The Independence of the Federal Reserve and the Trump Administration (2025)

Despite repeated attacks on the Federal Reserve and calls for significant interest rate reductions by President Trump and his officials, significant legal, political and economic obstacles make it unlikely that the executive will gain any meaningful degree of control over monetary policy. Even a successful attempt to install a loyalist (or two) at the Federal Reserve would not lead to a shift toward a significantly different policy, let alone a broader diminution of the Fed’s independence. This comment analyzes the legal foundations of the Fed’s monetary policy independence, assesses the president’s ability to install loyalists at the Fed, and argues that institutional, political and economic factors make it unlikely that the Fed’s independence will be diminished under the Trump administration, continued attacks notwithstanding.

Legislation provides for robust safeguards supporting monetary policy independence

The Fed’s independence in terms of monetary policy rests on several acts of Congress.[1] The founding Federal Reserve Act (1913) provided for the independence of Fed governors who can only be removed “for cause”, meaning for misconduct in office, inefficiency or neglect of duty. The Banking Acts of 1933 and 1935 codified the relationship between the Fed and the executive and removed the treasury secretary from the Board of Governors. The Treasury-Fed Accord (1951), not a piece of congressional legislation, liberated the Fed from a prior, war-time-era commitment to support the treasury market, thereby providing it with operational independence to set monetary policy. Finally, the Federal Reserve Reform Act (1977) committed the Fed to promoting “the goals of maximum employment, stable prices, and moderate long-term interest rates.” It was not until 2012 that the Fed publicly defined “stable prices” to mean two-percent inflation, while failing to provide a numerical target for “maximum employment.”

Legal Foundations of Federal Reserve Monetary Policy Independence
Federal Reserve Act (1913)	Establishes Federal Reserve system; sets ten-year terms for governors, who can only be removed “cause”
Banking Acts (1933)	Creates FOMC without giving voting rights to the Federal Reserve Board; establishes staggered twelve-year terms for governors
Banking Acts (1935)	Shifts power from the regional reserve banks to the Board of Governors; codifies relationship between the Fed and the executive and legislative branches; raises governors’ terms to fourteen years
Treasury-Fed Accord (1951)	Liberates Fed from commitment to cap long-term treasury yields and support treasury debt management
Federal Reserve Reform Act (1977)	Commits Fed to “dual mandate” of promoting maximum employment and price stability

Source: Author’s compilation

As far as monetary policy is concerned, the Federal Reserve is structured as follows. The Federal Reserve Board of Governors (or Federal Reserve Board) is responsible for setting bank reserve requirements and the interest rate on excess reserves (see below). The Fed Board consists of seven members who serve non-renewable fourteen-year terms. Members need to be nominated by the president and confirmed by the Senate. Serving renewable four-year terms, the chairman and the vice chair (as well as the vice chair for supervision), who need to be board members, require separate nomination by the president and confirmation by the Senate. The Fed Board takes decisions by majority.

The Federal Open Market Committee (FOMC) is responsible for setting the Fed’s main policy rate, the federal funds rate, as well as the overnight reverse repo rate. The FOMC consists of the seven members of the Board of Governors, the New York Federal Reserve president and the other eleven regional Federal Reserve Bank presidents, only four of whom are eligible to vote (on a rotating basis) at any one time. Unlike the governors, the regional presidents are appointed by nine-member regional private sector boards for renewable five-year terms, subject to approval by the Board of Governors. FOMC decisions, including interest rate decisions, also require support from a majority of members.

Long, non-renewable, staggered terms for governors, Senate confirmation (for governors), the inability of the president to remove governors (except for cause) and the inability to remove or appoint regional Federal Reserve bank presidents help insulate monetary policy decisions from undue political influence by the executive. The COVID-19 crisis excepted, these institutional safeguards, combined with the Fed’s dual mandate of “price stability” and “maximum employment,” have allowed the Fed to successfully maintain low inflation for the past four and a half decades.

Other than rhetorical attacks, the most direct way for the president to influence monetary policy is to change the composition of the FOMC by stacking it with political loyalists (or individuals sharing the president’s policy preferences). However, barring unforeseen resignations, President Trump will only beable to appoint two new governors during the remainder of his time in office. He is about to replace Adriana Kugler, who resigned in August (and whose terms was originally going to expire in January 2026) and he will be able to replace Jerome Powell, whose term as governor expires in January 2028. The president will also have an opportunity nominate a new Fed chair when Powell’s terms as chair expires in May 2026. But even if the president managed to get two loyalists confirmed, including one of them as chair, it would not change the composition of the twelve-member FOMC much, nor its policy.

 

Member of the Board of Governors	Term Expires
Adriana Kugler*	January 2026 (vacated seat in August)*
Jerome Powell (chair)	January 2028*
Christopher Waller	January 2030
Michael Barr	January 2032
Michelle Bowman (vice chair)	January 2034
Philip Jefferson	January 2036
Lisa Cook	January 2038

Source: Federal Reserve
* Terms expiring during Trump presidency

The president could also try to remove Fed Board members “for cause”. (This is what the administration may be preparing to do by blaming Fed Chair Powell for the cost related to the renovation of the Fed’s D.C. headquarters.) If the president were to dismiss Powell as governor, the case would very likely be litigated and the case would end up before the Supreme Court. As per 1913 Federal Reserve Act, it is less clear that the same safeguard applies to position of Fed chair. However, even if the administration managed to dismiss Powell as chair, it would not be able to remove him as board member (other than “for cause”) and Powell could then decide to stay on as board member until January 2028, thus limiting the president’s ability to nominate a political loyalist to the Board and forcing him to choose among broadly “traditionally-minded” Board members. 

