Is monetary policy still regulatory policy today?
Speech at the University of Lucerne, Reichmuth & Co Lecture No 19
23.09.2022 | Lucerne | Joachim Nagel
1 Introduction
2 Understanding regulatory policy
3 Price stability is what matters
4 The Maastricht regulatory framework
5 Non-standard monetary policy measures
6 Current environment in the fight against inflation
1 Introduction
Dear Thomas Jordan,
Dear Professor Schaltegger,
Ladies and gentlemen,
Thank you very much for inviting me to this distinguished series of events.
You are in an enviable position here in Switzerland! Not just because of the glorious
scenery here at Lake Lucerne, but also because of the country's inflation rate, which
is admittedly also too high, at 3.5% in August. I would be happy, though, if we had
that rate in the euro area right now, instead of 9.1%.
Yet my counterpart Thomas Jordan and I won't be focusing, like we often do, on
economic activity and price developments today. I am pleased to be speaking on a
subject that is of a fundamental nature but is nonetheless topical and of practical
relevance at the same time.
2 Understanding regulatory policy
Is monetary policy still regulatory policy today? That is a question that is almost
impossible to answer without delving first into what regulatory policy means and
how it originated. But I will keep the backstory brief, I promise.
In some quarters these days, regulatory policy has a bad reputation, is couched in
negative terms, and is sometimes seen as "typically German". [1] Properly
interpreted, though, it is neither a matter of harping on about principles nor
dogmatic. I would like to show you that it offers important insights and serves as
the backbone, so to speak, of a welfare-oriented economic policy - and that it also
sets suitable guidelines for monetary policy. The theoretical roots of regulatory policy
can be traced back to Walter Eucken and other co-founders of the Freiburg School,
who shaped German ordoliberalism.
One hugely important aspect for ordoliberals is competition. But for them, it is not
about a laissez-faire, unregulated interplay between market forces. Rather, the
rationale is to design a framework competitive order in such a way that
decentralised decisions yield the best possible outcomes for the economy as a
whole. For this to be possible, economic power, for example, also needs to be kept
in check. This school of thought posited that government intervention is legitimate
and desirable, provided the interaction of individual decisions produces a better
outcome as a result. Yes, it may even be justified to replace the market mechanism.
Ordoliberalism, then, is by no means an approach that is hostile to government or
regulation.
At its heart, though, is the organisational power resulting from private,
decentralised, individual decisions. These decisions are steered by prices. This is why
a functioning price mechanism is the primary steering function. Undistorted prices
provide key signals and information on the scarcity of goods, say, so that economic
resources can be used to maximise welfare. High inflation rates, for example, disrupt
this signalling and steering function of prices.
Walter Eucken witnessed hyperinflation and the Great Depression for himself, and
his experiences fed into his oeuvre. [2] He understood that a competitive order can
only be made a reality if monetary stability is assured. Thus, Eucken gave priority to
a policy of stable currency, calling this the "primacy of monetary policy". [3]
Eucken's philosophy laid the foundations for German post-war economic policy,
which was built around the concept of a social market economy. The social market
economy made a conscious departure from a planned economy and steering
approaches by combining unfettered market forces with a social safety net. The idea
was that a growing economy should benefit not just a small elite but deliver
"prosperity for all", to use Ludwig Erhard's familiar phrase that became the title of
his famous book. In that book, Ludwig Erhard wrote that the social market economy
is unthinkable without a consistent policy of price stability. This policy alone can also
ensure that individual sections of the population do not enrich themselves at the
expense of others. [4] Ludwig Erhard's policies ultimately made Germany's economic
miracle possible after the poverty of the immediate post-war period. The economy
boomed, wages increased, and broader sections of the population were indeed able
to share in the welfare gains.
3 Price stability is what matters
So what legacy do these origins of regulatory theory and policy represent for
monetary policy nowadays? Can regulatory policy even hold its own under today's
framework conditions?
The main concept that we have inherited, in my view, is the firm belief that
monetary stability is the foundation for economic growth and "prosperity for all".
Hearing a central banker utter those words won't come as much of a surprise to
you. And yes, monetary policy today is still regulatory policy in action, in my opinion.
You see, the chief task of monetary policy in the euro area is to preserve price
stability. This makes it part of the overall regulatory structure, in which it plays a
crucial role. Echoing Walter Eucken's words, Otmar Issing remarked that the primacy
of monetary policy had been reconfirmed by the establishment of European
monetary union. [5]
That said, Walter Eucken was not thinking of a central bank to safeguard price
stability. In his opinion, a good monetary constitution should, like the competitive
order, function as automatically as possible. This is because Eucken warned of
weaknesses in central bankers and their influence. I quote: "... experience shows
that a monetary constitution which gives those in charge of monetary policy a free
hand places greater confidence in them than it is advisably possible to do.
