The ECB at 25: tried, tested and ready for whatever comes next
By far the youngest of the world’s major central banks, and the only one without a federal government behind it, the ECB successfully navigated the euro zone crisis that threatened the very existence of the currency it underpins, emerging with a strengthened reputation that has helped enhance the cohesion and integrity of the single European currency.
To be sure, there have been mistakes along the way, but the ECB and its policymakers have shown an ability to correct and learn from their missteps. They have also proven adept at innovating and developing policy tools while showing the political nous to forge a truly independent and credible ECB brand. This gives us confidence that the bank has the adaptability to deal with the period of structurally higher inflation it likely now faces.
The ECB’s biggest achievement: emerging from the shadow of the German Bundesbank, on which it was modelled, to establish itself as lender of last resort for banks and governments in the euro zone. Getting there was not without pain – there were some high-profile resignations along the way. But that development process – and the policies that came with it – have created a more robust euro zone, and a battle-hardened ECB that financial markets have learned to take on at their peril. Despite the central bank implementing in the last year the fastest interest rate increases in its short history, financial markets have remained stable and bond spreads – the premium investors demand to hold government debt from southern euro zone countries like Greece over German paper – have not blown out, defying the expectations of even more optimistic ECB watchers like ourselves.
The ECB began life in 1998, exercising its full powers from January 1, 1999, with the introduction of the euro in 11 countries. The early years focused on delivering stable prices under the first president, Dutchman Wim Duisenberg, and his French successor, Jean-Claude Trichet, who liked to stress: “There is only one needle in our compass, and it is price stability.” They were successful and inflation averaged just below 2% on their watch. A misjudgement came in 2011, when the ECB raised interest rates in consecutive quarters – hikes flagged in advance by Trichet using his code words “strong vigilance”, to signal a move was coming – only to cut them again later in the year as the economy slumped. (The then Bank of Italy Governor, Mario Draghi, who later introduced “forward guidance” to ECB policy communications did not oppose the 2011 hikes). That same year also saw some high-level resignations as trouble began to brew over the ECB’s posture towards troubled euro zone debtor states. Then the euro zone crisis blew up in full. Periphery bonds spreads blew out, posing an existential threat to the euro project. The austerity policies implemented by governments in the south of the bloc as they sought to win back market confidence exacerbated a disinflationary environment that allowed the ECB to devise and deploy exceptional measures. The alternative would have been to stand by and allow deflation to take hold, which would have run counter to the ECB’s mandate to deliver price stability. Hence, under the ECB’s third president, Italian Mario Draghi, the bank ramped up its provision of liquidity before he famously vowed in 2012: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro … And believe me, it will be enough.” The policy tool that followed bitter debate between Governing Council hawks and doves – “Outright Monetary Transactions” (OMT) – allowed for unlimited government bond purchases on condition that countries affected signed up to a formal reform plan. That ‘conditionality’ has helped shape up the euro zone's weaker economies and stabilise the currency union, whose members now number 20. The ECB has subsequently withstood legal challenges to its bond-buying programmes in Germany’s Constitutional Court.
Draghi’s successor, Frenchwoman Christine Lagarde blundered in 2020, just a few months after taking over the presidency, saying it was not the ECB’s role to “close the spread” in sovereign debt markets, a comment that roiled the Italian debt market. But she was quick to correct the mistake and the ECB launched its pandemic emergency purchase programme (PEPP) a few days later, aiming to lower borrowing costs and increase lending in the euro area. Lagarde has since rebuilt unity among Governing Council members and, after a slow start, is leading the fight to tame inflation, which she has called “a monster that we need to knock on the head”. So far, the ECB under Lagarde has fought that fight without pushing the euro zone into recession. With the pedigree the bank has built up over its first 25 years, we are confident it will adapt again and find a way to deal with today’s new sticky inflation environment.