Christine Lagarde Should Worry Less About the Germans Now

(Bloomberg Opinion) -- The stakes couldn’t be higher for Europe. With the U.S. Federal Reserve aggressively cutting interest rates to buoy the U.S. economy in the face of the Covid-19 crisis — and the Bank of England following suit — a “too little, too late” policy on the part of the European Central Bank risks sending the euro soaring to uncompetitive levels and Europe into recession.

European policymakers should keep in mind that in March 2015, it was the soaring euro that forced the ECB to adopt quantitative easing to bring its monetary policies in sync with those of the U.S., which had begun easing in 2008. The ECB had sought initially to take an independent path and not resort to QE but the euro rising to $1.40 put a stop to that.

Former ECB President Mario Draghi, whom I met with regularly during that period to discuss this very issue, understood and fretted about the fact that the Germans would be very much against the move to QE. He nonetheless chose to protect the entire euro zone economy from deep recession and possible deflation, incurring the wrath of ECB hawks and Germans in the process.

That is precisely the model that the ECB should follow in the face of the coronavirus crisis; if the central bank wants to avoid a surging euro in addition to the direct economic dislocations attributable to the virus, the key is to get its monetary policies as stimulative as those in the U.S.

That seems unlikely under Draghi’s successor, Christine Lagarde. The recent arguments made by several ECB officials, that the best way to counteract the economic effects of the virus is fiscal policy, not monetary policy, hint of a “too little, too late” response that significantly raises the odds of a soaring euro and recession.

So far, apart from Italy, there has been no large-scale fiscal policy response from EU countries to match the monetary stimulus in the U.S. (or the fiscal measures now under consideration from the Trump administration). That may change as Britain unveils its new budget Wednesday, and as the virus spreads to more regions.

What is particularly worrisome about the Covid-19 crisis is that it comes at a time when Lagarde is pursuing a political agenda of restoring unity to the ECB’s governing council and improving the ECB’s standing in Germany. That agenda made good sense. Years of QE built up resentment among German savers; many saw it as an expensive subsidy for poorer, less fiscally prudent euro zone countries.  

However well-meant, Largarde’s strategy increases the chances that the ECB will make a major policy mistake. To promote unity on the governing council, Lagarde is showing sympathy for the argument that the ECB is running out of ammunition, a line ECB hawks such as Austrian Central Bank Governor Robert Holzmann, the Dutch central banker Klaas Knot and Bundesbank President Jens Weidmann have been pushing to limit further monetary stimulus.

The argument, however, is a red herring. If the ECB wants to replenish its supply of bullets all it has to do is relax the political constraints it has placed on its QE program, through which bond purchases are limited to one-third of a country’s overall public debt and also to no more than one-third of a specific debt issue. This so-called “capital key” was established to keep the ECB from breaching the EU’s prohibition against the monetary financing of public government debt. But there’s nothing magical about the ECB’s formula; it’s a political fudge, though one that has held up so far against legal challenges.

In other words, the ECB is not running out of bullets if it can replenish the supply with a simple political act. Yet it’s precisely that simple political act and the predictably bitter fight over a rules change between ECB doves and hawks that Lagarde wants to avoid.  Hers is the opposite of Draghi’s “whatever it takes” approach, which sacrificed the good feelings of ECB hawks and Germans toward him for the sake of the health of euro zone’s overall economy.  

Lagarde’s reluctance to offend the Germans, coupled with further cuts in European interest rates, suggest that the ECB’s  response to the Covid-19 crisis will be too timid. Monetary policy can’t cure the problems the virus causes. But it can disrupt the exchange implications.

The virus creates a momentum toward recession that will put downward pressure on the euro. But if monetary authorities in Europe refuse to match the Fed’s stimulus, the natural exchange rate response is thwarted. The result will be a strengthening euro against the dollar, imposing an additional burden on the euro zone economy that it doesn’t need right now. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Melvyn Krauss is a senior fellow at the Hoover Institution at Stanford University and an emeritus professor of economics at New York University.

©2020 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.