86 NEW ECONOMY

The European Central Bank (ECB), whichstarted running the monetary policy ofthe 11 countries adopting the euro on

1 January 1999, is a creation of the MaastrichtTreaty, which designed it to be the most inde-pendent monetary authority in the world. TheMaastricht Treaty established the ECB with itssole aim to pursue price stability. Article 3Amakes this goal legally explicit and thereforebinding, whilst stating that other objectivesmay be pursued only ‘without prejudice’ toprice stability. The ECB is forbidden by itsfounding charter to balance the goal of pricestability against other aims such as growthand job creation.

The ECB’s architects at Maastricht soughtto insulate it completely from political pres-sures, both at the national government and atthe European level. By contrast, the US Fed-eral Reserve is required to take into accountoutput and employment objectives along-side inflation objectives, whilst being subjectto fierce, regular scrutiny by Congressionalcommittees with wide powers of investiga-tion and review.

The position of the ECB under the MaastrichtTreaty permits no clear accountability to anynational or European institution. It stipulatesthat the ECB Council’s deliberations remainconfidential, although Wim Duisenberg, the

ECB’s President, suggested that minutes ofCouncil meetings could be made public aftera time lag of 16 years! The only method of ques-tioning the ECB’s policies is through periodicreports to the European Parliament. This is inthe context of an EU structure of decision-making widely acknowledged to be alreadysuffering from a ‘democratic deficit’, which theunaccountability of the ECB will exacerbate. AsCharles Dumas of Lombard Street Bank hasargued, ‘the ECB’s “excessive” independencewas the price paid for persuading Germanvoters to give up the mark’.

In some countries, it is more explicitlyrecognised that monetary policy is requiredin practice to balance a range of objectives. Bycontrast, the ECB appears to reject any sug-gestion that monetary policy has to balancethe objective of price stability against itsimpact on the real economy and unemploy-ment. The ECB’s legal responsibility is tomaintain price stability, but that target hasbeen attained in France and Germany for thepast five years. The ECB appears to ignore thesuccess of the UK and the US in achievingprice stability, whilst simultaneously deploy-ing monetary policy to generate falling unem-ployment. The explanation of this conundrumlies in the ECB’s origins and the macroeco-nomic theory it has adopted.

The real Euro-sclerosis

The ECB and the natural rate

MARK BAIMBRIDGE,BRIAN BURKITT &PHILIP WHYMAN

Department of Social andEconomic Studies,University of Bradford

1070-3535/99/02086 + 06 © 1999 IPPR

THE REAL EURO-SCLEROSIS 87

The ECB’s credibilityThe economic case for independence, uponwhich the philosophy of the ECB rests, isbased upon two theoretical propositions thatappear to have become generally accepted byeconomists over the last decade:● that no long-term trade-off exists between

growth and employment on the one hand,and inflation on the other. Consequently thepursuit of price stability can become the soleobjective of monetary policy without prej-udice to the long-term level of unemploy-ment;

● the existence of the political business cycle,through which politicians manipulate mon-etary policy to maximise votes.

However, both premises lieupon insecure foundations.

The idea that centralbanks should be indepen-dent from political influencehas deep historical roots andfeatured in the debates lead-ing to the establishment ofmany twentieth century cen-tral banks. Originally theconcern was to impose lim-its upon the government’sability to fund itself throughseignorage. The more con-temporary argument is that politiciansmanipulate monetary policy to win elec-tions; with policy tending to exhibit a stop-go character, reflecting an excessiveconcentration upon short-term macroeco-nomic fine tuning. Consequently long-runefficiency requires the removal of mone-tary policy from the sphere of democrati-cally accountable politics and its delegationto an independent central bank, with aneffectively designed constitution and aninternal reward system that imposes pricestability as the overriding policy objective.However, only in recent years has the

concept of policy credibility been definedand analysed rigorously.

The establishment of an independent cen-tral bank with strong anti-inflationary pref-erences is seen as a way for the state to bindits hands against the electoral temptation ofinducing unanticipated increases in the pricelevel. As commitment increases credibility,orthodox theory predicts that divergencesbetween the central bank’s policies and peo-ple’s expectations will be smaller. Thereforelower costs and fewer delays are incurredwhen adjusting to shifts in monetary policy.It is from this theoretical perspective that theECB was launched. However, just weeks afterits inception, the ECB faced intense pressure

from European politicians tocut interest rates. Given thelevels of inflation and unem-ployment prevailing in early1999, the case for a relaxationof monetary policy wasstrong, but the ECB fears thedanger of being seen as opento persuasion. It argues thatan independent central bankmust guard its credibility. Ifthe financial markets suspectthat the Bank is susceptible topolitical influence, long-run

inflation and the cost of controlling it wouldbe higher.

