Chapter 8: The European Central Bank De Grauwe: Economics of Monetary Union.

Chapter 8:The European Central Bank

De Grauwe:Economics of Monetary Union

Two models of central banking• Two models of central banking• Anglo-French model versus German model• These models differ with respect to:

– Objectives pursued– Relations with government

Objectives of central bank

• In the Anglo-French model, the central bank pursues several objectives

Price stability is only one of the objectives and does not receive any privileged treatment

• In the German model price stability is considered to be the primary objective of the central bank

Relations with the government• In Anglo-French model

– The monetary policy decisions are subject to the government’s approval

– Political dependence

• In German model– Monetary policy decisions are taken by the

central bank without interference of political authorities

– Political independence

• The German model prevailed in the design of the European Central Bank

Statutes of the ECB• Objectives

– “The primary objective of the ECB is the maintenance of price stability” (article 105)

– Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of the Community as laid down in article 2. (Article 105(1).)

• Political independence– Enshrined in article 107: “The ECB (…) shall not

seek nor take instructions from Community institutions or bodies, from any Government of a Member State or from any other body”.

• The Treaty also recognizes that political independence is a necessary condition for ensuring price stability

Why has the German model prevailed?

• Two reasons:– Intellectual development, i.e. the ‘monetarist

counter-revolution’ – Strategic position of Germany in the process

towards EMU

• In order to accept EMU, the German monetary authorities insisted on having an ECB that gives an even higher weight to price stability than the Bundesbank did

• This victory was greatly facilitated by the fact that most central bankers had been converted to monetarism

The ECB: a ‘conservative’ central bank

• Creation of ECB was dominated by fear of inflation bias

• Rogoff proposed a solution to inflation bias: appoint a conservative central banker – i.e. a central banker who attaches greater weight

to price stability and lower weight to output and employment stabilization than the rest of society

• This conservative attitude leads to some problems

Eurozone’s preferences

ECB preferences

Unemployment

Inflation

UN

How to eliminate the inflation bias?Appointing a conservative central bank

•The steep stabilization line represents the preferences of society •The flatter stabilization line is the one of the conservative central bank, the ECB•On average Euroland will have lower inflation without any loss in employment•However, there will be less concern for stabilization•This leads to a potential conflict between the ECB and elected politicians

How to solve conflicts: first best solution A ‘target conservative’ central bank

UNUnemployment

Inflation •Suppose target unemployment rate equal to the natural unemployment •Then the optimal stabilization line shifts to the right and intersects with the natural unemployment point on the horizontal axis •Inflation bias disappears •As a result, unemployment is stabilized in the same way for both central bank and society

• Solution to the problem is to appoint a central banker who is ‘target conservative’, in contrast to the ‘weight conservative’

• It has been claimed that inflation targeting achieves this solution

Eurozone•ECB does react to movements in output gap•Thus it gives some weight to output stabilisation•US Fed reacts more strongly to decline in output gap than ECB•It appears that Fed attaches greater weight to output stabilisation than ECB•In this sense ECB is more conservative than Fed•Note: this is evidence of only 5 years•It may change in the future

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Figure 8.6: Short-term interest rate and output gap (1999– 2005)

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Figure 8.8: Inflation in Eurozone and in US (1999– 2005) (%)

Previous conclusion is not affected by inflation experiences

Both US and Eurozone experienced similar inflation rates except in last two years

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Optimal relation between independence and accountability

ECB

Bundesbank

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Independence

Accountability

The ECB: institutional framework

• The Eurosystem it consists of: – The European Central Bank (ECB) – The national central banks (NCBs) of member

countries • Governing bodies are:

– The Executive Board – The Governing Council

• Executive Board consists of President, Vice-President, and four Directors of ECB

• Governing Council consists of the six members of the Executive Board and the governors of the twelve national central banks

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Decision stage

Implementation stage

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E u r o s y s t e m

ECB NCB1

NCB2

NCB3

NCB13

Executive

Governors of Board ECB

NCBs

Governing Council

European Central Bank

NCB1

NCB2

NCB3

NCB13

• Governing Council is main decision-making body of the Eurosystem

• It takes decisions concerning interest rates, reserve requirements, and the provision of liquidity into the system

• It meets every two weeks in Frankfurt. During these meetings, the 18 members of the Governing Council deliberate and take the appropriate decisions

• Each of the members has one vote – Note: with enlargement this will change

• There is no qualified voting in the Governing Council

• The rationale is in the Treaty:– Members of the Governing Council should be

concerned with the interests of Euroland as a whole, and not with the interests of the country from which they originate

– Qualified voting would have suggested that the members of the Governing Council represent national interests

• The Executive Board of the ECB:– Implements monetary policy decisions taken by the

Governing Council – Gives instructions to the NCBs – Sets the agenda for the meetings of the Governing

Council

• Thus, Executive Board has strategic position in the decision-making process in the Governing Council

Is the Eurosystem too decentralized?• Is influence of the NCBs in the Governing

Council too large so that national interests prevail at the expense of the system-wide interests?

