Select Committee on European Union Minutes of Evidence

Memorandum by Professor Niels Thygesen, Professor of International Economics, University of Copenhagen

  Since the draft questions addressed by the Sub-Committee to witnesses were formulated in April the ECB published on 8 May its internal evaluation of the ECB monetary strategy. In trying to answer (most of) the Sub-Committee's questions I draw on the 8 May announcement, in particular Professor Issing's presentation, whenever relevant.


  From its initial announcement of its monetary strategy in October 1998 the ECB pointed to two key elements ("pillars") to underpin a monetary policy aiming at price stability: (1) A "prominent role for money", and (2) a "broadly based assessment of the outlook for further price developments". This continued strategy was widely seen as a compromise between the desire to underline continuity with the earlier and quite successful strategy of the Bundesbank and the preference of some euro area participants to move towards more explicit inflation targeting in parallel to the practice, which had developed over the 1990s in a number of central banks managing independently floating currencies (including since 1992 the Bank of England). The compromise was criticised by a majority of academic economists on the double grounds that it would complicate the communication of ECB strategy while giving an undue importance to changes in one or more selected monetary aggregates as a prediction of future inflation, particularly in periods of relatively low inflation.

  Both these criticisms seem to have been confirmed by developments over the initial period of a little more than four years. The growth rate of the preferred monetary aggregate (M3) has been almost continuously well above the reference value, set at 4½ per cent a year from the start and not subsequently modified, hence always maintaining an argument for caution in setting interest rates. Nevertheless, the ECB on a number of occasions lowered its policy interest rate despite relatively rapid growth of M3; the Bundesbank had, however, also shown some capacity to disregard monetary aggregates without hereby losing credibility. Strong reliance on movements in M3 for policy purposes was in any case inadvisable in the early years of the euro in view both of the uncertainty surrounding the stability of money demand after the unification of national currencies and of the difficulties of arriving at the most relevant definition of M3, notably by excluding non-resident holdings originally included, but of limited relevance in evaluating risks of future inflation. At some points, notably in May 2001 when the series had been revised, M3 appeared to be given more emphasis, but a move in this direction has not continued in the most recent two-year period when M3-growth has again departed significantly from its reference value.

  In its recent strategy evaluation the ECB has retained a two-pillar strategy, though with three notable refinements: (1) The reference value for M3-growth has been de-emphasized, eliminating speculations about whether it would be revised (and, if it was not, why not); (2) greater emphasis on money as a medium to long-term benchmark, a cross-check, for evaluation of impact of the monetary stance over a longer time horizon than that of the staff projection published since late 2000; and (3) more attention is to be given to the sources of money creation, notably credits to the private sector, and to asset price developments which may impact on price developments. So, henceforth, the ECB will conduct both an economic analysis, focusing on the implications of projections based on the second pillar for adjustments in the current monetary scene, and a monetary analysis based on growth in money and its counterparts as well as in asset prices.

  This reformation of the two-pillar strategy is a modest one and had already to some extent been foreshadowed in recent ECB communications through the Monetary Bulletin and elsewhere. It does show, however, that the ECB is not currently moving towards the adoption of a straightforward inflation target such as that of the Bank of England, though it may have come a bit closer to such a strategy. The new context for "monetary analysis" as described above suggests a wider objective for monetary policy with some role for financial stability in addition to monetary stability. In this context, it may be a handicap for the ECB that the present and developing structure of financial supervision in the EU is not one that places the ECB in any central role—though several of the participating national central banks have supervisory roles over their respective banks.

  The Sub-Committee raises the general question of the role of money in promoting economic growth. Here I can be very brief. The only, but important, role of money in this respect is to provide a stable and predictable nominal environment for the firms and households of the economy. By aiming at low and stable inflation monetary policy contributes to keeping output near potential and to raising potential output because of low uncertainty and minimal distortions. The latter gains in welfare can be assumed to continue to accumulate until inflation is reduced to near zero.

