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The evolving nature of central banking: Where next for Europe?
German and Italian history reveals evolving institutional structures and central banking models; ongoing changes at the ECB are only the latest manifestation of this historical process
EDITORIAL COMMENT: The posts on the Money Inside and Out Substack are normally written by Exante Data team members. But today we are making an exception, by having Francesco Papadia provide the first guest post on this stream. Francesco is most known for his time as Director General for Market Operations at the ECB. And we always value his opinions on European policy matters. The views in this Substack are not necessarily shared by Exante Data. But they might be. Since we like to provide a diverse set of global perspectives, we generally welcome guest writers. Hence, reach out to us on email@example.com if you have a specific proposal that fits the format and topic of the blog:
Daniel Kahneman earned a Nobel prize in economics, curiously not having ever had a course in this field, for having developed and researched his basic intuition that we think in two modalities: the fast and the slow one.
I think there is something of an analogy in economic developments: some are slow, producing effects only in the medium to long run. Some others are fast, resulting in short-run changes. Both are important for economic agents, whether they are investors, consumers, workers, producers or public authorities. Under the urgency of events, however, there is a risk of focusing on fast-moving developments, leaving the slow ones for another day. I indulged myself in this attitude in my long years as responsible for market operations at the ECB. In this short contribution, I would instead like to address slower-moving developments which will, eventually, produce profound effects, which it is wise to ponder over.
The changing nature of central banking
My story starts with the central banking model that had come to prevail, practically in all advanced economies, at the end of the last century: an independent central bank, with the dominant objective of price stability, pursued by changes in interest rates, along Wicksellian lines and according to some version of Taylor’s rule, controlled through a corridor approach. The Great Recession and then, in relatively quick succession, the Covid 19 crisis drastically changed that model. Tenets of that model were: the exclusive focus on very short-term interest rates, the separation between fiscal and monetary policy—with the latter having the upper hand—and the avoidance, in central bank action, of resource allocation as well of income and wealth distribution aims.
Now we have: monetary policy strongly interacting with fiscal policy, in a modality which cannot be characterized as fiscal dominance but not as separation either; central banks actively caring about resource allocation as well as income and wealth distribution; and engaging, either in the explicit form of Yield Curve Control or in the more implicit variant of Quantitative Easing, in permanent “twist” operations. Another important and recent change for the ECB is that it now supervises banks in the euro-area.
All these changes were dictated by events and, even if I dislike some of them in principle, I believe they were all necessary, given the two crises the global economy went through.
This creates an inner dilemma out of which I see only two pleasant paths: either, once the Covid crisis is over, we get back to the old central banking model, with the experience of the last 15 years or so just an important detour; or we find a new model, as elegant and effective as that prevailing until 2008. A third possibility, which I do not wish, is that we go back to the model of central banking under fiscal dominance. Let me be very frank and admit that I don’t know which one of these three possibilities will prevail, and even less which could be the new prevailing central banking model, if we would indeed come to that. What I can do is to try and find some inspiration from looking at the intellectual bases of the most important change in central banking history after the establishment of the Federal Reserve in 1913: the creation of the ECB in 1998. Then I will dwell on some possible scenarios.
To address the intellectual bases of the creation of the euro I can draw from a book I have recently edited with Thomas, Mayer, Christiane Liermann and Matteo Scotto: The Value of Money: Controversial economic cultures in Europe, Italy and Germany.
Lessons from history
The book starts from a staggering observation: between 1973 and 1998 the lira lost 83 per cent of its value towards the D-Mark: this observation leads to the conclusion that Italy and Germany had different, indeed radically different, central banks as well as very different economic results.
The Bundesbank model is extensively illustrated in the book: its critical features are independence and a nearly exclusive emphasis on price stability, which were squarely transposed in the ECB design of the Maastricht Treaty. Rules, drawn from the monetarist approach, were also visible in this model at the expense of discretion, while bank supervision was shunned, lest it affects monetary policy. Fiscal policy, of course, came to be dictated by the Stability and Growth Pact rules.
The Banca d’Italia model is more Keynesian oriented, gives more weight to discretion rather than rules, sees bank supervision as an essential task of the central bank, strives for independence, but recognizes its limits.
