Jens van 't Klooster is a political economist at the University of Amsterdam's Department of Political Science. Jens rejoins David on Macro Musings to discuss the changes taking place at the European Central Bank. Specifically, Jens and David talk about the ECB’s recent commitment to a gradual process of monetary tightening, the prospect and limitations of market neutrality in setting monetary policy, the rise of technocratic Keynesianism and questions surrounding the political legitimacy of the ECB’s recent policy decisions, as well as the politics surrounding the ECB’s approach to government debt.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Jens, welcome back to the show.
Jens van ’t Klooster: Yeah, great to be back.
Beckworth: Well, it's great to have you. One, you were last on the show in July 2020. The pandemic had just been started, been going for a few months and we had a fascinating conversation on a paper of yours, about the question of market neutrality when a central bank intervenes and does its thing. And we'll come back to that paper. We'll quickly review it, but I encourage listeners to go back and check out that show, if you haven't already. It was a really fascinating conversation about what does it mean for a central bank asset purchase to be neutral, if at all.
Beckworth: Okay, but we want to move on to what's happened since then, that's July 2020. Here we are in 2022 and man, a lot has happened since we talked last, and at the ECB, a lot of change. A lot of change at the Fed as well, new frameworks in both central banks. Let me just give a quick recap of what has happened at the ECB and you can correct me if I make any mistakes here and flesh out what I'm saying. But the ECB was very aggressive, its balance sheet expanded pre-pandemic from around 37% of GDP to about 70%. The US by comparison went from about 18% to 35%. So that's the assets on this balance sheet relative to the size of the economy. So the ECB has grown about 70% of Euro economy, where the Fed is about 35%. Of course, you look at the Bank of Japan right now, it's around 130%, and Swiss National Bank is 140%. So everything in perspective.
Beckworth: But the ECB has been aggressive. It had new programs. We talked about this last time, the Pandemic Emergency Purchase Programs. The LTROs, we've talked about those before and I think most importantly, a new framework for the ECB. So I want to get to that. Before we get to those details though, Jens, I want to talk a little bit about what the ECB is doing now, just to kind of get this conversation going. So the ECB recently announced it's going to take a very gradual slow approach to tightening. It might start tightening in the third quarter, which is very different than the Fed. The Fed is eager to go, already has rate hikes. They're talking about half a percentage point increase, maybe even 75 basis point increase here soon, where the ECB has taken it easy, very slow.
Beckworth: I read one Financial Times article where Otmar Issing was very shocked and alarmed by this and gave dire warnings that the ECB is going to get sucked into an inflation spiral. But I think the argument can be made what's happening in Europe is very different than what's happening in the US. I think in the US, you can make a reasonable argument that there is some excess aggregate demand pressure, but in Europe is a lot more supply shocks. The high inflation is much more driven by supply shocks. And there was a recent article by Martin Sandbu in the Financial Times, where he made this case that nominal GDP is just barely getting back up to where it was pre-pandemic, which suggests to me, most of the inflation in Europe is supply side driven. Therefore, the ECB is probably smart and wise in taking this more gradual approach. What are your thoughts on the ECBs approach? Are they doing the right thing?
The ECB’s Gradual Approach to Tightening
Van ’t Klooster: Yeah. Well first to take a step back, I think it's very interesting that Otmar Issing takes this view because Otmar Issing is really the architect of the old ECB strategy. So 2003 was the last strategy review, we’re at the strategy review now, and then it took a very long time to review that strategy because there were all these crises that needed to be fought. And that strategy and the strategy also before that from 1998, that's really the strategy of market neutrality where central banking is supposed to be very simple. So you have one objective, price stability, and you have one instrument, the interest rates. And then as a central bank, what you do is you look at the economy and you try to predict where is inflation going to go? What's the interest rate that we need to steer money creation so as to achieve the target rate, and then you adjust your interest rate. And this is also the time that was very strongly an assumption that monetary policy would be in a very deep sense market neutral. So there would be one interest rate and otherwise the banks and private sector financiers, they would really allocate credit to different uses.
Van ’t Klooster: Now, interestingly enough, already in that strategy, there was one difficult point, named supply shocks. And there already, then it was of course observed that if there is a supply shock, there's really an open question on whether you should raise interest rates to aggressively bring down inflation or whether you should temporarily accept inflation to spare the economy the costs of using interest rates. Because of course using interest rate is very painful way of fighting inflation. So, you probably only want to do that if it's at least quite effective and the type of inflation that’s issued also has some risk of becoming more ingrained in the economy.
Van ’t Klooster: It's interesting that Otmar Issing now comes out so strongly on the side of not waiting with raising interest rates. And I guess that reflects at the moment in general, a bit of crisis of this very specific corner of the central banking paradigm in that, yes, we're facing supply shocks, but it's one supply shock after another. So first you had this big transition from services to goods, so people stopped going to cafes, stopped going out, suddenly we're buying cars and all this expensive equipment. And now, particularly in Europe, of course, the whole Ukraine crisis. Already before that energy prices were going through the roof, gas prices, natural gas is six times as expensive at the moment in the Netherlands as it was only a year ago. So this is just one supply shock after another. And at that point, I guess the old debate, is this temporary and we should just briefly accept it, or this is permanent, that maybe no longer really the right debate to have.
Van ’t Klooster: Now, how to navigate that. Interestingly enough, there's not been that much thinking about that during the ECB strategy review, because that was just not the problem that they were thinking about at that moment. So this strategy review is in part still about, "Okay, what do you do if inflation is too low?" Also, a lot of thinking about how to deal with government debt, a lot of thinking about climate, but now suddenly, actually you see that the problems that the ECB face at the moment, this strategy really doesn't provide that much guidance anymore. And I think this is a very deep fact about central banking at the moment, that this old world where you had this one simple objective, one instrument and everything else could be market neutral, that world is really over. You will be confronted with one new crisis after the other. And the idea that you do one strategy review, and then you can just technically implement monetary policy for 15 years and then maybe do a new review, I think that's really over. And I figure more in a time of just permanent strategy review and much more difficult political questions.
