Select Committee on European Union Forty-Second Report



1. The European Central Bank is one of the most influential financial institutions in the world economy. Endowed with an extraordinary degree of independence, the European Central Bank (ECB) sets interest rates for the countries that have adopted the euro. A few months before the ECB was established on 1 June 1998, we conducted an inquiry that examined how and whether the bank would work.[1] Five years have elapsed since the bank announced its monetary policy strategy, and so we consider that it is an opportune time to review and evaluate the ECB's strategic framework.

2. The current Inter-Governmental Conference (IGC), which is discussing the draft Constitution prepared by the Convention on the Future of Europe, offers Member States an opportunity to review the institutional framework of the European Union (EU). In this context, we decided that our inquiry should not only look at the ECB's monetary policy strategy but should also consider issues around the structure and governance of the bank, as well as the broader question of the institutional arrangements for the economic governance of the EU as a whole and the euro area in particular.


3. As well as following up our previous report on the ECB, this report, looking at how monetary policy is conducted in the euro area, complements the report we produced earlier this year on the Stability and Growth Pact.[2] This report does not consider whether, when and in what circumstances the United Kingdom should adopt the euro; it is intended rather as a contribution to the debate on the ECB itself, irrespective of whether the UK and other Member States outside the euro area decide to adopt the single currency. Our dual aim was to review the workings of the bank since it was established in 1998 and to look forward and ask whether any changes should be implemented ahead of enlargement of the EU and the euro area. The report looks at these issues from a European perspective, focusing on the wide European interest. In preparing the report, we heard from witnesses from 9 different Member States, as well as from the United States of America (US).

4. The rest of this section provides an introduction to how the ECB works and concludes with an assessment of the bank's record of monetary policy decisions so far. Part Three of this report analyses the ECB's monetary policy strategy as a framework for making those decisions and as a means of communicating them to the public. In Part Four we examine the governance of the ECB, and in particular the issue of reform of the Governing Council, asking what would be the optimal solution to the problems posed to the workings of the Governing Council by enlargement of the euro area. In Part Five we consider the issues of transparency and accountability. Part Six looks at the broader question of economic governance of the EU and the euro area in particular. Part Seven provides a summary of our conclusions. A glossary is provided in Appendix 3.


5. The inquiry was carried out by Sub-Committee A of the European Union Committee. The Membership of the Sub-Committee is listed in Appendix 1. Our witnesses are listed in Appendix 2; we are grateful to all of them and all those who assisted us in the course of the inquiry, particularly those who gave oral evidence.[3]

6. As well as taking evidence in the House, the Sub-Committee visited the ECB at its headquarters in Frankfurt. The Sub-Committee met the President of the ECB, Wim Duisenberg, and the other members of the ECB's executive board, all of who were most open and helpful. The frankness of their responses to questions greatly assisted the Sub-Committee as it pursued its inquiry and prepared this report. During its visit to Frankfurt, the Sub-Committee also held an informal meeting with the President of the Deutsche Bundesbank, Ernst Welteke, and we are also most grateful for his time and constructive contribution to our work.

The Structure and Governance of the ECB and ESCB

7. The European Central Bank took over monetary policy decision-making for those Member States participating in the euro area on 1 January 1999, when the euro was formally created at the start of Stage Three of Economic and Monetary Union (EMU)—see Box 2.[4]

8. The EC Treaty established three levels of governance within the ECB in connection with the single currency. These levels can be conceived of as a set of concentric circles. First, at the centre, forming the inner circle, there is the full-time Executive Board of the ECB, which is comprised of the President, the Vice-President and four other members (Article 112(2)(a)). Second, moving outwards away from the centre, there is the Governing Council of the ECB, which normally meets twice a month and comprises the Executive Board members and the governors of the national central banks of the countries in the euro area (Article 112(1)). Finally, representing the outside circle, is the General Council of the ECB, which meets four times a year; its membership comprises the President and Vice President of the ECB plus the governors of the national central banks of all EU Member States.
Box 2

Economic and Monetary Union (EMU)

The Delors Report in 1989 envisaged a three-stage transition to full Economic and Monetary Union (EMU). The EC Treaty, as revised in Maastricht, set out a timetable for the transition to a single currency in the final stage - Stage Three -of EMU.