Ignorance, weakness with regard to interest groups and public opinion, incorrect
theories, all these things influence those responsible for monetary policy, to the
great detriment of the task they have been assigned." [6]
As Otmar Issing admitted, Walter Eucken is not a name that springs immediately to
mind when searching for the intellectual antecedents of the euro. [7] What is
noticeable instead is Eucken's general scepticism towards central and uncontrolled
monetary policy institutions. Today's advocates of regulatory policy see central bank
independence in a more positive light. It is precisely this, together with a narrow
mandate, which shields monetary policymakers against being co-opted for political
purposes and is the sine qua non for striving for price stability without compromise.
Last year saw the ECB (European Central Bank) Governing Council complete the
review of its monetary policy strategy, a key component of which was to recalibrate
the manner in which the Governing Council intends to preserve price stability in the
euro area. [8] The Eurosystem is now aiming for an inflation target of 2% in the
medium term. The target is symmetrical, meaning that positive and negative
deviations of inflation from the 2% target are equally undesirable. By setting this
target above zero, monetary policy has a greater safety margin against deflationary
risks.
The medium-term orientation accounts for the fact that short-term fluctuations in
inflation can balance out over time and that monetary policy measures will only fully
feed through into prices with something of a lag. It is therefore inevitable that the
target might be missed in the short term. Monetary policy does not have to hastily
respond to every change in the data. However, the Governing Council very much
does have to respond to signs that the target will be missed over a medium-term
horizon. And the Council has to explain its policy to the general public. That's more
important today than it ever was, given that inflation in the euro area has been
above 2% for more than a year now, and currently exceeds 9%. And it looks set to
persist well above 2% next year, too - the latest ECB (European Central Bank) staff
macroeconomic projection expects the rate to come to 5.5%.
Alongside its narrow mandate focused on price stability, the Eurosystem's
accountability is an important counterpart to its independence. In a democracy, you
see, the general public must be able to understand whether the central bank is
fulfilling its mandate - whether it is doing its job properly. The monetary policy
strategy is also supportive in this regard as a benchmark for successful monetary
policy.
4 The Maastricht regulatory framework
The Maastricht Treaty created the institutional framework for the euro. Besides
enshrining the ECB (European Central Bank)'s mandate and independence, it also
lays down the prohibition on monetary financing of government. This underscores
the separation between monetary policy and fiscal policy. In addition, that treaty
established limits for new borrowing and debt levels so that monetary policy does
not come under pressure in practice and is not forced to step in and support fiscal
policy.
Theory and practice alike have shown just how important sound government
finances are for the success of a stability-oriented monetary policy. The Maastricht
regulatory framework has the single monetary policy on the one side and the
national fiscal policies on the other. The Stability and Growth Pact then followed
soon thereafter, fleshing out the provisions of the Maastricht Treaty. In practice,
though, this set of rules lacked binding force.
The European Commission will now soon be presenting its proposals on the reform
of European fiscal rules. The Bundesbank also sees a need for reform. [9] Above all, it
is important that the rules are designed to be transparent, comprehensible and
verifiable enough to ensure greater credibility and binding force than in the past.
Clear, quantified requirements are crucial for this. These need to be selected in a
way that high debt ratios can be relied upon to decline if the rules are complied
with. While flexibility and discretionary leeway are needed as well, too much of this
undermines the rules and counteracts their purpose, which is to effectively limit
government debt.
This brings me back to the question of whether regulatory policy still has a place, or
whether it is a relic that has outlived its usefulness. I think the review of the
monetary policy strategy and the forthcoming reform of the fiscal framework
exemplify two things. First, that a clear regulatory framework is needed. Viewed
through this lens, the rationale underpinning regulatory policy is timeless: it is about
creating an overall regulatory policy structure with the appropriate institutions in
which the economy can thrive and deliver prosperity for all. Second, as part of this
framework it must be possible to adapt, as and when necessary, to an evolving
environment, new insights and weaknesses that come to light so that it can
continue to deliver the best possible results.
5 Non-standard monetary policy measures
The global financial crisis and the euro area debt crisis showed that the regulatory
framework enshrined the Maastricht Treaty only works well if the rules set forth
therein are rigorously adhered to. In the years that followed, monetary policy
operated in a setting characterised by very low inflation rates and proximity to the
lower bound.