It's interesting that Otmar Issing now comes out so strongly on the side of not waiting with raising interest rates. And I guess that reflects at the moment in general, a bit of crisis of this very specific corner of the central banking paradigm in that, yes, we're facing supply shocks, but it's one supply shock after another...And at that point, I guess the old debate, is this temporary and we should just briefly accept it, or this is permanent, that maybe no longer really the right debate to have...I think this is a very deep fact about central banking at the moment, that this old world where you had this one simple objective, one instrument and everything else could be market neutral, that world is really over. You will be confronted with one new crisis after the other. And the idea that you do one strategy review, and then you can just technically implement monetary policy for 15 years and then maybe do a new review, I think that's really over.
Beckworth: So when did the most recent review of the framework take place? What was the date? Was it last year or the year before?
Van ’t Klooster: So it was already meant to take place, I think in 2008 from the top of my head. Then of course, well things happened.
Beckworth: Eurozone crisis.
Van ’t Klooster: And then Christine Lagarde really made this a priority when she started. "Okay, we're going to do this strategy review." Of course immediately another crisis started. And then now July 2021, we had the outcome of the strategy review, one and a half page. A lot of people were disappointed. So the three main outcomes of it were that the target would be applied more symmetrically. Before that, there was this enigmatic formulation, close to, but below 2%. Beautiful poetic formulation, maybe not very clear. Housing prices were not in the inflation metric. That's of course notoriously difficult to put housing into an inflation metric. And then the third point was that they would do something with climate, but actually there are also a lot of the real key decisions are still to be made. So people felt this review doesn't really end the discussion. And I think the events of the past months have really emphasized that.
Beckworth: Yeah. So the symmetric parts, the interesting one is, does that symmetric language imply anything about doing like makeup policy? In the US, they introduced a flexible average inflation target. And that average means if you're below 2%, you can run it above 2% until the average is at 2%. That only works from below, it's not a symmetric average inflation target. But nonetheless it does have makeup policy. So you missed your target, you make up for it. Was any of that implied in the symmetric language? Or is symmetric just kind of like, we're going to try to be evenly distributed above and below 2%? Any thoughts?
Van ’t Klooster: Yes, exactly. It was more about where you are targeting, and then also specifically of course, that it wouldn't be bad to be a bit higher for a while. Because at that point been below its target for years. So really from, I think, 2014 or so onwards, really below targets. And then every year projecting that inflation would go to the target. And I think that was also really an important concern during the review, that these projections were just going in a direction that really didn't justify the actual monetary policy stance. So the monetary policy stance was really not accommodative enough in line with the projections.
Beckworth: Well, let me ask the question this way. Let's say there'd been no pandemic and we were still stuck in that pre 2020 world where inflation was running well below 2% in Europe. Would the ECB intentionally aim for above 2% to make inflation symmetric to make it on average 2%?
Van ’t Klooster: Well, yes. So that would've been, but not with the intention of making up for lost... Well, luckily of course we have now made up most of that.
Beckworth: Not as planned, but yes. Okay. So it's symmetric, it's not makeup policy per se. But your point is, this review process should be a dynamic ongoing event. I know here in the US, they're going to do another review, I think 2024/2025, so every five years. I know the Bank of Canada was really good at this. They've been having a five year review for many years, many decades past. So it will be interesting to see if the Euro area authorities step forward and say, "Hey, let's do the same thing. Let's make this a regular process."
Beckworth: Now, Jens, you probably know my answer to the supply shock problem is nominal GDP targeting. I'm a big fan of that. I think that makes it a lot easier. It both provides a nominal anchor, so it prevents inflation spirals, but it also allows the central bank to see through those supply shocks. And it seems to me, if there's any central bank you could benefit really greatly from a nominal GDP target right now, it would be the ECB. It would empower the ECB to stay the course. And it could say, "Hey, we're restoring nominal GDP to its pre pandemic trend path. We're almost there. We don't want to tighten too soon, otherwise, we'll fall back off that path." I know there's not a lot of conversation though, when you're about nominal GDP targeting, is that right?
Van ’t Klooster: Well, there is indeed going to be a new review in 2025, so we're going to definitely bring it up around that time. But look, I guess if you take a step back, yes, you can plan a regular review, but if a crisis hits like the pandemic in 2020, like the war that we have now, you just have to think outside your existing strategy. And it's not always that you can really anticipate that. And you cannot hope for a strategy to cover all those eventualities. So once you move beyond this very narrow role of just focusing on one interest rate and particularly stabilizing prices in a very benign macroeconomic environment like you had in the early 2000s, 1990s, then you will just constantly face these new questions. A lot of the earlier strategies developed in a time when you have really cheap goods coming in from all over the world, when you had also a lot of money flows from Asia to Europe, but time when it was just a lot easier to stabilize prices. And I think now what you see with energy price shocks, commodity price shocks, it's not clear that central banking will be so simple the coming 10 years, the crisis of 2020, 2022. Let's see what we're thinking about in 2024.
Beckworth: Let's move on to your papers. There are two main papers I want to get to, but I want to quickly go back and review the paper we discussed back in 2020. And that paper will be provided on the show page, a link to it. The title is “The Myth of Market Neutrality: A Comparative Study of the European Central Bank’s and the Swiss National Bank’s Corporate Security Purchases”. And maybe you can summarize for us, what is this notion of market neutrality? When a central bank buys assets, conducts monetary policy? What is this intent of market neutrality?