Moreover, despite the ability to set the agenda, a loyalist Fed chair would need to win majority support from FOMC members in terms of monetary policy decisions. Just because historically the Fed chair rarely has been on the losing side of votes does not mean that a controversial, political Fed chair would be able to secure majorities for significant changes or shifts in monetary policy. Another (minor) obstacle arises from the fact that although the Fed chair, by convention, is also FOMC chair, the FOMC chair is not a legally defined position and FOMC members, by statute, could elect another committee member, instead of a controversial Fed chair. Granted, this would increase uncertainty and may raise concerns among investors, but it would also prevent a loyalist from heading up the FOMC. 

The preceding analysis rests on the premise that present legal safeguards concerning Fed independence remain in place. The Trump administration often invokes the so-called unitary executive theory, which stipulates that the president has wide-ranging authority over the executive branch, including the authority to dismiss officials of independent agencies. In a recent decision, the Supreme Court ruled in favor of the administration’s decision to remove the heads of two independent government agencies. But in its decision the Court also made it clear that this decision would not apply to the Federal Reserve. [2] This makes it likely, though not certain, that the Supreme Court would balk at granting the president the ability to fire Fed officials at will, should the executive invoke such authority. On balance, this makes it unlikely that the administration would prevail legally, meaning that the president’s ability to remove Board members will remain highly restricted. 

Barring unforeseen vacancies, the president will therefore be able to appoint only two new members to the seven-seat Fed Board, and two out of twelve FOMC members. This would not meaningfully affect the independence or monetary policy of the Fed, for the president’s ability to fire regional bank presidents, let alone replace with loyalists, is virtually nil, according to dominant legal opinion.[3]

Placing a couple of loyalists on the FOMC will be difficult, and likely not very effective 

Apart from setting the federal funds rate, political loyalists could seek to weaken Fed policy by pushing for an upward adjustment of the two-percent inflation target or a further tweaking of the monetary policy framework.[4] But these decisions also require majority support on the FOMC. But it is the Fed Board, not the FOMC, that sets the interest rate on reserve balances (IORB). Under the current ample-reserves regime, a majority of governors could seek to lower the IORB, thus potentially compromising the FOMC’s ability to set a lower bound for the federal funds rate. Such a move is perhaps not very likely given how potentially damaging it would be for Fed credibility and financial instability it might cause. But either way, such a decision would require the support of a majority of governors, which would be easier than gaining majority support on the FOMC.[5]

For any of the above scenario to materialize, the president would need to dismiss a substantial number of governors to have the opportunity to be able to “gain” majorities on the Fed Board, let alone the FOMC. But the larger the number of dismissals (assuming they prove successful), the greater the economic-financial turmoil this would trigger, and the less likely such a move becomes politically judging by the president’s April decision to suspend reciprocal tariffs after their announcement triggered significant financial market volatility. 

Moreover, even if the president managed to dismiss substantial numbers of governors, their replacement would require Senate confirmation, unless the president manages to make a recess appointment.[6] The Senate balked on several occasions at supporting and confirming controversial unofficial and official nominees during the first Trump term (e.g. Judy Shelton). The Republican’s present 53-47 majority would make it very difficult for a controversial political loyalist to be confirmed. Democrats would oppose such a candidate, as would, at least until the mid-terms, several retiring “traditional” Republican senators as well as some purple-state senators.[7] Finally, it is far from clear that Trump-nominated governors (or chair), even if confirmed, would do the president’s bidding once in office, something President Trump understands Quote: “Sometimes they’re all very good until you put them in there and then they don’t do so good.” 

Federal Reserve independence will survive Trump administration

None of this means that attempts to fire Board members “for cause” (or other reasons) would not lead to market volatility. But legally, the obstacles to removing governors are extremely high, and the president lacks the ability to remove regional Reserve Bank presidents. 

If the president managed to put one or two or even three loyalists on the Fed Board, that Fed monetary policy might become marginally more dovish than it would otherwise have been. But this would be very different from the Fed abandoning its commitment to price stability or forfeiting its independence. After all, there are almost always grounds for legitimate disagreement about the optimal course of monetary policy in view of the Fed’s price stability commitment. Placing two dovish governors on the FOMC would make the median members slightly more dovish without leading to a significantly more dovish policy given the need for majority support. 

A more dovish policy would, all other things equal, lead to a moderately weaker dollar, moderately higher long-term interest rates and stronger equity markets. Meanwhile, a broader assault on the Fed in the guise of an attempt to dismiss several Board members, let alone regional presidents, would likely trigger severe market turmoil, at least initially until the legal situation is clarified. 

