The advent of EMU in Europe has led to a new economic power being created in the form of the European Central Bank. Paul Slattery explores the options available to this new institution in managing monetary policy for the eleven countries that have adopted the euro. He examines the stated primary aim of price stability and looks at the importance of the ECB's independence in its pursuit of monetary targets.
As recently as ten years ago the idea of merging the European Union's national monetary systems seemed fantastic. On January 4th 1999 this remarkable vision became a reality: the currencies of the 11 participating members of Europe's Economic and Monetary Union were irrevocably fused. The institution at the very heart of European economic policy is now the European Central Bank.
In designing EMU, the architects laid great emphasis both on the independence of the European Central Bank and on the simplicity and severity of its anti-inflation objective. It undoubtedly faces many challenges. These stem from institutional debates over policy direction and statistical methods, and from the diverse political standpoints of the eleven cultures that it represents. In this essay I will overview these problems.
The European System of Central Banks (ESCB) comprises the European Central Bank (ECB) and the National Central Banks (NCB) of the Member States which have adopted the Euro in Stage 3 of EMU. If and when all 15 Member States participate in the euro area, the term ‘Eurosystem' will become a synonym for the ESCB. The Eurosystem is governed by the Governing Council and the Executive Board of the ECB:
The Governing Council comprises all the members of the Executive Board and the governors of the NCB's of the Member States who have adopted the Euro.
The Executive Board comprises the President, the Vice-President and four other members appointed by the Heads of State or Government of the Member States which have adopted the Euro.
The Central Issue: Price Stability
As set out in Article 2 of the Protocol on the Statute of the ESCB agreed at Maastricht, "the primary objective of the ESCB shall be to maintain price stability". Only then, when this is achieved (i.e. "without prejudice to the objective of price stability"), is the ECSB to "support the general economic policies and the objectives of the Community as laid down in Article 2 of this Treaty" .
The reason for this owes a lot to the legacy of the German Bundesbank. Its rigid concentration on the achievement of such stability is cited as being responsible for its comparative success in achieving a successful combination of comparatively low inflation and high economic growth. The ECB outlines very clear reasons for this objective in its initial monthly bulletin:
Charles Goodhart points to another "more intuitive" reason:
"with there being no trade-off in the medium and longer term between growth and employment on the one hand and inflation on the other (a vertical Phillips curve), the best that any authority with responsibility for controlling nominal variables can do is to achieve price stability".
No direct qualitative measure could be set for the concept of ‘price stability' during the first two stages of European Monetary Union. Instead the Maastricht criteria were seen as the working requirements to the ideal. The interpretation and flexibility of the criteria was a hotly contested issue. The ‘fudging' of government deficits provided a stumbling block for the EMI, despite its preference for starting the euro on the road to price stability with a small group of strict adherers. The objective of price stability is set by the Maastricht Treaty, yet its method for reaching that goal is not. Effective monetary policy will be where the new European System of Central Banks will consolidate the price stability ideal.
The EMI 1996 report to the Commission suggested five candidate strategies for overall monetary policy: exchange rate targeting; interest rate pegging; nominal income targeting; monetary targeting; and direct inflation targeting.
Intermediate monetary targets have formed the centrepiece of Bundesbank monetary frameworks since the late 1970s. In contrast, many smaller states generally adhered to an exchange rate objective and refrained from setting monetary targets in their pursuit of the common objective of price stability. The larger EU members downgraded their monetary targeting systems in the 1980s, with the exception of the German Bundesbank. It is argued that this emphasis on assessing monetary developments from a medium term perspective has helped the Bundesbank reduce the inflation rate, which had risen in the wake of unification. Annick Bruggeman argues that a monetary targeting strategy is more transparent than an inflation targeting strategy; it leaves less room for interference from governments and it enables the ECB to inherit the credibility of the Deutsche Bundesbank, which will be particularly important at the start of EMU.
The main elements of the ECB's strategy were presented to the public on the 13th October 1998:
- A prominent role for money, as signalled by the announcement of a reference value for the growth of a broad monetary aggregate.
- A broadly based assessment of the outlook for future price developments and the risks to price stability in the Eurosystem as a whole.