The Myth of Market Neutrality
Van ’t Klooster: So the idea of market neutrality specifically in the context of the ECBs corporate sector purchase program is that you buy bonds in proportion to the volume of bonds outstanding in the market. So you look at all the issuers that are issuing corporate debt, that fulfills the credit rating requirement, that you're denominated. Then you try to buy from all these issuers in similar volumes. Already with the Swiss National Bank, it's a much broader notion of buying general indices rather than specific companies. And I think more generally, it's a conception of how a central bank should be implementing monetary policy, mainly in a way that leaves relative prices, pricing of risk to the market where you're as a central bank, only steering the risk free rate.
Beckworth: Yeah. So we had this conversation before. And it's so fascinating to me, is the Fed more market neutral? Is the ECB more market neutral? And there's two views we talked about last time. And Ulrich Bindseil came on the show. I was really thrilled to have him come on. He at the time was I think a head of the operations side of the ECB, at least at the headquartered office. But he outlined these two visions of market neutrality. One is what you just described, I guess the German view, if you can call it that, that you want to mimic the average portfolio out there. Whatever's in the average investor's portfolio, which is kind of hard to define, but just imagine you can define that. Then if the central bank buys a portfolio that's very similar to that, then it's having minimal market impact, which is the goal.
Beckworth: Then there's like the US, the UK vision, and that is the way to minimize impact, the way to be market neutral is to only buy government securities. Because from a consolidated budget perspective, you're just swapping central bank liabilities for treasury liabilities. So it's a wash, so you're having minimal impact. But then the German view would say, "No, no, no, no. You're actually really intervening excessively in the treasury market." So there's this debate, but my sense is the ECB is following the German view more, so is the Swiss National Bank. Is that a fair way to characterize those two views?
Van ’t Klooster: Yes, absolutely. So there is a long history of course. It also has to do with the very specific position of the European Central Bank as a central bank of 19 member states. And all these member states issued debt, and they issued debt in very different volumes. So Italy has a lot more debt outstanding than Germany, although it's a smaller economy. And of course in that context, you immediately get into a very complex set of questions if you do a purchase program that involves government debt. Earlier, this was an issue specifically for setting collateral rules. Then of course the central bank wasn't purchasing debt, but deciding on what debt to accept as collateral. Now, there was also the fear that if the ECB would only be accepting government debt as collateral, then it would be unduly privileging those governments as issuers as compared to the market. And this would be a disruption of the neutrality of the central bank.
Van ’t Klooster: I think in general, there was this big anxiety about the European Central Bank coming in as a sort of arbiter benefiting member states by buying their debt. The treaty contains, it took a prohibition of monetary financing that says the central bank cannot give out direct credit to member states. Now, that of course was drafted explicitly to allow for government debt purchases. So they could buy them in the market, they just couldn't buy them directly from governments. And in this whole context, also this German tradition of market neutrality emerges where you just look at the market as a whole, and you don't, like the Federal Reserve did, really focused your implementation on treasuries, or in this case, government debt of the individual member states.
Beckworth: Now that's a great point that is a lot more complicated in the Euro area than the us because you have all these countries who issued debt. So if the ECB did stick solely to government securities, it would be implicitly favoring Italy and its bonds because they just have so much outstanding. So you have to have a more careful thoughtful approach, and the German view does make sense.
Beckworth: And if we go back and look, again, pre pandemic, because a lot of things changed in the pandemic, but pre pandemic, so the ECB had bought corporate bonds, is that right? And then the Swiss National Bank of course had bought not only corporate bonds but securities. And I went back and looked at what kind of stocks they have bought. Now they prefer a stock index, as you mentioned. But what I found is 23% of their assets are in stock index investing, but they also have some individual stock purchases as well. And this is what I found, I guess they report this to government agencies, but they have like 11 billion in Apple, 9 billion in Microsoft, 5.78 billion in Amazon, 3.38 billion in Tesla, another 3 billion in Alphabet, Inc, which is Google. So they actually they're a sizable holder of these different firms. Now, again, it's a small country, it's far more complicated maybe than it is in the us as we consider these things. But a lot has changed over the pandemic, I guess. So that's kind of what we talked about last time.
Beckworth: Let's talk about some of the big changes. So in the us as you know, the Fed actually introduced some corporate bond facilities. Now these are only emergency facilities, but to me it's opened the door. It's saying, "Hey, we are going into buy corporate bonds, not corporate stocks, corporate bonds." And the ECB, they also kind of pushed the envelope. They kind of pushed the frontier of what's acceptable. In fact, I think that's a nice segue into your next paper and that paper's title is “Technocratic Keynesianism: A Paradigm Shift Without Legislative Change.” Now you're speaking here to the ECBs changes, but feel free to address this more broadly as well, like what the Fed did, what the ECB did. But what are the big changes? What is technocratic keynesianism? And what are the big changes that you saw happen at the ECB?
Van ’t Klooster: Yeah, so I think this is in a way a paper that is to my mind first and foremost about the European situation. And really I'm not an expert about US monetary policy. So you will probably have to tell me if this is recognizable or not at all. I think some of these developments just haven't played out in the US yet. I think if you look at the purchases, corporate bond purchase in the US in 2020, this is almost a carbon copy of the ECBs corporate sector purchase program from 2015. So you might imagine that the debate for that to get started, this took a couple of years and then rethinking this. And that this might just be debates that are still going to start happening in the US.
Van ’t Klooster: So the key issue with the corporate sector purchases, of course has been that it's a program that conflicts in a very direct way with the EUs climate agenda. So it's a program that was developed as part of another important policy agenda of creating a capital market union, so moving away from the EU economy, that very bank-based in terms of it financing sources, to more funding from capital markets. And the idea was that buying corporate bonds would really facilitate that shift. Now what happened in practice due to the nature of the kind of companies that fund themselves in these markets, is that fossil fuel energy-intensive manufacturing industries were very overrepresented in that program. So rather than being a program that's neutral with regard to what's really happening in the economy, by making that program market neutral, it became a program that really benefited very specific sectors of the economy. And there through that focus, came in very direct conflict with another part of the EUs agenda, namely, transitioning the whole industry to a much more sustainable energy sources and much more sustainable manufacturing.
