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BACKGROUND This section provides background material about the institutions and functioning of the monetary union, starting with a short history. EMU was considered by some as likely to fail when the going gets tough. After ten quite successful years the ECB in its eleventh year was provided with a formidable challenge. But the ECB is widely considered to have dealt competently with the 2008-09 financial crisis, boosting its stature and its prospects of longevity.The ECB can be seen as a "Europeanised Bundesbank", having adopted many of the institutions and philosophy of the Bundesbank and running monetary policy much as the Bundesbank before. The emphasis is on containing inflation. It cherishes its independence and attempts to introduce a "political counterweight" failed. The Stability and Growth Pact aims to ensure fiscal discipline. The ECB has the final say about exchange rate policy. Germany in particular is pleased with the way things have turned out.
Note: Strictly speaking the abbreviation EMU stands for Economic
and Monetary Union, but it is widely understood to stand for
European Monetary Union ("Economic union" remains to be
achieved). The term European Economic and Monetary Union is also
used.
Without the approval of the prestigious Bundesbank, Chancellor Helmut Kohl would never have succeeded in ramming through his unpopular policy of ditching the DM and creating monetary union. To obtain approval the ECB had to be cast in the image of the Bundesbank. The ECB is located in Frankfurt and its institutions mirror those of the Bundesbank. Above all the primacy of price stability and political independence was writ large into the ECB’s constitution. Hence the “europeanisation of the Bundesbank.” 27 members of the European System of Central Banks The European System of Central Banks (ESCB) is composed of the ECB and all the national central banks of the (currently 27) member countries of the EU. But, as not all the EU countries are part of the euro zone, the ESCB could not function as the monetary authority of the euro zone. Instead the Eurosystem is entrusted with this task. It consists of the ECB and the central banks of the member states which have adopted the euro (16 as of the beginning of 2009). The ESCB and the Eurosystem will coexist until all EU member countries have adopted the euro. Moving to Frankfurt’s historic vegetable market As a further concession to Germany for relinquishing its trusted DM, the ECB is domiciled in Frankfurt, seat of the Bundesbank. (Address: Kaisersstrasse 29, D-60311 Frankfurt-am-Main, Germany; Tel (switchboard): +49 69 13 44 0); web site ECB: European Central Bank home page. The ECB is scheduled to move to its own purpose built premises in 2014 (originally already in 2011). Located on the grounds of the old Frankfurt wholesale vegetable market on the banks of the Main, the futuristic building is not yet under construction. The old market hall (Grossmarkthalle), a listed building, will be preserved and form part of the ECB’s space. The building, designed by an Austrian firm, will be dominated by two futuristic towers (connected by an atrium). It is, according to the ECB, to become a landmark building for the entire world (picture below). Six man executive board The ECB is headed by a six member Executive Board appointed (for a non-renewable eight-year term) by common accord by the governments of the member states which have adopted the euro: -President (since 2003) Jean-Claude Trichet (France, born 1942). -Vice-President (since 2002) Lucas Papademos (Greece, born 1947) -Member (since June 2005) Lorenzo Bini Smaghi (Italy, born 1956) -Member (since June 2006) Jose Manuel Gonzalaz-Paramo (Spain, born 1958) -Member (since June 2006) Jurgen Stark (Germany, born 1948) -Member (since 2003) Gertrude Tumpel-Gugerel (Austria, born 1952). The Executive Board prepares the meetings of the Governing Council and implements its monetary policy. Some whisper that this is where the vital decisions are forged. President Trichet will retire in Oct'11 and there is already much speculation about who might succeed him. Reportedly the Italian government has started to lobby for Bank of Italy Governor Mario Draghi (62). Bundesbank President Axel Weber (52) is also mentioned as a possible successor. 