SURVEY EMU
A bank is born
Nuts and bolts
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Running Europe’s monetary policy will be hard; answering for it even harder |
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The bank’s monetary-policy instruments are also clearly defined. Most interventions will take the form of repo operations against recognised collateral. The bank will also offer a deposit rate. It will not run a discount facility along the lines of the Bundesbank’s, for that has been used as a way of subsidising smaller banks. It may, however, follow the Bundesbank in imposing reserve requirements on banks, although at the EMI’s Frankfurt office there is a clear distaste for what can amount to a tax. And it has already set up and tested a euro-area payments mechanism called Target.
Yet technical instruments are no use without clear policies to guide them. Here the ECB will suffer from two uncertainties. The first, which should be clarified before next January, concerns the sort of target it should aim at. There is a choice of two: a money-supply target, as used by the Bundesbank and a few other continental central banks, or a direct inflation target, as pursued by the Bank of England and most of the rest. The trend is moving in the direction of the second, because money-supply figures have proved unreliable predictors of inflation. But the argument of continuity (and probably also the ECB’s top brass) may favour sticking with the money supply.
In practice, the bank will have to pay attention to both targets. This is at least partly because of its second uncertainty: about the usefulness and meaning of euro-wide aggregates. Getting inflation figures for the euro area may be relatively uncontentious. But money-supply figures are a different matter. There will be no monetary history to go on. And the bank will have to wrestle with Goodhart’s law, which states that any variable that becomes a policy target immediately changes its behaviour.
The central bank’s difficulties are likely to be felt immediately because of differences between the core group of euro countries and the rest. The EMI constructed monetary models which suggested that the demand for money would be more predictable for a group consisting just of Germany, France, Austria, the Benelux trio and Ireland than for a broader group that also includes Finland, Spain, Portugal and Italy. That was one big reason why German and Dutch central bankers favoured a small EMU.
To make things more difficult, the euro countries’ cycles are recognisably out of synch. In particular, Ireland, Spain, Finland and Portugal all seem to have pulled out of recession faster than France and Germany. That is why short-term interest rates in the peripheral countries have been higher than in the core. Now, when it comes to imposing a single interest rate on the entire euro area, the odds are that it will either be too low for the periphery or too high for the core—or both.
Of the 11 prospective euro members, Ireland is the most awkwardly placed. Partly thanks to its links with Britain, it came out of recession earlier than the rest of Europe and has recently enjoyed dizzy economic growth. For over a year its exchange rate was well above its central parity in Europe’s exchange-rate mechanism, prompting a 3% revaluation in mid-March. Yet that may not be enough to slow incipient inflation. Prices in Ireland in 1999 are forecast to rise faster than anywhere else in the euro zone, and a speculative asset-price bubble is already forming. Entry into EMU will bring lower interest rates just when higher rates might be called for. Responding with tighter fiscal policy, when the budget is already in surplus, will win the government few friends.
One size won’t fit all
Ireland is a microcosm of the problems the ECB will encounter in its early years in fashioning a single monetary policy appropriate for all euro members. There is a risk of an asset-price bubble emerging in Spain and Portugal too. And if these peripheral countries were then to move back into recession, ahead of France and Germany, the policy dilemma could become even worse.
To complicate things further, from 1999 to 2002 the euro will be circulating alongside national currencies. True, those national currencies will, technically, be mere subdivisions of the euro. But for Germans or Frenchmen, the fact that their bank accounts will still be denominated in D-marks or French francs, as will the banknotes they use, will have a psychological effect. The euro may not seem as irreversible as it is. This is why several EMU-watchers complain about the length of the transition period.
Other economists go further, predicting that speculators might try to blow the euro apart during this transition period. Yet, although there may be scope for some speculation up to January 1st 1999, it is hard to envisage what form it might take thereafter. Legally speaking, the D-mark and the Italian lira, say, will not be distinctive currencies. It would be perfectly possible for all holders of lira accounts to redenominate them in D-marks—but it would make no difference to anyone.
That might change if doubts were to emerge about the durability of EMU—as there were about the ERM. Yet the parallel is false. Leaving the ERM was easy; leaving EMU would be far harder. A country wishing to get out might reintroduce its previous currency, but that would mean reneging on an international treaty and perhaps, say some Brussels lawyers, having to leave the European Union and losing access to the single market—not the best basis for rebuilding confidence. The legal and economic problems of disentangling such a mess would be daunting. Short of a political earthquake, such as the one that blew apart the Soviet Union’s single currency, it seems unlikely that any euro member would ever want to go through all this.
The great accounting
EMU’s permanence may help to boost the ECB’s credibility. But credibility is not likely to be its biggest worry in the early days, even though it clearly has to work to inherit the Bundesbank’s reputation for solidity. The bank’s statutory independence, enshrined in an international treaty, should do much to reassure the markets. For Europe’s citizens, a more serious issue will be how to hold the bank accountable for its actions.
The drafters of the Maastricht treaty were understandably anxious to model the new bank on such independent central banks as the Bundesbank and America’s Federal Reserve, because these banks have a better inflation record than their politically controlled counterparts; but more recently the French have been arguing for a “political counterweight” to the ECB. Purists have been trying to fend this off, for fear that such an animal might compromise the bank’s independence.
This has proved confusing because the two sides have failed to distinguish between political control and accountability. The first, which many French politicians do indeed hanker after, is undesirable. But the second is essential, and lies at the heart of the success of both the Bundesbank and the Fed. Both operate in a clear political context in which they account for their actions not just to politicians but to a wider public. As a result, both have acquired immense prestige, and even popularity, with voters.
The ECB will find it much harder to establish this kind of role for itself, because there is no obvious political context in which it can operate. Euro-MPs have eagerly put forward the idea that they might hold regular hearings with the ECB modelled on congressional hearings in America. Finance ministers of the euro countries will also invite the bank president to their monthly meetings. But neither will be enough: the European Parliament itself lacks sufficient credibility with the public, and a monthly meeting in Brussels is no substitute for the Fed chairman’s weekly breakfast with the Treasury secretary.
Something more is needed, and fast—or it will be too easy for national politicians, and even national governments, to blame Frankfurt for all economic ills. There could be a backlash against the bank (and against the euro) if structural reforms prove unpopular, and especially if they add to unemployment. Many people are already in the habit of blaming Brussels in general and EMU in particular for domestic problems. What should the ECB do to counter this risk?
Clearly the bank’s top brass need to sharpen their public relations, to build good links with the press and to be ready to make speeches all over Europe. The bank’s board members should testify to national parliaments, alongside the national central bank governors on the ECB’s governing council. And the ECB’s president will need to cultivate links with Europe’s heads of government to avoid the risk that some of them might start attacking the bank for being too restrictive.
Whatever else the bank does, it should make its operations as transparent as possible, something that goes against the grain of many central bankers. Both British and American experience has shown that immediate publication of decisions and lagged publication of the minutes of council meetings help to boost central banks’ credibility. Unfortunately the early signs are that the ECB may not want to espouse too much openness. That could be unhelpful to another side of its agenda: looking after what will be one of the world’s two biggest international currencies.
