Mark A. Wynne
On January 1, 1999, the European System of Central Banks (ESCB) began conducting monetary policy for eleven of the fifteen nations of the European Union, formally creating an economic and monetary union. The ESCB is governed by the decision-making bodies of the European Central Bank (ECB) and manages Europe’s new currency, the euro. The structure of the ESCB is in many ways similar to that of the Federal Reserve System, with the ECB playing a role similar to that of the Board of Governors and the various national central banks occupying positions not unlike those of the regional Reserve Banks.
In this article, Mark Wynne compares the two central banks, drawing on the insights of economic theory to shed light on how monetary policy is likely to be made in Europe under monetary union. He documents two key differences between the ESCB and the Federal Reserve System. First, the ESCB has a much stronger price stability mandate. Second, power is much more diffusely distributed in the ESCB. The strong mandate for price stability will enhance the euro’s credibility. But the diffuse power structure may make it difficult to resolve conflicts, which will undermine credibility. The monetary union’s fate depends on which of these two features of the monetary policy process dominates.
In the early hours of May 3, 1998, the leaders of the European Union (EU) took the most significant step toward European integration since the signing of the Treaty of Rome in 1957. In giving the green light to the economic and monetary union (EMU) of eleven of the fifteen EU members –the EU11–they took another major step toward a more unified Europe. 1
This latest development culminates a process of European integration that began shortly after World War II and that may one day lead to a Europe as politically and economically integrated as the United States is today. The substance of monetary union is that the countries in EMU no longer have distinct national currencies. A new currency –the euro– has replaced them, and monetary policy for the EU11 is no longer determined by their national central banks but by the European System of Central Banks (ESCB). (See Glossary, box.)
The unprecedented monetary union of such a large and disparate group of sovereign nations will pose enormous challenges to the ESCB, which consists of the recently established European Central Bank (ECB) and the national central banks (NCBs) of EU members. The ECB commenced operations on June 1, 1998, and assumed responsibility for the conduct of monetary policy for the euro area on January 1, 1999. The euro has replaced the national currencies of the EU11, and in 2002 the notes and coins that currently circulate in these countries will cease to be legal tender. 2
The ESCB is conducting monetary policy on a continental scale. Table 1 presents comparative statistics for the United States, the EU, the EU11, and Japan. In terms of population and aggregate output, the EU11 is comparable to the United States. Should EMU eventually incorporate all fifteen members of the EU, its economic weight would significantly exceed that of the United States. Table 1 also compares the recent economic performance of the four groups. The most significant difference is the much poorer employment performance of the EU, whose unemployment rate is more than twice that of the United States. The consensus among economists is that the bulk of this unemployment is structural rather than cyclical and reflects the greater rigidity of Europe’s labor market institutions. 3
The extent to which the euro can credibly challenge the U.S. dollar’s primacy in global finance will depend largely on the ECB’s success in maintaining the euro’s purchasing power and making it attractive to international investors. The structure of the ESCB is similar in many ways to that of another central bank charged with conducting monetary policy on a continental scale–the Federal Reserve System. In this article, I review the structure of the new central bank, sketching out key similarities to and differences from the Federal Reserve.
THE ROAD TO EMU
EMU is the latest step in the move toward greater economic (and political) integration in Europe that began with the establishment of the European Payments Union in 1950. That entity was little more than a technical device to facilitate the reconstruction of Europe following the devastation of World War II. But it can also be seen as the first manifestation of the political will to forge closer bonds between the wartime belligerents so as to preclude future conflict. A more substantive step was taken in 1951 with the formation of the European Coal and Steel Community, which created a common market for these commodities involving Germany, France, Italy, and the Benelux countries (Belgium, Netherlands, and Luxembourg). This entity was supposed to be accompanied by stronger political and military ties (including the creation of a European army), but concerns about loss of national sovereignty led to abandonment of these plans. Instead, the emphasis shifted to greater integration on the economic front, and in 1957 the Treaty of Rome created the European Economic Community (EEC), or Common Market. Coordination of economic policies was always seen as integral to the success of the Common Market, and in 1964 the Committee of Governors of the central banks of the European Community (EC) was formed to coordinate monetary policies. The central banks of Europe have had varying degrees of success coordinating their monetary policies over the past three decades. 4
Monetary union of EC members was proposed in 1970 in the Werner Report. While this report envisioned a monetary union by 1980, two key international developments derailed the plan. The first was the breakdown of the Bretton Woods system of fixed exchange rates in August 1971; the second was the 1973 oil crisis. The EC responded to the exchange rate turbulence that followed both events with a system of quasi-fixed exchange rates, the so-called snake, but this rapidly collapsed to an arrangement involving only a few members. The second attempt to fix exchange rates, the European Monetary System, was established in 1979. It proved more durable, although it, too, experi- enced a number of major and minor crises. By the mid-1980s the EC had expanded to twelve members, and in 1989, renewed interest in a formal monetary union resulted in the Delors Report.
