Challenges for New ECB Head – Will Christine Lagarde Pursue Tighter Monetary Policy?


By Tim Bartz, Martin Hesse and Christian Reiermann

As Christine Lagarde prepares to head the European Central Bank, the ECB’s critics are urging her to stop the flow of cheap money. At stake is the economic stability of eurozone member states — and the savings of millions of ordinary people.

If there’s one thing Christine Lagarde can’t complain about as she prepares to take over the presidency of the European Central Bank on Nov. 1, it’s that there has been a lack of care on the part of her predecessor. There are only three months left before Mario Draghi vacates his office in the imposing double towers in Frankfurt’s Ostend neighborhood, and until then, his goal is to provide his successor with as smooth a start as possible.

And so it was on Thursday, after the meeting of the Governing Council, that Draghi did everything in his power to prepare the European public for the further loosening of monetary policy. “A significant degree of monetary stimulus” continues to be necessary, he announced. The ECB didn’t mention any concrete measures, but in view of the bleak economic outlook, Draghi indicated that he wanted to lower interest rates again in the autumn. He would also like to relaunch the purchasing program for government bonds, which the Germans are particularly suspicious of. In short, Draghi is plotting a course to maintain the status quo.

The latest figures provide him with useful fodder: The International Monetary Fund (IMF) expects growth of only 1.3 percent in the eurozone this year, with Italy and Germany delivering especially weak performances. Meanwhile, inflation in the currency area is stuck at 1.3 percent, far below the ECB’s target.

Flooding the Markets With Money

In view of the weak forecasts, it seems appropriate to boost growth with cheap money. But Draghi’s radical easing course harbors risks and side effects. At the same time, there is growing concern that the ECB, under the leadership of the ex-politician Lagarde, may be tempted to yield to growing pressure from governments to provide cheap money on a permanent basis, making it easier for them to service their debts. But the Fed, the central bank in the United States, is currently experiencing just how difficult this can be. It will likely yield to the constant pressure from U.S. President Donald Trump and lower interest rates soon.

Banks and depositors are already feeling the downside of the ECB’s low-interest policy. Fixed deposit and overnight money accounts are barely yielding any interest anymore — and that is unlikely to change anytime soon. In addition, now depositors are threatened with penalty fees for having too much money in their accounts, fees that in past have been directed largely at credit institutions or big companies. Life insurers, pension funds and financial institutions are already suffering from the fact that it is growing increasingly difficult to invest in profitable ways.

Lagarde will likely maintain Draghi’s course for the foreseeable future. As the head of the IMF in Washington, she has earned a reputation for viewing central banks as a kind of all-purpose weapon for all sorts of problems. Under her aegis, the IMF regularly urged central bankers to flood the markets with money. As head of the ECB, she’ll likely tone down her rhetoric, but her election is a further sign that the German central bank’s time as a role model for the ECB has come to an end. When the ECB was founded 20 years ago, the Bundesbank provided both organizational and conceptual inspiration. The Germans, in particular, were skeptical and needed to be convinced of the stability of the euro. To this day, the Bundesbank is regarded as the seat of the monetary policy hawks, as those who advocate a strict course geared toward price stability are called.

Hawks vs. Doves

Under Draghi’s patronage, however, the so-called doves — the supporters of monetary easing measures by the ECB — have gained the upper hand. Draghi is the first ECB president who did not raise interest rates a single time during his entire term in office. Of course, this largely had to do with the fact that the sovereign debt crisis threatened to completely destroy the eurozone.

At the same time, Draghi has also refrained from bringing the key interest rate back up from zero as the economy has recovered. The interest rate turnaround that was announced months ago has so far failed to materialize. And Draghi has continued to buy bonds. As a result, the ECB is poorly equipped for the impending economic downturn.

And now, of all times, the Executive Board, which heads the ECB and prepares the decisions of the Governing Council, is struggling with a brain drain of sorts. Chief Economist Peter Praet left in May, while Vice President Vitor Constancio said his goodbyes a year ago. Benoit Coeure, another board member, is also planning to leave this year.

Experienced monetary policymakers and seasoned economists are increasingly being replaced by former government ministers without any real monetary policy experience. Lagarde’s deputy, Luis de Guindos, left the Spanish government directly for the ECB’s Executive Board. Lagarde, for her part, used to be France’s finance minister. The ECB’s new chief economist, Philip Lane, who was previously the head of Ireland’s central bank and a university professor, is the only economist with academic merits on the board.