The first stage of EMU began on 1 January 1990; Stage Two began on 1 January 1994. On 3 May 1998 11 Member States were judged to meet the conditions for adopting the single currency, the euro; and the third stage of EMU started on 1 January 1999, with the launch of the euro.

In Stage Three of EMU the exchange rates of participating currencies were locked together and these currencies became denominations of the single currency, the euro. Euro notes and coins followed three years later, on 1 January 2002, and gradually replaced participating national currencies.

The original 11 countries were later joined by Greece, which it was agreed could join the euro area in 2000 and which adopted the euro on 1 January 2001.

Responsibility for determining monetary policy for those countries participating in Stage Three passed to the Governing Council of the ECB, which consists of members of the Executive Board of the European Central Bank, plus governors of participating Member States' national central banks.

9. The Executive Board implements the monetary policy of the ECB, prepares the meetings of the Governing Council and deals with the day-to-day business of the ECB. The Governing Council represents the Eurosystem, the central banking system of the euro area, which is constituted of the ECB and the national central banks of the Member States that have adopted the euro. President Duisenberg, the first President of the ECB, compares the Eurosystem to a wheel, with the ECB in Frankfurt as its hub, and the national central banks as its spokes.

10. The General Council represents the European System of Central Banks (ESCB), which consists of the ECB and the national central banks of all the Member States of the EU. The General Council has oversight of the advisory and reporting activities of the ECB, the collection of statistical information, the conditions of employment of the staff of the ECB and certain other matters. The governors of the national central banks of the acceding countries participated as observers in a meeting of the General Council of the ECB for the first time on 26 June 2003, giving a foretaste of the enlarged ESCB.

11. Because the UK has so far chosen not to adopt the euro, the Bank of England is not represented in the Governing Council. However, the Governor of the Bank of England does sit on the General Council of the ECB, which has certain responsibilities under the Statutes[5] and which also holds general discussions about progress within the euro area. The Bank of England is also represented on a number of technical working groups and committees of the ESCB.


12. The ESCB is governed by the decision-making bodies of the ECB (Article 107(3) TEC). The independence of the Executive Board and the Governing Council in the performance of their tasks is protected by the terms of Article 108 of the EC Treaty: the members of the ECB's governing bodies shall neither seek nor take "instructions from Community institutions or bodies, from any government of a Member State or from any other body. The Community institutions and bodies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the ECB or of the national central banks in the performance of their tasks." It is an important reflection of this provision that the national central bank governors of the euro area participate in the work of the Governing Council, not as representatives of the Member States from which they come but as independent experts.

The ECB's monetary policy strategy

13. The Treaty assigns the ESCB the principal objective of maintaining price stability. Article 105(1) TEC states that:

"The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community".

This formulation leaves the ECB with a very substantial measure of discretion as to the way it achieves these objectives: the Treaty neither defines the concept of price stability, nor lays down a method by which the bank is to take into account the Community's other specified objectives, which are laid down in Article 2 of the EC Treaty and include "a high level of employment" and "sustainable non-inflationary growth".

14. In October 1998, the Governing Council of the ECB announced its quantitative definition of "price stability" as being a "year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%". As well as declaring that it was to use Eurostat's headline HICP (the consumer price index that has been harmonised across the EU), the bank also specified that it would aim to maintain price stability "over the medium term".[6] Accordingly, the Governing Council would set short-term interest rates with a view to keeping inflation for the euro area below 2%. In reaching its decisions on interest rates, the ECB declared that it would use a two-pillar approach. Under the first pillar, the bank attributed a prominent role to monetary indicators; under the second pillar, the bank would make a broadly-based assessment of non-monetary indicators of price developments.[7] The role to be attributed to monetary indicators would be signalled by a quantitative reference value for the growth of the broad monetary aggregate M3.[8] In December 1998, the Governing Council set the first reference value for monetary growth at 4.5%, explained the derivation of the reference value and said that they would review this figure annually.[9] The ECB reviewed its monetary policy strategy in the first half of 2003. The outcome of that review is presented and discussed below (see Part Three).

