The Euro and Its Central Bank: Getting United after the Union

THE EURO AND ITS CENTRAL BANK GETTING UNITED AFTER THE UNION

TOMMASO PADOA-SCHIOPPA

The Euro and Its Central Bank

The Euro and Its Central Bank Getting United after the Union

Tommaso Padoa-Schioppa

The MIT Press Cambridge, Massachusetts London, England

© 2004 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. MIT Press books may be purchased at special quantity discounts for business or sales promotional use. For information, please email [email protected] or write to Special Sales Department, The MIT Press, 5 Cambridge Center, Cambridge, MA 02142. This book was set in Stone Sans and Stone Serif by SNP Best-set Typesetter Ltd., Hong Kong and was printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Padoa-Schioppa, Tommaso. The euro and its central bank : getting united after the union / Tommaso Padoa-Schioppa. p. cm. Includes bibliographical references and index. ISBN 0-262-16222-9 (alk. paper) 1. Euro. 2. European Central Bank. 3. Monetary policy—European Union countries. I. Title. HG925.P33 2004 332.4¢94—dc22 10 9 8 7 6 5 4 3 2 1

2003070615

To Paolo Baffi and Franco Modigliani

Contents

Preface ix Acknowledgments 1 1.1 1.2 1.3 1.4 1.5

2 2.1 2.2 2.3 2.4 2.5 2.6

3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9

4 4.1 4.2

xix

The Roads to the Euro: A Historical Overview

1

Politics: From War to Sweet Commerce 1 Fall of the Berlin Wall and Rise of the Euro 6 The United Kingdom, European Union, and the Euro Economy: Resolving an Inconsistent Quartet 11 Central Banking: From Old to New Anchors 15

9

A Profile of the Eurosystem: The Newest Central Bank The Eurosystem 21 Center and Periphery 23 Decision-Making in the Eurosystem 27 Independence and Accountability 32 A Polity in the Making 35 Appendix: Institutions of the European Union

36

Economic Policies: A Special Economic Constitution Policy Assignment 42 Interplay 45 Coordination 47 Market Policy 51 Money and Exchange Rate 52 Fiscal 53 Employment 59 While the Jury Is Out 61 Appendix: Euroland’s Economic Structure and Challenges

Monetary Policy: As Strong as the Deutsche Mark Mandate, Strategy 68 Debates on the ECB Strategy

72

21

41

63

67

viii

4.3 4.4 4.5 4.6

5 5.1 5.2 5.3 5.4 5.5 5.6

6 6.1 6.2 6.3 6.4 6.5 6.6 6.7

7 7.1 7.2 7.3 7.4 7.5 7.6

8 8.1 8.2 8.3 8.4 8.5

Contents

Practice and Evaluation of the Strategy Operations 83 Transmission 86 Transparency, Communication 91

78

Financial System: The Euro as Unifier

97

Single Market and Currency Segmentation 97 The Continental European Model 99 The Shock of the Euro 102 Regulation and Supervision 107 The Institutions of Supervision 111 The Eurosystem and Financial Stability 115

The Payment System: The Plumbing of Euroland Historical Background 119 New Risks, New Technologies 122 One Currency, One System 124 Banknotes and Other Retail Payments Large-Value Payments 130 Securities Settlement Systems 133 Main Challenges 135

119

127

The Eurosystem in the Global Arena: A New Actor in a New Play The Euro outside Euroland 139 Fall and Rise of the Euro 143 Three Floating Currencies 147 Pegs and Corners 151 The Euro as an Anchor 154 Cooperation for Financial Stability

157

The Trials Ahead: From Infancy to Maturity Price Stability and Growth 165 A Perfect Central Bank 168 Incoming Countries 173 A Reluctant Global Actor 176 Policy, Politics, Polity 179

Abbreviations Notes 185 Bibliography Index 243

183 231

165

139

Preface

This book goes to the press thirty-five years after I entered the profession of central banking, which I have practiced almost without interruption. I was hired by the Bank of Italy in 1968, and in the 1980s and 1990s my work involved active participation in the making of the European monetary union. In 1998 I joined the European Central Bank to serve a yet to come currency and an institution that almost no one expected to see evolve from the rarefied empyrean of utopian projects to the bumpy ground of factual reality. The main purpose of this book is to offer a guided tour of the euro and its central bank (the Eurosystem) to readers who, due to the novelty of the enterprise, are unfamiliar with it. It is to be expected that people’s information about institutions adjusts slowly, and that any profound change takes time to become common knowledge. My purpose is to explain in simple terms the euro, the structure and activities of its central bank, its economy, the financial system to which it refers, its monetary policy, the way its monetary policy interacts with the overall process of economic policy, and its international dimension. The historical process that led to the adoption of a single currency is reviewed in the first chapter. The main challenges facing this young institution, today and for the years to come, are identified throughout the course of the book and specifically addressed in the final chapter. Although the guided tour is limited to the territory of Europe, the road map used is a general paradigm of what I believe central banking involves. I gradually developed this, not quite standard, belief over the course of my banking career, when searching for a single and consistent conceptual order in which all the activities of a central bank would have their place. To each of these multiple activities—from monetary analysis and policy, to banknote printing and handling, to market operations, banking super-

