. . . . the heart of what a Central Bank does is essentially monetary policy and price stability, which includes the stability of the monetary and payment systems. Eddie GeorgeWith the establishment of the European Monetary Institute (EMI) earlier this year the existence of a European Central Bank (ECB) comes a step nearer. If a single currency were to be established, this institution would have control of European monetary policy, with the basic objective of price stability. This essay attempts to give the reader some idea of the environment in which an ECB could exist, given the direction in which central banking, in general, is going. I stress the word attempt, because the structure and operations of an ECB are very difficult to predict. The Maastricht Treaty sets out that an ECB would have to be independent; this is consistent with the international tendency for countries to grant their Central Banks independence or at least make them less subservient to their associated governments.
This essay is divided into four sections. The first section discusses the possibility of a causal relationship between independence and price stability and briefly outlines a definition and measurement of independence. The second section discusses the contentious issue of a Central Banks credibility and the accountability of its actions to the public. The third section outlines why an ECB should exist and if its process of establishment has anything to learn from the experience of the Bundesbank and the US Federal Reserve. The final section concludes the essay and comments on the recent changes within the European Monetary System (EMS).
The growing consensus is that a highly independent CB with the overriding objective of price stability results in lower mean levels of inflation and less uncertainty about future inflation. While the former is important the latter is most salient as uncertainty results in sub-optimal investment decisions by shortening effective planning horizons.
Source: Central Bank Independence and Monetary Stability Issing, O (1993)
Attempting to prove a causal relationship between low inflation and highly independent CBs has been difficult. Measuring independence is an arbitrary process. Independence does not mean a CB can do anything it pleases. It means the freedom to pursue price stability possibly at the cost of other objectives. It involves the following integral elements:
1. Formalised Independence: the CBs charter must allow it legal authority to do what is necessary to achieve its objective(s) without seeking constant government approval.
2. Material Independence: the CB should be permitted to execute day-to-day operations without obligation to exchange government gilts.
3. Personal Independence: the executive council of the CB must be granted security and optimal duration of tenure.
4. Financial Independence: a revenue pool that is adequate and guaranteed to satisfy daily operational expenses.
Cuckierman (1990) minimises anomalies by including such variables as level of legal independence, turnover rate of CB governors and results from returned questionnaires in his independence index (see Diagram). Swiss and German CBs, observed during the period 1980-90, have successfully combined low inflation with a high degree of independence. Not featured is New Zealand. Had it been, these results, having been formed before its CB was made legally independent (l990), would have shown a mean level of inflation of 14%. In the subsequent years of independence, the New Zealand CB has achieved a mean inflation level of 1.5%. But not all countries fit the trend. It must be noted that this inflation-independence relationship breaks down when applied to less developed countries due to their inadequate macroeconomic and bureaucratic frameworks for accommodating such an institution.
Adam Posen (1993) refutes the suggested relationship between CB independence and price stability as being causal. He claims that low inflation will be a corollary of CB independence only if a consensus exists within the respective financial markets promoting that independence. He goes on to say that open economies, because they are in direct threat of imported inflation, are more aware of its costs and so more averse to it. This implies that the financial markets in an open economy, in realising the accompanying benefits of price stability, would welcome their CB becoming independent. Their confidence in that CB would lessen the risk of imported inflation.
This essay will now focus on the role which formalised independence will play in the future of central banking and especially that of the ECB. For the ECB to promulgate true independence (i.e. an independence in which the public will believe), its charter will have to accommodate a strong sense of formalised independence an independence which is encapsulated in the essence of credibility.
What charter could consolidate these two conflicting factors? A charter must be decisive in defining the CBs objectives, (the principle objective being price stability) and must restrict the CBs activities to only those that are necessary to achieve these objectives. Such a charter leaves little room for government intervention and keeps the nations best interests in focus. The latter also satisfies the condition of democratic accountability. But because it is impossible for the charter to include appropriate instructions for the panoply of contingencies that may arise, it cannot be followed verbatim in every situation. This infers that in the case of extraordinary circumstances, the charter should allow independence to deviate from that level which is legislated. Therefore, the CBs charter must be flexible enough to allow its incumbents to act intuitively in certain situations, while maintaining optimal credibility.
The issue of central bank independence is a direct illustration of the time inconsistency theory developed by Kydland and Prescott in 1977. A policy may seem optimal in period of announcement t, but may become sub-optimal in the period in which that policy impacts upon the economy, t+i. But at this stage contracts have already been agreed upon given the policy projections of period t. Future policy formulation is considered incredible in the eyes of the public, thus they heavily discount announced policies believing that actual policy will deviate from its announced counterpart. If government policy announcements are time inconsistent, then the monetary policy of a subservient CB will suffer from their inflationary bias. In this instance should the independent CB be allowed operate with complete discretion? No. This will conflict with the accountability obligation imposed on all CBs. The rules alternative for CB operations is too inflexible as it does not allow for contingency situations like economic shocks. Is there an optimal operational mix within the spectrum of CB regulation? The New Zealand Reserve Bank (granted independence in 1990) has struck an interesting balance between these two regulation extremes. It sets a target every three years for inflation and includes a punishment clause to affirm a commitment to achieve that target if inflation exceeds 2% (subject to re-evaluation in exceptional circumstances), then the governor of this CB is dismissed.
