A European Central Bank Primer
It’s been suggested to me that if I’m going to complain about how people underrate the importance of the European Central Bank, I ought to explain what it is and how it works. So here goes.
The Eurozone: The European Central Bank is the monetary policy authority for the Eurozone. What is the Eurozone? Well, formally it’s the EU member states that have adopted the Euro as their currency. In other words, it’s Ireland, Portugal, Spain, France, Belgium, the Netherlands, Luxembourg, Slovakia, Germany, Italy, Austria, Greece Finland, Slovenia, Malta, and Cyprus. In addition, the Euro has been unilaterally adopted as currency by the microstates of Andorra, Liechtenstein, San Marino, and the Vatican City along with the non-micro states of Kosovo and Montenegro. In addition, there are four EU members that while not using the Euro do participate in the second European Exchange Rate Mechamism (ERM II) and thus have their monetary policies largely determined by the ECB without participating in its governance. The idea of ERM II is that it’s a halfway house for countries that will be joining the Euro soon (you have to do a two-year probationary period on ERM II before you can join) but Denmark has no actual plans to sign up.
Governance: Much like the Federal Reserve, the ECB is run by two overlapping boards. The smaller board, called the Executive Board, is composed of the bank president, the vice president, and three other governors. It runs the bank day-to-day. In principle, a larger group, the Governing Council, composed of the Executive Board plus the governors of the 16 national central banks has ultimate authority. The bank is physically located in Frankfurt, Germany which is also the home of Germany’s central bank, the Bundesbank.
History: I think the Euro has to be understood as fundamentally a political project rather than an economic one. Monetary union meets some real economic policy objectives, but those objectives could have been met via a more flexible exchange rate mechanism. The ultimate purpose of the Euro is to create a physical instantiation of the ideal of European unity. Consequently, national decisions about whether to adopt the Euro have tended to track the general popularity of “Europe” as an idea rather than any economic logic. Hence, we have Finland, Ireland, and Greece on the Euro despite being geographically isolated from the Eurozone while Denmark abstains. But of course the Euro has important economic consequences.
Political Economy: The background of the ECB is that several European countries, primarily in southern Europe, developed a reputation as bad credit risks due to questionable fiscal policy and a habit of engaging in currency devaluation in order to maintain competitiveness. This annoyed Germany (and some others in northern Europe) and also made borrowing costs high in southern Europe. Credibility and reputation matter a lot in monetary policy, so the easiest way for countries with bad reputations to secure credibility was to essentially say “we get it, we’re drunk drivers, we’re selling our cars and resolving to get around on a German-piloted bus.” This is not an explicit rule of the ECB, but it reflects the underlying logic of the enterprise and is symbolized by the ECB’s location in Frankfurt. The essence of the bargain is that Germany gets to make every country’s monetary policy in accordance with Germany preferences while every country gets to borrow money at Germany-esque rates.
Independence: The ECB puts a lot of weight on independence. Formally speaking, the board members are specifically prohibited from seeking or listening to European government advice on policy matters. What’s more, the executive council members have non-renewable eight year terms. Both provisions offer much stronger independence than the Fed has. More to the point, in practice there’s no political authority to which the ECB could be subjected. The Fed was created by Congress and Congress can always change the rules. The ECB was created by a European Union treaty and changing the rules would require the unanimous consent of 27 different national governments.
Mandate: Unlike the Fed, the ECB has a single mandate: price stability uber alles. What’s more, since it lacks a track record it’s very invested in building up its reputation as an inflation-fighter. European politics is also different from US politics. In the US, we tend to count on growth and low unemployment to make a threadbare social safety net tolerable to the middle class. In Europe, they tend to count on low inflation and light taxation of capital to make a robust social safety net tolerable to the rich.
Problems: The whole enterprise has always has its doubters. American economists felt the zone wouldn’t be able to adjust to recessions. Germany worried that others would take on two much debt and leave them holding the bag. Small countries worried that they’d be forced to suffer through inappropriate monetary measures. Essentially all of these problems are now occurring simultaneously.