Similarly, it would require a major weakening of Fed independence for the international role of the dollar to be threatened. The dollar retains many important structural advantages, benefitting from America’s geopolitical power, economic size, rule of law (comparatively speaking), and large, liquid financial and government bond markets, as well as an incumbency advantage and weak competitors. Against the backdrop of less predictable U.S. fiscal, trade and financial sanctions policies under the Trump administration, further international currency diversification by official investors and an increasing shift into non-dollar assets by private investors is possible, even likely. The political attacks on the Fed will at the margin also support such a shift without it however leading to a broader meaningful diminution of the dollar’s status as the dominant international currency.

Non-legal factors also limit likelihood of wholesale assault on Fed independence

Significant legal, political and economic obstacles make it unlikely that the Fed will see a diminution of its monetary policy independence under the Trump administration. Legally, the Supreme Court is unlikely to grant the president the authority to dismiss governors at will. Dismissing governors “for cause” would run into opposition from courts. Even if successful, the Senate would then need to confirm the presidential nominees but would balk at confirming individuals seen as too politically beholden to the president and weakening the de facto independence of the Fed. And even if several of the presidents’ preferred nominees were to be confirmed, it is far from clear that they would do the president’s bidding. Majority decision-making would further limit the influence of political loyalists on the Board and especially the FOMC. Barring a major reversal of the courts, the legal-institutional obstacles that stand in the way of President Trump gaining meaningful control or influence over Fed monetary policy are very significant.

Economically and financially, a major assault on the Fed’s independence would lead to extreme financial market volatility and weaken the economic outlook, thus sharply reducing the administration’s incentives for such a move. Politically, the incentive to make a major attempt to weaken Fed independence is also limited because it is unlikely to succeed and because it would deprive the Trump administration of a convenient scapegoat if the U.S. economy were to weaken.

---

[1] In addition to monetary policy, the Federal Reserve is responsible for financial stability, supervision and regulation, and the payments system.

[2] Financial Times, Supreme Court signals it could shield Federal Reserve from Donald Trump, May 23, 2025. For a “contrarian” view, Lev Menand, The Supreme Court’s Fed carveout, Columbia Public Law Research Paper forthcoming, May 27, 2025

[3] For a contrarian view, Financial Times, How to kill the Fed’s independence, February 25, 2025

[4] Federal Reserve, Statement on Longer-Run Goals and Monetary Policy Strategy, adopted effective January 24, 2012; as amended effective August 27, 2020

[5] Federal Reserve, Implementing monetary in an ‘ample-reserves’ regime, FEDS Notes, 2020

[6] A temporary appointment by the president to fill a vacant position when the Senate is in recess. Such an appointment expires at the end of the Senate’s next session. The Senate can block recess appoints by holding pro forma sessions.

[7] It remains unclear if the nomination of Trump loyalist Stephen to replace Kugler requires Senate confirmation or via recess appointment. As he will only serve out Kugler’s term till January 2026, the Senate may (or may not) be more receptive to the nomination if Senate confirmation is required.

U.S. Economic Policy and the Dollar (2025)

The appreciation of the euro against the dollar will lead the European Central Bank (ECB) to lower interest rates further in 2025, even though by itself this is unlikely to weaken the euro, which will make it less likely that the U.S. administration will pursue destabilizing financial policies aimed at weakening the dollar further. Despite expectations that protectionist U.S. trade policies would lead to an appreciation of the dollar, the U.S. currency has depreciated since President took office in January. Meanwhile, U.S. equity markets have reached or remain close to all-time highs, despite the risk of trade-related economic disruption. Thus far, dollar depreciation has been orderly, suggesting it is driven by a gradual shift of private investors into non-dollar-denominated, including euro-denominated assets.

> Since President Trump took office in January, the dollar has depreciated 11% against the euro. The dollar has also depreciated in trade-weighted terms, meaning against a broader basket of currencies.

> The dollar-euro interest rate differential has widened year-to-date. The Fed has left its policy rate unchanged at 4.25-4.5%, while the ECB has lowered its policy rate by a cumulative 100 basis points. A widening rate differential in favor of the dollar should have, all other being equal, led to dollar appreciation.

Higher U.S. tariffs combined with a stronger euro will weigh on euro area inflation and economic growth and will lead the ECB to lower interest rates by another 25-50 basis points this year. The dollar-euro interest rates differential will not change significantly with the ECB lowering rates by 25-50 basis points this year, and the Federal Reserve (Fed) by 0-0.75 basis points. A high level of uncertainty will continue to attach to U.S. economic policies and the U.S. inflation outlook. While increased government spending in Europe, particularly by Germany following the reform of the debt break, will help support domestic demand, a stronger euro and higher U.S. tariffs will weigh on exports. Nonetheless, the outlook for increased investment and defense spending will help attract investment into the euro area, further helped by erratic, dollar-negative U.S. economic. Increased investment and more predictable euro area policies will also support the greater diversification into euro-denominated assets.

> Euro area inflation has declined to the ECB’s two-percent target in June. Markets and analysts expect the ECB to lower interest rates by 25 basis point one more time, bringing the policy rate to 1.75%. The ECB has lowered its policy rate from 3% at the beginning of the year to 2%.

> In its April World Economic Outlook, the IMF forecasts U.S. real GDP growth of 1.8% and 1.7% in 2025 and 2026, respectively. Meanwhile, the respective forecasts for the euro area are 0.8% and 1.2%.