The Eurosystem's monetary policy responded to this with unconventional measures.
The various non-standard measures were designed to counter the risk of
deflationary tendencies and safeguard the transmission of monetary policy.
Additional instruments were deployed, such as targeted longer-term refinancing
operations for banks, forward guidance and purchases of private and public
securities. From a regulatory perspective, it was particularly the purchases of
government bonds that came in for criticism.
Large-scale government bond purchases create undesirable incentives for
policymakers and risk blurring the boundaries between monetary and fiscal policy.
[10] There was no shortage of critical remarks, such as "regulatory lapse" [11] or
"capitulation of regulatory policy". [12] One thing is for sure: unconventional
measures have to be justified on monetary policy grounds. They also need to comply
with the prohibition on monetary financing of government. And they must be
proportionate.
"Unconventional monetary policy - a regulatory policy appraisal" was the title of a
speech delivered by the then ECB (European Central Bank) Executive Board member
Yves Mersch, [13] in which he argued that the European Central Bank's actions were
motivated by monetary policy and consistent with regulatory policy principles.
Mersch added, though, that "at the same time, we should be under no illusions that
these market interventions are sometimes significant. For this reason, too, our
market interventions are explicitly defined as non-standard measures and are not
intended for the long term. It could also be said that the objective of our
unconventional measures is to make themselves superfluous."
Well, the persistently low level of inflation meant that the net purchases of
government bonds continued for quite some time. Under the public sector purchase
programme, or PSPP (Public Sector Purchase Programme) for short, net asset
purchases ultimately went on for seven years - from March 2015 to June 2022 (with
a break in 2019). And the pandemic emergency purchase programme (
PEPP (Pandemic Emergency Purchase Programm)) introduced in response to the
monetary policy challenges posed by the coronavirus crisis saw government bonds
being purchased in net terms from March 2020 to March 2022. However, unlike
under the PSPP (Public Sector Purchase Programme), the Governing Council granted
a degree of leeway under the PEPP (Pandemic Emergency Purchase Programm) by
allowing the net asset purchases to deviate temporarily from the
ECB (European Central Bank) capital key so as to provide a targeted response to
pandemic-related risks to transmission.
Principal payments from maturing securities under both programmes are being
reinvested, so the stocks of assets are not declining yet. After net asset purchases
under the PEPP (Pandemic Emergency Purchase Programm) were discontinued, the
possibility of deviating from the capital key was retained for the reinvestment phase.
The flexibility of reinvestments under the
PEPP (Pandemic Emergency Purchase Programm) is intended to counteract further
pandemic-related risks to the transmission of monetary policy.
Picking up on what Yves Mersch said, I believe it is important that we swiftly end
our non-standard measures once they have fulfilled their task.
In addition, other programmes have been adopted in principle to safeguard the
monetary policy transmission mechanism: the
OMT (Outright Monetary Transactions) programme from 2012 and the recently
adopted Transmission Protection Instrument (
TPI (Transmission Protection Instrument)). Subject to certain criteria, the
TPI (Transmission Protection Instrument) enables targeted purchases of individual
jurisdictions' government bonds in particular as a way of countering market
dynamics that are not warranted by the fundamentals. These market dynamics must
furthermore pose a serious threat to the transmission of monetary policy such that
the preservation of price stability would be at risk.
From a regulatory policy perspective, focusing on certain countries' bond yields is
obviously a balancing act. On the one hand, it is about ensuring a functioning
transmission mechanism. On the other hand, there is the danger of intervening in a
market that is actually still functioning or of governments having less of an incentive
to put their public finances on a sustainable path.
For this reason, the TPI (Transmission Protection Instrument) contains safety
precautions. Hence, before making any purchases the Governing Council will
consider a list of criteria to assess whether the jurisdictions in which the Eurosystem
may conduct purchases under the TPI (Transmission Protection Instrument) pursue
sound and sustainable fiscal and macroeconomic policies. This examination needs to
be rigorous and consistent, including and especially when it comes to assessing the
debt sustainability of Member States.
I would, however, like to reiterate that the objective of the
TPI (Transmission Protection Instrument) and OMT (Outright Monetary Transactions)
is precisely not to influence government bond yields as one sees fit, thereby
disabling the signals sent by prices. Instead, it is merely about countering those
shares of yields that cannot be tallied with the Member State's fundamentals so as
to ensure the functioning of the transmission mechanism. Since situations like these
come up rarely - fortunately - and are not easy to identify - unfortunately - a
decision by the Governing Council to activate the
TPI (Transmission Protection Instrument) is to be based on a comprehensive
assessment of market and transmission indicators, so that there is sufficient
evidence that transmission is disrupted.
