In the looking-glass moment of November 2020 we should perhaps no longer be surprised to see the chairman of the U.S. Federal Reserve, Jerome Powell, and the head of the European Central Bank (ECB), Christine Lagarde, demanding more fiscal action to address the coronavirus crisis. But one does have to pinch oneself. Did we ever dream that we would see the central bank guardians of price stability taking on the role of lead cheerleaders for massive fiscal activism?
Earlier in the year they hardly needed to make the case. Fiscal activism was the order of the day. Central banks were crucial in stabilizing the financial markets in March and April. But the main burden of the coronavirus response lay with fiscal policy. The pandemic has triggered a crisis of the real economy first and foremost, not a collapse of credit. The U.S. CARES Act was a prompt and massive stimulus measure. At first the European Union flailed. But then in July the Europeans agreed a quasi-constitutional settlement, with a common program of borrowing to fund the joint Recovery Pact. This would provide the fiscal backdrop to enable Europe to achieve not just a recovery, but the first steps toward its much-vaunted Green Deal. With fiscal policy taking the lead, central banks could play a supporting role, juicing financial markets with quantitative easing.
What has now driven the central bankers into action is that since the summer, on both sides of the Atlantic, the political agreement on the terms of fiscal policy has broken down. And that puts the central banks in an exposed position.
In the absence of government spending or tax cuts, the burden of sustaining the economy is inevitably left with the central bank. Under normal circumstances, politicians are happy to hand off their problems to central bankers working quietly on the margins of political life. But the partisan conflicts and disagreements that have emerged this year on both sides of the Atlantic are so deep that a more dramatic possibility has emerged: that the central banks themselves are sucked into the political fray.
2019 gave a foretaste. At the time, the world faced a mini recession brought on in part by U.S. President Donald Trump’s trade war. The Fed faced vicious attacks from Trump for failing to respond with lower interest rates. Powell found himself compared by Trump to Chinese leader Xi Jinping. In Europe, the recessionary storm clouds were even darker. Berlin was standing pat on fiscal austerity. To meet the threatened deflation, then-ECB President Mario Draghi was prompted to launch a final round of quantitative easing. This was welcomed by the markets, but it unleashed a storm of protest from within conservative European central banking circles. The anti-Draghi revolt was figure-headed by Jens Weidmann of the Bundesbank.
One year on, as Europe and the United States confront the second phase of the coronavirus crisis, American politicians wrangle over the still-disputed presidential election, and Europe faces its nationalist-populist demons, we are witnessing a new cycle of politicization.
In the United States, the stimulus consensus broke down over the summer, ahead of the election. The Democrats were hoping that an electoral blue wave would give them control of Congress and the political platform for a $2 trillion stimulus. That hope came crashing down on the night of Nov. 3. Assuming the Republican Party retains control of the Senate, Majority Leader Mitch McConnell will have a deciding say in any legislation from President-elect Joe Biden and the House Democrats.
That painful prospect triggered open discussions in the Biden camp about the possible use of the remaining funds in the Fed’s emergency programs as a way of sidestepping the Republican roadblock in Congress. But the Trump administration and its allies in Congress saw that coming. On Nov. 19, Treasury Secretary Steven Mnuchin ordered the Fed to wind up programs to support lending to America’s small and medium-sized businesses, and backstop the municipal funding market. He did so over protest from the Fed and the Chamber of Commerce, an unusual alliance for a Republican treasury secretary to find himself facing. Unusual too was the remark made by the Chamber of Commerce that Mnuchin’s action would “prematurely and unnecessarily tie the hands of the incoming administration.”
Effectively, America’s most prominent business lobby is condemning the refusal of a Republican-led Treasury to honor the basic cooperation on which the functioning of the U.S. Constitution depends. Aggressively acting to curb the Fed’s ability to lend doesn’t just limit its ability to offset the lack of fiscal stimulus over the coming months. It will also make it far more difficult for the Biden administration to relaunch stimulus in the new year.