> While the euro area’s second and third largest economies, France and Italy, have limited room to increase fiscal spending, Germany has committed to spending an additional $ 1 trillion on infrastructure and defense over the next few years, which is a sizeable amount given euro area GDP of EUR 15 billion. This has helped make previously undervalued European equities more attractive to investors.

A weaker dollar and highish U.S. interest rates are suggestive of concerns about erratic U.S. economic policies, including attacks on the Federal Reserve as well as large fiscal deficits and increasing government. Strong U.S. equity markets suggest investor optimism in the context of the ongoing AI boom, the Trump administration’s deregulation agenda and the relative growth outperformance of the U.S. economy vis-à-vis Europe. A combination of high U.S. interest rates and sizeable fiscal deficits has historically led to a strong dollar. The significant uncertainty attaching to U.S. trade and foreign economic policies helps explain why investors are eager to increase their holdings of non-dollar assets. A weaker dollar, the risk of lower interest rate due to government pressure on the Fed, and deregulation also benefit U.S. equity valuations, while weakening demand for dollar-denominated fixed income assets. Increased concern about Fed independence and more broadly erratic U.S. economic policies may also explain the unusual behavior of the dollar and treasuries following the announcement of reciprocal tariffs when both the dollar and U.S. treasuries sold off.

> U.S. headline and core personal consumption expenditure inflation, the Fed’s preferred inflation gauge, reached 2.3% and 2.7% year-on-year, and thus remained above the Fed’s two-percent inflation target. In its Summary of Economic Forecasts, the Fed forecasts 50 basis point worth of interest rate cuts this year. U.S. unemployment was 4.1% in June, suggesting a tightish job market, not conducive to rapid disinflation.

> The Congressional Budget Office estimates that the budget reconciliation bill will add $3-4 trillion worth of debt until 2035, or roughly 10% of 2035 GDP), compared to a scenario where the cuts would have expired. Continued large fiscal deficit will lead to an increase of the debt-to-GDP ratio, which currently stands at 100% of GDP/

A weaker dollar will help limit the incentives for the Trump administration to pursue unorthodox, risky and potentially destabilizing financial policies aimed at further weakening the dollar in the context of continued large U.S. trade deficits. Uncertainty about U.S. economic policy, including trade policy, will continue to weigh on the dollar. The interest rate differential is not change much, if at all in the dollar’s favor this year. Whether recent dollar weakness will lead to a tangible narrowing of the U.S. trade deficit remains to be seen. Even if it did, it would not lead the U.S. administration to pursue less protectionist policies than it would otherwise have done. However, given the risk attached to other “unorthodox” financial policies aimed at weakening the dollar that various members of the Trump administration have floated, including a tax on capital inflows or foreign holdings of U.S. assets, or a restructuring and maturity extension of U.S. debt held by foreigners (Mar-a-lago accord), a weaker dollar will make such policies less likely to pursued. Anecdotal evidence suggests that it was the unusual instability and volatility of the U.S. treasury that led the Trump administration to suspend tariffs in April. The Treasury will be opposed to any market-destabilizing financial policies aimed at further weakening the dollar, and even the president is likely to balk given the April events.

> During the electoral campaign, Donald Trump floated a tax foreign capital inflows. Members of the Trump administration have floated the idea of asking allies to restructure their holdings of U.S. government debt to reduce U.S. interest payments and possibly weaken the dollar. Congress almost approved a so-called “revenge tax” in the context of the recent budget reconciliation bill that would have allowed the U.S. authorities to impose additional, targeted taxes on foreign holdings of U.S. assets. Any of these measures has the potential to seriously undermine foreign investor confidence, raising the risk of significant dollar and U.S. treasury market volatility.

 

 

The Euro Area Crisis Fifteen Years On (2024)

Although the euro area has come a long way in terms of institutional strengthening and enhancing financial resilience future shocks since the financial of the late 2000s and early 2010, significant institutional weakness remain. The single European currency, the euro, was created in 1999-2002. In the first decade of its existence, it contributed to economic and monetary convergence among its members, as capital flowed from the low-interest core to the high-interest periphery, leading to an economic and financial boom as well as a gradual build-up of financial vulnerabilities in the context of overborrowing by government and excessive lending to the real estate sector by banks. The euro area debt crisis was triggered in in late 2009 when the Greek government was forced to acknowledge that it had systematically underreported its fiscal deficit. The ensuing crisis, which risked forcing significant losses on euro area banks and cast doubt on the creditworthiness of highly indebted governments, almost led to the financial and institutional collapse of the single currency. The single currency came about as a political agreement between France and Germany, largely reflecting German preferences. As such, Economic and Monetary Union (EMU) was established as an incomplete monetary union. Among other things, it included a no-bail out provision meant to force members to pursue fiscally prudent policies and prohibit the central bank from providing monetary financing to member-states in view of preserving monetary stability. The Maastricht criteria and later the Stability and Growth Pact sought to obligate members to maintain low government debt and small fiscal deficits, but the accompanying enforcement mechanisms were too weak. The regime lacked the instruments to backstop governments and banking system in financial trouble, beyond national level, to prevent financial contagion in the euro area.