21 member Governing Council The ECB Governing Council sets the monetary policy of the euro zone. It consists of the Executive Board and the governors of the central banks of the countries which have adopted the euro (see current members). Each has one vote and is not to vote as a national representative but in a fully independent personal capacity. Originally decisions were to be taken by simple majority. The president of the EU’s Council of Ministers and a Commissioner from the European Commission can attend the Governing Council meetings but have no vote. The Governing Council has in practice adopted a consensus seeking approach, rather than taking decisions by simple majority as is the case at America's Fed and the Bank of England. Reportedly the ECB has never had a formal vote on interest rates. The consensus principle does not mean unanimity, but that most members are in broad agreement with the decision and that those who are not can nonetheless "live with" it. (see Otmar Issing, The Birth of the Euro, 2008, Cambridge University Press, p154) From the beginning of 2009 when the number of euro zone countries rose from 15 to 16, a rotating voting scheme was to apply. But in Dec'08 it was decided to postpone the move until the number of euro zone countries reaches 18 (at the very earliest in 2012, see Prospective Member Countries). New voting system The previous system of one country, one vote was considered not sustainable because it would give considerable voting power to the smaller countries at the expense of the bigger countries. Also, once more members join, the meetings, it was felt, would have too many participants to be an efficient policy-making body. Considerable attention was given to devising the new voting system. A rotation system was devised by the ECB and approved by heads of state of the EU member countries in March 2003. The new system combines elements of rotation (on the lines of the US Federal Reserve Board's FOMC) and the formation of country groups with group representatives (on the lines of the IMF and the World Bank). The Executive Board members will continue to have one vote each. All central bank governors will attend all meetings, but not all will have a vote all the time. It was subsequently decided that governors will rotate in and out of the voting right after one month. A governor will thus be without a vote for only a short period. First Thursday of every month The Governing Council usually meets in Frankfurt on the first Thursday of every month to assess the economic and monetary conditions in the euro zone and to take its monetary policy decisions. This is announced at a press conference just after the meeting, followed by a Q & A session (can be viewed live on the ECB web site). A change in policy is often pre-announced through coded words. When during the press conference President Trichet pledges "vigilance" over inflation, a rate hike is a possibility. When this changes to "strong vigilance" a rate hike becomes very likely. The term "appropriate" to describe its policy stance usually signals that a change is unlikely in the near term. A second monthly meeting is held later in the month and deals with other, mostly administrative, matters. Two Governing Council meetings per year are held elsewhere in the euro area (Luxemburg 2 Jun'09, Venice 8 Oct'09; 6 May'10 Lisbon, 7 Oct'10 Amsterdam). Little known General Council There is also a General Council which consists of the president and vice-president of the ECB and the governors of the central banks of all the EU member states. It will disappear once all EU members are part of the euro zone. Among its tasks is to strengthen the coordination of monetary policies in the EU and the necessary preparations for the irrevocable fixing of the exchange rates of the member countries which have not yet adopted the euro. It usually meets once a quarter.
ECB independence: politicians keep off The ECB lays great store on its independence which it considers to be unique in the world of central banks. It is independent of political influence in order to avoid politically motivated measures diverting it from its central task, assuring price stability. The Bundesbank was instrumental in making this aspect clear in the Maastricht Treaty. The ECB and the national central banks are prohibited from seeking or taking instructions from any government of the member states or from any of the European Community institutions. Nor are member states or community institutions to seek to influence members of the decision-making bodies of the ECB. Moreover any changes in the constitution of the ESCB have to be unanimous and approved by all the member countries. The ECB provides an annual report to the European Parliament and other EU institutions and its president appears before the Parliament’s committees. The Parliament has the right to be informed, but not to take decisions. Primary objective: to maintain price stability As laid down in the treaty establishing the ESCB, the primary task of the ECB is to maintain price stability. This has subsequently been clarified by the ECB to mean inflation rates of below, but close to, 2% over the medium term. Inflation refers to a general increase in consumer prices as measured by the Harmonised Index of Consumer Prices (HICP). This is the weighted average of the (harmonised) consumer price indices of the euro zone countries. The treaty also stipulates that “without prejudice to the objective of price stability”, the ESCB is to support a high level of employment, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance. Basic tasks