Van ’t Klooster: And of course, particularly in 2017, 2018, a lot of the companies also in the manufacturing industry were really funding new infrastructure that wasn't very well aligned with, for example, the Paris Agreement. So what you saw there already was a conflict between on the one hand, much more traditional market liberal objective of just creating a capital market, and then leaving it really to private investors to use market and to allocate funds. And on the other hand, by instituting this in that specific way, not particularly contributing in some ways really directly, conflicting with the EUs climate agenda.
Van ’t Klooster: Now technocratic Keynesianism is in some ways about the sort of solutions that over time came to be developed in the central banking community to navigate some of these tensions. So let me take a step back what the paper is about. The paper is really about the way in which from 2020 also already before that onwards, really a new set of policy instruments were introduced that look a lot like much older policy instruments. So monetary financing in the case of the pandemic emergency purchase programs really directly purchasing that in proportion, roughly to what was needed to fund the pandemic response. So overall the ECB bought 92% of the deficit of that year through its purchase program. And in that way, really returning to a much older tradition of central banking where as the central bank, you just support governments, issuing large volumes of debt, both to stabilize the market a bit, but also to facilitate a health response.
The key issue with the corporate sector purchases, of course has been that it's a program that conflicts in a very direct way with the EUs climate agenda...Now what happened in practice due to the nature of the kind of companies that fund themselves in these markets, is that fossil fuel energy-intensive manufacturing industries were very overrepresented in that program. So rather than being a program that's neutral with regard to what's really happening in the economy, by making that program market neutral, it became a program that really benefited very specific sectors of the economy.
Van ’t Klooster: And what's really interesting if you look at the communications around that program, is that this is very explicit. So Christine Lagarde says, "Well, look, this program facilitates an environment for governments to borrow. This is part of supporting the response to the health emergency. This is our way of supporting the pandemic response." On the other hand, and this is why I described this in terms of strategic ambiguity, alongside these new objectives, she always also emphasizes that this is in line with the price stability mandates implemented in markets. So also emphasizes that the continuity with these older ways of thinking. So always invoking this world of one interest rate, one objective. And in that sense, also moving back and forth between these two narratives. One, the old Keynesian narrative where the central bank supports the governments in its fiscal activity. On the other hand, the liberal paradigm where the central bank is independent and only focuses on inflation.
Van ’t Klooster: That's what I describe as technocratic Keynesianism – strategic ambiguity. And I think something very similar is happening now in the response to the climate impact of these corporate bond purchase programs, and also the collateral framework, that on the one hand the discussion is formulated in terms of risk, so we have to manage climate risk on our investment portfolio in the right way, we are a prudent central bank in line with the old paradigm that doesn't take risk itself, because that would be also favoring certain counterparties, on the other hand, of course, "Yes, why are we so concerned about climate related risks?" "Well, because of course, to not be concerned about that is to make policies that conflicts with the climate agenda." So also there, you see this moving back and forth, to on the one hand a narrative that has some continuities with these earlier practices of credit guidance, where supervisors would really try to steer a bit where credit flows in the economy are going. That was of course supposed to have ended with the creation of the EU and the single market.
Van ’t Klooster: Now, that is in some ways now, again, happening through all sorts of... And this gets very complex. So once you go into this world of banking supervision, and the tools that banking supervisors have to steer bank lending it gets even more complex. Now also there are all these measures to change the design of the corporate sector purchase program on the table, gets very complex, but I think if you skim through all the technical details, what's happening is steering credit in line with the EUs climate agenda. So that's in a nutshell, I think, how the ECB has responded to some of the very justified criticisms of the corporate sector purchase program, also in this way responded to some parts of its response to the sovereign debt crisis, when the ECB didn't buy bonds. And when that really exacerbated the crisis in Europe as compared to the US. But it's a very messy process. There is a lot of different ideological narratives moving through each other. And it's hard to keep up where things are at the given point in time.
Technocratic Keynesianism is in some ways about the sort of solutions that over time came to be developed in the central banking community to navigate some of these tensions...that's in a nutshell, I think, how the ECB has responded to some of the very justified criticisms of the corporate sector purchase program, also in this way responded to some parts of its response to the sovereign debt crisis, when the ECB didn't buy bonds. And when that really exacerbated the crisis in Europe as compared to the US. But it's a very messy process. There is a lot of different ideological narratives moving through each other. And it's hard to keep up where things are at the given point in time.
Beckworth: Yeah. So many questions this brings up. And just to recap, to summarize what you said, as I understand it, technocratic Keynesianism is your recognition that there's been two big changes at the ECB that's been done without legislative support or legislative actions. And the two changes are, one, a more favorable view to, what you call monetary financing. We might say debt monetization here in the US. Kind of a dirty word for some. But on one hand, much more explicit support of fiscal activity, buying up these government debts. The other one is a more favorable view of credit guidance. And you mentioned climate change being one of them, but you also mentioned in your article, macroprudential actions. So being much more active about countercyclical, capital buffers, things like that. So you got to move towards monetary financing that's more acceptable and you got to move towards credit guidance that's more acceptable.
Beckworth: And a key point of your article though, is that there hasn't been legislative or formal approval by the governments, that this is the ECB kind of taking the reins and free ranging out there and doing its own thing. So couple questions that come to mind is, how sustainable is this? And just where we are right now, for example, we have high inflation. Again, we just talked about how Christine Lagarde is steady as she goes, she's not going to jump the gun. But you have, we talked about Otmar Issing, I don't know if he's representative of the German view, but you can imagine there's people, constituents who might be worried that the ECB is doing this. There might be questions of political legitimacy. Is the ECB getting ahead of the EU and what it wants? The Russia-Ukraine war is raising questions about energy supplies. What if Germany cuts off oil from Russia? Is it going to be as interested in those green goals as it once was, and therefore raise questions about the ECBs efforts? So I guess there's a lot going on there, but the basic question I have is how sustainable is this move, on this front, given political legitimacy questions surrounding it?