> Starting in 2010, the euro area cobbled together in a less and after 2012 in a more systematic manner financial rescue programs to contain financial contagion and prevent a broader financial breakdown of the euro area. Greece received financial bailouts in 2010 and 2012, Ireland in 2010, Portugal in 2011 and Cyprus in 2013.

> Banking crises in Spain, Ireland and Cyprus led the respective governments to request financial bailouts, which, in the case of Cyprus, was accompanied by a bail-in of bank depositors. The Greek government restructured its debt in 2012 and has engaged in several voluntary debt exchanges since then.

In the face of the quasi-existential debt crisis, the euro area has seen major institutional reform, which have helped make the single currency more resilient. The financial crisis forced the euro area into wide-ranging institutional reform to prevent a complete financial breakdown, manage the risk of a breakup of the single currency, reestablish economic stability and prevent future financial crises. The existence of a “no bail out clause” (Art. 125 of TFEU) made the single currency vulnerable to destabilizing financial contagion. Typically, central banks act as a lender-of-last-resort, not just to the banking system but also to the sovereign. In the euro area, the European Central Bank was prohibited from playing this role. Once signs of financial distress and investors began analyzing the various cross-cutting financial linkages, from Greek government debt to European and Cypriot banks as well as from weakened banking systems to generally financially solid sovereigns, like in Ireland and Spain, the euro area was forced to address the immediate consequences of the crisis and implement broader reforms to reduce future crisis risks. Despite establishing a financial rescue mechanism, it was the ECB with its notionally unlimited financial resources and its commitment to do “whatever it takes” that helped stabilize the euro area. In addition to establishing a bail-out mechanism implicitly if conditionally backed by the European Central Bank, the euro area reformed its fiscal regime and made some, if limited progress toward banking union in an attempt to prevent future sovereign crises to spill over into the banking sector as well as minimize the risks of a banking crisis causing sovereign financial distress (so-called sovereign-bank nexus).

> During the initial emergency in 2010, the euro area members were forced to provide financial support to prevent broader financial contagion and the systemic destabilization of the euro area. This took place, first, in the guise of the European Financial Stability Mechanism (EFSF) and the European Financial Stability Mechanism (ESFM). Due to their limited size, both funds were replaced by the newly established only euro area member funded European Stability Mechanism (ESM) in 2021. The ESM today effectively functions as a euro area IMF, providing financial resources to distressed members in exchange for economic adjustment and reform.

> The ECB created new instruments to stabilize markets. Through the Securities Markets Programme (SMP) it sought to contain long-term interest rates in financially weaker countries. In 2012, it established an instrument called Outright Monetary Transactions (OMT), which promised to backstop sovereign unconditionally under certain conditions, such strict policy conditionality under an EFSF/ ESM programme. In 2022, the ECB created a so-called Transmission Protection Instrument (TPI) in 2022, which officially is meant to ensure the smooth transmission of monetary policy but effectively allows the ECB to contain the interest rates spreads of financially weaker member countries relative to the stronger ones by allowing it to purchases unlimited amounts of medium- and long-term debt securities, again provided the country is pursuing a sound fiscal policy, does not suffer from macroeconomic imbalances and is compliant with EU fiscal rules. In addition, the ECB created a Public Sector Purchase Programme (PSPP) as well as other programmes that allow it to make large-scale purchases of non-sovereign financial assets in the secondary market in the context of its quantitative easing policy. At the beginning of the COVID-19 pandemic, it also created a Public Emergency Purchase Programme (PEPP), worth EUR 1,350 billion. Central bank purchases of sovereign debt help keep down borrowing costs and are seen by purists as monetary financing of government debt.

> The euro area members also implemented several reforms of their fiscal regime. In 2011, it introduced the so-called “six pack” of regulation aimed at tightening the rules of the Stability and Growth Act. In 2012, the fiscal compact replaced by and rolled into the Stability and Growth Pact and further tightened the fiscal regime governing national financial policies in terms of restrictions and enforcement of rules, adjustment requirements and transparency. The compact subjects member countries’ fiscal policies to European Commission surveillance, commits countries to a mandatory balanced budget rule, strengthens the excess deficit procedure and requires convergence toward medium-term objectives, among other provisions. The compact was updated in 2024 to make them less complex and hence less complicated to enforce.

> The euro area also took steps to limit the risk of systemic banking crises. It established a Single Supervisory Mechanism (SSM, 2014), which gives the European Central Bank supervisory powers over large euro area (and selected EU) banks. (Smaller banks largely remain under the supervision of national authorities.) It created a Single Resolution Mechanism (SRM) to allow for the orderly resolution of banks. The Single Resolution Fund (SRF) is meant to help resolve failing banks in case bail-ins are not viable and prevent disorderly bankruptcies in the banking sector through bailing in of creditors or an orderly winding up.. The SRF is funded by banks and is meant to cover 1% of all euro area deposits (or EUR 55 billion OR EUR 78 billion in July 2023). The euro area failed to make progress on the third pillar, namely a European Deposit Insurance Scheme (EDIS, 2015, not adopted) to limit the risks and costs to governments of bank failures. A recent reform, currently in the process of being approved, is seeking to deploy the ESM as a backstop to SRF through revolving credit line.