Another factor which will enhance the likelihood of a successful and efficacious independent CB is the reduction of its responsibilities and workload. The too many cooks analogy is drawn by The Economist in this regard. It speculates that a CB with too many things to do is unlikely to do any of them well. The servicing-out of subordinate activities allows a CB to focus on achieving its primary objective(s). This was the intention of the Bundesbank when it created a national treasury agency , thus off-loading the task of debt management to a separate entity. In Europe this could lead to the introduction of a Securities Exchange Committee (SEC) type authority with the specific chore of supervising commercial banking activities. This would also eliminate the risk of imprudent banking which damages the reputation of the associated CB, as occurred with Threadneedle St. and the BCCI controversy.
At the time the US Fed was founded, world trade had developed to an extent that it was sufficient to describe the banks goal as, . . . to furnish an elastic currency. The currency was defined as elastic vis-à-vis seasonal variations in the needs of business. The bank would be facilitated in achieving this goal by the Real Bills doctrine. This proposed that the bank should confine its discount rate manipulations and open market operations to . . . short term and self-liquidating paper. The subsequent increased lending (due to lender of last resort obligation), derived from this doctrine, would finance stock market loans and fuel speculation. This seems far from conducive to the projected charter of a EuroFed. Furthermore, such intervention could seriously impair the reputation of an ECB.
The US Fed and the Reichsbank (predecessor to the Bundesbank) share the similarity that both were formed after political unification of their dependent states/landes, was achieved. Furthermore, even before unification, Germany had a single currency being issued by a single bank the Prussian which was integrated with the Reichsbank on the completion of unity. The European Union (EU) will be attempting to form a similar institution without such political and economic cohesion. Given that the Reichsbank primary functions were to serve as the governments fiscal agent and earn seigniorage to augment its reserves, it seems anachronistic and even irrelevant to hope for inspiration in structuring a CB on the scale of the ECB from the experiences of the German model of independent central banking. I acknowledge that the Maastricht version of an ECB was based on the Bundesbank, but this was only used as an example of a precedence where combining independence with an overriding objective of maintaining the value of money in a European country proved successful. Secondly, the Bundesbank was formed in a background of hyperinflation resulting in a highly inflation averse bureaucracy. All this indicates to the a priori structure and operations of an ECB as being a whole new ball game!
Penultimately, this essay discusses the extent to which fiscal and/or monetary policy will feature in the daily operations of the ECB. The ECB will not be obliged by a Bretton Woods type convention to intervene on international markets to stabilise third currencies. Nevertheless, the Louvre Accord (1987) may have set a precedence, whereby in the case of certain currencies in exceptional circumstances, foreign exchange rate intervention would be deemed as highly desirable. This could open the EU to imported inflation. The degree of independence granted to the ECB will determine how willing it will be to threaten price stability in order to stabilise exchange rates and hence stabilise trade with the associated countries. Thygesen and Gros (1992) have suggested that pooling of international reserves to finance currency stabilisation activities would imply partial pooling of certain monetary instruments and thus by definition, some pooling of operations. Sufficient pooling of authority will be necessary for the interest rate arbitration function of the ECB and for reserve requirement co-ordination. This calls on EU Members to voluntarily relinquish control over some important fiscal and monetary instruments. In Article 104.1 of the Maastricht Treaty, the EU was adamant about the role which fiscal policy would play in the ECBs operations: Overdraft facilities or any other type of credit facility with the ECB or with the national central banks of the Member States in favour of Community institutions or bodies, central governments, regional, local or public authorities, other bodies governed by public law, or public undertakings by Member States shall be prohibited as shall the purchase directly from them by the ECB or national central banks of debt instruments.
Independence is also a function of the extent to which a government can borrow from its associated CB. The above regulation seems very stringent, but it is vital if the ECB is to be attributed with optimal credibility. With the Belgians tradition of high budget deficits, compulsory independence will restrict its CBs ability to facilitate fiscal policy, a facility the Belgians would claim is crucial to them for protecting their own economic agenda. This is true for other Members including Ireland and Greece. It illustrates the problems associated with lack of cohesion among Member CBs.
Finally, I will consider the recent developments within the EMS which could threaten the future prospects of the ECB. The break up of the ERM has been blamed on the Bundesbanks inconsiderate response to the European currency crisis. Yet blaming the Germans only contradicts a belief and perpetuates a disbelief in the efficiency of independent central banking. Even if the Bundesbank had reduced its Lombard rate at the time, the face of the EMS would still appear quite war torn. This experience highlights the problems of converging the economies and financial markets of countries with such diverse historical and cultural backgrounds. Ultimately, it will be the success of stage 2 of the Delors road to EMU which will dictate that of stage 3, a stage in which the largest, most powerful and influential financial institution in the world will be established. It must be said that whether they were aware of it or not, the people of Europe ensured the future of the ECB when they ratified the Maastricht Treaty. So while its structure and operations may be in moot, its future existence is not.
Cukierman, A (1992) Central Bank Strategy, Credibility and Independence
DeCecco, M (1989) A European Central Bank?
Gross, D & Thygesen, N (1992) European Narrow Money & Too Many Pies for the Old Lady
Issing, O (1993) Central Bank Independence and Monetary Stability
Mankiw, N (1992) Macroeconomics
Posen, A (ed. 1993) Finance and the International Economy