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

2. Two models of central banking
Anglo-French model versus German model
These models differ with respect to:
Objectives pursued
Relations with government

3. 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

4. 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

5. 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).)

6. 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

7. 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

8. 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

9. The Barro-Gordon model and optimal stabilisationπ1 A B’
Inflation C U’ U UN U1 U2
Unemployment

10. Inflation equilibrium in point A
Unemployment is at its natural level
The short-term Phillips curve is tangent to the authorities’ indifference curve
Authorities have no incentive any more to create surprise inflation
The upward sloping dotted line is the optimal stabilization line
Slope of the optimal stabilization line is determined by the weight the authorities attach to the stabilization of unemployment
The higher this weight the steeper is stabilization line
With a steep stabilization line authorities stabilize a lot at the cost of a high inflation bias

11. How to eliminate the inflation bias?
Appointing a conservative central bank
Inflation
Eurozone’s preferences
ECB preferences UN
Unemployment

12. 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

13. How to solve conflicts: first best solution A ‘target conservative’ central bank
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
Inflation
Unemployment UN

14. 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

15. A new problem arises: uncertainty about natural rate
ECB’ s new estimate UN
Inflation UN
Unemployment

16. UN Initial natural unemployment rate and observed unemployment rate coincides with it
Target unemployment rate is at its natural level
Suppose a temporary increase in unemployment
ECB interprets this as an increase in the natural unemployment rate, and increases its target unemployment rate
Optimal stabilization path shifts to the right: the ECB will not attempt any stabilization
ECB behaves as super-conservative by attaching a zero weight to unemployment stabilization

17. Is there evidence that the ECB acted as a conservative central bank?
Figure 8.5: Policy interest rates in the Eurozone and the US (%)
US Fed seems to have reacted much more to the economic slowdown of 2001 than ECB
But were the economic conditions the same in the US and the Eurozone?

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

19. 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

20. Independence and accountability
Whenever the government delegates power to the central bank there is a corresponding need to have accountability
The reason is that the government maintains its full accountability towards the voter
Thus it cannot afford to delegate power without maintaining control over the use of this power
Independence and accountability are part of the same process of delegation

21. Optimal relation between independence and accountability
ECB
Bundesbank
Fed
Accountability

22. ECB is more independent than any other major central banks
The degree of accountability is weaker than in the FED
This goes against the theory according to which accountability should be increased together with the degree of independence

23. Accountability is also related to the degree of precision with which central bank’s objectives are specified
The Treaty is vague about the other objectives besides price stability
The ECB has interpreted this to mean that it has to pursue only price stability
As a result, the ECB has drastically restricted the domain of responsibilities about which it can be called to account

24. Modern central banks have a wider responsibility than simply price stability
Conflicts between the ECB and the European governments will arise when the ECB is perceived to act too little to avoid recessions and escalating unemployment

25. What ECB could do to avoid conflicts?
Enhancing informal accountability through greater transparency
Larger openness in the decision-making process
Inflation targeting promotes informal accountability

26. 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

28. 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

29. 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

30. 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

31. 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

32. Taylor rule rt = a + bt + cxt rt = nominal interest rate
t = inflation
xt = output gap

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

34. Asymmetric distribution of desired interest rates using Taylor Rule (2005)
Without ECB-Board
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
With ECB-Board

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. This proposal has been adopted by the Heads of State
It will take effect as soon as the number of Eurozone members exceed 15

42. 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

43. 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

44. 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