This argument has been challenged. If cen-tral bank independence increases credibility,it should be associated with greater rigidityin the setting of nominal prices and moneywages, reflecting the fact that the bank’spromise to keep inflation low is believed.However, a study of 17 OECD countries byPosen (1998) using data from 1950 to 1989indicated that neither effect occurs. Indeedindependence not only fails to reduce thecosts of disinflation, but rather seems toincrease them. Getting inflation down takes

“Given the levels ofinflation and

unemploymentprevailing in early1999, the case for a

relaxation ofmonetary policy wasstrong, but the ECBfears the danger of

being seen as open topersuasion.”

88 NEW ECONOMY

as long and calls for a bigger short-term sac-rifice of output and jobs, on average, in coun-tries with relatively independent centralbanks.

The ECB’s approach to unemployment

The dominance of monetarism in the 1980sand 1990s led to the widespread conclusionthat low inflation is an essential, or at least avery important, condition for sustainedgrowth, thus reinforcing the central bank’ssearch for credibility. However, the belief thatlow inflation is conducive to high growth isnot supported by the evidence. The consen-sus from recent research suggests that no sig-nificant relationship exists between inflationand growth, until prices increase at double-digit rates (Stanners 1993).

The ECB argues that all or almost all of theEurozone’s historically high unemploymentoriginates from structural deficiencies on thesupply side of its member states’ economies.Consequently it denies the efficacy of increas-ing aggregate demand to lower unemploy-ment, believing that there is no further roomfor expansion in the Euro-11 economies. Insupport of this thesis, another impeccablyorthodox economic institution, the OECD, haspublished estimates of the natural rate ofunemployment for most of the industrialisedeconomies (see the table on page 80). The esti-mated weighted average of the natural ratefor the 11 Eurozone countries was 10.9 percent in 1997. The actual unemployment ratein the Eurozone was 10.6 per cent in January1999. On this reasoning, no scope exists toreduce unemployment in Europe withoutaccelerating inflation. Such a view emphasisesthe grip that the natural rate of unemploy-ment hypothesis potentially exerts over ECBpolicy making.

If the sole objective of the ECB’s monetarypolicy is to maintain a constant rate of infla-tion, wide variations in output and employ-ment may be required. In so far as a potential

conflict exists between steady inflation and fullemployment, the latter should enjoy priority,because the consequences of fluctuations inemployment are more serious than those in therate of inflation. Apart from the human costsof lower income, job insecurity, loss of skills,poorer mental and physical health, and high-er crime rates, the industrial cost is enor-mous, since lost capacity cannot subsequentlybe made good when demand recovers.

These problems do not seem to havedeflected Europe’s establishment from itsobjectives. As Strauss-Kahn, the FrenchFinance Minister, said in a speech to the Cen-tre for Economic Policy Research on 9 Novem-ber 1998: ‘We have made the choice of havingan independent central bank. Its autonomyvis-à-vis national governments and the EUinstitutions, which results from an interna-tional treaty, is more soundly guaranteedthan anywhere else in the world...We haveclearly enshrined in our treaty a fiscal policythat emphasises the need for fiscal responsi-bility and we have drafted secondary legis-lation that will make sure that member stateswill deliver on this commitment’.

On the change from an international econ-omy dominated by the fear of inflation, whenthe Maastricht Treaty was signed in 1991, totoday’s deflationary climate, Strauss-Kahnremarked: ‘Our task is to make this systemwork in a context which is clearly differentfrom the one the architects of Maastricht hadin mind when they drafted the Treaty’. Thealternative of changing the policy decision-making framework as circumstances changeis self-evidently not on the agenda.

Strauss-Kahn did, however, accept the‘need for institutions that can deliver effectiveco-ordination between the 11 governments ofthe Eurozone, and between them and theindependent ECB’, because ‘in the absence ofeffective co-ordination, doubts about the otherplayers might well lead the Eurozone toadopt a less than optimal policy-mix’. How-ever, difficulties arise when Strauss-Kahn

THE REAL EURO-SCLEROSIS 89

claims that ‘the efforts made since the late1980s have created conditions for a long EUcycle of growth’. The EU was a low growtharea over the last decade, when these ‘efforts’were being undertaken, expanding at 1.7 percent per annum between 1991 and 1997 com-pared to 3.5 per cent for the rest of the world.Consequently unemployment in the EU was7.7 per cent in 1990 but had risen to ten percent in 1998. Similar increases have notoccurred in some other OECD countries.Nonetheless the ECB’s monthly bulletin inFebruary 1999 asserts that monetary and fis-cal conditions ‘are favourable for sustainedoutput and employment growth in the Euro-zone in line with price-stability’.