“The danger of a politicization of monetary policy is clear,” warns Clemens Fuest, the head of the Ifo Institute, a Munich-based economic think tank. Low inflation apparently gives politicians the idea that monetary policy can be a panacea without costs or risks. “It’s seductive and it pressures central banks to justify themselves, and at the same time, it’s very dangerous,” Fuest says.

He views Lagarde’s appointment favorably, “but she should make it clear to the public as soon as possible that she stands for an independent monetary policy and for an ECB that is limited to its mandate,” Fuest says.

Back-Door Remedies

Ansgar Belke, an economics professor at the University of Duisburg-Essen, sees the recruitment of ex-politicians as an attempt by euro member states to remedy a fundamental error in the currency union through the back door. The eurozone’s central monetary policy lacks a fiscal counterweight. “The appointment of former finance ministers to the Executive Board of the ECB has indirectly brought fiscal policy interests on board at the central European level,” Belke says. Many finance ministers in the member states seem to be OK with this at a time when the lines between monetary and fiscal policy are blurred and when the ECB is involved in bailouts for cash-strapped states, handles banking supervision and, by buying government bonds, ensures that governments have access to cheap money.

When the ECB purchases government bonds, the price of those bonds rises and interest rates fall as a result. Higher inflation would also take some of the pressure off eurozone countries, including those currently facing high debt loads like Greece and Italy, but also Lagarde’s home country France.

Since 2008, the average interest rate on Italy’s national debt has fallen from 4.9 to 2.8 percent, saving the country 260 billion euros ($289 billion). For all countries in the eurozone, interest savings over the past 10 years came out to 1.4 trillion euros, according to the Bundesbank’s calculations. Germany, too, has benefitted: From 2008 to 2018, federal, state and municipal governments have saved almost 370 billion euros in interest payments.

The ECB has increasingly become a lender to the euro member states. Its balance sheet contains more than 2.6 trillion euros worth of government bonds. This corresponds to 22 percent of the eurozone’s economic output. The hawks on the ECB Governing Council fear Lagarde could now begin seeking debt relief for highly indebted states, such as Italy, by printing money.

German Reservations

Resistance within the central bank is unlikely. When he was in the running for the ECB’s top job, Bundesbank President Jens Weidmann, abandoned his previous criticism of the European Central Bank’s bond-buying programs in what many observers saw as an effort to make the candidate more palatable to other eurozone countries. Now that he has come away empty-handed, those reservations could well return. Otherwise, Lagarde is striking a chord in the ECB’s Governing Council, according to insiders at the bank. “There’s a broad majority among the doves,” says one German central banker.

This does not bode well for depositors in Germany. The future looks bleak for the financial sector, too. Commercial banks can borrow money inexpensively on the capital market, but they have trouble lending it at higher interest rates the way they did before.

Although meager interest rates are a global phenomenon, for which there are myriad reasons, Germans are particularly angry about them. “With its glut of money, the ECB is laying the foundations for a new financial crisis,” says Florian Toncar, financial policy spokesman for Germany’s business-friendly Free Democratic Party (FDP) in the German parliament. “The more unconventional measures the ECB takes on, the less incentive there is for reform,” he believes, with a view to Europe’s southern countries.

“If the ECB mutates into a perpetual interest rate brake, it is risking the next crisis,” says Andreas Jung, deputy leader of the conservative Christian Democrats in parliament. “Cheap money causes a flash in the pan — and all that remains after a flash in the pan is ashes.” Behind the fierce middle-class criticism is not only concern about the savings of Germans, but also fears that the ECB’s cheap money policy could drive new voters to the euroskeptic and right-wing populist Alternative for Germany (AfD) party.

Helmut Schleweis, the president of the German Savings Banks Association (DSGV), points to Japan as a warning. Interest rates there have remained at extremely low levels for more than 20 years, which has contributed to a banking crisis in the country, without the economy regaining its momentum. “If the negative interest rate phase continues or is even further aggravated, this will be clearly noticeable for the economy and for everyone in this country. Given the experience in Japan, we can only warn against underestimating these long-term negative effects,” says Schleweis.

Debatable Impact

More than anything, Schleweis is worried about the business model of the banks whose interests he represents. On Thursday, Draghi hinted that he could further reduce the deposit rate that banks have to pay if they park surplus money at the ECB. Currently, that rate is at -0.4 percent, but it could fall even lower in the future.

Draghis’ penalty interest, or negative interest, is intended to ensure that banks lend money to boost the economy rather than bunker it at considerable expense. That sounds logical, but it is still controversial today, even within the ECB.

