The Principal-Agent Problem at the ECB

The incentive structure at the ECB has become distorted and favors high-debt countries

Jens Weidmann resigned as President of the Bundesbank in 2021. His departure followed that of other prominent Germans in the Eurosystem (the ECB and national central banks in the Euro zone), including Axel Weber and Jürgen Stark. The common thread in all these resignations is that people who oppose the ECB’s use of its balance sheet to cap government bond yields of overindebted countries have no place in the Eurosystem. They’re consistently outvoted and vilified in popular discourse.

Now think about what incentives this creates for remaining Eurosystem reprentatives from low-debt countries. They’re substantially outnumbered by representatives from high-debt countries, so - if they want a successful career - they bend to the majority. This may be in their own interest, but it certainly isn’t in the interest of countries like Germany and the Netherlands. There’s a “principal-agent” problem in the Eurosystem, which means the interests of low-debt countries are no longer being represented.

All this has been building for many years, but it came to a head mid-2022. At the time, the post-COVID inflation shock was driving up bond yields around the world, putting stress on high-debt countries like Italy and Spain. The ECB held a highly unusual “emergency meeting” on June 15, intervened in July - when Mario Draghi resigned as Italy’s prime minister - to cap Italian and Spanish yields as the chart above shows and - also in July - introduced its controversial anti-fragmentation tool, the Transmission Protection Instrument (TPI), which allows the ECB to cap bond yields when it deems these have gone above what fundamentals justify. Of all the things the ECB did that summer, this was by far the most egregious, because it institutionalized yield caps.

These things should have been fiercely opposed by representatives from low-debt countries, but instead they helped design the TPI and promoted it, as in this speech by ECB Executive Board member Isabel Schnabel that summer. This would never have happened if Jens Weidmann had still been around. In his wake, representatives from low-debt countries have learned that you can only get ahead if you go along with the majority. The interests of low-debt countries - i.e. keeping the ECB out of fiscal bailout territory - are de facto no longer being represented in the Eurosystem.

In economics, the principal-agent problem is when one party (the principal) delegates decision-making authority to another party (the agent), but the agent’s interests diverge from those of the principal. This is exactly what’s happened at the ECB. At the root of this lies the fact that high-debt countries outnumber low-debt ones, so the majority will always favor ECB help for high-debt countries. That in no way absolves the current set of representatives from low-debt countries, nor does it absolve the governments in low-debt countries who’re afraid of standing up to high-debt ones.

All this has major ramifications for the Euro zone and needs to be fixed. Markets have learned the ECB will backstop a high-debt country like Italy, so - as the chart above shows - its 10-year yield is falling steadily as markets start trading Italy and Germany more and more like substitutes. Any incentive for Italy to pursue debt reduction goes out the window, which will only change when the principal-agent problem at the ECB is fixed. The best way to do that is for governments in low-debt countries to remind their representatives in the Eurosystem of their principal responsibility, which is to do monetary policy and not run fiscal assistance programs. If that doesn’t work, one or all of these representatives should be replaced.