Report to ECON: The Euro at 25: Fit for purpose? Reichlin, Pisani-Ferry, Zettlemeyer,

07 February 2024

This paper reviews the record of European Central Bank policymaking since the 2010-12 euro crisis in order to develop recommendations on: (1) the ECB’s future monetary policy strategy, (2) its operational framework, and (3) the governance of European Economic and Monetary Union. Conclusions below:

Authors : Lucrezia REICHLIN, Jean PISANI-FERRY, Jeromin ZETTELMEYER

5. CONCLUSION
Over its twenty-five-year history, and particularly during and after the 2008-2012 crisis, the ECB has proven resilient, adaptive and innovative. To interpret and evaluate ECB policy changes, it is useful to classify them into two broad buckets.
The first comprises the evolution of the ECB’s operational framework, monetary policy tools and strategy. In chronological order, this includes the switch to fixed-rate, full-allotment refinancing operations in 2008, the introduction of forward guidance in 2013, the use of negative deposit rates in 2014, the move to full-fledged asset purchases in early 2015, the 2020 Pandemic Emergency Purchase Programme and the 2021 strategy review which codified some of these achievements and eliminated the problematic asymmetry in the ECB’s price stability objective.
These changes paralleled those of other major central banks, which all adapted and innovated in response to new economic and financial stability challenges. Given its origins however, the ECB often had a greater distance to travel. For the most part, it has done so decisively and speedily, notwithstanding its more complicated governance. In some cases, it was even ahead of its major peers, such as for the emergency liquidity provision in 2007 and the negative interest rates in 2014.
In two cases, however, the ECB has been slow, with significant adverse consequences for both price stability and secondary objectives. The 2015 APP should have started two years earlier. And the ECB was again slow to react to the inflationary surge triggered by the combination of COVID-19 aftershocks and the brutal rise in energy prices. As we have argued in this paper, these delays reflected a structural handicap: the politically and fiscally heterogeneous nature of the euro area. Monetary policy decisions were delayed whenever they had important fiscal consequences. In such cases, the ECB needed extra time, compared to single-country central banks: time to evaluate, confront and mitigate the distributional (2015) or financial-stability (2022) consequences of its actions.
The second set of ECB innovations consisted of actions to neutralise – or at least mitigate – the structural handicap just described. These included the 2012 OMT instrument, the elaborate risk-sharing arrangements underlying the 2015 APP, the flexibility element of the 2020 PEPP, the decision to ‘grandfather’ collateral quality ratings of sovereign bonds in 2020, and the 2022 TPI. Again, the ECB proved innovative and, for the most part, fast in following through decisions of principle with concrete actions.
The future agenda of the ECB and the EMU in which it is embedded can be linked to these two classes of actions.
1. In the area of monetary policy strategy and operational framework, the ECB has a rich agenda, which is largely under its control. The next strategy review should tackle a range of questions that are important, fascinating and difficult, including: whether there should be a process for regular review of the definition of price stability and what it should be based on, how the ‘medium term’ should be defined and to what extent this definition should be linked to the central bank’s secondary objectives. We have also argued that the current ‘ample reserves’ framework should be maintained. But if it is modified, finding an alternative that preserves most of the strengths of the current system will create its own challenges.
2. In contrast, with respect to innovations designed to offset its structural handicap, the creativity of the ECB may by and large have reached the limits of feasibility. The sole exception is that the TPI might be amenable to simplification; we have proposed some ideas on this. For the most part, however, the innovations will now need to come from reforms to the EU governance that sit largely outside the ECB.
The Euro at 25: Fit for purpose?
PE 747.834 37
A wholesale reform of the EU fiscal system is currently not in the cards – changes in the fiscal system generally do not arise from macroeconomic considerations. However, the combination of piecemeal reforms can go a long way. These would involve a larger EU budget involving common bond issuance backed by adequate own resources, effective implementation of the ongoing fiscal governance reform to reduce fiscal vulnerability, and steps to reduce the exposure of banks to their domestic sovereigns, while providing flexibility in times of stress. We have proposed pragmatic steps in this direction. To these, one must add the longstanding objective of completing banking union and deepening and integrating capital markets, which were not discussed in this paper, but which would make the job of the central bank much easier by improving private risk sharing across the euro area.
Short of politically implausible radical changes, an imperfect solution to a structural problem is the best response one can hope for. This will require invigorating, coordinating and implementing reforms on multiple fronts: building a common fiscal capacity, striving for a larger pool of EU assets, and reducing fiscal and financial vulnerabilities. There is also limited scope to further strengthen existing ECB instruments, particularly the TPI. Our discussion shows that achieving consensus to pursue these objectives, in particular the first two, will be hard. But without significant progress on several of these fronts, the euro will likely remain fragile.

ECON

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