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vision, payment systems, relations with other policies and other public institutions, and international cooperation—I had been assigned at different stages of my professional life. And for some of these functions I had discovered that I lacked the powerful support of a university background I had for monetary policy, because these activities were scarcely treated both by the literature and by ordinary textbooks on money and banking. Indeed, what I had not realized as a young economist and only came to understand through practice is how much central banking is about issues other than monetary policy. As I explain in chapter 2, the paradigm proposed is drawn from the threestage evolution of modern central banks over the last two hundred years. This evolution began with the invention of a new medium of exchange— paper currency replacing, but backed by, gold. It continued with the development of commercial bank money (deposits replacing, but backed by, banknotes) and culminated when the currency severed all links with a precious metal to back its value. The monetary system emerging from this evolution is one in which the currency has no other value than its purchasing power, which is in turn exclusively based on trust, whence the expression fiduciary money. The stock of money is composed by liabilities of both the central bank and commercial banks, and its total is determined by the response of a profitdriven market to the policy-driven action of the central bank. Modern central banks are the institutions in charge of the public interests associated with the currency in a regime of fiduciary money. Central banking thus consists of a range of highly interdependent activities, whereby the public interest involved in currency-related matters is pursued. Such activities have technical and policy aspects and are strongly influenced by institutions. No doubt, they involve economic analysis in the first place, but cannot be fully understood if their legal, technological, organizational, and political dimensions are not considered. The three historical stages have generated and shaped the triadic configuration whereby any central bank operates for the functioning of payment circuits, the stability of the banking system, and the conduct of monetary policy. And it is worth noting that the three activities are respectively related to the three well-known functions of money as medium of exchange (an efficient payment system), store of value (the safety of bank deposits), and unit of account (the stability of prices). There are reasons why the European experience provides a very convenient case for expounding the central bank paradigm I’ve outlined above. Indeed, in the move from the old ground of the nation-state to the still

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largely incomplete ground of a new European polity, central banking and currency matters had to be thought out anew. Without a clear paradigm it would have been impossible to design a new central bank and to build it on solid foundations, while still acknowledging the very diverse traditions, monetary structures, and institutions encompassed in the new design. For a newly created monetary jurisdiction—the land of the euro, or euroland—it was necessary to write a new central bank charter, to construct a new infrastructure, to adopt and communicate a new policy framework. This endeavour required a model and called to service legal expertise, market practice, experience in organization, and information technology, as well as economic analysis. Over the last thirty years I have seen central banking change profoundly everywhere in the world. The profession I joined in 1968 was one where currencies were anchored to gold and the issuing institutions strictly obeyed, in most countries, the nation’s executive power. With few exceptions, the Treasury thus was de facto the real maker of monetary policy. Insofar as the link to gold left some scope for a discretionary monetary policy, this was often committed to pursue full employment together with, and sometimes even more than, price stability. Indeed, back then many central bankers and a large part of the academic profession were convinced that monetary policy could durably elevate the growth rate of the economy by appropriately balancing low inflation and high employment, and possibly by partially sacrificing the former to have more of the latter. Most central banks were in charge of bank supervision. While no significant banking crisis had occurred since the 1930s, supporting an ailing bank—not only with liquidity but also with capital—was seen as a hallmark of the good central banker. Deposit insurance was an American speciality, and the notion of moral hazard was confined to the jargon of private insurers. Payment practices were based on the hand-to-hand transmission of cash and on orders to transfer deposits imparted to banks through checks or giros. The technology used—paper, hand-written signatures, and the postal service—had settled decades earlier and was widely accepted as a stable, if not immutable, component of the monetary system. Banks’ chief executives and top central bank officials had since long stopped devoting much attention to payment system matters. In that not too distant era, monetary policy, financial stability, and banking supervision formed a single composite whose parts were difficult to disentangle. It was the national currency itself, with its multiple func-

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tions, that unified the constituent parts. Central banks were seen by the public, and were in fact, the creators and the overall custodians of the currency. Seemingly generic expressions like “to secure the currency” could be read in the charter of many central banks. In many respects, and notably from an institutional point of view, that world of thirty years ago was closer to what central banking had been 100 or 150 years earlier than to what it is today. Today currencies are no longer anchored to gold. Central banks are granted independence, albeit in various degrees in different places. They have been assigned the mission of preserving price stability. Economic theory has firmly re-established the long-term neutrality of money. Meanwhile a new combination of information and communication technologies, coupled with the explosion of financial transactions in both volume and value, has brought payment system issues back to the highest consideration for both commercial and central bankers. Finally, the financial industry has been transformed by the powerful waves of innovation, deregulation and globalization, and instability has come back. Recently the task of supervising banks has been taken away from the central bank in a number of countries. Some wonder if financial stability—a “land in between” monetary policy and prudential supervision—still ranks among the tasks of a contemporary central bank. All these changes were accompanied, and to a certain extent fostered, by the emergence of ideas and policy attitudes strongly oriented to reduce the role of government relative to markets. After moving for many decades toward expanding intervention of public powers in economic activity, the pendulum reversed its direction in the late 1970s. The emancipation of central banks from the tutelage of the political power, the narrowing and focusing of their mandate, and, in many countries, the assignment of banking supervision to a separate agency were part of this evolution. These developments seem to have altered the old composite to the point that one may question whether the old triadic configuration is still a valid description of central banking. I think it is. The triadic framework is derived from the inner structure of monetary and banking systems, which recent changes have not wiped out. Central banks are most prominently involved in monetary policy and payment system issues. As to financial stability, despite the recent creation of separate supervisory agencies, no central bank in the world regards it as lying outside its sphere of interest. Commercial banks are critically close to central banks as primary creators of money, providers of payment services, managers of the stock of savings, and counterparties of monetary policy operations. In point of fact, no central bank stays out of the management of a financial