Although the euro area proved resilient in face of COVID-19 pandemic and Ukraine war related shocks, the present institutional architecture continues to make it more vulnerable to severe shocks than, for example, the dollar.  The euro zone architecture is incomparable more robust than 15 years ago, but it continues to be characterized by important weaknesses, particularly compared to countries with a more centralized fiscal authority and a national central bank. First, while a financial rescue mechanism makes the system more resilient, their funding capacity is limited. This is why the ECB’s OMT is an indispensable element of the euro area’s financial architecture, as it provides the financial firepower to credibly backstop even larger member governments. Second, the financial firepower of the SRM is also quite limited. Again, while the ESM provides additional financing under certain conditions, the financial capacity, accounting for just 1% of euro area banking deposits is small, particularly if there is no additional explicit or implicitly actor able and willing to backstop the system in case of a severe crisis. Many national banking systems remain vulnerable given their government’s limited ability to backstop to the system and no common euro area wide deposit insurance, which will exacerbate bank runs in moment of crisis, as local depositors will move their money to euro area countries not at risk of default of currency denomination. Since the end of the euro area debt crisis in in the mid-2010, euro area governments have benefitted from low nominal interest rates and extensive central bank purchases of their sovereign debt. While they have thus far weather higher policy rates, it remains to be seen how well they will cope with higher interest rates as well as wider spreads. The medium- and long-term financial outlook will also prove challenging in view of the need to increase spending on defense, the green transition and social welfare due to population aging. This will be particularly challenging for countries with low economic growth. In the face of these pressure, the domestic consensus in favor of prudent fiscal policies and compliance with euro area fiscal rules may erode and lead to increased conflict with national-level fiscal priorities and euro area level restrictions. This in itself has the potential to upset markets and lead investors to charge higher interest rates, thus exacerbating the financial outlook of financially challanged countries.

> Euro area government debt has increased significantly in euro terms, hence relative to the financing capacity of the ESM. Italian and French government debt amounted to around EUR 3 trillion, respectively, or 140% of GDP and 110% of GDP. ESM total lending capacity amounts to a mere EUR 500-700 billion. Domestic credit to the private sector, a proxy for the banking sectors’ non-sovereign lending as well as a sovereign contingent liabilities in the case of a banking sector bail-out, stood at 70% and 120% of GDP, respectively. EUR 500 billion ain’t a lot of money.

> The recently created NextGenerationEU or European Union Recovery Instrument, adopted in 2020, provides for common EU funding financed by EU-level resources. But the financially stronger, net payer governments have made it clear that it will remain a one-off, it will run from 2021-2027 and provide a mere EUR 750 billion to support post-pandemic investment and reform. However, the financial challenges of many of the weaker euro area members are much larger in financial scope and time horizon. The new instrument is drop in the bucket as far as the longer-term fiscal challenges are concerned.

The politics of euro area reform and crisis-proofing will remain contentious and significantly increased direct or indirect resource transfers and risk sharing will remain unlikely in the next few years. The reforms pit low-debt “creditor” countries in the North against high-debt “debtor” countries in the South, with France (as a country with large government debt) leaning towards the latter. Reform will be slow, absent another major, systemic crisis. Although all member countries have an interest in increasing the resilience of the euro area to shocks, they disagree as to how to distribute the actual and potential costs of the reforms. Reforms that risk creating a so-called “transfer union” by enshrining the possibility of a permanent resource transfer is not attractive to creditors, financially, economically or politically. The creditor countries retain veto power of any such reform. This is also why any resource transfer and risk sharing is limited and typically conditional, whether this relates to emergency lending, banking resolution or banking union. Financially more vulnerable countries, namely countries with large government debt and a banking sector owning large amounts of national government debt, is simply not in a position to make a major contribution to risk sharing. The fiscal conservative countries will continue to resist reform aimed at substantially greater risk sharing or resource transfers, while the debtor countries will continue to oppose institutional reform that transfers the costs of financial distress, whether in terms of macroeconomic adjustment, sovereign debt restructuring or banking sector insolvencies, to financially weaker countries. Absent another major shock, the euro area will likely prove sufficiently resilient in the next few years so as not to require important reform. At the same time, the euro are is unlikely to suffer any defections due to popular opposition in member countries or adverse legal rulings that undermine key elements of the current financial-institutional architecture. The euro remains very popular in virtually all euro area countries, and legal challenges brought against the new financial architecture have been largely, if not completely defeated by national constitutional or European courts.

> The interests of fiscally conservative, largely Northern European euro area members, and less financially disciplined countries in the South continue to diverge, making it difficult to make progress in terms of euro area institutional reform. The former broadly oppose significant resource transfers and direct or indirect risks sharing. Government debt exceeded a 100% of GDP in Greece, Italy, France, Spain, Belgium and Portugal. It was below 70% of GDP in Germany, the Netherlands, Ireland and the Baltic countries.

> Virtually all euro area government face significant long-term fiscal challenges caused by a combination of aging populations and welfare systems, including pension and health spending. In addition, increased spending on the green transition and defense will also put upward pressure on fiscal deficits and, in most cases, government debt ratios. Significant fiscal reform necessary will prove politically controversial. It will make it unlikely for significant intra-euro redistribution to take place. Ergo, no Hamiltonian moment.

