Journal Issue

Regional Focus: Seven Years on: Assessing Europe’s Central Bank

International Monetary Fund. External Relations Dept.
Published Date:
November 2006
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After five years of almost no growth, the euro area is finally enjoying an economic recovery. But the European Central Bank (ECB), which sets interest rates for the euro area’s 12 member states and whose policies are shadowed by many other European Union (EU) countries outside of the monetary union, is worried about inflationary pressures. It has embarked on a tightening of monetary policy, which has led some policymakers to complain that it risks choking off the recovery. Camilla Andersen spoke to Peter Kenen, Senior Fellow at the Council of Foreign Relations, about the role of the ECB.

IMF Survey: Has the euro been successful?

Kenen: The euro is the second most important currency in the world today. For a young institution to have achieved that is a major accomplishment. There is also evidence that the euro has stimulated trade, although on a more modest scale than some of my colleagues, for instance Andrew Rose, had originally predicted. And it has enormously stimulated the growth of European capital markets—to the extent that we are now seeing the unification of European stock markets. Even though London is still the main financial center, the consolidation of the continental securities markets has proceeded at a rapid pace.

IMF Survey: Inflation in the euro area has generally been low. But for the past few years, the ECB has not been able to completely meet its own target of keeping inflation “close to but below 2 percent.” What does that say about the ECB?

Kenen: That is a difficult question to answer because inflation rates have been falling all over the world since the ECB began operating in 1999. The ECB’s track record is good, but not much better than that of the other major central banks, the Bank of England and the U.S. Federal Reserve. As you probably know, its inflation target has been widely criticized. Most central banks have a single target surrounded by an acceptable band of 1 percent on either side. In contrast, the ECB does not have a range around its target. That has put the institution under unnecessary pressure. If the target had been set at 2 percent with a margin on either side, it would have been well within its target most of the time. Instead, it has missed its own target over and over again.

IMF Survey: Is the target too ambitious?

Kenen: The target may be somewhat low, particularly since we don’t know how much below 2 percent the ECB wants the inflation rate to be. Putting aside for a moment the problems faced by those EU member states that would like to join the euro area, the original 12 members of the euro area lucked out in that some of the higher-inflation countries did not weigh heavily in the ECB’s aggregates. While Italy is a decidedly different case, the two biggest countries, France and Germany, have experienced a decline in their inflation rates, and this set the tone for the entire euro area. That has made the ECB’s job a lot easier than if the faster-growing accession countries had joined monetary union from the beginning.

IMF Survey: What about the ECB’s accountability?

Kenen: Virtually all central banks are in some way subject to government oversight. That’s certainly true of the Bank of England, whose governor must write a letter to the chancellor if inflation exceeds 3 percent. In the United States, the chairman of the U.S. Federal Reserve spends a good deal of his time testifying before congressional committees. There is no comparable intergovernmental oversight of the ECB, and it is more independent than any other central bank in two ways. First, while the European parliament does hold hearings and has established a committee to oversee monetary policy, it has no power over the ECB. Second, there is only one way of changing the mandate of the ECB, and that is to amend the Treaty of Maastricht—something that requires the unanimous approval of every EU country. So in a way, the ECB is the most independent central bank in the world, which leads to a strong and effective executive board and a good deal of autonomy.

IMF Survey: How influential are the 12 national central bank governors?

Kenen: Outsiders have no way of knowing to what extent the debate in the ECB’s governing council focuses on the euro area or on individual countries. But the whole point about monetary union was that the ECB would look at euro area aggregates, not at national performance. National central bank governors participate in the ECB’s council meetings to debate the performance of the whole economy of the euro area, just as the regional bank governors in the United States debate the entire U.S. economy when they meet at the Federal Reserve. The president of the Fed bank in Dallas does not pound the table and say “things are going awry in Texas,” at least not to my knowledge! I would credit Wim Duisenberg, the first president of the ECB, and also Otmar Issing, the bank’s first chief economist, for establishing a similar principle at the ECB.

IMF Survey: How does the ECB’s credibility as a central bank compare with that of the U.S. Federal Reserve?

Kenen: I would think that the Fed enjoys greater credibility, although I would measure the difference in inches rather than miles. The ECB has done very well in establishing itself. It is highly regarded by most central banks and most monetary economists. The inflation targeters, such as my colleague Lars Svensson, would say it should have a symmetrical target (a target with a margin on each side), and I agree. But overall the performance has been pretty good, and I would certainly not blame the ECB for the sluggish economic performance of the euro area. Much of the debate in Europe right now is about why the sustainable growth rate is so low. And that is a reflection of real, not monetary, factors.

The European Central Bank explained

The European Union has 25 member states, but only 12 countries have so far adopted the euro. These countries—Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—form the euro area, also known as the eurozone or euroland.

The European Central Bank (ECB) conducts monetary policy on behalf of the euro area countries. But it does not act alone. As part of the eurosystem, it works together with the national central banks of the 12 euro area countries. The ECB executive board and the ECB council are the two decision-making bodies of the eurosystem. Both are chaired by the president of the ECB, currently Jean-Claude Trichet of France. The executive board consists of six members who are appointed for a nonrenewable eight-year term of office. The council, which meets twice a month, is composed of the six members of the board and the governors of the euro area’s 12 central banks. The council makes decisions about interest rates on the basis of simple majority voting (each member has one vote). The board is entrusted with implementing the policies decided by the council and conducts the daily business of the ECB.

IMF Survey: Is the ECB to blame for the lack of growth in the euro area?

Kenen: No. The forces that slowed down the European economy are caused by the structural features people talk about so much and by the fact that much of the recovery has been export-based. Until recently at least, investment had not picked up and consumer spending was slow, and I don’t think that is the influence of monetary policy.

IMF Survey: Do poor performers, such as Italy and Portugal, threaten the viability of monetary union?

Kenen: Let’s take the extreme case. What is the probability that Italy will withdraw? This has been discussed by some less responsible politicians in Italy from time to time. The answer to that is twofold. The first problem is that you cannot legally withdraw. ECB membership is an obligation of EU membership, except for those countries that have not qualified or have opt-outs, like Britain and Denmark. The second problem has to do with international law. If a country chooses to introduce a new currency and redenominate its debt, that is its legal right. The trouble is that the euro is not Italy’s own currency. It is a European currency. And debt denominated in euros is not something that is uniquely Italian. If Italy were to withdraw, the new Italian currency would depreciate, thereby increasing the debt burden. But there is also the possibility that if I was holding euro-denominated bonds, in Italy and under Italian law, I might still have the right to go to the European court and say I am entitled to be paid in euros. This would increase the debt burden even more. So withdrawal is a very remote possibility and fraught with all kinds of dangers.

What Italy does face is what Germany faced in the early years of monetary union. Germany came in with an overvalued exchange rate and experienced a long period of stagnation partly for that reason. Italy now faces an overvalued currency, and this is going to mean a period of austerity until the Italians can bring their wage costs down. That is one reason why there is a certain dissatisfaction in Italy right now. It is going to be a painful process. Spain is another country with similar problems.

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