Christine Lagarde: the renovator of the house Duisenberg built?
In the years following major crises in financial and sovereign sectors, a period of uncertainty has seemed to fall upon central bankers across the world, as they re-evaluate the efficacy and viability of their missions and the tools they use to best accomplish them. While disagreement on technicalities of monetary policy remains plentiful, one thing is for sure: now is the time to begin the reinvention of the central banking system.
This very debate is already occurring in many central banks, as they deepen into negative interest rates. The last decision of the outgoing European Central Bank president Mario Draghi to further reduce the deposit rate to a record low -0.5% and to pursue its €2.6tn quantitative easing program drove a new stake into the already divided Governing Council of the ECB, leading to the departure of Sabine Lautenschläger two year before the end of her mandate .
The war is being waged with a knife drawn. Last October, a group of former central bankers, led by Helmut Schlesinger, the former president of the Bundesbank, and backed by Jacques De Larosiere, a former governor of the Banque de France, published a memorandum  against the loose monetary policy of the ECB. They deemed inflation to be high enough, 1.3% in 2019, and posited that the Eurozone would not be substantially threatened by a deflationary spiral. On the contrary, they held that reducing the interest rate endangers the Eurozone, given that the central bank would be moving into uncharted territory. They warned: “The longer the ultra low or negative interest rate policy and liquidity flooding of markets continue, the greater the potential for a setback”.
The crux of this disagreement centers on what level of inflation corresponds to the definition of price stability decided by the Maastricht Treaty in 1998. At the time, the definition of price stability was “less than 2% in a medium-term perspective”. Then, in 2003, the ECB Governing Council clarified its definition on the back of criticism from several economists, who argued the ECB had too large a range for inflation, from 0% to 2%, including that deflation could appear as part of the mandate, close to 0%. The amended definition was then “below but close to 2%”. A decision to clarify was followed by the US Fed and the Bank of Japan, respectively in 2013 and in 2014. They followed in suit, also targeting 2% inflation in their definition of price stability.
Still, inflation in the European Union registered at 1.3% in 2019 and is expected to fall to 1.1% in 2020. Responding to the critics of the low rates, Jean-Claude Trichet, the former president of the ECB, defended his mandate and his successor M. Draghi by explaining that the ECB still needs a boost to support inflation and that the new package is welcome. He added that the ECB succeeded in achieving its primary goal, citing average yearly inflation of the euro area, which has been hovering around 1.7% since 1999.
In his answer , Trichet refutes the argument that their inflation range target was from 0% to 2% “Contrary to what is written in the memorandum, it is not in 2014 that the ECB concluded that a low inflation could create a deflationary risk”. He also responded that the ECB’s definition of price stability included informally symmetry, a concept which says that periods of low inflation should be compensated by higher levels of inflation in the medium term. However, he specified that “symmetry does not imply a kind of mechanical rule that periods when inflation has been lower than the target must be compensated by equivalent periods when inflation is higher than the target”.
The appointment of Christine Lagarde as head of the European Central Bank comes at a crucial time in the Eurozone’s history, when brinkmanship is more prevalent than ever and technical arguments are sacrificed in lieu of more impassioned, partisan ones. More than anything, the move is seen as a political decision, given that her qualities as a negotiator are recognized and will be useful in reconciling the members of the Eurozone on the way forward for European monetary policy . Placation of the advocates of flexible monetary policies, known as doves, with those solely concerned with more austere policies keeping inflation low, nicknamed hawks, seems to be the first thing on the agenda. She announced at a press conference: “Once and for all, I am neither a dove nor a hawk, my ambition is to be this owl, that is often associated with a little bit of wisdom.”
During her first press conference, Lagarde announced that the Central Bank would reconsider the inflation target that defines its core price-stability mandate, along with the effectiveness and potential side-effects of the tools used to achieve it. A new strategic review  is more than welcome, as, over the past eight years, the European Central Bank largely failed to achieve its primary objective of price stability, despite several interest rate cuts and the expansion of its balance sheet up to 2.6 trillion euros of bond purchases. Clarifying or changing the definition of price stability might help policy makers finally hit their mandate.
A review of various implemented monetary policy tools is also necessary. Many people are worried that the ECB has nothing left in its toolkit to react to a new crisis or economic downturn, leaving the Eurozone susceptible to events out of their control, such as the trade war between US and China and the threat of the coronavirus on foreign markets.
Her ambitious review will also include a reflection on how much the central bank should do to tackle climate change by promising to examine “how other considerations, such as financial stability, employment and environmental sustainability, can be relevant in pursuing the ECB’s mandate.”
Despite more qualitative progress in light of Lagarde’s appointment and the slow cooling of relations between central bank ideologues, negative interest rates remain, signalling danger on the horizon.
Firstly, it means that investors will continue to lose money on government bonds offering a negative rate. Rudimentary economic theory teaches us that negative bond rates are supposed to encourage investment, rather than the possession of a safe but costly asset. However, many investors still prefer losing money rather than putting their capital in risky ventures, where they see no real growth perspective .
Secondly, it means that countries that would be considered non-liable in normal times now have access to low interest rates, even if they still entail financial risk, such as Greece. Greece sold debt offering a negative rate for the first time in October 2019 . Despite structural progress and growth expected to reach 2.8% in 2019, the long-term viability of such a solution is questionable at best, especially when considering that Greek bonds were offering 30% yield in 2012.
Thirdly, some economists warn that low interest rates create zombie firms, defined by the OECD as firms that would no longer be alive and would have gone bankrupt if interest rates were normal. The number of these zombie firms as a proportion of all firms rose to a staggering 16%, according to the Bank For International Settlement . A famous paper studying the effect of zombie firms in Japan during the 1990s, written by Ricardo Caballero, Takeo Hoshi and Anil Kashyap, described the relationship between the rise of zombie firms and the decline in productivity gains, something that normally triggers inflation .
Last but not least, a recent paper written by economists Ernest Liu, Atif Mian and Amir Sufi argues that big companies use low interest rates to borrow with leverage and invest in startups and rivals. Market concentration rises when interest rates fall, thus limiting productivity . (You can read an article by Jeppe Damberg on the rise of monopsy and its impact on inflation.)
However, we can also look at low interest rates as an opportunity to rethink fiscal austerity. French economist Daniel Cohen says “the obsession to reduce debt no longer means anything when getting into debt means making money”. But Lagarde will have to persuade orthodox countries such as Germany to change their minds.
Above all, Lagarde will have to convince the member states to boost investment through expansionary fiscal policy, something that many advising economists already encourage many sovereigns to do. (You can read an article about the limits and legality of the Asset Purchase Program by Marie Holzer.)
These investments can then be made to finance, for instance, the environmental transition, or other non-inflationary tasks on the ECB docket. According to the European Commission, investments of at least 260 billion euros each year until 2030 would be needed in the areas of energy efficiency, renewable energy and other green energy to meet the target of the COP 21 .
This is why President Lagarde sees this situation as an opportunity to rethink the central banking system completely, and ended her address in a similar vein by quoting Cohen, the singer this time: “There is a crack in everything that’s how the light gets in”.
 Ricardo J. Caballero & Takeo Hoshi & Anil K. Kashyap, 2008. “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review, American Economic Association, vol. 98(5), pages 1943-77
 Liu, Ernest and Mian, Atif R. and Sufi, Amir, Low Interest Rates, Market Power, and Productivity Growth (August 1, 2019).