European Affairs

Spring 2000

 

The ECB: Too Much Focus on Prices, Not Enough on Growth
by William Keegan

"I see my duty as a central banker to make the conditions for monetary union as tough as possible. But, personally, I think the politicians would be crazy to go ahead."

Thus spoke a member of the Delors Committee, which was asked by European heads of government in June 1988 to report on how economic and monetary union in Europe could be achieved. Although chaired by the French politician Jacques Delors, who was President of the European Commission, the Delors Committee was packed with central bankers: apart from Delors himself and five other experts, the committee contained twelve central bankers, one each from the 12 member nations (subsequently to rise to 15 countries) of what was then known as the European Community.

With central bankers ac-counting for two-thirds of its membership, it was hardly surprising that the Delors Committee recommended that any future European central bank should be politically independent and "committed to the objective of price stability." For good measure, the Delors Report added, "in the budgetary field, binding rules are required that would impose effective upper limits on budget deficits."

The Delors Report was considered by European heads of government at a summit meeting in Madrid in June 1989, some months before the fall of the Berlin Wall. Despite the fact that the final decisions on monetary union and the new central bank were made by the politicians who met in Maastricht in December 1991, little of substance was altered from the blueprint laid down in the central bankers' Delors Report.

Thus, the Maastricht "Treaty on European Union" stated "the primary objective of the European System of Central Banks shall be to maintain price stability" and that "Member States shall avoid excessive government deficits," giving "reference values" of a maximum of "3 percent for the ratio of the planned or actual government deficit to gross domestic product" and "60 percent for the ratio of government debt to gross domestic product at market prices."

Central bankers are fond of lecturing governments on their budgetary practices, but it is seldom that they have such a golden opportunity to influence them so directly. Insofar as fiscal profligacy makes the job of monetary policy harder, Europe's central banks had ensured, somewhat to their surprise, an auspicious start for the conditions in which the new European Central Bank would operate. Moreover, strict budgetary and monetary discipline was required of aspirant countries in the run-up to European Economic and Monetary Union (EMU).

Monetary union had been a long-term goal of the European Community since the Treaty of Rome in 1957. Nothing had come of the Werner Report on the subject of 1970. After the perceived failure of the first Mitterrand government's "dash for growth" in 1981-83, the French had decided that the real force in economic policy in Europe was the German Bundesbank: it became a goal of French financial diplomacy to "Europeanize" the Bundesbank by working towards a European central bank in which all member countries should have a vote, so that monetary policy within Europe would not be dictated largely by German interests.

It is debatable whether French monetary policy was so impotent that such a revolutionary step was really required, but that was the way the French appeared to see it. To prepare themselves they adopted a "franc fort" policy and practiced financial rigor for many years before finally "getting their hands in the Bundesbank's till" as their strategy was often vulgarly described.

It was therefore somewhat ironical that, as Peter Kenen has written, "it was clear to all participants that the actual design of EMU would have to satisfy German concerns. The ECB would have to resemble the Bundesbank." Indeed, the Bundesbank fought hard and successfully to ensure that, while losing its control over monetary policy, it should do so to an institution, the ECB, whose statutes were at least as tough as those of the Bundesbank itself.

In a Europe where average unemployment was around 10 percent, the ECB began its life on 1 January 1999 with instructions to achieve price stability. By contrast, under the 1978 Full Employment and Balanced Growth Act, the US Federal Reserve is charged with the twin goals of maximum employment and price stability.

If the French had been the political driving force behind monetary union during the 1980s, Germany, in the formidable shape of Chancellor Helmut Kohl, was certainly not in the rear during the 1990s. French President François Mitterrand, in common with British Prime Minister Margaret Thatcher, had at first opposed German unification in 1990.

After Mitterrand had been won round, he saw economic union as the vital way of "tying Germany down" in Europe; in this he was joined by Kohl, who made a number of passionate speeches evoking fears about a resurfacing of the dark demons from Germany's past should the plans for closer economic and political union be abandoned. But it was Mitterrand who secured from Kohl, at Maastricht, the deadline of 1999 for the formation of the single currency.

This was, however, a big sacrifice for Germans: to give up their sacred D-mark, a symbol - perhaps more than a symbol - of their postwar economic success. It was, after all, in Germany that Weimar inflation, and all that, had caused such untold social destruction after the first world war. So, for Germany, the new European Central Bank was not just to be founded on the strict principles of the Bundesbank: it was to be sited in Frankfurt.

In return the French demanded that the first president of the ECB should be a Frenchman. But the Germans held out: if it could not be a German, then it had to be the Dutch central banker, Willem Duisenberg, who was the nearest one could get to a Bundesbanker, outside Germany.

The May Day weekend of 1998 saw a meeting in Brussels at which the exchange rates for monetary union were announced, and the first president of the ECB was formally appointed. This was supposed to be an historic occasion, but it was sullied by an unseemly dispute, lasting well into the night, during which the French stuck out for their candidate.