Questions of Political Legitimacy at the ECB
Van ’t Klooster: That's exactly the question. So to be clear, it didn't now suddenly happen that everybody thinks monetary financing is amazing, banking supervisors should be doing credit guidance. I think that's very far from where we are at the moment. So what I try to argue in the paper is that if you just look at the facts, so what's happening? What are these instruments doing? What effects do they have on financial markets? Also, what are the sort of narratives that we also find around them? Then a case can be made that some of the design features of the bond purchase programs really suggest much more traditional monetary financing for particularly the targeted nature. So it wasn't that the ECB bought government debt in the same volumes from every member state, it was really looking specifically at where spreads were going up too much, and then also I think credit guidance. I mean, this is a very complex set of policies that clearly all have a basis in prudential considerations, but that also clearly served to steer credit away from certain industries towards other industries.
Van ’t Klooster: But crucially of course, that's indeed why I call it technocratic Keynesianism is that it takes place in depoliticized institutions that act from the basis of a legal mandate. These legal mandates for monetary policy haven't been changed at all for banking supervision. There's a bit more movement, but there's also still there a lot that is about very narrowly risk, also risks that are very easy to measure based on historical data, which is not the case for climate related risks. So yes, there is, I think a very welcome effort to address new challenges. So I don't think we would want to go back to the world where ECB just follows the market and allows a debt crisis to get out of hand as much as it did in the Eurozone crisis. That's of course, a topic of my article and the politics of the ECBs market-based approach to government debt.
Van ’t Klooster: I don't think we want to go back to that world. And I also think that, yes, it makes sense to look at how a financial system fits with your broader economic policy. As EU, you really want to make this incredibly difficult shift towards a green economy, then it makes sense to also look into to what extent your banking system supports that or not. I think no economy in the history of the world has made this kind of transition without also doing some forms of credit guidance or at least very heavy public steering of where credit flows are going. So yes, it's desirable, and there I also agree very much with what you emphasize, it's very shaky.
Van ’t Klooster: If you do this within existing mandates without this very strong legislative basis, there are going to be accidents along the way. You've already seen in 2020, there was the Karlsruhe with the German constitutional court ruling that even the older ECBs debt purchase program was illegal. So a few weeks after the ECB started the pandemic emergency program, which is much more clearly intentioned with the existing legal mandate, the Karlsruhe constitutional court ruled that even that older program was illegal under their reading of the competencies as they were convert on the ECB by the 1992 Maastricht Treaty. And this is, I think, the elephant in the room, that if you build so much of your legitimacy and your legality on a treaty that's by now 30 years old, it is very difficult to address new problems and to flexibly find something that really works. And I think we don't yet have an answer to how to resolve that.
Beckworth: It was striking, Jens, you noted that 92% of the budget deficit was financed through the ECB, or the ECB bought up that much. So effectively the ECB's doing fiscal policy kind of through the back door. It's providing that kind of fiscal support that one could get if you had a true fiscal authority in the Euro area. So stepping back from all of this, my question to you, maybe you don't know the answer, but what is your sense? Is this change going to stay? Is it going to persist or are there growing winds from Germany and other places that might push back? What is your forecast, I guess, going forward? Will these changes, you think, stay with us or maybe it's just purely pandemic crisis related developments?
I also think that, yes, it makes sense to look at how a financial system fits with your broader economic policy. As EU, you really want to make this incredibly difficult shift towards a green economy, then it makes sense to also look into to what extent your banking system supports that or not. I think no economy in the history of the world has made this kind of transition without also doing some forms of credit guidance or at least very heavy public steering of where credit flows are going...this is, I think, the elephant in the room, that if you build so much of your legitimacy and your legality on a treaty that's by now 30 years old, it is very difficult to address new problems and to flexibly find something that really works. And I think we don't yet have an answer to how to resolve that.
Van ’t Klooster: I think that's a really good question. There's one view and I think Otmar Issing is really a representative of this. Someone who comes from the 1990s really understands very well what people agreed on in the early nineties and he's looking at what's happening, and he just thinks, "This is all illegal. This shouldn't be allowed." And there I'm like, "Okay, no, but look, we should be adults about this. There's really difficult and unanticipated problems that people in the early nineties didn't anticipate very well, both around sovereign debt and around climate. And I think the ECB is really doing a good job in at least trying to navigate these challenges." So I think this impulsive saying, "Look, this is all illegal." Yes. I can see exactly where it's coming from. And I think to some extent it's justified, but it's not a very promising way forward. So I imagine that there will be some, I don't think we go back to the role of that central bank that has this very narrow task that was conceived then in that period. But how we move forward, I think there, there are really some very different possibilities.
Beckworth: But what I'm sensing from you then is that the Europeans are very open to change. They see that something works better with, as it did during the pandemic, they're more flexible, more open to allowing the ECB to evolve. Is that what I'm hearing from you?
Van ’t Klooster: Yeah. I think at least the idea that we should go back to how things were is very slowly disappearing off the table. Like some programs that were called temporary in 2009 still exist. But then how to really move forward, I guess that's also where you get to another discussion that's now going on in Europe, that's very complex, very emotional, where people have very different rules, is how to reform the fiscal rules. So one of the reasons why the European Central Bank has to do so much in Europe is because governments are really constrained in their fiscal space. Now there, I guess, if you find rules that fit better, so now these rules require governments to have a maximum debt of a 60% of GDP and a 3% deficit per year.