> The euro remains popular. Support is high in all euro area member countries, but much lower in in virtually all non-euro area EU members. Popular opinion can change quickly if euro area membership were to be associated again with economic conditionality and financial crises. Although the economics of common currency areas are complicated, the median voter’s intuition that the benefits of membership in the single market and the single currency are significant and that the costs of exiting are very large is sound. The economic reality is that exiting the euro area would prove a financial disaster and would likely force the country out of the single market, even if no legal mechanism to force it to do so exists. This has forced populist parties to back away from calls to exit the single currency to make themselves more electable, thus reducing the risk of a politically driven euro exit.

Governability and Dollarization - The Case of Ecuador (2024)

A challenging financial outlook and significant governability challenges make for a difficult economic and political outlook in Ecuador, leaving the government with little choice to agree to a another IMF program if it wants to avoid a destabilizing economic and financial crisis by 2026. Ecuador has a history of governability challenges and financial stability. The presidency of Rafael Correa (2007-2017) proved an exception, which can be largely attributed to a favorable international economic environment. A significant increase in oil revenues allowed for a significant expansion of social spending, which supported political stability. More typically, however, a combination of economic challenges, socio-economic discontent and, at the institutional level, legislative-executive deadlock circumscribe the ability of Ecuadorian governments to pursue a forward-looking economic policies and contributes to recurring financial problems. Most recently, President Guillermo Lasso was effectively forced out of office in the context of a stand-off between the executive and the legislature. Ecuador is also a serial defaulter and mostly recently restructured its international bonds as well as its debt owed to China in 2020-22. 

> In the past 30 years, many Ecuadorian presidents were ousted, deposed or impeached (e.g. Bucaram in 1997, Arteaga in 1997, Mahuad in 2000, Gutiérrez in 2005, Lasso in 2023). 

> Ecuador has defaulted almost a dozen times since its independence. Most recently, the government was in default on its international bonds in 1997-2000 and in 2008-09, and it restructured its international bonds in 2020, which economically translated into a default due to a reduction in the net present value of the bonds.

> In 2020-22, Ecuador also restructured its debt with Chinese banks, while an oil-based credit agreement with PetroChina was modified to allow for debt relief. In May 2023, Ecuador’s creditors also agreed to a debt-for-nature debt swap.

Governability challenges are compounded by a dollarized economy and commodity dependence, which makes the Ecuadorian economy more susceptible to exogenous shocks, while it limits its to pursue forward-looking economic policies consistent with the macroeconomic constraints imposed by dollarization. Full dollarization is constraining in macroeconomic terms because it effectively removes monetary and exchange rate policy from the government’s toolkit to stabilize the economy in the face of shocks, including commodity-related terms-of-trade or interest rates shocks. Dollarization also eliminates seigniorage. This forces policymakers to rely even more on fiscal policy to stabilize the economy and the financial situation. By severely curtailing the central bank’s lender-of-last-resort function and removing the ability to stimulate the economy through currency depreciation or lower interest rates, fully dollarized economies are more susceptible to greater economic and financial volatility as well as fiscal and debt crises. A fully dollarized economy that is subject to large terms-of-trade or inflation shocks will experience greater interest rate, price and inflation volatility, which can undermine the government’s financial position. Governments need to save oil-related windfalls so as not to be forced into pro-cyclical austerity during the next downturn. This requires a government that is able to pursue prudent, forward-looking fiscal policies. Failing to build up fiscal buffers when economic growth is high or keeping inflation under control when experiencing favorable commodity price shocks, governments in dollarized monetary regimes are then often forced into protracted low economic growth and fiscal restraint, which raises the risk of socio-economic and political instability. In face of increasing financial instability, governability challenges, such as the executive’s limited control of the legislature, tends to undermine market confidence further, as policymakers prove unstable to implement the measures necessary to counteract instability. This captures Ecuador’s experience under dollarization fairly well. Political stability and economic progress was relatively high when Ecuador benefitted from oil-related revenue windfalls under Correa, but instability increased after oil prices declined and the government had overspent and over-borrowed. 

> Ecuador’s export revenues are highly dependent on volatile commodity prices. According to the World Trade Organization, fuels and mining products account for almost 40% and agricultural products for more than 50% of total exports. Meanwhile, dollarized export markets, the United States and Panama, account for 40% of all Ecuadorian exports.

> Social spending doubled between 2007 and 2016 from 4.3% to 8.6% of GDP, the Gini coefficient declined, and both inequality and poverty fell. A fair share of the improvement has reversed in the past few years, while homicides increased sharply, as Ecuador was forced into fiscal adjustment in the face of external shocks (oil after 2015, COVID-19 in 2020).

> Government debt did initially decline when oil prices increased, but the government failed to save enough revenues when the times were good and failed to resist increasing difficult-to-reverse social spending. After the end of the oil price related boom in 2015, successive governments have failed to stabilize the economy.

