Transcript Chapter 7

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
–
–
•
In German model
–
–
•
The monetary policy decisions are subject to the
government’s approval
Political dependence
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
How to eliminate the inflation bias?
Appointing a conservative central bank
Inflation
Eurozone’s
preferences
ECB preferences
UN
Unemployment
•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
•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
UN
Unemployment
• 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
Figure 8.6: Short-term interest rate and output gap (1999– 2005)
2,0
7
Output gap
Interest rate
1,5
Eurozone
6
1,0
5
Eurozone
0,5
0,0
0
3
Interest rate
4
-0,5
2
-1,0
1
-1,5
-2,0
0
1999
2000
2001
2002
2003
2004
2005
2,00
7
Output Gap
US
1,50
Interest rate
6
1,00
5
0,50
0
-0,50
3
-1,00
2
-1,50
1
-2,00
-2,50
0
1999
2000
2001
2002
2003
2004
2005
Interest rate
4
0,00
•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
Figure 8.8: Inflation in Eurozone and in US
(1999– 2005) (%)
3,5
Eurozone
US
3
2,5
Inflation
2
1,5
1
0,5
0
1999
2000
2001
2002
2003
2004
2005
Previous conclusion is not affected by inflation experiences
Both US and Eurozone experienced similar inflation rates
except in last two years
Optimal relation between
independence and accountability
Independence
ECB
Bundesbank
Fed
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, VicePresident, 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
Eurosystem
ECB
Decision stage
NCB1
NCB2
NCB3
Executive
Governors of
Board ECB
NCBs
………..
Governing Council
European Central Bank
Implementation stage
NCB1
NCB2
NCB3
NCB13
……….
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 + bt + cxt
rt = nominal interest rate
t = inflation
xt = output gap
Table B15.1: Desired interest rate using the
Taylor rule (2005)
C o u n try
R e la tiv e s ize
D e s ire d in te re s t ra te
N e th e rla n d s
0 ,0 6
1 ,7 6
F in la n d
0 ,0 2
1 ,9 2
P o rtu g a l
0 ,1 8
2 ,4 7
G e rm a n y
0 ,2 8
2 ,9 2
F ra n c e
0 ,2 1
2 ,9 6
A u s tria
0 ,0 3
3 ,0 5
E C B B o a rd
3 ,4 7
Ita ly
0 ,0 0
3 ,6 0
B e lg iu m
0 ,0 4
4 ,0 3
Ire la n d
0 ,0 2
4 ,5 0
S p a in
0 ,1 1
5 ,6 8
L u xe m b o u rg
0 ,0 2
5 ,8 0
G re e c e
0 ,0 2
6 ,9 8
0,70
0,60
Asymmetric distribution of desired
interest rates using Taylor Rule (2005)
4
Without ECB-Board
country size
distribution
3
Size
0,40
2
0,30
Distribution of votes
0,50
0,20
1
0,10
0,00
0
<2%
2-3%
3-4%
4-5%
>5%
Interest rate
0,70
0,60
9
With ECB-Board
country size
8
distribution
7
0,50
0,40
Size
5
4
0,30
3
0,20
2
0,10
1
0,00
0
<2%
2-3%
3-4%
Interest rate
4-5%
>5%
Distribution of votes
6
Assumptions:
Governors are nationalistic
ECB-board cares about Eurowide interests
ECB-Board only needs three
votes to find majority for its
proposal
ECB-Board has strategic
position despite asymmetries in
shocks
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 ECBBoard 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