In the end a dubious "compromise" was reached, under which Duisenberg would officially be appointed for eight years, but would "voluntarily" step down halfway through in favor of the French Central Bank Governor, Jean-Claude Trichet.

Even the greatest champions of the single currency acknowledged that this initial scrap was hardly a good omen. Mr. Duisenberg has since made ambiguous statements about whether he really intends to comply with what has euphemistically been described as "a gentlemen's agreement."

With economic growth in Europe so much slower than in the United States during recent years (growth in the "euro" area appears to have been barely above 2 percent in 1999) even the most ardent political enthusiasts for the single currency have begun to wonder whether the bias of the ECB is not deflationary.

Much criticism has been leveled at the Europeans for the putative "structural rigidities" and excessive regulation of their economies. There is, no doubt, some force in this criticism. But in the long run-up to the formation of the ECB on 1 January 1999, sluggish European growth and high unemployment were also associated with cautious macro-economic policies. Indeed, proven ability to wear a hair-shirt became a qualification for membership of EMU.

Against this background, the ECB decided that "price stability is defined as annual increases of below 2 percent in the Harmonized Index of Consumer Prices (HICP) for the euro area" (Christian Noyer, Vice President of the ECB).

In making its decisions about appropriate interest rates, the ECB would be guided principally by the course of monetary growth (the "reference value" being 4.5 percent annual growth for the main monetary measure, M 3) and by forecasts of how prices were likely to develop.

The Governing Council of the ECB comprises 17 members: the central bank governors of the eleven member countries of the euro area, and the six person executive board, which includes Duisenberg, the President, Noyer, his French deputy, and Otmar Issing, the ECB's chief economist, formerly of the Bundesbank.

The Council usually meets twice a month, with a proper respect for the European August holidays. It made two changes to interest rates in 1999, lowering them on 8 April (from 3 percent to 2.5 percent) and raising them again on 4 November (back to 3 percent). The Governing Council raised rates further on 3 February 2000, to 3.25 percent, and on 22 March to 3.5 percent

The ECB has been accused of many sins: it is said to be undemocratic, unaccountable, and to suffer from the ultimate vice in international financial circles these days, "a lack of transparency." In the face of such criticism, its executive board has gone out of its way to explain itself, and to make public speeches. The ECB prides itself on giving press conferences immediately after its meetings, and the publication of a monthly bulletin which is rich in analysis of economic trends in the euro area.

The interest rate reduction on 8 April 1999 was made after strong hints from Issing and others that the ECB was disturbed by the underlying weakness of the economic recovery in the euro area. The ECB subsequently emphasized that the rate reduction was made despite the fact that monetary growth was above its "reference value."

In response to attacks from, among others, the economist Paul Krugman, executive board members pointed out that they were not intent on deflation, and they would care if the price level began to fall: their brief was to keep prices within the 0 to 2 percent band, a common definition of price stability.

But what other critics such as Willem Buiter, a member from 1997 to 2000, of the Bank of England's Monetary Policy Committee, point out is that the ECB's inflation target is not "symmetrical." The ECB is not obliged by European finance ministers, who appoint the executive board, to take expansionary action if the rate of price increases falls below a certain point. By contrast the Bank of England has strict instructions from the British government to take stimulatory action if the rate of inflation falls to 1.5 percent.

The interest rate increases of 4 November 1999 and 3 February 2000 were taken against the background of a deteriorating price outlook, although the figure was still nearer to 1.5 percent than 2 percent. In order to appreciate why such seemingly minute details are important, it is worth noting that during the 12 years to 1999, inflation in the United States only once fell below 2 percent. The much-lauded Mr. Greenspan was far more relaxed about inflation than the ECB has proved to be during its very short life.

The rises in interest rates have been accompanied by forecasts that economic growth in the euro area may reach 3 percent this year - not great by US standards, but good by recent European ones. Yet they also took place in the face of conflicting evidence about the strength and durability of economic recovery in Germany. Germany is undoubtedly the core economy of the area, accounting for about a third of "Euroland" gross national product.

The most publicized aspect of the euro's first year has been its weakness against the dollar. The new currency was devalued by over 15 percent between the beginning and end of 1999. Yet, as the German finance minister Hans Eichel has recently acknowledged, via its competitive impact on exports, the weakness of the euro has been a useful boost to such economic recovery as there has been.

One is left with the overwhelming impression that the ECB's brief is over-concerned with price stability, and insufficiently with the achievements of economic growth. It might well be that the "structural change" which is so fashionably advocated in Europe would be easier to achieve in a more expansionary atmosphere. After all, the first impact of structural change is redundancy: a buoyant economy is needed to absorb slackness in the labor force.

In other words, what the fledgling European Union attempt at economic governance needs is something like the US Humphrey-Hawkins, or Full Employment and Balanced Growth Act of 1978.