6 Current environment in the fight against inflation
Ladies and gentlemen,
The main issue right now is the fight against inflation. Historically high inflation rates
are posing a stiff challenge for monetary policy. We central banks must not leave
any doubt that we take this test very seriously, and that we shall prevail.
The ECB (European Central Bank) Governing Council acted decisively with the two
significant key interest rate hikes totalling 125 basis points in July and September.
Further tightening steps have been signalled and will have to follow, in my view.
I make no secret of the fact that combating inflation will create burdens. It is likely
to temporarily dampen growth. But doing nothing and letting things run their
course is no alternative. Inflation erodes prosperity. It depresses economic
participation because it hits the weakest hardest. This puts it at odds with promises
to deliver "prosperity for all".
Monetary policy and its toolkit evolve over time. That's because new academic and
scientific insights come to light, but it's also primarily due to changes in the
economic environment. Over time, monetary policy needs to be updated, as it were,
to enable it to perform its statutory - and crucial regulatory policy - mandate of
preserving price stability.
Time and again, crises, or transmission disruptions triggered by market failures,
might necessitate new interventions. However, these updates need to remain within
the guidelines. In particular, account needs to be taken of the specific challenges
inherent in the euro area, whose regulatory framework is enshrined in the European
Treaties.
I am aware that some of the updates carried out in the Eurosystem bring with them
regulatory policy risks. That is why, when I look at the
TPI (Transmission Protection Instrument), there is an important point to bear in
mind: if temporary activation were to be considered, we have to be able to provide
compelling evidence that we would be correcting a fault in the markets that is
severely restricting monetary policy.
If we confine ourselves to necessary regulatory interventions, I am convinced that
good monetary policy remains, to this day, regulatory policy in action.
Thank you very much for your attention. I am now eager to hear what my Swiss
counterpart has to say on this topic. And I look forward to our discussions
afterwards.
Footnotes:
1. Young, B. (2017), Ordoliberalism as an 'irritating German idea', in
Ordoliberalism: A German oddity?, pp. (pages) 31 ff.
2. Eucken, W. (1923), Kritische Betrachtungen zum deutschen Geldproblem, Jena;
Eucken, W. (1951), Unser Zeitalter der Misserfolge. Fünf Vorträge zur
Wirtschaftspolitik, Tübingen.
3. Eucken, W. (1952/1990), Grundsätze der Wirtschaftspolitik, 6th edition,
Tübingen, pp. (pages) 255-256.
4. Erhard, L. (1957/1964), Wohlstand für Alle, 8th edition, Düsseldorf, p. 15.
5. Issing, O., Walter Eucken: vom Primat der Währungspolitik, speech in Freiburg
on 7 March 2000.
6. Eucken, W. (1952/1990), Grundsätze der Wirtschaftspolitik, 6th edition,
Tübingen, p. 257.
7.Issing, O., On the primacy of price stability, speech in Prague on 10 June 2004.
8. Deutsche Bundesbank, The Eurosystem's monetary policy strategy, Monthly
Report, September 2021, pp. (pages) 17-60.
9. Deutsche Bundesbank, Public finances in the euro area: current developments
and challenges, Monthly Report, June 2022, pp. (pages) 75-81; Deutsche
Bundesbank, written statement by the Deutsche Bundesbank on the European
Commission's public consultation on the EU (European Union)'s economic
governance review, October to December
2021, https://www.bundesbank.de/content/884874
[/en/homepage/public-debate-on-the-review-of-the-eu-economic-governance884874]
, December 2021.
10. For example, Weidmann, J., Bundesbank round-up, in Deutsche Bundesbank,
Annual Report 2020, p. 22.
11. EZB (Europäische Zentralbank): Ordnungspolitischer Sündenfall (wiwo.de)
[https://www.wiwo.de/politik/konjunktur/ezb-ordnungspolitischersuendenfall/9779322-3.html]
.
12. Die Kapitulation der Ordnungspolitik » Ludwig Erhard Stiftung - Ludwig Erhard
Stiftung (ludwig-erhard.de)
[https://www.ludwig-erhard.de/erhard-aktuell/standpunkt/die-kapitulation-derordnungspolitik/]
.
13. Mersch, Y., Unkonventionelle Geldpolitik - eine ordnungspolitische Würdigung,
speech in Freiburg on 16 June 2016.