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crisis when one occurs. The triadic paradigm is indeed a leitmotiv of the book and is used to organize its structure. A consequence of this choice is that compared to other books on central banking, this one devotes a relatively small proportion to monetary policy (chapter 4) and larger proportions to the financial system and the payment system (chapters 5 and 6 respectively). Turning from central banking to Europe, the relationships among European states have immensely changed over the same third of a century in which I served as central banker, following a path that at a point intersected the evolutionary path of central banking. As I am a central banker by profession, so I am an advocate of a united Europe by political conviction. Actually I embraced the political conviction before embracing the profession, the citizen making his choice before the worker. As a child, I had seen the bombing of bridges and cities, witnessed the passing of German and then American troops through the street outside the house, and sensed the anguish and insecurity pervading the atmosphere around. As a teenager, I listened to my history teacher explaining to the whole school that the day before (March 25, 1957), an important Treaty had been signed in Rome. Six European countries had just committed themselves to creating a common market where goods, services, capital, and persons could circulate freely. To achieve such goal, and as a step toward a politically united Europe, in which solid peace would be established after centuries of bloody warfare, they were to renounce part of their sovereignty. That a united Europe was a worthwhile objective became the strongest of my political convictions. The process of European integration (of which the Treaty of Rome is the foremost foundation) gradually transformed the nature of the relationships between European states. A new and unprecedented institutional construct was gradually created, something in between an international organization and a federation of states, more than the former and less than the latter. The construct was primarily economic in content but eminently political in nature, because its very essence—indeed the objective that aroused simultaneously positive support and fierce opposition—consisted in reorganizing the structure of power. Agitating an ugly image to help their fight, opponents claimed that the project pursued the replacement of nationstates with a new European super-state. In reality, it pursued the distribution of government through several layers (of which the European Union was to be just one), in order to have a minimum and efficient overall power structure. What was to be superseded was not the power of the nation-state but its unbounded character.

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The evolutionary path of intra-European relationships can be visualized as the gradual move of the European Union from the international to the domestic model of economic order. The move went from the dismantling of tariffs and quotas, to the creation of a customs union, to the removal of nontariff barriers through the adoption of a pervasive common economic legislation, to the creation of a central authority to enforce common competition rules. To appreciate the relevance of such move, suffice it to note that, in the late 1950s, the free circulation of goods, services, capital, and persons was not yet fully in place within the states signing the Treaty of Rome. The evolutionary path of European integration and that of central banking crossed in the late 1980s. In the economic field, the completion of the single market was well underway. In the monetary field, it seemed that the time had come to grant central banks full independence and a narrowly defined mandate. In the political field, there was the strong will to make a big new step toward a united Europe. The creation of a single European monetary policy lies at the crossroad of these three paths. Thus in Europe the transformation of central banking has led not only to reforming the functions and the charter of the institution described above but also to detaching both the currency and the central bank from the center of political power. Recalling Alexander the Great’s effigy on ancient coins, one should realize how big a break with history has occurred. The full implications of this detachment are still unfolding, and it is impossible to predict today where they will lead economic, monetary, and political reality. Both paths have amply occupied my life because, for a curious accident, money became the leading project for further European integration just at the time when I was in the maturity of my professional life. My profession and my European conviction thus became a single activity. I served at the EU Commission in 1979 to 1983, the early years of the European Monetary System. I was directly involved in the preparation of the blueprint for a single currency in 1987–89, in the 1989–91 negotiation leading to the Maastricht Treaty, and in the 1993–97 preparatory work for the launch of the euro. Because the euro and the Eurosystem are at the crossroads of the two paths, this book is about both central banking and European integration. E pluribus unum is the title I first proposed for the book. The publisher objected that such a title would mislead a computer, or even a person in a bookstore, making them believe that the book is about the United States, whose seal carries this motto. I reluctantly surrendered to the needs of com-

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merce, but I recall this little episode to highlight a leitmotiv of the whole book. This leitmotiv is the process of effectively making the Eurosystem— composed as it is by the European Central Bank and the national central banks of the countries that have adopted the euro—the single, strong, effective, publicly recognized central bank of the euro. Through its chapters the book shows that, five years after the birth of the euro, this process is still at an early stage and proves dauntingly arduous. As the Eurosystem is for the euro what the Federal Reserve System is for the dollar, common sense suggests that it should rapidly and forcefully organize itself as a system across the full range of the multiple central bank activities reviewed above. Indeed, I extensively explain how inextricably linked such activities are in practice. However, I also show how distant the Eurosystem still is from achieving a full and balanced blend of these activities into a single central bank. Anyone who compares the central bank of the euro with a traditional central bank is struck by the fact that while for monetary policy this condition has been reached, for most other activities the single, excellent (effective and efficient) central bank of the euro is still in the making. Each of its national components maintains the full infrastructure of a standalone central bank and endeavours to keep it active. Each has its own banknote printing process, a proprietary system for transferring central bank money, a dealing room, and a foreign exchange reserve management capacity. Each defines its own position and speaks its view in most international forums, offers (or can offer) to other central banks around the world to manage their reserves in euro, and entertains (or can entertain) its own representative offices abroad. These various activities are hardly harmonized, shared, or pooled. Reflection can mitigate the surprise caused by this state of affairs. The fact is that for a very long time each national central bank had separately performed the full range of central bank activities reviewed in this book. Each bank has joined the Eurosystem with the full-fledged—and often quite overstaffed—structure it needed to operate as a stand-alone central bank. After the euro, this organization entails heavy economic costs, difficult problems of internal coordination, creeping competition between national central banks, and the risk of giving contradictory signals to the outside world. It also entails that the Eurosystem as a whole lacks the control or the information a central bank normally has over its area of jurisdiction. For example, it lacks a comprehensive and integrated picture of the main financial institutions operating in the euro area.