Van ’t Klooster: Now, everybody was very dramatically above that, the past two years, but particularly also debt levels are now sometimes over two times as high as what these rules require. And then specifically, also you have some medium term targets and they're just not realistic. Combine that with the big recovery fund that you had in 2020 where the EU borrowed money and then transferred that to go governments, I think that's really one place where a lot of the moving forward would happen. And if a lot of problems get resolved there politically, then that also means you take a lot of weight from the ECB. So the ECB is maybe not the ideal institution to solve every problem of the European Union. And if the member states get together, then you can maybe move forward. But the member states, they are the Senate of Europe. They have all these different views. A lot of things have to happen on the basis of unanimity. So imagine you have 27 member states and they have to all agree on something, it doesn't move very quickly. That's the rule.
Beckworth: At least it sounds like though that change is slowly happening, it may take time to be official, to be formalized, but the ECB is almost forced into providing the support that in the past would've seemed as unorthodox, as unholy even, but it's been tried and it wasn't the end of the world. And if inflation does come back down, if we get past the Russia-Ukraine war, it will be interesting to see the conversation that you have there in Europe about this. Just by comparison I look to the United States, I think the large amount of fiscal support, the FED's really aggressive support as well. I think both of those may swing us in the other direction. People will over respond by being much more austere, more conservative. I think fiscal policy, for example, will be much tighter going forward because we had this big run up in public debt. And I worry that any of the gains from having the new framework might be lost because people see the high inflation in the US, the Fed didn't tighten in time. So one prospect in the US could be, we swing 180 degrees in the other direction. But it sounds like in Europe, that's not quite the possibility over there. Maybe it's more of a gradual moving forward for the ECB.
Van ’t Klooster: I would say, well, this is a lesson that people have learned after the austerity years after 2010, which were just dramatic. So still you see the damage of that in infrastructure, in now also just not prepared for security challenges. And I guess this is a lesson, I hope, that the US won't learn in this way. I'm also a bit surprised how visceral this response to inflation is on a policy level. I can see it on a personal level, I hate it too. But if you look at it from a policy perspective, you've just had the worst health crisis. You can imagine we've locked down the whole society for over a year. And then you have a bit of inflation. It's not the end of the world compared to the incredible hit that we as a society took during that year.
Beckworth: Now I agree with that. If you look at the counterfactual, they hadn't stepped in would be a far worse outcome. I think in Europe though, you can make the case much easier that you over there, the Europeans, the ECB is still experiencing, again, the spate of supply shocks. You've had all these negative supply shocks one after another. The US we've also had that, but in addition, we've had, arguably, one can debate this, but a big demand shock. And I think what's unfortunate is that, that demand shock is going to get all the attention. It will overlook the supply shock part of the story. So people will say, "Hey, we can't afford to have this excess aggregate demand problem in the future." But you're right, I think if you look at even inflation in the US, some part of that is still tied to supply side issues, not just demand issues. Okay. Jens, the time we have left, I want to move to your final article. We'll have links to all of these. The article's title is, *The Politics of the ECB’s Market-Based Approach to Government Debt.* And it's about collateral policy for government debt, the importance of how does the ECB think about getting debt from Italy, from Germany, other places. And I understand this is part of a bigger project though. You're writing an entire book on this, is that right?
The Politics of the ECB’s Approach to Government Debt
Van ’t Klooster: Yeah, exactly. So I'm writing a book that covers this whole history of risk management on monetary policy operations from the earliest discussions on starting the Euro in the late 1980s, to the present, the pandemic, the climate crisis. And this article is really a core chapter from, from that book in which a lot of things that happened earlier come to ahead and get us into the Eurozone crisis. So what happens earlier is that this issue of collateral isn't really covered very much in the Maastricht Treaty. So the treaty from 1992, that sets up the EU and the European Central Bank. There just says, credit of the European Central Bank should be secured with adequate collateral. But what adequate means, isn't further explained. And then in 1994 till 1998, you get the so-called European Monetary Institute where they start thinking through how to design the European Central Bank if it goes into operation. And what's really interesting is, at that point we don't know yet whether the Euro will actually happen. So all these people are thinking through how to do a central bank, but don't know yet whether any of that will ever actually happen.
Van ’t Klooster: And then I have been immensely fortunate to have received minutes of the discussions at the Monetary Institute, particularly on the issue of the collateral framework. So the European Central Bank to this day issues, is refinancing operations through repos and loans, which are secured with collateral. And then what comes like the biggest topic of debate at this Institute is what should be eligible as collateral and specifically how you decide that. So there's basically three groups. There's one group that just want public debt, so the US option, where you just implement monetary policy with public debt. And it would've been possible, but they are opposed on the one hand by a more market based approach from Netherlands and the UK. And interestingly enough, the UK is also at the table. So they are just like, "Look, we might I still join." They are very focused on getting foreign currency denominated debt eligible, but they are in the discussion.
Van ’t Klooster: And then there's the third group, which I think is really interesting, of France, Germany, and Austria who have eternal credit rating facilities. And they do that to this day, just do credit rating themselves. Now, particularly the Germans, just think that is really the right approach for everyone and the central bank should just implement its monetary policy by rating bank loans, and then of course you would also have more than enough collateral to secure all the monetary policy operations. You wouldn't maybe even need to accept government. This is a lot of discussions. And then-
Beckworth: Jens, let me ask a question. So just to clarify, so you have this discussion that's going on from 1992, all the way up to the beginning of the Euro, right?
Van ’t Klooster: Yeah.
Beckworth: And I guess that the observation I have, this is a particularly tough issue for the ECB compared to the Fed. I mean, the Fed is just US treasuries, but this is particularly challenging because you're going to have to deal with many different countries’ public debt. And then the other thing you have going on in the background is the stability pack. The part of the EU is you can't run a deficit above a certain percent, the stability and growth pack, the SGP. So that's kind of lurking in the background too. Is that right? And making this more complicated?