The quantitative definition of price stability "shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP)". A figure of below 2% is to be maintained over the medium term. This measurement presents a challenge to the Eurostat analysts. Among economists in academic, financial and central banking circles, there is a broad consensus that various forms of ‘measurement bias' can exist in consumer price indices (CPI's). The HICP is relatively new and long runs of back data do not exist. Therefore, studies of the magnitude of bias are inconclusive. A quantitative reference value for monetary growth has been announced by the Governing Council as one pillar of the overall stability-oriented strategy. On 1 December 1998 the Governing Council announced its reference value for M3 growth. The derivation of the reference value was based on the following medium term assumptions:
In the other areas of monetary policy, the new ECB will use repurchase operations i.e. buying and selling securities to affect interest rates. The EMI report outlines in careful detail the criteria that it will use to assess the eligibility of prospective counterparts and assets. A broad range of eligible counterparts is consistent with the ESCB's principle of decentralisation in its execution of monetary policy operations. The EMI claim "it will enhance policy efficiency and equal treatment and facilitate the smooth functioning of the payment system". With regard to asset eligibility the ESCB will prioritise with two types of lists:
The minimum reserve system which the Bundesbank uses to rein in the money supply is also referred to in the EMI report, stating that:
"The minimum reserve system which will also be available could be used for stabilizing money market interest rates, creating or enlarging a structural liquidity shortage in the money market and possibly contributing to the control of monetary expansion".
These ratios effectively involve a pecuniary penalty on banks to the extent that interest paid by the central bank on them is below market rates.
In the heyday of monetarism in the early 1980s, economists and traders pounced eagerly on every new money supply statistic. Most central banks then set formal money targets, and every wiggle in the data set was scrutinised for clues to the next move in interest rates. Since then, the notion that faster money supply growth automatically causes higher inflation has fallen out of favour. The announcement by the ECB to nominate a ‘reference value' derived from the M3 measurement of money growth represents a renaissance in economic thinking.
The money supply is useful as a policy target only if the relationship between money and nominal GDP - and hence inflation - is stable and predictable. The way the money supply affects prices and output depends on how fast it circulates through the economy. The ‘velocity of money' can suddenly change as a result of financial innovation and deregulation. This can drastically affect the usefulness of broad money supply measures as reference value indicators for monetary policy.
Several economic studies suggest that pan-European measures of money are much more stable and a good indicator of growth and inflation in the region as a whole. One reason is that in closely integrated economies, firms and individuals tend to switch between currencies in response to interest rate differences, an option no longer available under EMU. However, the shift from national currencies to the euro, combined with the liberalisation of financial markets represents a huge structural change. This may cause big changes in the behaviour of firms and individuals and hence the previous relationship between money and inflation could be endangered. The Euro money supply could therefore be unstable.
"The money supply can often be a useful early-warning signal. A wise central banker, like a wise driver, should regularly check the speedometer. But a driver who stares solely at the speedometer is likely to have a nasty crash. Likewise, central bankers need to monitor a large range of economic and financial indicators if they want to be sure of achieving their ultimate goal of low inflation".
This is why the Governing Council has announced that the second ‘pillar' of the stability-oriented monetary policy shall be the scrutiny of a wide range of economic variables. One of the institutional challenges facing the ECB will be the collection and careful sorting of statistical data from which to optimise monetary policy. The statistical information that is needed will be wide ranging. In addition to monetary and balance of payments statistics, it will use statistics on costs and prices, government finance, output and demand and the labour market.
The 1996 EMI report provides analysis of the collection process. It suggests the importance of harmonisation and consolidation of aggregates. Harmonisation refers to the creation of consistent statistical variables and is necessary due to the inconsistency of definition in statistical practice. Consolidation is required because the revised money stock "will not be simply the sums of the national money stock and its counterparts and the balance of payments, but will include cross-border holdings of deposits and other monetary instruments within the area".
An argument against the monetarist approach links to the credibility and accountability of the new central bank. The ECB would like to adopt the credibility of its blueprint, the Bundesbank. Yet in practice the Bundesbank does not pursue a pure monetary target. Because of its long track record of delivering low inflation, occasional overshoots have not undermined the Bundesbank's credibility. The ECB starts without this advantage. Establishing such credibility will prove hard if it sets a monetary target and then is forced to overshoot it. The ECB could be judged by its results more easily under an explicit inflation target.
The Issue of Independence
It could be argued that the new European Central Bank is the most fiercely independent bank in the world. America's Federal Reserve is required by law to take output and employment into account alongside inflation, for which no numerical target is set. Independence entails the legal framework, the political resolve and the economic manoeuvrability necessary to achieve a consistently low inflation rate with growth, despite outside influences.
In his article "An ECB and Independence", Rolf Ceasar highlights the arguments for and against independence. The first political reason in favour stipulates that an independent central bank is recommended because it can operate regardless of the political pressures that government and parliament cannot avoid. It is therefore consolidated as a guarantor of continuous stabilisation policy due to its long term policy horizons. The second economic reason highlights the danger of a central bank subordinated to political bodies risking ‘fiscal inflation'. This is because of the fact that politicians tend to look at the central bank as a source of financing, neglecting the risks and detrimental effects of inflation. The third ‘technical' reason cited is that an independent central bank is recommended due to its faster decision making process and because of the superior economic qualifications of central bankers over politicians(!).