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The central bank running the euro is thus, for the moment, a very special one. A normal central bank perform in an integrated way the three central banking functions, involving monetary policy, payment systems, and banking supervision. It exerts operational and regulatory powers, interacts with other public authorities, practices a special magistery over the financial community, intervenes in crises, works with other central banks, and takes clear-cut positions on international monetary and financial matters. It does all that in one way, with one style, under a single command, not in a variety of ways across its organization. From the point of view of the perceptions of people and markets, all such activities refer to one and the same public good, confidence in the currency. And we know that in a modern market economy, confidence—rather than intrinsic value—is the foundation of the value of money. A normal central bank is a monopolist. Today’s Eurosystem is, instead, an archipelago of monopolists. Could e pluribus unum then be taken as the guiding motto for the evolution the Eurosystem has just started and is bound to pursue in the coming years? Philologists say that the right interpretation of the motto on the seal of the United States should not be derived from classical Latin, where it means “one among many,” but rather from a later tradition where it means making “a union out of many.” The book indeed argues that the “unum” should be the Eurosystem, not the European Central Bank. The Eurosystem should evolve from the present archipelago to a single central bank, but it should not do so by transferring all activities from the national central banks to the European Central Bank. It should do so by organizing, rationalizing, consolidating, and controlling activities from the center, while letting the conduct of activities be performed by national central banks or groups thereof. The various chapters of the book explain how this could gradually happen. In sum, the American version of the motto, rather than the classical Latin one, should be adopted for the Eurosystem. A paradigm of central banking, not the Treaty, should be the road map to perfection. It would indeed be an illusion to expect, or pretend, to obtain a full and satisfactory answer solely from legal interpretations. And while the Treaty provides useful guidance, those who carry the responsibility to manage the euro and are accountable for that responsibility have known for years what a central bank is and how vague the wordings of central bank statutes have historically been. The book aspires to be instructive for students, interesting for scholars, and accessible to the general public. In a certain respect it is an interdis-

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ciplinary work because, in addition to economic concepts and propositions, it frequently uses categories and conceptual instruments from the historical, political, and legal literature. I am not part of the academic profession and in two respects this is not an academic book. First, it does not use the formal tools of the academic literature. Second, it does not incorporate in the text a systematic review of the literature on the various subjects it touches upon. Yet the book aims at being based on rigorous analysis and aligned to recent strands of economic research. To keep the text short and readable, extensive references to the literature, to the academic debate, as well as a host of historical references, conceptual clarifications, and institutional commentaries are provided in the endnotes as background and extensions of the main text. The apparatus of endnotes almost makes up—with the main text—a second and extended book. The reader should also be warned that I am not a remote observer of the subject I treat. I am an ECB-actor, not an ECB-watcher. No author is ever objective, but every author must strive to be intellectually independent and honest. Although I consider this book to be consistent with the fundamental orientation of the European Central Bank and its charter, I am sure that any of my colleagues in the Council of the Bank would have written a different, and perhaps quite different, book on the same subject. Each would have probably made a different selection of topics, and chosen a different structure. Some colleagues will certainly disagree, and even strongly disagree, with some ideas, passages, or statements. The book expounds my own views and opinions; in no way can it be interpreted as the official view of the European Central Bank. A degree of subjectivity is simply part of the pluralism that characterizes and enriches an institution governed by two collegial bodies, composed of individuals with diverse experiences, views and backgrounds, appointed by governments rather than by co-optation. As far as I am concerned, this is also the legacy I owe to my two eminent masters in central banking, to whom the book is dedicated, Franco Modigliani and Paolo Baffi. As teacher at MIT, Franco had given me the foundations of monetary and central banking, or—I would say—the robust and flexible footwear, with which I have walked for the rest of my life, perhaps not always going to places he liked. Thereafter, and until today, he has been an incessant interlocutor, a generous co-author, a wise friend, and an admirable example of how to combine rigor and common sense, passion and objectivity, simplicity and analytical thoroughness, pedantry

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and imagination*. Paolo Baffi was the governor for whom I closely worked in 1975 to 1979, and he ranks among the distinguished and internationally respected monetary economists of his generation. For the Bank of Italy, where he served for more than fifty years, Paolo Baffi has been above all the founder and the inflexible applicant of principles, which are essential preconditions for the integrity and effectiveness of any institution. To innumerable officials, including me, he taught that decisions require rigorous analysis though the product is mechanical, that analysis and internal debate must be completely free, and that the hierarchy of the grades must never eclipse the quality of the arguments. * Franco passed away in September 2003, a few days before receiving the manuscript of this book and reading this dedication.

Acknowledgments

In the two years in which work on this book almost exhausted my free time, I have received precious help and support by many persons, to whom I want to express my warm gratitude here. Two stand on the top of the list. The first is Pierre Petit, my counsellor at the ECB, who assisted me indefatigably from the elaboration of the first outline to the final completion of the manuscript. Pierre has been an independent and congenial daily interlocutor, providing enormous background work, comments, suggestions, checks and critical remarks, that were rigorous, penetrating, careful, and precise. The second is Elizabeth Murry, economics editor at The MIT Press, who decisively contributed to this book becoming what it is. She guided me in identifying the appropriate structure and language of the book and in getting me to come close to the best I could do. The great deal I have learned from her about writing will remain with me beyond this book. C. Randall Henning, Charles Wyplosz, and several anonymous reviewers have thoroughly and carefully read the manuscript, providing a host of precious comments and suggestions. A number of colleagues in the Bank have assisted me in putting together materials for the book and contributed to checking the facts and the literature. I am particularly grateful to Ignazio Angeloni, Thierry Bracke, Ettore Dorrucci, Andrea Enria, Koenraad de Geest, Gabriel Glöckler, Peter Hördhal, Arnaud Marès, Ignacio Terol, and Christian Thimann. Els Ysewyn has patiently and carefully assured the handling of the manuscript and the thorough check of bibliographical references. Early and decisive encouragement to undertake the project came from Rudi Dornbusch and Olivier Blanchard. Alan Blinder gave me precious advice at a critical juncture. By reading the manuscript, Franco Continolo, Wim Duisenberg, and Barbara Spinelli have comforted me that I was not sinking in the muddy waters of abstruseness, platitudes, or personal hobbyhorses, while providing me with precious comments. Needless to say, neither these persons nor the European Central Bank bear any responsibility for the content of the book.