Van ’t Klooster: Yes. Well, also some people say, "Look, we don't need to think about this because we already have the fiscal rules. So we can just accept any debt collateral, because we know the fiscal rules will work. But, and I think that's something that happens over time, that the trust in these fiscal rules becomes less, so where initially out of all these very messy discussions in the nineties, there's a bit of a vague compromise where it's just set up. "We're just going to accept all the debt subjects to high credits standards." But there's no real specific account of what that means. And when operations of the ECB start is basically unclear under what condition government debt is eligible or not. The assumption in the market is basically government debt will always be eligible.
Van ’t Klooster: When it comes to corporate debt, though, it's very clear that the ECB only accepts that with a relatively high credit rating. And then in 2005, suddenly you get a decision. And that's also again where Otmar Issing was directly involved, where US credit rating agencies get a really pivotal role in deciding which government debt should be eligible as collateral. And this was sort of a nightmare vision of some central bankers in the nineties that you would give up so much power to private US based rating agency. That this would be giving up of sovereignty, one central banker even says. But still that happens in 2005. And that's then in a very different context where there is the fear that the ECB is unduly benefiting some of the member states that are in violation of the stability and growth pact. And you also see that at that moment that the spreads between the debt of the individual member states are incredibly small. So you would basically lend to Greece at the exact same conditions as you would be lending to Germany.
Van ’t Klooster: Now, in that context, the ECB is a bit like, "Okay, well, we don't want to be seen as being responsible for the spreads being this narrow. So we're going to say we're going to rely on the market. The market is pricing risk, is setting the prices. And we're going to take our hands off sovereign debt market." This wasn't really how that wasn't envisaged in the nineties. And I think in the early nineties, they should have thought about this a bit longer. But in any case that decision is made. And then a few years later in the Eurozone crisis, that becomes one big disaster. Because there you have suddenly member states facing these banking crises and they just have to issue a lot of debt. They have to bail out their banks, they also have the fiscal impact of the crisis and where the US and UK launched QE programs that basically effectively removed a lot of that debt from the market. In the EU context, this debts stayed in the market, and that then became the basis of a panic. And spreads debt started rising because of self-enforcing panic dynamics.
Van ’t Klooster: But at the root of that is I think central bank that really doesn't provide a very traditional role of backstopping very large issuances of debt. And this longer history puts that bit in perspective. And I think that is one of the things that the book tries to do, it also tries to do this a bit for the current climate discussions that we now have. It also sort reflects a bit on the shifting role of central bankers from these earlier very narrow roles to these much broader roles. But I think the issue of sovereign debt is really sort of the pivotal, irresolvable, impossible topic that central bankers get on their plate because it hasn't been resolved by politicians, and really also don't have the legitimacy and the legal basis to address very effectively.
A few years later in the Eurozone crisis, that becomes one big disaster. Because there you have suddenly member states facing these banking crises and they just have to issue a lot of debt. They have to bail out their banks, they also have the fiscal impact of the crisis and where the US and UK launched QE programs that basically effectively removed a lot of that debt from the market. In the EU context, this debts stayed in the market, and that then became the basis of a panic. And spreads debt started rising because of self-enforcing panic dynamics...But at the root of that is I think central bank that really doesn't provide a very traditional role of backstopping very large issuances of debt...I think the issue of sovereign debt is really sort of the pivotal, irresolvable, impossible topic that central bankers get on their plate because it hasn't been resolved by politicians, and really also don't have the legitimacy and the legal basis to address very effectively.
Beckworth: So a big takeaway from your article is that this 2005 decision to rely on private credit rating agencies in the Euro area was huge. It was very consequential, right? That decision really played a key role in the Eurozone crisis, in that it created a procyclical bias in rating the debt. So when the economy gets weaker, then the ratings go down, which kind of feeds into what you call this doom loop for banks. Italy's banks hold a lot of domestic government debt. Well, the domestic government backs up those banks, and so they're both lined upon each other. And as the rating agencies go down, it creates problems. So putting this 2005 change into a law, making it the official policy of the ECB really poured fuel on a fire that later became the Eurozone crisis.
Beckworth: It's pretty remarkable to look back at that. And just briefly going back, why this decision? And one of the things I got from your article was there were a lot of people who were upset that the Euro area wasn't enforcing the stability and growth pack for Germany and France in 2003. So you have this amazing quote from Joachim Fells, I may not be saying his name right. But he has a Financial Times op-ed where he says, "Now that the European union stability and growth pack has been officially buried and replaced by a toothless waffle, it is imperative to enable markets to punish fiscal sinners in the Eurozone." I mean that's like a moral call. It's like something from the Bible. You got to go out and punish the sinners. They need to all be baptized into fiscal prudence. Was that the main motivation? This fear that the EU had lost its way on fiscal solvency issues and therefore the ECB had to step up to the plate and deliver an alternative?
Van ’t Klooster: Well, I guess in that time, there was a very strong group, very visible group of financial market analysts. And listen, and it's also very different time, right? If I talk with some of the people, they just said like, "Look, I can't even remember that time because things were so different then." And I think that time, the ECB doesn't have that big of an audience for this kind of decisions. So in relation to that position, they, I think, try to steer more of a middle course, where they say, "Look, it's not our role to punish fiscal sinners, we are just the central bank, but also we're not a bank that's going to provide support to governments, whatever happens." So I think they try to depoliticize this whole discussion a bit to say, "Look, we're just going to take a prudent middle road." And I think that was really then a few years later, suddenly a very extreme position.