In spite of the substantial increase in cross-border banking and financial integration, banking supervision remained a national task. Much was, however, done over the years to advance cross-border supervisory cooperation and convergence, for instance by the Committee of European Banking Supervisors. The ECB was closely involved in a consultative role. The Maastricht Treaty does allow for specific supervisory tasks to be entrusted to the ECB and in Jan'09 the ECB indicated that it sought a wider role in bank supervision,, particularly of large banks operating across euro area borders ("cross border banking groups"). EU governments, however, decided (19 Jun'09) that national supervisors would retain their role, though supported by a "European Systemic Risk Board" and a "European System of Financial Supervisors". According to a European Commission proposal (published 23 Sep'09), the proposed Risk Board is to be staffed mostly by the ECB and national central banks and is to be located in Frankfurt. The proposal requires approval by the European Parliament and the 27 EU member states and is subject to change. Political counterweight sought: creation of Euro Group The emphasis and priority given to price stability and central bank independence in the treaty was not to everyone’s taste. The French in particular sought a “political counterweight” to the ECB in order to co-ordinate the economic policies of the euro zone, to ensure the competitiveness of the euro and to deal with general economic and social aspects. It was seen as sort of “economic government”, filling what some saw as a void in the monetary union construct. This was emphatically opposed by Germany who feared that the independence of the ECB would be compromised. This discussion eventually led to the creation of the Euro Group, an informal meeting of euro zone finance ministers held on the eve of the monthly ECOFIN Council. Calls to strengthen the Euro Group continue to be heard but continue to be met with German resistance. In Oct’08, in the midst of the financial crisis, French President Sarkozy called for an “economic government” for the euro zone countries so as to better respond to the financial upheavals. This was once more opposed by Germany. There is a feeling that Germany may have given up the DM, but, at least for now, is more than ever in control of the euro zone's monetary policy. The ECB is perceived as implementing Bundesbank style monetary policies on a European scale. This may not always be the case in the future. There are also calls for the euro zone to be represented by a single voice in such bodies as the IMF and the Group of Seven. Fiscal policy remains in hands of national governments… The lack of a common fiscal policy to complement the common monetary policy was seen as a negative feature of the currency union right from the start (though the lack has not up to recently been the hindrance the critics foresaw). Fiscal policy is important. Expenditure by the general government sector (central, state and local government as well as social security) amounts to around 48% of GDP in the euro area, compared to around 34% in the US and 40% in Japan. …but is a “matter of common concern” Little has changed over the years. Fiscal policy remains in the hands of the member countries, albeit hemmed in. The Maastricht Treaty, establishing the single monetary policy, states that the economic policies of member countries are “a matter of common concern”. Moreover the “excessive deficit procedure” defines the requirement of a sound budget position. Also, on the recommendation of the European Commission, the EU Council adopts Broad Economic Policy Guidelines (BEPGs) which are to provide the general economic policy objectives of the EU member states. Country specific recommendations can also be included in the BEPGs. Stability and Growth Pact: imposing a measure of fiscal discipline Mainly on the insistence of Germany, the Stability and Growth Pact was adopted at the Amsterdam summit of EU heads of states in 1997. The Pact complemented and clarified the fiscal provisions in force during the run up to monetary union. Its provisions call for member countries to pursue a medium term budget position “close to balance or in surplus”. This is in order to provide room for budgets to slip into deficits in times of weak or negative growth while, however, keeping the budget deficits below the reference value of 3% of GDP. The reference value of the government debt-to-GDP ratio is 60%. Should the 3% budget deficit limit be exceeded, the excessive deficit procedure is invoked which calls on the offending member to rectify the position. In theory exceeding the 3% limit could lead to the offending member being fined (except in the case of a deep recession, defined as an annual fall of real GDP of at least 2%). In practice no country overstepping the 3% mark has yet been fined and the provisions were subsequently made more elastic. Annual stability programmes: rectifying excessive deficits Annual stability programmes are submitted to the European Commission by each country. They contain the measures which are to bring the country’s fiscal position to balance. Towards the middle of the current decade a majority of countries failed to respect the 3% limit (including