The monetary policy record of the ECB


15. The charts below show money growth, inflation and interest rates in the euro area since the ECB started operating on 1 January 1999.

16. On average in 1999 M3 grew by 5.7%, substantially above the ECB's reference value of 4.5%. After a slowdown between spring 2000 and early 2001, M3 growth increased significantly in the course of 2001. Following this marked increase in M3 growth, the average annual growth rate of M3 remained well above the ECB's reference value of 4.5%. (see Box 3). The annual growth rate of the broad money aggregate M3 averaged 4.9% in 2000 and rose to 5.5% in 2001. The average annual growth rate of the broad money aggregate M3 increased further in 2002 to 7.4%. This upward trend in M3 growth continued during the first half of 2003.

17. According to the latest set of data, average headline inflation (measured in terms of the HICP) was 1.1% in 1999, 2.1% in 2000, 2.3% 2001, and 2.3% in 2002. Since June 2000 inflation has been consistently slightly above the ECB's definition of price stability (see Box 4).

18. In December 1998 the Governing Council set the interest rate[10] for the euro area at 3%. In April 1999 the bank cut the interest rate by 0.5% to 2.5%, and it remained unchanged at that rate until November 1999, when it was raised by 0.5% back to 3% (see Box 5). The Governing Council then successively raised rates until October 2000, when they reached their highest level so far of 4.75%. The interest rate stayed at that level until May 2001. The bank then successively reduced rates until June 2003, when rates reached their historical low of 2%.[11]

19. The Governing Council normally meets twice a month, and it usually takes its decisions on interest rates at the first meeting of the month. Following the terrorist attacks on the US, however, an extraordinary meeting of the Governing Council was held on 17 September 2001 by means of teleconferencing. "In concert" with the decision that day of the Federal Open Market Committee in the US to lower its target for the federal funds rate, the Governing Council reduced interest rates for the euro area by 0.5% from 4.25% to 3.75%.[12]


20. A number of witnesses drew our attention to the fact that the ECB was a relatively young institution. They also pointed out that the bank had had to deal with a number of challenges during its first few years. For example, Mr Paul Volcker, who was Chairman of the Board of Governors of the US Federal Reserve System from 1979-87, considered that, despite the difficulty of getting cohesion among the 12 countries of the euro area, the bank had gone "a long way in establishing the legitimacy and the authority of the institution". On balance, it had done "a good job." (QQ 85, 123-24). The ECB had also had to oversee the replacement of national currencies by the euro. This euro cash changeover, which started with the introduction of euro banknotes and coins on 1 January 2002, went far more smoothly than expected (p.25). Sir Samuel Brittan, commentator for the Financial Times, said:

"we should pay tribute to the ECB for the efficiency with which it introduced the euro. It was not really very easy to substitute a new currency for about 12 national currencies, and it was a much more successful operation in terms of the general public than either decimalisation in Britain, or the move to the new franc in France some decades ago. It went over extremely smoothly but, above all, the ECB negotiated the difficult transitional period when exchange rates were locked together but there was no actual currency in circulation." (Q 148)

21. Professor Thygesen, Professor of International Economics at the University of Copenhagen and a Member of the Delors Committee on EMU 1988-89, also gave a positive assessment of the ECB's monetary policy, in particular because the bank had delivered inflation at around 2%, which was a commendable outcome given the disturbances the euro area had experienced over the few years of the bank's operation. The ECB had to deal with the economic effects in the euro area of a number of significant shocks, including the financial crises in Asia and Russia, a strong increase in oil prices, an increase in food prices due to animal diseases and bad weather, the terrorist attacks in the US, and other geopolitical tensions. But inflationary surges which came largely from such uncontrollable factors were subsequently dampened by the cautious policy of the ECB (Q 62).