  My answer to the next question: Is the ECB's inflation target too low? will be implicit in this view. Aiming for an inflation rate just below 2 per cent per annum is neither inappropriate nor over-ambitious. Inflation measured by harmonised consumer prices (HCP) averaged about 1.9 per cent over the initial four years of the euro and the 8 May announcement confirmed that continuing such performance as an average over the medium term will remain the objective. With two rather short exceptions—the spring of 1999 and the spring of 2001—the measured inflation rate has moved in the 1-3 per cent range. In the light of observed behaviour and explanations given in the 8 May announcement the future objective seems rather clear and not as open to criticism of asymmetry as has often been claimed by academic and financial sector critics. In particular, there should no longer be any speculation as to whether the central inflation objective might be 1 per cent—as would seem to be implied by a 0-2 per cent range—or 1½ per cent as one might have inferred from the way in which the reference value for M3 growth was justified. The objective is rather "close to 2 per cent over the medium term". In this sense the reformulated strategy marks continuity of behaviour, but clearer communication.

  One can, of course, discuss whether "just under 2 per cent" is too low an inflation to aim for. The ECB argues that this objective is sufficiently high to avoid any major risk of deflation; I agree with this view, also after taking into account the national inflation differentials inside the euro area which may imply that Germany, currently (but only recently) with the lowest rate, may get close to zero inflation in the course of 2003-04. The ECB may still be too sanguine about the disinflationary impact to euro appreciation; if 10 per cent appreciation of the euro in effective rate terms takes one per cent of the euro area price level one would not have to believe in massive further appreciation to predict the average inflation rate to fall close to zero and the German rate possibly below zero. But in such a scenario the ECB monetary strategy would oblige it to react vigorously to cut the policy interest rate.

  In short, the recent reformulations and clarification of the monetary strategy seems to be broadly appropriate and reassuring. The ECB strategy does indeed aim at slightly lower inflation than the central point of the ranges used by a member of central banks, but only marginally so. Over the next couple of years it may be difficult to prevent the average inflation rate from dropping below "close to 2 per cent", so explicitly trying to raise it could seem to be self-defeating.


  The ECB Council in late 2002 fulfilled the mandate given to it in the Nice Treaty by proposing changes in the voting modalities to accommodate enlargement of the EU and the likelihood that many new Member States will join the euro area within the foreseeable future. Although the consensus proposal of the ECB Council has subsequently been approved at the political level there are good reasons to be concerned about the outcome.

  The ECB Governing Council currently consists of 18 voting members—the six members of the Executive Board and 12 national central bank governors. This is already a very large body for efficient decision-making, though this is understandable in view of the desire to retain the noble principle of "one man, one vote" as far as possible in a new and unfamiliar institution. The proposed new composition of the Council is a compromise between the need to assure continuing democratic legitimacy and efficiency (through equality of participants)—in the sense of avoiding a structure in which a coalition of many small countries could override the consideration of the large, economically significant participants. The proposed new structure distinguishes between three groups of countries: The five largest ones of which four would have the right to vote, a group of medium-sized countries with eight voting members out of somewhere between 11 and 14, and finally a group of small countries with three voting members out of six to nine members, the total number of participants of course being subject to uncertainty. The six Executive Board members would be joined by a total of 15 national governors, constituting an unprecendently large body for monthly monetary decision-making, also when keeping in mind that all the currently non-voting members will also be participating in the debate. There will be some frustration that equality of treatment of participants has been discontinued without significant gains in efficiency.

  Rather than the proposed unwieldly structure it would have seemed preferable to opt clearly for more efficiency and go for a more radical restructuring of the ECB, most simply by upgrading the six Board Members to be the main decision-making body. The Council would remain the supreme body setting general guidelines for monetary policy in, say, quarterly meetings and monitoring the policy execution by the Board. The national governors would continue to contribute their unique, indeed indispensable, knowledge of economic developments and sensitivities in their own area, but they would delegate decisions on policy interest rates to the Board which is presumably also better placed to evaluate the financial market indicators for the euro area as a whole crucial to reaching the proper monetary stance in the shorter run. (This line of approach is argued more fully in a report which I co-authored last year, Gros et al (2002)). Such a reform would bring the decision-making process in the ECB closer to that observable in some well-functioning central banks outside the euro area, notably the Bank of England, though the purely national context in which the latter operates facilitates going further in the direction of appointing individual experts to the decision-making body such as the four independent economists who serve on the Monetary Policy Committee of the Bank of England.

