She's the One

By Roy C. Smith

Yesterday, the European Parliament nominated Christine Lagarde, 63, Managing Director of the International Monetary Fund (IMF) to replace Mario Draghi as President of the European Central Bank (ECB) at the expiration of his 8-year term. Lagarde is a former French Minister of Finance under Nicholas Sarkozy, who took over at the IMF also in 2011, after the global financial crisis of 2008-2009 had spread to threaten European financial markets and economic stability.

The financial crisis had profound effects in Europe. It was only through the painstaking efforts of Germany and France, the IMF and the ECB over about 2 years that the subsequent “European sovereign debt” crisis of 2010 could be resolved. The resolution involved the Euro-Area (countries using the euro) establishing voluntarily a $1 trillion fund to make direct loans to the troubled countries (on the condition of strict reforms to be approved and enforced by the IMF), and later, for the ECB to break historical precedent by (1) extending large loans to euro area banks to restore financial stability (“the ECB will do whatever it takes…”) and (2) to support euro-area government bonds in secondary markets, in a form of “quantitative easing” to encourage recovery. Between these two efforts, the ECB’s contribution, which involved employing several trillions of euros in market interventions to provide liquidity, was by far the more important in ending the crisis.

But the sovereign debt crisis clearly revealed some major flaws in the euro system. It was not a typical federal system that could impose fiscal policy and enforce standards on the members, nor did important members of the system want it to be so if that would mean extending a mutual guarantee of member country debts. Indeed, the German constitution prohibited participation in such guarantees and a seminal case was brought to the German Constitutional Court to decide what, if anything, Germany could do to assist other countries in the debt crisis. (It could participate in case-by-case relief but only if these were approved by the Bundestag.)

However, much was learned in the slow process of discovery of what was possible. There was much give-and-take, and many ideas were proposed by the European Commission (the EU’s executive authority) that were not taken up, including jointly-backed Eurobonds, a Banking Union with common deposit insurance for euro-area banks, a European Monetary Fund to act like the IMF for euro members, and a financial transaction tax to help pay for such reforms. On the other hand, a step was approved in 2011 to require members to limit their budget deficits and debt-to-GDP ratios, and the temporary European financial stability fund that assisted Greece, Ireland, Portugal and Cyprus, was renamed the European Stability Mechanism and made permanent. 

Most important, however, was the agreement of the euro-area countries to authorize new and substantial interventionist and regulatory powers for the European Central Bank, which gave credibility to the euro-area’s willingness to do what was necessary to end future crises. This important shift in the role of the ECB came about with the appointment of the former Bank of Italy head, Mario Draghi, 71, an activist former head of the G20’s Financial Stability Board, to replace Jean Claude Trichet, a traditionalist former head of the Banque de France. Draghi knew that the considerable resources of the ECB would be necessary to regain the confidence of financial markets in the euro system, but he had carefully to gain the support of the various European heads of state (and the US Treasury and Federal Reserve) to do so.

The Sovereign Debt Crisis, however, made it clear that the EU was a two-tiered economic system, with some members (the euro-area) operating according to one set of rules (which became much more restrictive during the crisis), and the non-euro members working under different rules that were mainly related to trade and the four freedoms of the Single Market Act. Several of these latter countries, especially some from Eastern Europe that were able to enjoy growth rates higher than those of the euro-area as a result, were not eager to see more powers accrue to EU institutions.

Of course, all this made Draghi very controversial.  Many in Europe (especially in Germany), believed he had usurped and applied powers never intended under the Maastricht Treaty. He used massive ECB resources to intervene in markets that some thought ought to have been left free, and had directed that new European controls and regulations be applied to large banks that had previously only had to contend with more lenient and forgiving national rules.

By 2012 it was clear that the EU had evolved into a “confederation” (a voluntary association of states for a common but limited purpose) and the euro-area into something more than that but still far less than a federalized fiscal union, i.e., a centrally administered tax and spending regime that absorbs most of the sovereign economic powers of its member countries. Most of the EU members are protective of their sovereign powers, and their voters are reluctant to give them up, so increasing the federal function of the EU is a tall order. But, as the Sovereign Debt Crisis revealed, tall orders can be less tall in extremis.

In a confederation there are no fiscal powers so economic management hangs on monetary powers delegated in this case to the ECB, making it the most important institution in the EU.

Christine Lagarde is the best possible choice to replace Draghi. She worked with Draghi for eight years on these and related problems and was one of the insiders in addressing the Sovereign debt crisis. She is known in Europe as a skillful politician (abilities needed in the job) who is respected by all of Europe’s heads of state and financial officials. She is the former head of the world’s largest international law firm, Chicago-based Baker McKenzie, speaks several languages and is a former member of the French national swimming team.

She has no experience in central banking but this is of no importance – the ECB has an outstanding professional staff of economists and bankers upon whom she can rely, just as she did at the IMF. What the EU wants is someone able to get the most out of its most important institution.  Europe’s future is very unclear, with populism, Brexit and member country discipline all creating new financial challenges for the EU. Lagarde is the one for the job.

So, addio e grazie Mario, and bienvenue, Christine, et bonne chance.