The Delors Report laid out the basic plan and timetable for monetary union that has been followed since the early 1990s. The proposals in the report were incorporated into the Treaty on European Union, which was agreed upon at a meeting of the European Council in Maastricht, Netherlands, in December 1991 and signed in February 1992. This agreement, commonly known as the Maastricht Treaty, was the most comprehensive change in the basic law of the European Community since the Treaty of Rome. It established the institutional framework for monetary policy under EMU, a timetable for the creation of a monetary union, and the criteria for countries’ participation. Many academic economists and others have questioned the wisdom of a monetary union between such disparate countries, but the debate became moot with the decision to proceed. 5
However, the points made by the critics of monetary union indicate where stresses may arise in the future and the kind of challenges the ECB may face.
INSTITUTIONAL STRUCTURES
The Maastricht Treaty established the institutional arrangements for the conduct of monetary policy under EMU. The treaty provides for the formation of the ESCB, which in many ways is indirectly modeled on the Federal Reserve System. 6
At the top of the ESCB is the Frankfurt-based ECB, which has a role similar to that of the Federal Reserve’s Board of Governors. The various national central banks play a role similar to that of the regional Federal Reserve Banks.
Table 1
Comparative Statistics on the U.S., EU, EU11, and Japan
U.S. EU EU11 Japan
Population 263 million 373 million 290 million 126 million
GDP (current $6.955 trillion $8.497 trillion $6.809 trillion $5.217 trillion dollars)
GDP (constant $6.149 trillion $7.203 trillion $5.721 trillion $3.168 trillion dollars)
GDP growth 3.8 percent 2.6 percent 2.4 percent .9 percent
Inflation rate 2.3 percent 1.9 percent 1.7 percent 1.7 percent
Unemployment 4.9 percent 11.1 percent 11.7 percent 3.4 percent rate
SOURCES: Population and GDP for 1995: United Nations (1997). GDP growth, inflation, and unemployment for 1997: OECD Economic Outlookand OECD Main Economic Indicators.
Monetary policy decisions are made by the Governing Council of the ECB, which consists of the Executive Board of the ECB and the governors of the participating countries’ central banks. The Executive Board consists of the president and vice president of the ECB and four other members. The president of the ECB chairs the Governing Council, in essence occupying a position similar to that of the chairman of the Fed’s Board of Governors. Under the Maastricht Treaty, the Governing Council is responsible for formulating monetary policy for the single-currency area, while the Executive Board is responsible for implementing monetary policy. 7
Executive Board members are appointed for nonrenewable eight-year terms, shorter than the fourteen-year terms of Federal Reserve Governors but the same as the terms of members of the Directorate of Deutsche Bundesbank.
RELATIONSHIP OF THE ECB AND NCBS
While there are many similarities in the structures of the ESCB and the Federal Reserve System, there are also important differences. The Executive Board of the ECB will be in a permanent minority on the Governing Council, whereas the Board of Governors has a permanent majority on the Federal Open Market Committee (FOMC). All NCB governors have a vote in all policy decisions of the Governing Council, whereas with a single exception, Reserve Bank presidents participate in FOMC votes every two or three years, depending on which Bank they represent. Indeed, the relationship of the ECB and the NCBs probably bears a closer resemblance to the relationship of the Board of Governors and the Reserve Banks in the early years of the Federal Reserve System than to the situation today. For its first twenty years, power was more diffuse in the Federal Reserve System than it is now. Some critics have argued that this diffuse distribution of power and the struggle for hegemony contributed to the Fed’s inability to deal with the Great Depression (see in particular Friedman and Schwartz 1963). 8
Friedman and Schwartz (1963) contend that the distribution of power in the Federal Reserve System was a key contributor to the “ineptness” of monetary policy during the Depression. In the 1920s, the institutional structure did not present a problem as long as all regional Reserve Banks and the Board were willing to accept the leadership of the governor of the New York Bank, Benjamin Strong. But with Strong’s departure in 1928, the structure became unworkable. The other Reserve Banks were no longer willing to accept the domination of the New York Bank, and the Board was not in a position to impose its will on the System. Friedman and Schwartz argue that the Board’s weak position was due to the fact that it had not played a leadership role in the System in the 1920s but had instead functioned primarily as a supervisory and review body.
