Chapter 8: The European Central Bank

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Chapter 8The European Central Bank

• De Grauwe
• Economics of Monetary Union

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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

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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

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Relations with the government

• In Anglo-French model
• The monetary policy decisions are subject to the
  governments approval
• Political dependence
• In German model
• 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

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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).)

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• 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

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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

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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

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The Barro-Gordon model and optimal stabilisation
B
p1
A
B
Inflation
C
U
U
UN
U1
U2
Unemployment
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• Inflation equilibrium in point A
• Unemployment is at its natural level
• The short-term Phillips curve is tangent to the
  authorities indifference curve
• Authorities have no incentive any more to create
  surprise inflation
• The upward sloping dotted line is the optimal
  stabilization line
• Slope of the optimal stabilization line is
  determined by the weight the authorities attach
  to the stabilization of unemployment
• The higher this weight the steeper is
  stabilization line
• With a steep stabilization line authorities
  stabilize a lot at the cost of a high inflation
  bias

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How to eliminate the inflation bias? Appointing a
conservative central bank
Inflation
Eurozones preferences
ECB preferences
Unemployment
UN
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• 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

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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
Unemployment
UN
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• 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

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A new problem arises uncertainty about natural
rate
ECB s new estimate UN
Inflation
UN
Unemployment
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• UN Initial natural unemployment rate and observed
  unemployment rate coincides with it
• Target unemployment rate is at its natural level
• Suppose a temporary increase in unemployment
• ECB interprets this as an increase in the natural
  unemployment rate, and increases its target
  unemployment rate
• Optimal stabilization path shifts to the right
  the ECB will not attempt any stabilization
• ECB behaves as super-conservative by attaching a
  zero weight to unemployment stabilization

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Is there evidence that the ECB acted as a
conservative central bank?
Figure 8.5 Policy interest rates in the Eurozone
and the US ()

• US Fed seems to have reacted much more to the
  economic slowdown of 2001 than ECB
• But were the economic conditions the same in the
  US and the Eurozone?

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Eurozone
Figure 8.6 Short-term interest rate and output
gap (1999 2005)
Eurozone

• 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

US
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Figure 8.8 Inflation in Eurozone and in US
(1999 2005) ()
Previous conclusion is not affected by inflation
experiences Both US and Eurozone experienced
similar inflation rates except in last two years
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Independence and accountability

• Whenever the government delegates power to the
  central bank there is a corresponding need to
  have accountability
• The reason is that the government maintains its
  full accountability towards the voter
• Thus it cannot afford to delegate power without
  maintaining control over the use of this power
• Independence and accountability are part of the
  same process of delegation

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Optimal relation between independence and
accountability
Independence
ECB
Bundesbank
Fed
Accountability
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• ECB is more independent than any other major
  central banks
• The degree of accountability is weaker than in
  the FED
• This goes against the theory according to which
  accountability should be increased together with
  the degree of independence

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• Accountability is also related to the degree of
  precision with which central banks objectives
  are specified
• The Treaty is vague about the other objectives
  besides price stability
• The ECB has interpreted this to mean that it has
  to pursue only price stability
• As a result, the ECB has drastically restricted
  the domain of responsibilities about which it can
  be called to account

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• Modern central banks have a wider responsibility
  than simply price stability
• Conflicts between the ECB and the European
  governments will arise when the ECB is perceived
  to act too little to avoid recessions and
  escalating unemployment

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What ECB could do to avoid conflicts?

• Enhancing informal accountability through greater
  transparency
• Larger openness in the decision-making process
• Inflation targeting promotes informal
  accountability

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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,
  Vice-President, 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

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• 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

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• 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

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• 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

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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

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Taylor rule

• rt a b?t cxt
• rt nominal interest rate
• ?t inflation
• xt output gap

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Table B15.1 Desired interest rate using the
Taylor rule (2005)
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Asymmetric distribution of desired interest rates
using Taylor Rule (2005)
Without ECB-Board
Assumptions Governors are nationalistic ECB-board
cares about Euro-wide interests ECB-Board only
needs three votes to find majority for its
proposal ECB-Board has strategic position despite
asymmetries in shocks
With ECB-Board
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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

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• 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

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• 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

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• 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

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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

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• 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

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• This proposal has been adopted by the Heads of
  State
• It will take effect as soon as the number of
  Eurozone members exceed 15

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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

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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 ECB-Board
  will loose its strategic position and that
  interest rate decisions will stop representing
  the needs of Euroland as a whole

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• 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