Germany over the 2002-05 years) and the restrictions were eased in 2003-04. The Pact has nonetheless had a restraining impact on fiscal policy. No bail-out clause A further measure to promote fiscal rectitude is the Treaty’s “no bail-out” clause which aims to ensure that the repaying of public debt remains national. Moreover the ECB and national central banks are forbidden to provide monetary financing for public deficits (“printing money”) or to provide public bodies privileged access to financial institutions. The ECB is thus not permitted to lend directly to a national government or to buy its securities directly. But there are no restrictions on buying government securities in the secondary market. Early in 2009, in response to the severely strained financial situation of some euro area countries, e.g. Ireland, the European Commission announced that (unspecified) provisions were in place to financially assist a euro area country in financial difficulties. It is not known whether the ECB would be involved in any way. In fact the "no bail-out clause" allows bail-outs of a member country following "natural disasters or other exceptional occurrences beyond its control." Exchange rate policy: shared with ECOFIN, but ECB has final say Decisions on foreign exchange rate policy is a shared responsibility of the EU Council of Finance and Economic Ministers (ECOFIN) and the ECB. But according to the Treaty any decisions regarding foreign exchange policy are to be fully consistent with the ECB’s primary objective of price stability. Also the sole competence for deciding and carrying out foreign exchange operations lies with the Eurosystem. Policy of benign neglect adopted As the ECB has as prime task the maintenance of price stability it does not have specific measures regarding the foreign exchange rate of the EUR. The exchange rate regime is generally characterised as “benign neglect”. Officially the ECB intervenes in the foreign exchange market only to iron out excessive short term fluctuations or imbalances. The considerable movements of the EUR against the USD has nonetheless been at times of considerable concern and has often resulted in “verbal intervention”. As far as it is known there have been only two instances late in 2000 when the ECB has openly intervened in the foreign exchange market (both times to support the euro). Exchange Rate Mechanism II (ERM II): currently five members With the launching of the euro at the start of 1999 the existing ERM came to an end and was replaced by the ERM II. Its aim is to promote exchange rate stability in the EU. But on the insistence of the UK membership was voluntary. Membership is mandatory only as a precursor to full euro zone membership. Only two countries initially became members: Denmark and Greece. Greece joined the euro area in 2001. Currently there are four currencies in ERM II. As a prelude to joining EMU, the Danish krone was joined by Lithuania’s litas and Estonia’s kroon on 28 June 2004 and by Latvia’s lats on 2 May 2005. The Cypriot pound, Maltese lira, Slovenia’s tolar and Slovakia’s koruna were temporary members before being replaced by the euro. (see also prospective members) Currencies in the ERM II float within a range of +/- 15% against the central euro rate, but most countries impose a much tighter band of +/- 1% or less. In the case of turbulence, ECB foreign exchange intervention and financing at the margin of the standard or narrow intervention bands are, in principle, automatic and unlimited, with very short term financing available. This can, however, be suspended if it conflicts with the ECB’s primary objective of price stability. Tenth anniversary: high credibility achieved, initial doubts overcome In June 2008 the ESCB celebrated its tenth anniversary. On the 1st of January 2009 the euro itself celebrated its tenth anniversary. Contrary to the initial widespread scepticism, the euro had, over the ten years grown in stature. It had become a fact of life. Until the turmoil which engulfed the financial world in Sep’08, it was hard to imagine that the single currency could still fail. In terms of its exchange rate against the USD the early years were difficult as the currency devalued steadily. But since 2002 it appreciated and reached early in 2008 a level which few thought possible. The euro also steadily raised its share of world official foreign exchange reserves: end-2008 its share of global central bank reserves stood at 26.5%, up from 17% in 2000. The dollar still dominates with a share of 64%. From 2003 until the financial crisis struck the euro zone economy prospered. Unemployment fell sharply. But early claims, some extravagant, that monetary union would raise overall growth and boost internal trade have not been realised. Intra euro area trade has grown, but less rapidly than world trade. The underlying growth rate has shown no improvement. Per capita income has remained at around 70% of that of the US. EMU has thus neither fulfilled the prophesies of its doomsayers nor the feats of its champions. Inflation remained moderate. In