The Euro and Its Central Bank

1 The Roads to the Euro: A Historical Overview

Maastricht is the small town of the Netherlands where, in 1992, the member states of the European Union (EU) signed the Treaty that created the euro and its central bank. Rather than a sudden decision, the euro was the result of a long-term development that started in the aftermath of World War II. After experiencing political oppression and war in the first half of the twentieth century, Europe undertook to build a new order for peace, freedom, and prosperity. Despite its predominantly economic content, the European Union is an eminently political construct. Even readers primarily interested in economics would hardly understand the euro if they ignored its political dimension. In reality, the Treaty of Maastricht and its implementation in the 1990s represent the meeting point of three, not just one, different roads, going through political, economic, and central banking fields. Although they have influenced each other significantly, movement along each road was, to a great extent, driven by an inner logic specific to each field. The overall development was thus the outcome of a complex interaction. To highlight this complex evolution it is necessary to follow each road separately, while explaining the key interactions. Sections 1.1 to 1.3 are devoted to political developments, section 1.4 to the economic ones, section 1.5 to central banking. Table 1.1 is a recapitulation of the overall process. 1.1

Politics: From War to Sweet Commerce

The intellectual seeds of a politically united Europe were laid down by enlightened figures of the early 1940s, when mutual hatred seemed the only bond between the European peoples. Persons like Jean Monnet, Altiero Spinelli, Jacques Maritain, Luigi Einaudi, and Helmut von Moltke (to quote just some names) searched what kind of arrangements could put

2

Chapter 1

Table 1.1 General chronology 1948, May 1951, April 1952, April 1954, August 1957, March 1958, January 1968, July 1971, August 1972, March

1973, January 1979, March 1979, June 1981, January 1986, January 1986, February 1988, June

1989, April 1990, 1992, 1993, 1994, 1995, 1997, 1998, 1999,

October February January January January October June January

2001, January

Congress of The Hague Treaty of Paris signed, establishing the European Coal and Steel Community Treaty signed, establishing the European Defence Community French National Assembly fails to ratify the European Defence Community Treaty Treaty of Rome signed, establishing the European Economic Community (EEC) Start of the EEC Customs union completed End of the Bretton Woods system with declaration of the inconvertibility of the US dollar into gold Introduction of the “snake,” an exchange rate agreement between five European countries (Belgium, France, Germany, Italy, the Netherlands) The United Kingdom, Denmark, and Ireland become members of the European Communities Start of the European Monetary System (EMS) First elections for the European Parliament by direct universal suffrage Greece becomes a member of the European Communities Portugal and Spain become members of the European Communities Single European Act signed, which provides for the completion of the internal market by 1992 European Council in Hannover, where a Committee, chaired by Jacques Delors, is charged with the task of studying and proposing stages leading toward an economic and monetary union Delors Report presented, which gives a blueprint for Economic and Monetary Union Reunification of Germany Maastricht Treaty signed, establishing the European Union Single European Market inaugurated European Monetary Institute (EMI) established Austria, Finland, and Sweden join the European Union Treaty of Amsterdam signed Establishment of the European Central Bank On January 1, the euro introduced as the official currency in eleven member states (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland) Adoption of the euro by Greece

The Roads to the Euro: A Historical Overview

2001, February 2002, January 2002, February 2003, April

2003, October 2004, May

3

Treaty of Nice signed, amending the Treaty on European Union and the Treaties establishing the European Communities Introduction of the euro bank notes and coins Convention on the Future of Europe opens in Brussels Accession Treaty signed by the existing fifteen member states and the ten acceding countries (the Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia, and Slovakia) Intergovernmental Conference (IGC) convened to discuss and agree on a new treaty for a Constitution for Europe The Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia, and Slovakia become members of the European Union

an end to centuries of wars, interrupted only by precarious truces based on a balance of power.1 Those precursors of history concluded that a lasting peace could only be established by creating a political order superior to the, as yet unbounded, power of nation-states. “Never again a war among us” was the motto of Robert Schuman, Konrad Adenauer, and Alcide De Gasperi, the three political leaders of France, Germany, and Italy who, in the late 1940s and early 1950s, undertook to unite Europe.2 The first step, proposed by the Frenchman Jean Monnet, was to pool and jointly manage coal and steel, the two strategically crucial resources for the control of which three wars had been fought between 1870 and 1945. In 1951 six countries (France, Germany, Italy, Belgium, the Netherlands, and Luxembourg) implemented Monnet’s idea by entrusting a common institution—the European Coal and Steel Community (ECSC) —with the governance of coal and steel production. For the first time European countries voluntarily agreed to forgo their sovereignty in a strategically important, albeit limited, field. The model for further projects had been set. The next attempt, directly addressing the heart of state sovereignty, was in the field of defense. In 1952 the six ECSC countries stipulated a treaty to create a European Defence Community (EDC), with a single European army under a unified military and political command. In France, however, one of the signatory countries, nationalist sentiments were still strong in the political establishment and in a segment of the public opinion. Eventually the French Parliament denied ratification and the EDC Treaty never came into force. Having failed on defense, attempts at molding a politically united Europe reverted to the economic field. In 1957 a third treaty was signed

4

Chapter 1

in Rome and founded a European Economic Community (EEC). The chief objective was to create a common market where goods, services, capital, and persons could freely circulate under common rules and institutions.3 Peace, the idea behind the Coal and Steel Community, was further pursued through tighter economic interdependence. Sweet commerce would replace barbarian bellicosity. As the French political philosopher Charles de Montesquieu had put it in the mid seventeenth century, “commerce cures destructive prejudices. . . . It polishes and softens barbarous mores. The natural effect of commerce is to lead to peace.”4 The founders indeed premised the new Treaty on building powerful common interests among European people with political union as the eventual result.5 The Treaty of Rome became the basis of the integration process in the four decades that followed its coming into force, and it still represents the most important founding act of a united Europe, almost the equivalent of a constitutional charter. Based on it are the state-like institutions that today rule the European Union, mainly from Brussels.6 The creation of a unified market was basically an implementation of the provisions of the Treaty by these institutions. I should note again that, although the integration process cornered primarily the economic field, its motivation and guidance were genuinely political.7 Over the years the advances, pauses, and temporary retreats in the implementation of the Treaty of Rome were chiefly determined by political factors. Between 1958 and 1965 the momentum remained very strong, despite political change in France, where in 1958 the weak and politically unstable IV Republic gave way to the more robust and nationalistic presidential system of the V Republic, led by Charles de Gaulle.8 This was due to the impulse coming from the recent adoption of the Treaty and from very pro-European government leaders in Germany, Italy, and the Benelux. Rapid progress was accomplished. The institutions of the EEC—the Commission, the Council of Ministers, the Parliament, and the Court of Justice—were set up. The method for implementing the common market was established. This consisted in adopting, economic sector by sector, legally binding European legislation, whose force was superior to national legislation, just as US federal law prevails over state law. Thus obstacles to the freedom of trade were removed and key national economic norms harmonized, mainly for manufactured goods. The customs union, the first step toward the creation of a common market for goods, was completed by July 1968, eighteen months ahead of schedule.9 For agricultural prod-