Van ’t Klooster: But of course, if you made that your official policy, if you've committed to it, you cannot just walk it back without all sorts of other questions coming up. And then it takes quite a long time before this new narrative develops, where Mario Draghi, "We do whatever it takes. We need to repair the transmission mechanism of monetary policy, where there's this sort of monetary policy justification for buying government debt." Where the idea is, well, if these spreads are this big, we cannot effectively steer interest rates everywhere, so we need to buy government debt for monetary policy reasons.
Beckworth: So the 2005 decision was a middle ground then. So Joachim Fels, he was like an extreme view. Then you have the other view. So the ECB was right in the middle with that 2005 policy. A middle ground where it's saying, "We don't want to be determining fiscal policy, but we also don't want to ignore it all together. And so we're going to have credit rating agencies play a role."
Van ’t Klooster: Yeah. I think it was particularly Willem Buiter, by the way, he really said, "Look, you should use the collateral framework to kick out member states that's aren't complying with stability and growth pack." And there even people in the ECB were like, "Whoa, whoa, whoa. That's too extreme."
Beckworth: So the ECB is actually moderate compared to some of these calls to use the ECB to impose fiscal discipline. Okay. Time is running in short here. Jens, I want to end on a question. So it was really fascinating to read how this 2005 change in collateral policy really played a big role in making the Eurozone crisis worse, making it what it was. But there's two other stories you could tell that contributed to the Eurozone crisis. I want to get your take on this.
Beckworth: One could be, it was just bad monetary policy, the ECB tightened in 2008, they also tightened in 2011 twice. So they were hawks. Before Draghi, Mario Draghi, they were very much very hawkish. So if you weaken the economy by tight monetary policy, you're going to contribute to this doom loop. The other thing would be just leadership. A change in leadership was huge. Mario Draghi, you mentioned some of the changes under Christine Lagarde versus the first leaders of ECB. So you have the 2005 policy change, you have the stance of policy, you got leadership. How would you rank those in terms of importance in contributing to the Eurozone crisis.
Van ’t Klooster: Yeah, that's of course a very difficult question. What if Christine Lagarde would've been president of the ECB in 2005?
Van ’t Klooster: I would think that played out. I think that's impossible to answer, but I think coming back to what I've already said, I think just the environment is so different. It's just the economic policy challenges that we have. Because previously nothing happened on a lot of these agendas. So specifically the climate transition that we have to do now is so much more steep than it would've been if things would've happened already 15 years ago. I think end of the day, it's really this very big changing problems that shift the behavior of central bank rather than individual personalities. And it's just the nature of a central bank that it doesn't lead the political process. But I think you see that also very clearly in how the ECB has shifted, that it follows broader changes in society and doesn't want to be the first to move.
Van ’t Klooster: And I think that's maybe also in the technocratic Keynesianism paper that I think, yes, these efforts have some role to play, but this is not going to be the answer to these problems. The issue of fiscal rules needs to be resolved by the member states. Climate policy, nobody knows how to do it. And it's certainly not going to be changes to an asset purchase program that drive that forward. I would tend more to think that it's really these big picture ideational economic shifts that are important than personalities. That said, it's clear that Lagarde has been pushing a lot of this forward. And I think she does it very well. And I look forward what she's going to do the coming years because her term is far from over. It just started.
Beckworth: So what you're saying then is that who leads the ECB, the views they take on the stance of monetary policy, all those things are a product of their time. So Jean-Claude Trichet, he was a product of the early German influence. And maybe we couldn't have expected something different because the Germans are known to be hawks. They're very much concerned about inflation. So again, 2008, they tightened policy, they increased rates, they talked up more rate hikes because they were worried.
Beckworth: In fact, 2008 was similar to today. It was a period where you had commodity prices going up. So inflation fears were going up, both at the Federal Reserve, similar discussions were going on. They didn't hike rates in 2008, the US, but they were talking about hiking rates. At the ECB, they actually did hike rates. And then 2011. And then Mario Draghi comes along. And so maybe you could say, he was the person at that time because things had gotten so bad. If things hadn't gotten so bad, maybe we never would've had a Mario Draghi saying, "We'll do whatever it takes." So your point is there's a bigger milieu, a bigger environment, that's shaping ideas and what's possible.
I would tend more to think that it's really these big picture ideational economic shifts that are important than personalities. That said, it's clear that Lagarde has been pushing a lot of this forward. And I think she does it very well. And I look forward what she's going to do the coming years.
Van ’t Klooster: Yeah. That's true. But listening to what you just said, I think you're also of course right that some of the decisions that were made could have gone differently. And then specifically, if you think about 2011 rate rise, and I think also this minimum credit rating on sovereign debt, yes, of course, there would've been scope for a better decision. And I think this discussion, for example, on the minimum credit rating just played out better in the nineties than they did in the mid two thousands, because there were different people. For example, I think one really key shift is that until early 2005, you have Tommaso Padoa-Schioppa as the Italian board member, really incredibly intellectual central banker. It's very hard to imagine that he would've been there and that they would've imposed this policy that played out so dramatically for Italy. And you might also imagine that looking back, you think that for example, the Italian central banker that was on the governing council was just sleeping at the wheel. That some of these members state governors should have anticipated, that this causes problem.
Van ’t Klooster: I think in the 1990s, these stakes were maybe a bit more clear to individual member states, that they were really thinking, "Okay, what is this central bank going to mean for us?" And then maybe in the mid-2000s, people could have paid attention and it would've been a different outcome. So I wouldn't want to deny that what individuals do in this context matter. But I think if you look at the big shifts of central banking, then this very narrow political role fits into the great moderation and the general macroeconomic environment of that time, and the now much more difficult political role central banks fits where we are now.
Beckworth: Well, like last time, this has been a very fascinating conversation. It leads me a lot to think about, Jens, so thank you for coming on. Our guest today has been Jens van't Klooster. Jens, thank you for being a guest.
Van ’t Klooster: Thank you. Yes. This was really a pleasure, David.
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