22. The Federation of German Industries (BDI) considered that the ECB's monetary policy strategy had "proved effective" (p.85). The Union of Industrial and Employers' Confederations of Europe (UNICE) agreed that the bank could take credit for the inflation record of the euro area (p.90). Likewise, Mr Klaus Regling, Director General of the Directorate-General for Economic & Financial Affairs at the European Commission, considered that "all in all" the ECB's monetary policy decisions had been successful (p.88). Professor George S. Tavlas, Bank of Greece, also concluded that the ECB had "delivered price stability."[13] Professor Jacques Mélitz, Professor of Economics at the University of Strathclyde, went further to argue that this situation could be expected to continue:

"The European Central Bank quickly convinced the markets that it is a worthy successor of the Bundesbank.[14] From the beginning, it has acted in a responsible manner. There is every reason to expect the ECB to continue to pursue moderate inflation in the future while paying reasonable attention to the business cycle."[15]

23. Mr Bootle, Managing Director of Capital Economics Ltd, said that in the UK the ECB had come in for "a lot of criticism for all sorts of things." But, he argued, a lot of the criticism had been "ill judged." The facts belied the rhetoric, and the ECB did not warrant the criticism that had been made of it (QQ 85, 89). Sir Samuel Brittan was particularly concerned that the ECB should not be made the scapegoat for the sluggish growth of the euro area, pointing out that the bank had "not moved very differently from the Fed or the Bank of England." He added that the ECB had simply moved "a bit more slowly and a bit more cautiously" (QQ 148, 165 and p.54). Sir Samuel was not alone in adding this caveat to his support for the ECB. For example, Professor Charles Goodhart, who had been a member of the Monetary Policy Committee of the Bank of England, said: "There has been a lot of criticism of the ECB, but in practical terms what they have actually done, in my view, they have done really extremely well, with one minor qualification which is that they have frequently been a month or two slow". Professor Willem Buiter, who had also been a member of the Monetary Policy Committee of the Bank of England, agreed that the bank had done "an effective job", but he concurred that the ECB had been "systematically slightly behind the curve, but only at the most a couple of months or so" (QQ 41, 44, 67). Professor Draghi, Managing Director and Vice-Chairman of Goldman Sachs, however, questioned whether this was so and if it was, what effect it had had:

"the ECB was widely criticised, especially in the United States by our American colleagues, for being too cautious and for reacting to events much more slowly than the US Fed had done […]. Have they been too cautious? With the benefit of hindsight now, we would not say so. We would say they were just on the mark. Could they have lowered interest rates more when the Fed was much more aggressive? They refused to do so, because they were afraid of inflation. Inflation did not materialise, but at the same time the case for lower interest rates in the year 2000 and beginning of 2001 is, with the benefit of hindsight, now much less strong than it looked at that time." (Q 193)

24. Professor Draghi argued that during its first four and half years the ECB's monetary framework had been "constantly reviewed, more in practice and in substance than in its formal wording". The ECB had shown itself willing and able to change its methods when weaknesses in them become apparent. It was this capacity the bank had to review and learn from its own actions that made Professor Draghi say that all in all the experience of the first few years had been positive. The Government agreed that it was "very encouraging" that the ECB that had demonstrated that it was "a learning institution" that was interested in ongoing policy debates and had "shown a willingness to evolve" (QQ 191, 213, 217, 224).


25. Our overall assessment of the ECB's monetary policy since its started operating on 1 January 1999 is positive. We commend the ECB for the fact that its monetary policy is achieving the desired objective of price stability. The consensus in the evidence we received was that the ECB had performed well so far given its mandate, and this is a view that we share. The ECB is still a young institution, but it has rapidly built up a high level of credibility. It is in the context of this positive assessment that our criticisms and recommendations that follow are to be understood.