The authors of a working paper issued by the central bank in August 2018 concluded that banks issue even fewer loans and instead tend to invest surplus deposits in riskier ways that offer potentially higher returns. As such, the positive impact on the economy is limited and the policy instead creates considerable uncertainty on the financial markets. It’s an astonishing finding that makes the justification for the penalty interest seem absurd.

The authors also have some prominent backers.

“I don’t believe that the higher penalty interest is going to lead banks to issue more loans,” says IFO head Fuest. “It might lead banks to make investments that could backfire and destabilize the system.”

A Growing Problem

German banks, in particular, are suffering as a result of Draghi’s penalty interest. It cost them a total of 2.4 billion euros in 2018. And they cost all banks across the euro zone a combined total of 7.5 billion euros. It is true that the penalty interest on German banks is miniscule and manageable when you consider the 85.5 billion euros that domestic banks and savings banks earned in 2017 alone as net interest income, their primary source of revenue.

But the problem is growing, because even as penalty interest rates are rising, banks’ net interest income has been shrinking for years. This is particularly problematic for institutions to which customers entrust a great deal of money: savings banks and credit unions.

“They still profit from the fact that they have invested money in high interest-bearing investments and granted long-term loans at higher interest rates,” says Oliver Mihm, founder and head of the consulting firm Investors Marketing. But many of these securities and loans are set to expire soon. “In 2020 and 2021, the dangerous interest rate confluence will have full impact on the banks’ interest results and will reduce net interest income by 20 percent or more in the next three years — even at the current interest rate level.”

If the ECB were to lower the deposit rate further, the effect would be even more pronounced, Mihm predicts. So far, many financial institutions assumed in their calculations that the interest rate may soon be raised slightly. But that illusion is now being shattered.

In addition, during the economic upswing of the past 10 years, many banks have dramatically reduced their risk provisions for loan defaults in order to increase their profits. If the economy falters, that could also change abruptly.

Passing Costs Down to Customers

What does seem clear is that financial institutions want to recover the penalty interest in the easiest possible way: through their customers. For some time now, account fees have been rising almost across the board. In some places, banks have introduced penalty interest for particularly wealthy people, a legally delicate step. For example, the Nassauische Sparkasse (Naspa) based on the prosperous city of Wiesbaden, collects 0.4 percent of the deposited sum as negative interest from private customers who have parked more than 500,000 euros in current and money market accounts.

Alternatively, like many other institutions, Naspa is increasingly talking to customers in an effort to convince them to invest their money in shares or funds, for which the banks collect commissions. Germans have always been notoriously wary of stocks and securities, and they display some pretty bizarre behavior when it comes to investing: They’re risk averse, preferring to hold on to their cash and spurn opportunities for the kinds of returns the stock market can deliver.

So what’s to be done? It’s unlikely financial institutions will also introduce penalty interest for small-scale depositors, because doing so would trigger a wave of lawsuits, says Niels Nauhauser of the Baden-Württemberg Consumer Advice Center. He says only borrowers can be required to pay interest. “The Civil Code does not contain negative interest rates for financial investments,” he says.

That may sound reassuring, but there is another term that is creeping into the debate that could prove to be extremely explosive: a “custody fee.” Banks already collect custody and storage fees when they hold securities, jewelry or gold, but in the future the same trick could also be applied to deposits.

‘ECB Policy Has Reached Its Limits’

Larger savings banks and banks have already been charging such custody fees to corporate customers and institutional depositors such as pension funds for some time now. The Stadtsparkasse München savings bank, for example, charges 0.4 percent for balances starting at over 250,000 euro and offers the justification that this is the market standard today. Legally, such fees could also be agreed in the private customer sector, but on an individual basis and not simply by changing the terms and conditions, says Nauhauser.

Peter Schneider, president of the Savings Banks Association of Baden-Württemberg (SVBW), recently made clear where the journey may be heading. If the ECB were to cut interest rates even further and not take countermeasures, there would be no way around a broad front of banks demanding money for the custody of account balances. If the savings banks are preempted by the competition, he says, they will have no choice but to follow suit.

But even if it were possible to pass on at least the full penalty interest burden to consumers, the situation would still remain fragile. “The ECB’s negative interest rates are like a bacteria attacking the immune system of more and more banks,” says bank consultant Mihm. Still, officials in Brussels are unlikely to pay much heed to these complaints from German banks and savings banks. “The EU Commission would like to see a market shakeout in the fragmented banking market, anyway,” he says.

In view of the growing side effects of the ECB’s policy, the question arises all the more as to whether it is achieving its objectives.

Ifo President Fuest has his doubts. “The ECB policy has reached the limits of its effectiveness.” And that’s not good news for Christine Lagarde.





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