most years the average fell into the 2% to 2.5% range, which, though, is slightly above the target set by the ECB. In the ten years since 1999 inflation averaged 2.1%. The ECB has gained credibility for its low inflation monetary policy. ECB acquires reputation for efficiency The ECB is also satisfied that the operational framework of the single monetary policy is functioning smoothly, as is its clearing and settlements system. Its provision of liquidity in crises (9/11, sub-prime mortgages) was quick and generally deemed to have been commensurate. The smooth introduction of euro coins and notes in Jan'02, a gigantic logistic exercise, enhanced the ECB's reputation for efficiency. Its response to the Sep'08 financial crisis was also deemed sure footed, quick and efficient, preventing a meltdown of the financial system by showering it with liquidity and accepting a broad range of collateral from the banks. The current President, Jean-Claude Trichet, who took over from Wim Duisenberg in 2003, is widely admired. He fully embraced the stability ethos of the Bundesbank. He retires in 2011. One-size-fits-all monetary policy: still questioned by some Whether the euro area formed an optimal currency union was intensely debated at the time, with many academic economists seeing a major impediment in the lack of labour mobility across member countries’ borders and rigidities in product markets. The absence of a common fiscal policy was also seen as a shortcoming. With no major problems encountered during the first ten years, initial concerns have faded but not disappeared. More tests could lie ahead. Inflation differentials between the first group of euro area members, which had declined steeply in the run-up to EMU’s start in 1999, stayed roughly the same in the ten years since. For instance inflation in Spain and Ireland was consistently above the euro area average, resulting in very low or negative real interest rates. Both countries also experienced strong growth and soaring property prices (which have now gone sharply into reverse). Germany, in contrast, consistently experienced below average inflation and growth rates as well as stable property prices, leading to occasional talk that the common monetary policy was too lax for Spain and Ireland, but too tight for Germany. Elsewhere the results were mixed. For example Finland experienced low inflation and high growth while Portugal experienced high inflation and slow growth. In its Nov'08 Monthly Bulletin the ECB warned that persistent differences in wage growth (not offset by differences in productivity growth) could undermine growth and employment in the high wage growth countries. The cumulative growth in unit labour costs over the 1999-2007 period amounted to 14% for the euro zone. But this average resulted from very divergent country developments: a 2.3% rise in Germany contrasts with rises in the 23% to 33% range in Italy, Spain, Portugal, Ireland and Greece. Current account developments have also been highly divergent. In 2008 Germany sported a current account surplus close to 7% of GDP. At the other extreme Spain, Greece and Portugal recorded deficits exceeding 10% of GDP. Whereas current account deficits of a euro zone country can not lead to a foreign exchange crisis, it can lead to a credit crisis if foreign capital ceases to flow into the country. (see Martin Wolf) Financial crisis to ruin or boost EMU? Many wondered whether the ECB's overall satisfactory first ten years would be upset by the 2008/09 financial crisis. It was such a deep crisis that if the ECB got through unscathed it will have truly earned its spurs. As 2009 draws to a close it seems that the ECB coped well. There were obstacles. The sixteen member countries retain important powers. This complicated the task of rapidly finding a unified and broadly based response to the crisis. The depth of the crisis demanded that all levers of policy be used. As not all the 16 countries faced exactly the same problems, finding a common response was not easy. Some east European countries not yet part of the euro area have been particularly hard hit and would have appreciate the safety provided by a large financial institution such as the ECB. Iceland too may have avoided the melt-down of its financial sector if it had the ECB as a lender of last resort. Some have suggested that Switzerland and even the UK would have been better placed to face the turmoil in financial markets if they had the ECB as a backstop. (for a detailed discussion see Buiter) Though the ECB was widely criticised for not cutting interest rates fast enough and low enough during the crisis, it did in particular flood the banking system with liquidity and accepted an exceptionally wide range of securities as collateral. All in all the ECB's response may be judged by posterity as "appropriate" or even as "good". Another difficult test lies ahead: how the monetary stimulus is withdrawn. If too soon a relapse into recession may result. If too late inflation may take hold. |
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