The ECB had consistentlybeen saying that it wouldhave to see clear signs ofdeflation before reducinginterest rates. The ECB hadalso been resisting a cutbecause it distrusted the fis-cal discipline of Europe’spoliticians and did not wantto be seen to be giving in topressure from the politicians.The precise reasons for thecut in interest rates in April1999 remain mysterious, pre-cisely because the ECB isloath to explain its decisionsin public. The rhetoric continues to empha-sise the goal of price stability and a focus ontrends in inflation and in the monetary aggre-gates as the main guide to policy.

The ECB deliberately keeps its inflation tar-get vague, as simply below two per cent, sothat it would not be beholden to the biddingof politicians once it meets its objective. How-ever, the attainment of a two per cent infla-tion target has not been achieved by anymajor economy in recent times.

The US inflation rate over the last decadeaveraged 3.3 per cent and that of Germany 2.8per cent. Therefore an unaccountable

institution has assigned itself an exactinginflationary goal, with ramifications for otherdimensions of economic policy. Even if theECB’s argument that Germany’s currentunemployment is structural not cyclical is cor-rect, embarking upon structural change andrealising its results, is a lengthy process. How-ever, distancing itself from democraticdemands and emphasising its independenceis seen as a crucial tactic for building the ECB’scredibility.

Division between the conduct of fiscal and monetary policy

One of the major problems stressed by econ-omists is the potential lack of co-ordination

between monetary policy,directed by the central bank,and fiscal policy, operated bythe government. The difficul-ties arising from such a lack ofco-ordination have beendemonstrated within the firstmonths of the euro’s life.

Economic policy has tradi-tionally been directed to thesimultaneous attainment offour policy objectives; highlevels of employment, stableprices, balance of paymentsequilibrium and economicgrowth. Within the Eurozone,

responsibility for price stability lies solelywith the ECB, whilst responsibility for theother three remain with national govern-ments. An obvious danger is that economicmanagement will become more difficultthrough the separation of fiscal and monetarypolicy. This was demonstrated by the short-comings of the Reagan-Volcker era in the USand Germany’s problems following reunifi-cation. In both cases lax fiscal policy result-ed in high interest rates. By contrast, with anon-independent central bank, fiscal andmonetary management can more easily becoordinated.

“The ECB argues thatalmost all of the

Eurozone’sunemploymentoriginates from

structuraldeficiencies on the

supplyside...Consequently itdenies the efficacy ofincreasing aggregate

demand to lowerunemployment”

90 NEW ECONOMY

Since the EU Heads of Government met atMaastricht in 1991 to finalise the blueprint forEMU, their political complexion has changedbeyond recognition. The centre-left now con-trols or shares power in 13 of the 15 EU gov-ernments (Ireland and Spain being theexceptions). The majority won elections bypromising to reduce unemployment and anew European consensus to this end hasemerged.

Consequently the theoretical possibility ofa division between the conduct of budgetaryand monetary policy has become a realitywithin three months of the launch of theeuro, far more rapidly than even scepticsanticipated. A crevasse has opened upbetween centre-left governments focusingupon unemployment and the ECB with itsthinking dominated by the natural rate ofunemployment hypothesis. Moreover, thebankers insisted in advance, via the Stabilityand Growth Pact, that governments shouldbe deprived of the ability to spend their wayout of recessions.

The battle between the ECB and Euro-politicians has been temporarily dampenedby the resignation of Oscar Lafontaine, but hisdeparture cannot solve the underlying poli-cy conflicts in Euroland, so that the danger ofdivergence between fiscal and monetary poli-cies remains.

Divergence between the economiesof the Eurozone

The euro-11 countries, even without the UKin membership, do not constitute an

optimum currency area. Consequently formany years to come, persistent nationaldivergences in growth and unemploymentare likely to recur.

This nightmare scenario has not taken longto unfold; Wim Duisenburg felt obliged toconcede on 4 March 1999 that the economiesso painfully corseted together by meetingthe convergence criteria are already diverg-ing. While countries such as Ireland andSpain benefit from big reductions in theirprevious interest rates, Germany appears tobe drifting ineluctably into recession. What-ever happens in the future, it is plain that onekey argument of the eurosceptics has beenproved correct; no single interest rate is suit-able for the Eurozone.

Any action of the ECB will cause troublefor some parts of the Eurozone. In the lastquarter of 1998, Germany’s GDP fell by 0.5 percent, yet Spain’s rose by 0.8 per cent, whilstIreland’s increased by 8.0 per cent over thewhole year. Such sharp divergences in eco-nomic performance will make the ECB’s stew-ardship a hazardous task.

ConclusionThe Eurozone possesses a clear route to pros-perity; with historically low inflation andmodest budget deficits, there is no credibleargument against an easing of macroeco-nomic policy to create jobs. It will be a tragedyif the ECB is so trapped by its economic phi-losophy into the habit of controlling inflationby repressing growth, that it cannot seizethis historic opportunity ●