The Roads to the Euro: A Historical Overview

5

ucts a Common Agricultural Policy (CAP) was created, based on a common administratively set price at which producers were entitled to sell their products on the market or, if market demand proved insufficient, to the EEC itself. This phase of rapid progress ended in 1965–66, when a major crisis occurred that virtually blocked the project of a clear, albeit gradual and limited, pooling of sovereignty to a supranational institution. The crisis came when, according to the timetable set by the Treaty of Rome, unanimity was to be widely replaced by qualified majority voting in the decision-making. It was caused by the French President Charles de Gaulle, who blocked the transition to the majority rule by imposing the practice that countries should have the right to veto any decision contravening what, in their exclusive judgment, they deemed to be a national “vital interest.” While the notion of vital interest suggested that veto would be used only in exceptional circumstances, in practice, unanimity became the conditions for taking decisions.10 As a consequence of the 1965–66 crisis, the creation of a common European market slowed down considerably and even rolled back.11 The stalling became particularly pronounced in the 1970s, a decade of economic stagnation, high inflation rates, and exchange rate instability. Nevertheless, even during this long stalemate, some progress was made in European unification, mainly through successive amendments of the Treaty. In 1970, the Community was endowed with its own sources of revenue.12 In 1972, the field of Community action was extended to environmental, social, industrial, and energy policies. In 1973, the United Kingdom, Denmark, and Ireland became new members. In 1974, periodic gatherings of the (by then) nine heads of state or government were formalized into a European Council, meeting at least three times a year. In 1975, a regional policy and a common regional development fund were created, aimed at helping the economically backward regions. In 1979, the European Parliament, previously a body of selected national parliamentarians, started to be elected directly by the people. Despite the limited powers of the European Parliament, this mobilized political parties and voters on European issues and began “democratizing” the otherwise elite- and executive-driven EU system. Finally, in 1979, the European Monetary System (EMS) was created, as a fixed, but adjustable, exchange rate system.13 While, these steps notwithstanding, the 1970s had been a decade of general stall, in the 1980s a decisive acceleration was imparted to the European process. This was partly due to the positive economic environment created by an expansion that started in 1982 and lasted for the whole

6

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decade. Not less, it was due to the prolonged political stability that prevailed in most countries and to the strongly pro-European Union leadership of Helmut Kohl, François Mitterrand, and other national figures in various countries.14 As president of the European Commission, Jacques Delors played a decisive role.15 Under these favorable circumstances, new impetus was given to old projects and new ones were launched. In 1986, a treaty (the Single European Act) amended the Treaty of Rome.16 To finally achieve a single market without internal frontiers (end 1992 was set as deadline), it introduced extensive recourse to majority voting for the adoption of the necessary legislation. The long standstill came to an end and in about five years hundreds of new EU laws were passed that implemented freedom of circulation not only for goods but also for capital, services and persons.17 The single market started on January 1, 1993. 1.2

Fall of the Berlin Wall and Rise of the Euro

The renewed dynamism of the 1980s reached a new milestone in 1988, when the single currency was set on the European agenda and a committee chaired by Jacques Delors was asked by the European Council to draw a blueprint for Economic and Monetary Union (EMU). The decision to replace national currencies with a single European one was perhaps the most advanced step in the long history of European integration. Together with an army, the currency is the foremost expression of national sovereignty. It is not by accident that names like Louis, real or sovereign, have been chosen in the past by the French, the Spanish, and the English to designate currencies. Although strong economic and technical arguments pleaded for a single currency, as explained later in this chapter, they would have been insufficient to determine the move to the euro had fundamental political decisions not driven the process. Like Adenauer, De Gasperi, and Schuman in the 1950s, Kohl, Mitterrand, Andreotti, and Gonzalez in the 1980s knew little about the economic and technical arguments for or against monetary union.18 In line with the original motivations of the 1950s, they saw the single currency mainly as a further step—and as a prerequisite for yet other steps—in the political unification of Europe. In the 1970s they had directly experienced how urgent the need for a tighter union was for their own countries and for Europe as a whole to play a role in the international world. To move forward decisively, they chose the monetary goal, sometimes against their own experts.19

