>> GROUP: Shadow ECB Council / EZB-Schattenrat  Andrew Bosomworth

Andrew Bosomworth: >> What should be the selection criteria for the next ECB-president?

The selection criteria for the role of ECB president should primarily be based on academic, management & people skills. First, a thorough understanding of macro and monetary economics, preferably at PhD level. Second, expertise in managing a large, diverse institution. Third, the ability to build consensus across a culturally and geographically diverse institution. Without a true European federal structure, the choice should also take into consideration the geographical diversity of appointments to other ECB Executive Board positions as well as roles of European Commission and Council presidencies. Gender diversity of the Executive Board should also be considered.

>> What are the most important challenges for the ECB in the next eight years?

The single most important challenge for the ECB during the next president’s term is to prevent inflation expectations slipping below 2%. The ECB faces four secular headwinds that, without a concerted monetary and fiscal response, look set to dislodge inflation expectations below the ECB’s definition of price stability over coming years.

Demographics: the eurozone’s demographics are on track to be the same as Japan’s today – measured by the dependency and working-age population ratios – by 2032. Germany and Italy will converge to Japan a few years sooner owing to their populations’ older age-structure. Aging societies typically display low and declining rates of growth of working-age populations, which empirically is associated with low real GDP growth and low inflation.

Institutional structure: while the eurozone in aggregate has fiscal space – measured by the public debt to GDP ratio – it lacks an adequate tool to distribute that space across member states from those with room to those without. During previous cycles, those countries with fiscal space were incapable of generating sufficient domestic demand to spillover and pull-up those countries without fiscal space. Under eurozone fiscal rules, those countries without fiscal space have very limited ability to use anti-cyclical fiscal policy. In the event of loss of market access they are obliged to undergo pro-cyclical, internal devaluations to restore international competitiveness, which are highly disinflationary. Without a common fiscal tool and risk-free asset, the ECB is unable to adequately set real interest rates low enough across the eurozone, which raises both the risk some countries fall into a liquidity trap and the probability that inflation declines further.

Fragile inflation expectations: each time the eurozone experiences a recession, core inflation declines from peak to trough by about one percentage point and the decline is not mean-reverting (in more recent years this owes to the internal devaluation process above). With spot core inflation currently running at 1%; with Germany, principally, unable to generate higher inflation; with financial market-based inflation expectations well below the ECB’s target, inflation expectations are at risk of being one recession away from falling permanently to zero.

Stage in global business cycle: the U.S. economy’s business cycle is more mature than the eurozone’s. The FED has signaled an end to its policy tightening cycle and markets discount an easing. Historically, whenever the FED paused or cut rates, more often than not the ECB and Bundesbank before it also eased policy. With the deposit facility rate already negative, the ECB is at risk of being unable both normalize its main policy rate back to zero and lower policy rates further. The longer interest rates stay negative, the more they entrench low inflation expectations.

The second challenge for the ECB is what to do about negative interest rates? Negative interest rates arguably incentivize banks with high retail deposit ratios to make loans, in the short-term. But this evidence ignores the time-dimension that negative interest rates have on the banking sectors’ profitability and on economic agents’ inflation expectations over the long-term. Evidence suggests negative interest rates for a short period of time are net positive for loan growth. But when negative rates persist, which increasingly looks to be the case, the net benefits may soon turn into costs and cause a tightening of the policy stance.

Eurozone banks’ aggregate deposits amount to approximately €12 trillion and it is a plausible assumption that they are floored at 0%. Asset purchases by the Eurosystem combined with negative interest rates have lowered the rate of return on the asset side of the aggregate banking system’s balance sheet. As new loans are made and as securities are reinvested over time at lower rates, the rate of return on the asset side declines while the cost of the liability side remains unchanged at zero percent, causing aggregate net interest income to decline. Over time, therefore, the Eurosystem’s unconventional policies erode the profitability of the banking sector, which forces it to restructure and cut costs and act as a headwind to loan growth.

For aggregate investment, high real asset prices caused by unconventional monetary policy lower the internal rate of return on investment projects, which explains why loan growth remains muted despite rock-bottom borrowing costs. For savers, the negative and low term-structure of interest rates encourages agents to save more, which reinforces lower inflation expectations. The longer negative interest rates persist, therefore, the weaker their efficacy. Tiering the deposit facility rate applying to banks’ excess reserves is not a solution to a persistently negative policy rate. To bring the policy rate back to zero, the ECB needs its fiscal partners to impart more stimulus to the economy. This looks unlikely. The risk that inflation expectations dislodge from 2% is therefore acute.

>> Who would be the best candidate to succeed Mario Draghi as ECB-president?

Jens Weidmann. Based on the criteria laid out above, Jens Weidmann is the best candidate to become the next ECB president, conditional on appointments to the European Commission and Council president roles. Francois Villeroy de Galhau, Klaas Knot and Marcel Fratzscher are additional, suitable candidates for the ECB presidency.
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