Financial Stability and Prudential Supervision

26. There is an on-going debate on the adequacy of the current EU institutional arrangements for financial stability. There is no institution at EMU or EU level which has responsibility for prudential supervision. Supervisory responsibilities remain at the national level. In the UK, for example, the Treasury, the Bank of England and the Financial Services Authority each have different responsibilities for ensuring financial stability. When the Treaties were formulated, financial supervision was explicitly considered to fall under the remit of the national authorities. The ECB consequently has no powers in the area of financial supervision; the Treaty simply calls on the ESCB to "contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system" (Article 105(5) TEC). As President Duisenberg put it, the only task that falls to the ECB is "to foster the smooth operation of banking supervision in the various countries and to try to harmonise at a distance."[16] In the US in contrast, Professor Thygesen pointed out, the Federal Reserve is very closely involved in banking supervision (Q 83).

27. The Economic and Financial Committee, which contributes to the preparation of the work of Ecofin, the Council of Ministers of the EU responsible for Economic and Financial Affairs, keeps under review the economic and financial situation of the Member States and makes regular reports thereon to Ecofin and the Commission. In addition, a Financial Services Committee was established in 2002 to advise Ecofin on issues to do with financial markets. Also in 2002, the ECB established a Directorate for Financial Stability and Supervision. The bank also operates a Banking Supervision Committee (BSC), which provides structural and macroprudential analyses. The ECB also sits on the Financial Stability Forum, a global body. The ECB has published parts of its output in the field of financial stability in its Monthly Bulletin. The February 2003 edition also contained a report entitled "EU Banking Sector Stability", which summarised analyses conducted by the BSC.

28. While the BSC appears to be a useful forum for exchanges between banking supervisors and central banks, there is still currently no framework which brings together all interested parties in the financial stability of the EU: finance ministries, financial sector supervisors, the ECB and national central banks. As the ECB itself said:

"EMU has changed the nature and scope of systemic risk, increasing the likelihood that disturbances originating in or channelled through wholesale and capital markets or market infrastructures will extend beyond national borders. […] In addition, the trend towards internationalisation and conglomeration of financial activities raises important issues as to the systemic concerns created by large and complex multinational institutions."[17]

29. Professor Buiter argued that the ECB should be charged explicitly with responsibility for systemic financial stability in the euro area. He said that the ECB should be "the guarantor of the integrity of the financial system, especially the banking sector, but also any financial market of significant import for the economy as a whole in which liquidity problems could possibly arise. They have to be there as the lenders of last resort, ready and willing to create liquidity instantly in any amount required to preserve the integrity of the financial system." Because of its mandate under the Treaty, the ECB did not have the long-term ability to recapitalise a sizeable chunk of the European banking system, which Professor Buiter saw as "a problem". This was an issue which needed to be cleared up and clarified: "ambiguity is never constructive in monetary policy", he argued. Sir Samuel Brittan shared these concerns about the current EU institutional arrangements for financial stability. Mr Volcker also agreed that the issues around who in the EU was the lender of last resort and in what circumstances were "a cloudy area" that needed "clarification". The Government also wanted the issue of how and when liquidity would be provided in the event of a banking crisis to be made more explicit (QQ 43, 143, 158-59, 226).[18]


30. In this inquiry, we did not examine the EU's institutional arrangements for prudential supervision, but we are aware of the debate on the adequacy of the current institutions arrangements for financial stability in the EU. We recognise that the Government considers that "official support operations remain a national responsibility for euro area members",[19] yet the Financial Secretary also called for "more clarity in the arrangements" as to who the lender of last resort should be in the euro area. We would like the Government to explain how it would like the system of prudential supervision in the EU to develop over time, whether it considers that the ECB should be given any powers in the area of financial supervision, and what it considers to be the ideal institutional set up for prudential supervision in the EU.