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7

Besides the vision of political leaders, unusual historical contingencies played a role. During the crucial phase in which the blueprint prepared by the Delors Committee was at the junction of either being shelved or becoming a concrete political commitment, the Berlin wall fell (November 1989) and the course of post–World War II European history suddenly changed. The reunification of Germany became possible. Both the hope of closing the last wound of World War II and the fear of a resurrection of German hegemony revived at once. From this situation came a decisive impulse to the implementation of the single currency. By supporting the single currency, the German government gave the clear sign that reunification of the nation and further European integration were two inseparable aspects of one and the same policy. The Treaty of Maastricht was negotiated in 1991 on the basis of the Delors Report and was signed in February 1992. With the exception of the United Kingdom and Denmark, which obtained a special “opt out” clause, the signatories committed themselves to start the single currency at an imperatively fixed final date (January 1, 1999).20 The date was not contingent on any further decision, nor on a minimum number of participants, but only on compliance with macroeconomic requirements.21 The requirements, the so-called Maastricht criteria, included convergence toward price stability, sound public finances, exchange rate stability, and low long-term interest rates. In the aftermath of the signing of the Treaty and concurrent with the process of ratification, the European fixed exchange rate system underwent a serious crisis. Severe tensions in foreign exchange markets led to the exit of the Italian lira and the British pound from the EMS in September 1992, to repeated devaluation of the Spanish peseta and the Portuguese escudo, and to extraordinary measures to support the French franc.22 The EMS was saved by the decision (August 1993) to widen its margins of fluctuation from 2.25 to 15 percent, but lost much of its disciplinary function. When the Maastricht Treaty was ratified and entered into force on November 1, 1993, the climate in Europe had departed from the euroeuphoria of Maastricht and a somewhat paradoxical situation had arisen.23 Because of the gravity of the 1992–93 EMS crisis, the goal of a single currency seemed to have drifted apart and so-called euro-scepticism had gained ground in official and political circles as well as in the public opinion. Indeed, toward 1994 few were convinced that EMU would actually start at the set date. Only some top political leaders, and most notably the German chancellor Helmut Kohl, did not abandon the project.

8

Chapter 1

Meanwhile, however, and to some extent independently, the macroeconomic requirements set for joining the single currency acquired a life of their own. They were adopted by markets and observers as benchmark of good economic policy behavior, to the point that complying with them became a central issue and an influential argument in the domestic economic policy debate of each country. As to the furthering of European unification, it was clear that failing to implement the single currency would have dealt a major blow to the decade-long design to build a united Europe. These circumstances largely explain why, in the 1994–97 period, significant progress was made toward meeting the Maastricht criteria. After the coming into force of the Treaty, technical preparation began for the move to the single currency. The European Monetary Institute (EMI), forerunner of the European Central Bank (ECB), was set up in Frankfurt in 1994. In 1995 the name of the new currency—the euro—was chosen. The definition of the monetary framework of the future ECB was initiated at the EMI. The design and features of the new notes and coins was approved. It was also decided that while the single currency would be introduced on January 1, 1999, with the disappearance of intra European exchange rates and the adoption of the single monetary policy, the national banknotes would be replaced by euro notes and coins only at the beginning of 2002. Toward the end of the 1990s, the overall economic and political climate became again propitious to the single currency. In May 1998 the heads of state and government of the European Union took the three final decisions needed to start the single currency. First, eleven countries were selected as eligible for joining the euro; second, the conversion rates between their currencies were set; and, third, the president and the other members of the executive board of the ECB were appointed. On January 1, 1999, the euro became the single currency. The Single European Act and the Maastricht Treaty brought some changes to the European vocabulary. With the former, what the Treaty of Rome called the “common market” came to be called the “single market,” to mark a fresh start. With the latter, the term European Union (EU) was adopted to designate the so-called three-pillar construct comprising the European Communities (the economic and monetary field), a common foreign and security policy, and cooperation in fields of justice and home affairs. While all the provisions, tasks, and procedures pertaining to the first pillar foresee a strong role for supranational institutions, the latter two pillars are up to now governed essentially by intergovernmental cooperation, involving the unanimity rule. In the rest of the book we will often

The Roads to the Euro: A Historical Overview

9

use the term “the Treaty” for the integrated European charter formed by the Single European Act, the Treaty of Maastricht, and the Treaty of Rome. After Maastricht, the political process of advancing the union by way of Treaty changes continued. In Amsterdam (1997) and in Nice (2000) two new treaties were stipulated, mainly focused on political and institutional aspects of the European Union. Attempts were made to strengthen the second and third pillars set up in Maastricht as well as to prepare the EU institutions for future enlargements to up to twelve new members. The results were modest. In particular, the Treaty of Nice produced rather complicated, and possibly unworkable, compromise formulas. Thus, while the member states declared the European Union ready for enlargement anyway, they also implicitly recognized the need to strengthen the Union and decided to launch, by 2004, yet another round of constitutional reform. In February 2002 a Convention on the Future of Europe, made up of government representatives and parliamentarians, comparable, in a sense, to the Philadelphia Convention back in 1787, was put in charge of preparing a new treaty reform.24 1.3

The United Kingdom, European Union, and the Euro

Throughout the process leading to the euro, a special element, one that has often been in the limelight, is the position of the United Kingdom. Those who focus exclusively on the economic and monetary significance of the euro may fail to see that behind the nonparticipation of the pound sterling in the euro there are strong political motivations, before the economic and monetary ones. Indeed, the reluctance to a single currency, and the final request to be exempted from a firm commitment, were just another instance of the cautious attitude toward European integration the United Kingdom has maintained over half a century. This attitude consisted in resisting and even opposing any transfer of national powers to a jointly governed supranational institution. At the same time, however, and in line with traditional British pragmatism, this attitude comprised a disposition to join EU arrangements and institutions, once implemented and proved successful. Some prominent examples illustrate the point. The United Kingdom tried to stop (in 1956–57) the stipulation of the Treaty of Rome, but asked to join the EEC three years after the start. With Greece and Denmark in 1984 it opposed calling the conference that negotiated the Single European Act, but adhered to it in the end. It stayed out of the EMS in 1979, but joined it eleven years later. It opposed the Social Charter in 1989, but signed it in