 

Despite the recent debt restructuring in during 2020-22, Ecuador continues to face significant external financing challenges, which will give it little choice but to sign up for another IMF program if it wants to avoid broader economic instability, even if it will not necessarily help it avoid another restructuring of international bonds. Ecuador faces high interest rates due to high U.S. interest rates and weak economic growth. Although the fiscal deficit has declined following the COVID-19 pandemic and IMF-supervised macroeconomic adjustment, increasing oil prices explain a fair share of improved budgetary outcomes. Unable to implement a structural fiscal adjustment, the government often resorts to one-off measures. This casts doubt on the long-term sustainability of the fiscal adjustment. The government remains in domestic arrears and its remains locked out of international capital markets, forcing to rely on multilateral borrowing, despite the 2020-22 debt restructuring. External debt service is set to increase significantly in 2025 and 2026, including IMF loans. (e.g. drawing down deposits, tapping the central bank. 

> As Ecuador was already granted exceptional access under its previous program, net new financing will be limited, but it will be helpful to effectively roll over IMF loans. Ecuador owes IMF almost $ 8 billion, which will be coming due in the next few years. IMF roll-over. But effectively rolling IMF loans and unlocking additional multilateral borrowing will help support Ecuador’s external financing outlook. But this does not mean that Ecuador will avoid another debt restructuring. But another debt restructuring in the context of an IMF program would prove less disruptive than “hard” default.

> The IMF understands that macroeconomic adjustment in a fully dollarized economy is financially and politically difficult. The older staff members will remember how quickly the Argentina program went off trach in the late 1990s and 2000s and how the Fund’s reputation was tainted, suggesting the risk of supporting adjustment programs in macroeconomically constrained, dollarized, commodity exporters. While the Fund will therefore demand significant assurances from the government, it will also be keen to agree to a new program in order to reduce the possibility of Ecuador defaulting on its IMF obligations.

A new IMF program would ensure that the government continues to implement macroeconomic adjustment, help unlock additional, multilateral and possibly bilateral funding with the aim of avoiding broader medium-term economic and financial destabilization. If it is to avoid a default on its IMF and private external debt, it will need to reach an agreement with the IMF. Negotiations with the IMF will prove challenging, and it remains to be seen whether the IMF’s insistence on financing assurances will lead to yet another restructuring of Ecuador’s international market debt. The IMF has already granted Ecuador exceptional access under its EFF, meaning the Fund will not be willing to run financial risks in the context of uncertain ability of the current government to stick with implementation and commitment of next president. At the same time, the IMF will have an interest in a new agreement if only to avoid broader destabilization, including potential default of Ecuador on its IMF debt.

> After an initial IMF program was terminated prematurely (March 2019 – May 2020), Ecuador signed up to a new Extended Fund Facility (EFF) arrangement in December 2020, after also receiving COVID-19-related IMF financial support in the guise of the Rapid Financing Instrument (RFI). The IMF completed the final review of an 27-month EFF program in December 2022. Although the program helped improve Ecuadorian fiscal and debt dynamics and help put shore up the dollarization regime by reversing much of the institutional erosion in terms of the government weakening the central bank, Ecuador remains shut out of international bond markets in view of the increasing external debt service in 2025-27. All major international credit rating agencies rate Ecuador close to default (CCC+/ Fitch, Caa3/ Moody’s, CCC+/ S&P). 

> The 2019 and 2020 IMF program helped strengthen the central bank after years of weakening of central bank and foundation of dollarization (e.g. central bank lending to state-owned banks, direct government financing), which had led to weakening of central bank balance sheet (e.g. reserve coverage of banks’ deposit) and help put the dollarized regime on a sounder footing. While fiscal targets were met, this was primarily due to increased oil-related revenues and higher growth. Some of the structural fiscal measures fell short, largely due to domestic political opposition and the president’s inability to get the relevant measures approved by congress.

President Daniel Noboa will not be able to reestablish access to international markets before his term expires in May 2025, unless his government agrees to a new IMF program, and even then regaining access to international markets will remain highly uncertain in the near term (> 12-15 months). Since taking office in November 2023, President Noboa has sought multilateral loans and in March official requested a new IMF program. But Noboa’s National Democratic Action alliance holds only 10% of all seats, which will make it difficult to push through necessary reform and especially fiscal austerity. The upcoming 2025 presidential elections will also make it politically costly (CAN RUN AGAIN?). Continued socio-economic pressures combined with congressional fragmentation will make it difficult to implement the necessary reform, not least because the next presidential elections will take place in 2025. Rather than adopt structural measures that promise putting Ecuador on a sustainable economic and financial path, the Noboa government will be more inclined to implement one-off measures to address the financial challenges. Significant fiscal retrenchment would weigh on economic growth and employment outlook and will fund at best limited political support from the executive and the legislature. Negotiating an IMF program in view of Ecuador’s economic challenges and political situation will prove challenging, and if a program is agreed, it remains to see to what extent Ecuador will live up to its reform commitment. 

> Government debt peaked at more than 60% of GDP in 2021, but medium-term debt dynamics remain vulnerable, not least due to a strong dollar and high U.S. interest rates. The Noboa government has relied on one-off measures rather than structural adjustment (e.g. reprofiling public debt held at the central bank), while deposits continue to fall and domestic arrears continue to increase, pointing to very considerable domestic and external financing challenges.