The first main argument against an independent central bank stems from Keynesian concerns over the lack of fiscal/monetary harmonisation, leading to serious ‘friction losses' resulting from a monetary policy not necessarily co-ordinated with fiscal policy actions. Politically there is also an argument that there is a deficient political justification for a foreign independent central bank.
Certainly the argument concerning poor fiscal/monetary policy harmonisation is a pervasive one. Ceasar also highlights the fact that actual independence will depend on the degree of social consensus on the "ranking of price stability as regards other economic objectives" and the "sustainability of an institution pursuing this in the risk of conflict with government".
Strong evidence suggests that central bank independence is indeed a good idea i.e. any given level of inflation can be achieved more cheaply in terms of forgone output and employment, if firms and workers believe that monetary policy is free from undue political pressure. The danger is that EMU's architects have gone too far. The European Union, with its weak parliament, is acknowledged in any case to have a ‘democratic deficit' at its centre; the powers of the new central bank could make that deficit all the greater. In economic terms, the danger is simply that the ECB will take its instructions literally – and will try to screw inflation down to nothing regardless of wider economic repercussions.
One of the greatest challenges that the new ECB will face is due to the diverse economic makeup of the countries involved in the project. A recession that affected the Euro 11 as a group could only be dealt effectively with an institution such as the new ECB. The more likely scenario will be the need for a response to fluctuations that are not system-wide.
The eurozone is not an ‘optimum currency area' i.e. it is not a region whose constituent parts are affected in broadly the same way by typical economic disturbances. It is subject therefore to ‘asymmetric shocks'. This problem is exacerbated however in a European context by disparities in relative prices and poor labour mobility within the Euro-11.
Governments see the need to improve the supply side by de-regulation. The price of over-regulation is a higher equilibrium rate of unemployment. However the recent shift to the left in European politics makes this kind of action seem implausible in the short run.
If a country suffers a recession, traditionally it could cut interest rates, stimulating demand by lowering the cost of credit and causing the currency to depreciate. Under EMU this option is no longer viable. That leaves fiscal policy, but policy-makers are to find little solace for stimulating demand here. The Stability and Growth Pact requires budget deficits to be held below 3% of GDP. Violators are to be fined subject to a vote of governments, unless output has fallen by 2% or more in the year in question.
The economic reasoning by the Governing Council is quite sound. Goodhart cites the problem of lax fiscal and tight monetary policy both in the USA in the early ‘80s and Germany since reunification.
"Thus if the EU should wish to achieve some particular outcome for the exchange rate and with monetary policy predicated to the achievement of internal price-stability, the EU fiscal policy has to be adjusted to that end."
Can this be achieved given the decentralised fiscal process in the E.U however? If the European Central Bank is to have more independence to achieve price stability then the political system must reflect a more harmonised and cohesive position to achieve the monetary/fiscal balance. This requires an "ever closer political union". With regard to the Stability and Growth Pact however falls in output of 2% or more are extremely rare; far smaller downturns would cause unemployment to rise quickly and be universally regarded as ‘recessions'. And the restriction is too tight in another way: governments that tried to anticipate a downturn by relaxing fiscal policy early, thereby breaching the 3% limit before output fell, would also face fines.
If demand in Europe grows more slowly than forecasted and the post-Maastricht fudges come to pass, deficits will rise asymmetrically. If the EMU survives then there would be two alternatives. To let the countries concerned endure the recession, thus bringing the entire venture into question or to enlarge the fiscal powers available to Brussels. This would allow automatic fiscal stabilisers to work within Europe as they do in the US.
Apart from the challenges outlined in this essay the ECB must make a clear effort to make itself known to the average European. This is the greatest political agenda, to assuage and convince the voter. Surprisingly, recent studies have reported that people ‘feeling well-informed about the euro' account for as low as 25% of those surveyed. The ECB must therefore pay attention to the economic and political climate which it inhabits. The best way to win popular opinion is to explain clearly what it proposes to do and by balancing the short-term demands of low inflation on the one hand, with growth in output and employment on the other. Independence to achieve the ‘price stability' ideal is fine once the bank can be made accountable in the long run by the surrounding political process. Governments will have to find a way to make fiscal policy respond far more flexibly to economic circumstances than the Stability and Growth Pact implies. This could be achieved perhaps, by requiring that budgets be balanced over the course of the economic cycle, but leaving them free to run further than 3% into deficit at times of slowing demand. In any event this seems likely to be the issue on which Europe's political future depends.
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