There has been much talk of the Trump administration taking a scorched-earth approach to China, escalating tensions to the point at which the Biden administration is deprived of options. It is alarming to see that same logic extended to economic policy. If in foreign policy, the tactic of the outgoing Trump team is to set more fires than the Biden administration can cope with. In economic policy, Mnuchin’s decisions amount to removing the fire extinguishers. Neither is consistent with the turn-taking required by democratic turnovers. We are fortunate that the vaccine news is good, otherwise one might expect a more violent market reaction, which the Treasury, Fed, and Congress would find difficult to quell.
If U.S. economic policy is being sucked into the Republicans’ stop-at-nothing effort to hobble the Biden administration, in Europe the question of the rule of law is front and center in Lagarde’s dilemma. The July fiscal package was feted in Europe as a breakout of the impasse that had threatened crisis in the EU. It was immediately applauded by the markets, which sent the euro higher against the dollar.
But it required ratification from the European Parliament and national governments. Any large-scale spending package raises the question of who will receive what. The European Parliament is deeply preoccupied with the increasingly aggressive deviations of Poland’s and Hungary’s governments from rule-of-law norms. As part of the July recovery package, Poland and Hungary are set to receive grants and loans from the EU that in both cases exceed 10 percent of GDP. The European Parliament decided to make this conditional on rule-of-law conditions—on recipient governments proving their commitment to democracy and transparency. But those terms are unacceptable to Poland and Hungary, which have also found an ally in Slovenia. Together they have vetoed the EU budget and the recovery funds, which also includes the EU’s proposed funding push for its green energy transition.
As in the United States, in the absence of political commitment and will, the current stability of European markets depends on the confidence that the ECB will step in where necessary. Its willingness to buy bonds blocks any return to the nightmares of the eurozone crisis seems to promise a more unified and forward-looking Europe. Unlike in the United States, the ECB does not have a partisan Treasury to deal with. But as 2019 revealed, the European system itself is marked by deep tensions among the central bankers, notably between a more conservative faction led by the Germans and the current ECB leadership and its allies in Southern Europe. Though the ECB has since March engaged in substantial bond buying to stabilize sovereign debt markets, taking the risk out of Italian and Greek bonds, it is clear that this has faced criticism internally, most likely from the Bundesbank side.
Where this conflict has exploded into the open is so far not over the purchases of sovereign debt but over green policy. Despite the EU’s commitment to investment policy, Weidmann of Germany has come out openly against any ECB involvement in green finance. He confines his comments to technical issues. But in the conservative German press, led by the formidable Frankfurter Allgemeine Zeitung, the stakes are higher. Green interventions are not just a matter of fossil fuel financing—they are seen as an effort by the current French leadership of the ECB to widen the remit of the central bank and redefine its source of legitimacy no longer around price stability but around a broader range of societal objectives. These include environmental sustainability but also, of course, the stability of the euro and the bond-buying programs that secure it. Green finance thus becomes a proxy battlefield for the main issue, which is whether the central bank’s mandate should be expanded beyond the task of maintaining price stability. Not now but some years down the line that will mean a battle over bond market support and the current elevated spending levels by national governments.
Of course, the parallels between American and European developments only go so far. Whereas the United States is a unitary state dominated by a single partisan cleavage, the political economy of Europe is split along two axes: East-West and North-South. Though that is more complex, it also means that the internal divisions within the European monetary system are not aligned with the conflicts with Poland and Hungary, neither of which is part of the euro. It will likely be possible to defuse the situation by stitching up a compromise with Warsaw and Budapest. This may come at the expense of the rule of law, but it would relieve the ECB. In the United States, even when the Democrats take control of the Treasury, the fundamental partisan division will remain, running across every area of policy and shifting the arena from the Treasury-Fed axis to the Senate.
Nevertheless, for all the differences in structure and divergences in their politics, in mid-November 2020 both of the big Western blocs have at least this much in common. They do not have in place a coherent fiscal policy response to the second wave of the crisis. In both cases, basic questions of a constitutional variety are being posed. And the firewall between politics and monetary policy has once more been breached.