• In order to analyze this: compute Taylor rule for each central banker

– Taylor rule computes the interest rates that each of the national governors desire, given the economic conditions that prevail in their own country

• Assume that the ECB Board applies the Taylor rule, using Eurozone wide aggregates of inflation and output gap

Taylor rule

rt = a + bt + cxt

rt = nominal interest rate

t = inflation

xt = output gap

Table B15.1: Desired interest rate using the Taylor rule (2005)

Country Relative size Desired interest rate

Netherlands 0,06 1,76

Finland 0,02 1,92

Portugal 0,18 2,47

Germany 0,28 2,92

France 0,21 2,96

Austria 0,03 3,05

ECB Board 3,47

Italy 0,00 3,60

Belgium 0,04 4,03

Ireland 0,02 4,50

Spain 0,11 5,68

Luxembourg 0,02 5,80

Greece 0,02 6,98

Asymmetric distribution of desired interest rates using Taylor Rule (2005)

Assumptions:

Governors are nationalistic

ECB-board cares about Euro-wide interests

ECB-Board only needs three votes to find majority for its proposal

ECB-Board has strategic position despite asymmetries in shocks

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Without ECB-Board

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Conclusion of previous analysis

• Today the ECB-Board has strategic position within Governing Council (Its interest rate proposal is close to median)

• This is maintained even when distribution of desired interest rates is very different among large and small countries

• This decision making process ensures that the interest rate that is decided is the optimal one from the point of view of the Eurozone as a whole

• This is so even if national governors are guided by economic conditions prevailing in their own countries

• This decision making model also ensures that large countries’ (France, Germany, Italy) interests are relatively well served, despite the overrepresentation of the small countries in the Governing Council

• Consensus is easy to reach and formal voting usually unnecessary

• In enlarged Eurozone the ECB-Board will loose its strategic position

• Its interest rate proposals will occasionally be overruled by coalitions of small countries who experience different economic conditions than the average (which is dominated by the large countries)

• Interest rate decisions will be made on the basis of economic conditions that prevail in a relatively small part of Euroland

• This will lead to grave conflicts within the Eurosystem

• Consensus model is likely to break down • The essence of the problem: small countries

are over-represented in the Governing Council

• In enlarged Eurosystem this will have fatal effect that interest rate decisions may not always be made on the basis of the average economic conditions that prevail in the union

How to reform the decision making process within an enlarged Eurosystem?

• The over-representation of small countries will have to be reduced

• This can be achieved in several ways: – The US Fed formula: all governors participate in

deliberations of Governing Council but voting rights are limited to a limited number of governors on a rotating basis

– The IMF formula: small countries group together in constituencies and are represented by one governor

– The centralised formula: the decision making is restricted to the Executive Board of the ECB. In this formula there is some scope for expanding the size of the Board

• On 20 December 2002 the Governing Council reached agreement that combines first and second formulas

– The number of governors with voting rights will be limited to 15. The members of the Executive Board will maintain their voting rights

– The governors will exercise their voting rights on a rotating basis. Frequency with which they can participate in the voting will depend on the relative size of the country they come from. Thus governors of large countries will exert their voting power more frequently than governors from small countries

• This proposal has been adopted by the Heads of State

• It will take effect as soon as the number of Eurozone members exceed 15

Bank supervision and financial stability in Euroland

• Principle of home country prudential control • Principle of host country responsibility for

financial market stability• These two principles might conflict in a

increasingly integrated market• The problem will be compounded during crisis

situations• Centralization of the supervisory and regulatory

responsibilities at the European level would be the solution

Conclusion

• The strong degree of independence of ECB (a positive thing) is not matched by equally strong procedure to control the performance of the ECB

• Enlargement creates the risk that the ECB-Board will loose its strategic position and that interest rate decisions will stop representing the needs of Euroland as a whole

• This is why new voting rules will be introduced giving less weight to small countries

• Failure to centralize the supervision of the banking system at the level of Euroland in an integrated Euro banking system might prevent a smooth managing of financial crises