There is no doubt that the Bundesbank was more successful than Banca d’Italia between the end of the Bretton Woods system in 1973 and the creation of the euro: the point made above about the large depreciation of the lira is reinforced by looking at the behaviour of inflation and interest rates, confirming that monetary stability was much better achieved in Germany than in Italy during this period.
However, a central message of the book is that monetary stability does not depend only on the action and institutional setup of the central bank. Fiscal policy, wage behaviour and, beyond them, economic cultures are critical factors. The book also documents that these factors change over the long run, so much so that monetary stability was better preserved in Italy than in Germany in the long period between the nearly contemporaneous creation of the two unitary states after the middle of the nineteenth century and the creation of the ECB in 1998—even after removing the German hyperinflation of the 1920s and monetary reform after World War II!
Even a cursory look at the ECB shows that it has now different characteristics than the Bundesbank: in 20 years, more reacting to economic developments than implementing a blueprint, the ECB has acquired some Banca d’Italia features, such as bank supervision, discretion and collaboration with the treasury, while remaining faithful to its statute and thus maintaining the essential characteristics of the German model.
In the grand scheme of things, I rate the ECB as a successful experiment, notwithstanding its important failure to reach the inflation objective now for about a half of its life. My positive judgment is based on two facts: first, the ECB did practically all it could to reach its objective; and second, too low inflation has been a phenomenon affecting practically all advanced economies central banks.
I take the pragmatic adaptation of the ECB to changing circumstances, and in particular the Great Recession and the COVID-19 crises, as a positive omen for subsequent changes: the ECB has shown its ability to adapt, and I expect that it will further show this ability going forward and successfully participate to the international search for a new central banking model. I don’t know what this model could be, but I am optimistic that the ECB will effectively contribute to its search and implementation.
The best I can do is to build some scenarios to start transforming the general points I have made so far into something that could be useful in planning for the future. The scenarios are built around three variables, which for simplicity I assume exogenous: central bank independence, sound fiscal/wage developments, global inflationary pressures. Out of the scenarios that could be obtained by combining these different variables, I choose the 4 in the enclosed table.
Looking at the rows one by one, one can draw the following conclusions:
· If the central bank is independent, domestic fiscal and wage developments are sound, or sustainable if you prefer, we are in an “All is well” situation and it does not matter whether there are global inflation pressures (either of the kind prevailing in the 1970s or those foreseen by Charles Goodhart due to demographics) or not, in any case there will be neither inflation nor tensions as the central bank would be able to offset global inflationary pressures, possibly letting the exchange rate appreciate. This case looks like the experience of the Bundesbank.
· If the central bank is dependent, as in the second row, “Good luck” is needed, to bring sound fiscal and wage developments and no global inflationary pressures, here again, there is neither inflation nor tensions. However, if there are global inflationary pressures, the dependent central bank may find it difficult to offset them and inflation could follow.
· In row three, the central bank is again not independent while fiscal and wage developments are not sound, in this case it does not matter whether there are global inflationary pressures or not, inflation will be generated since “No Control” is exercised by the central bank .
· In the last row we have a “Clash of the Titans” since the central bank is independent, but domestic wage and fiscal developments are not sound. In this case, whether there are also global inflationary pressures or not does not matter, there will unavoidably be tensions and unemployment as the central bank resists the domestic inflationary pressures. The experience of Banca d’Italia after 1973 and until 1998 can be seen as an average of rows three and four: it tried to resist both unsustainable fiscal and wage developments as well as global inflationary pressure but was finally overwhelmed.
Of course, one could build other scenarios, either with these same variables or adding other ones. Scenario analysis does not deliver central forecasts. Still, it is a useful thought organizing device. Consider this short piece as a contribution in this direction.
Appendix: Brief Biography for Francesco Papadia
He was, between 1998 and 2012, Director General for Market Operations at the European Central Bank. He worked previously at the Banca d'Italia. Currently, Senior Fellow at Bruegel and Chair of the Selection Panel of the Hellenic Financial Stability Fund (HFSF) and of Prime Collateralised Securities.
His most recent co-edited book looks at the economic cultural origins of the euro project - The Value of Money. His previous book, Central Banking in Turbulent Times, asks whether the model of an independent central bank devoted to price stability, which prevailed before the Great Recession, has been irrevocably altered.