
But they have been effective in enhancing our ability to deliver on our mandate in a medium-term
perspective. Our measures have been designed to complement each other and have proved
adaptable to and effective against the series of shocks which have buffeted the euro area
economy. The complex nature of unconventional measures has repercussions for the
transparency and accountability dimension of central bank independence. But they were a sine
qua non for our mandate to be respected. The challenge from the monetary policy
consequences of the financial crisis has placed a particularly heavy responsibility on the ECB to
explain how the measures taken fall within the ambit of its price stability mandate.
Non-standard measures have been designed in such a way that they cannot compensate for
failures in other policy areas. The evolving institutional structure of EMU is further contributing to
ensuring that, if at any critical juncture in future the macroeconomy faces risks, monetary policy
will be able to concentrate solely on preserving price stability.
As described in Barry Eichengreen (1992), Golden Fetters: The Gold Standard and the Great Depression, 1919-
1939, Oxford University Press, pp. 29-66, the credibility of the pre-World War I gold standard rested on
international cooperation, with Britain at the centre, enjoying considerable leeway in observing the rules of the
game, and France, Germany, and others willing to support sterling's stability. The United States, at the time an
agricultural exporter and a foreign borrower, with the Federal Reserve System not yet operating, faced more
binding constraints. Seasonal swings in the demand for money, for example, triggered gold flows which could
not be absorbed, thereby causing periods of deflation.
2
For a critical appraisal, see Charles Goodhart (1999), "Myths about the Lender of Last Resort", International
Finance, Vol. 2(3).
3
Barry Eichengreen, op. cit.; Milton Friedman and Anna J. Schwartz (1963), A Monetary History of the United
States, 1867-1960, Princeton University Press; and Ben Bernanke (2004), Essays on the Great Depression,
Princeton University Press.
4
Robert L. Hetzel (2008), The Monetary Policy of the Federal Reserve: A History, Cambridge University Press.
5
Milton Friedman (1963), Inflation: Causes and Consequences, Asian Publishing House.
6
Willem Buiter (2016), "Dysfunctional Central Banking; The End of Independent Central Banks or a Return to
'Narrow Central Banking' - or Both?", Global Economics View, Citi Research, 21 December; Otmar Issing
(2016), "Central Banks - From Overburdening to Decline?", SAFE White Paper Series, No 42.
7
Jakob de Haan and Sylvester C.W. Eijffinger (2017), "Central bank independence under threat?", CEPR Policy
Insight, No 87.
8
Transparency International EU (2017), Two sides of the same coin - Independence and accountability of the
European Central Bank, transparency.eu/wp-content/uploads/2017/03/TI-EU_ECB_Report_DIGITAL.pdf.