  This proposal would seem to be superior to what has come out of the ECB, backed by the political authorities. But that game is now over without the prospective participants including the UK and my own country, Denmark, having had any real influence on the outcome. Given the good record of the ECB so far it may even take some time before the potential defects of the proposed system become visible. With the present system and the proposed reform it would not seem to be useful to suggest major changes in communication, in particular to insist on publication of minutes of meetings and votes, as is done by the Bank of England. Identifying individual opinions of ECB Council members could be counterproductive by making it more difficult for national governors to stick as well to an aggregate view of the required monetary stance as they appear to have done up to now. The ECB has itself given an eloquent exposition of its approach to transparency and accountability, both of which the Bank sees in a collectivist perspective (see ECB (2002)). I have no problem in associating myself with this approach, at least as long as the ECB is structured as it is.

  When the Eurosystem started operating many observers, including myself, found that there could be risks of excessive decentralisation, the ECB as the junior institution finding it difficult to counterbalance the larger, well-entrenched national central banks. The relatively small size of the ECB staff and its absence from operational responsibilities seemed to pose potentially difficult problems. On the whole there is no evidence available to outsiders to justify these concerns as of today. The Eurosystem appears to have succeeded relatively well in orchestrating its very considerable joint capabilities, be it in operations or in analysis. The remarkably smooth introduction of euro notes and coins is the main logistical achievement. There seems to be no reason to consider changes in ECB-NCB relations, except to be aware of any problems that the rising member of participants raise for the balance between the two components of the Eurosystem, in particular with respect to efficient decision-making as explained above.

  Nor does there seem any need to review at this stage the manner of appointing the President of the ECB. Appointment by the European Council (following informal consultation with the ECB) and having "confirmation hearings" by the European Parliament seems entirely appropriate. It was unfortunate that, on the occasion of the appointment of the first President of the ECB, it was not possible to reach full consensus. On the other hand it is quite legitimate for the political authorities to take a keen interest in who is appointed President of the ECB; given the strong independence of the Bank this is one important decision that remains in political hands.

  The ECB is very much in the limelight. The decisions and the justification for them are very thoroughly scrutinised in the media and in the political debate in the participating countries. The Bank itself is steadily improving its communication strategy—and the 8 May announcement should help further to facilitate accountability. It seemed natural from the start to let the Bank set the monetary policy strategy, including the details of an inflation objective, rather than to leave it to the political authorities—in this case the Eurogroup—to set the mandate as is done by the Chancellor in the UK case. As the public and political debate has continued to demonstrate, the ECB is certainly held to account for this choice as well as for its interest rate policy.

  But accountability has a special significance in relation to the European Parliament. The quarterly testimony of the ECB President to the Parliament's Economic and Monetary Affairs Committee (EMAC) may not yet have reached the prominence and stature of the similar hearings with the Fed Chairman in the US Congress, but they seem to be improving the nature of the give and take which has increasingly been observable. But the ECB, while ready to listen, may learn even more from the many other opportunities it has to have its analysis and policies challenged.

  While I do follow the appearances of ECB officials in EMAC with some attention I have no information on the frequency with which they appear before national parliaments in the euro area. I do not see any obvious reason why ECB officials including national central bank governors, should appear in national political bodies. They are not, according to the Maastricht Treaty, accountable at the national level as inevitably the nature of questions would rely heavily on the national situation rather than that of the euro area as a whole.

28 May 2003


  ECB (2002), "The Transparency of the ECB", Monthly Bulletin (October)

  ECB (2002), "The Accountability of the ECB", ibid.

  Gros, Daniel et al (2002, "The Euro 25", Special Report on Enlargement by the CEPS Macroeconomic   Policy Group, Center for European Policy Studies, Brussels.

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