31. As part of its contribution to the smooth conduct of supervisory policies in the EU, we would encourage the ECB to publish regular broad reports on financial stability in the EU.

1   The subsequent report was published in June 1998 and called The European Central Bank: Will It Work? (Session 1997-98, 24th Report, HL 112). The report was debated in the House on 13 October 1998. Back

2   The Stability and Growth Pact (Session 2002-03, 13th report, HL 72). The report was debated in the House on 4 June 2003. Back

3   We would also like to thank all those who, although unable to supply us with new evidence in response to our questions, sent us copies of articles or reports that they had already produced on the ECB: Professor Dr Ansgar Belke, Universität Hohenheim; Professor Guillermo de la Dehesa, Chairman of the Centre for Economic Policy Research (CEPR) and Chairman of the Observatorio del Banco Central Europeo (OBCE-Spanish ECB Watcher); Dr Ellen Meade, Senior Research Fellow, Centre for Economic Performance, London School of Economics & Political Science; Professor Hans-Werner Sinn, President of the Ifo Institute for Economic Research; Professor Lars E.O. Svensson, Professor of Economics, Princeton University; and Professor Charles Wyplosz, Professor of Economics, Graduate Institute of International Studies, Geneva, Director of the International Center for Monetary and Banking studies (ICMB) and co-director of international macroeconomics at the CEPR. We also thank our Specialist Adviser, Professor Richard Portes, Professor of Economics at the London Business School and President of the CEPR, who provided valuable advice to the Sub-Committee at the start of its inquiry. Back

4   On 3 May 1998 the European Council unanimously decided that 11 Member States fulfilled the necessary conditions for the adoption of the single currency on 1 January 1999. The 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Back

5   The Treaty contains the provisions which establish these three bodies. A protocol annexed to the Treaty, Protocol (No 18) on the Statute of the European System of Central Banks and of the European Central Bank (1992), contains more detailed provisions. The responsibilities of the General Council are defined in Article 47; they are basically advisory and do not relate to monetary policy. Back

6   'A stability-orientated monetary policy strategy for the ESCB', ECB Press Release, 13 October 1998. Back

7   cf. 'The stability-orientated monetary policy strategy of the Eurosystem', ECB Monthly Bulletin, January 1999; and 'The two pillars of the ECB's monetary policy strategy', ECB Monthly Bulletin, November 2000. Back

8   See the glossary in Annex 3 for a definition of technical terms. Back

9   'The quantitative reference value for monetary growth', ECB Press Release, 1 December 1998. Back

10   That is, the "repo" rate, the main rate used in the ECB's interventions in financial markets. Back

11   The chronology of monetary policy measures of the Eurosystem taken in 1999 can be found on pp. 176-79 of the ECB Annual Report 1999; those for 2000 on pp. 205-08 of the ECB Annual Report 2000; those from January 2001 to October 2003 on pp. 97*-100* of the ECB Monthly Bulletin of October 2003. Back

12   'Monetary policy decisions', ECB Press Release, 17 September 2001. Back

13   'Monetary Union in Europe', taken from HM Treasury's EMU study Submissions on EMU from leading academics, p.215. Back

14   A study published in 2002 by the Centre for European Reform concluded that ECB monetary policy had been broadly adequate for the euro area economy and appeared "as effective as, if not more so than, the monetary policies of the EU's national central banks that preceded it." How to reform the European Central Bank, Jean-Paul Fitoussi and Jérôme Creel, October 2002, p.19. Back

15   Taken from HM Treasury's EMU study Submissions on EMU from leading academics, p.172. Back

16   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 12 June 2003. Back

17   ECB Annual Report 2001, p. 136. Back

18   For a succinct discussion of banking supervision under EMU, see Professor Christian de Boissieu's Briefing paper for the Economic and Monetary Affair Committee of the European Parliament 'Financial Stability, Banking Supervision and the ECB', May 2003 (available on that committee's website). Back

19   UK Membership of the single currency: An assessment of the five economic tests (Cm 5776), p. 193. Back

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