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1997. It still rejects the 1985 Schengen agreement, whereby most EU member states have abolished all controls at their common borders. It is fair to say that scepticism and pragmatism (or perhaps empiricism) have permeated British attitudes for fifty years. Scepticism, because most Britons simply disbelieve that continental Europeans really want a United Europe and generally assume Europeans will never do what they say they will. Not by accident, euro-scepticism is an expression coined by the British press, although the sentiment it depicts is present also in the European continent. The sentence spelled out by the British delegate when he left the Messina conference in 1955 (which drew the first plan of what became the Treaty of Rome) still stands out as a monument of euro-scepticism. “I leave Messina happy, because even if you continue meeting, you will not agree; even if you agree, nothing will result; and even if something results, it will be a disaster.” Many continental Europeans would like the unification process to benefit in full from the high tradition of political freedom and art of government the United Kingdom has built up over the centuries. They are frustrated by the reserved attitude of many British politicians, journalists, publishers and the general public. A reserved attitude, however, can be well understood when set against the background of history. For centuries the British Isles have been confronted with efforts by one or the other of European continental powers to unify the continent under a single rule through military, diplomatic, or dynastic initiatives. As an insular power, Britain was naturally protected from invasion and had its main interests on the sea. However, it felt threatened by the rise of a dominating power on the continent. When Philip II of Spain in the sixteenth century, Louis XIV in the seventeenth century, Napoleon in the nineteenth century, or Hitler in the twentieth century engaged themselves in such attempts, Britain acted to rally coalitions that restored the balance of power and impeded domination by one state. In playing this role, Britain protected the weak and built its own strength. In the five decades since the end of World War II, when the continent sought peace and security, no longer via the establishment of a precarious balance of power but by peacefully and gradually uniting, the deep-seated political instincts of Great Britain emerged again. The unification of the continent was seen as a threat rather than the foundation of peace and order. Hence there was a great reluctance to accept any transfer of sovereignty to common institutions. The debate about joining the euro is still very open in the United Kingdom. Some economic and monetary arguments echo those used when

The Roads to the Euro: A Historical Overview

11

the Treaty of Maastricht was prepared; others are more specific to the contingent or structural situation of the UK economy. Important as they are, however, economic arguments are perhaps not the crux of the matter. Eventually, and rightly so, the British élite and the voters will decide on the basis of the deeper, albeit less precisely formulated, political and historical considerations that are governing the relationship between the United Kingdom and the European continent. 1.4

Economy: Resolving an Inconsistent Quartet

What we have followed so far is the political road to the euro. We take now the economic road. Although its principal objective was to establish freedom of circulation of goods, services, capital and persons, the Treaty of Rome was more than that. Referring to the classic taxonomy proposed by Richard Musgrave (1958) for fiscal policy—allocation (aimed at efficiency), stabilization (aimed at stability), redistribution of resources (aimed at equity)—we can say that the full spectrum of economic policies was indeed covered by the Treaty. As for allocation, not only the market mechanism was contemplated but also other more command-directed methods. First and foremost these were in the field of agriculture through the CAP. As for stabilization, member countries committed themselves to “treat [their] exchange rate policy as a matter of common interest”25 and to “regard their economic policies as a matter of common concern and . . . co-ordinate them.”26 In the mid-1950s these loose prescriptions were deemed sufficient because other powerful arrangements were in place. In the monetary field, the key stabilizer was the dollar-based fixed exchange rate system founded at Bretton Woods.27 In the budgetary field, public sector budgets were broadly in equilibrium and did not threaten overall economic stability as large deficits were to do in the 1970s and afterward. As for redistribution, the task of helping less developed members and regions to catch up was entrusted to the European Community from the outset and extended considerably afterward. The instruments for this have been the so-called structural funds, the borrowing and lending activity of the European Investment Bank (EIB), and, more recently, the Cohesion Fund.28 Although the Treaty of Rome hardly mentioned money, it would be an error to think that its authors forgot to consider what monetary order was required by a single market. Rather, they knew that the yet to be created

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Chapter 1

single market had from the outset an exogenous monetary order and even an implicit single currency, which was the US dollar. The regime of Bretton Woods forbade countries to act unilaterally to gain competitive advantages through a devaluation. And in the mid-1950s, with Europe just emerging from the war and the United States dominating the world economy, that regime was seen as an everlasting one. The dollar-based fixed exchange rate regime was not everlasting, and it is noteworthy that as soon as it began to falter in the late 1960s, a debate started about how to replace it with a European arrangement.29 The economic road from Rome 1957 to Maastricht 1992 is the road from a dollar anchor to a “proprietary” anchor called euro. Two economic paradigms have led Europe along this road. The first is the theory of optimum currency areas and the second, the proposition of the “inconsistent quartet.” Robert Mundell’s path-breaking theory of optimum currency areas (OCA), by questioning the one-to-one correspondence between monies and states, made a monetary union spanning over several countries an institutional arrangement conceivable to economists. The theory identified several properties, namely the conditions under which an area would gain from adopting a single currency, regardless of the political borders. In the formulation developed in the 1960s by Mundell (1961), McKinnon (1963), and Kenen (1969), those conditions included, among others, the mobility of factors of production (notably labor and capital), price and wage flexibility, economic openness, and the diversification in production and consumption. Such conditions happened to largely coincide with the economic project underlying the Treaty of Rome and with the effective implementation of the four freedoms. After the 1960s the OCA theory further evolved through an academic debate that is still underway and has accompanied the main steps that led to the adoption of the euro. On the one hand, no conclusive case could easily be made ex ante to establish whether OCA properties were sufficiently present to warrant the adoption of a single currency, namely the euro.30 On the other hand, it has been increasingly recognized that the very adoption of a single currency can significantly contribute to fulfilling the optimality conditions on an ex post basis (the so-called endogeneity of OCA) by removing barriers and catalyzing the implementation of the Single Market Program and its four freedoms.31 The second paradigm is embodied in the proposition that free trade, mobility of capital, fixed exchange rates, and independence of national monetary policies are mutually incompatible. This proposition was put

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forward by Padoa-Schioppa (1982) to explain the difficulty the EC had encountered over a quarter of a century in implementing the free mobility of capital in a regime of fixed exchange rates, while leaving monetary policy to national authorities. The proposition was an application of the Mundell-Fleming analyses of the macroeconomics of open economies with capital mobility.32 It was further referred to by Krugman (1987), to argue that—with the establishment of the single market and fixed exchange rates—independent national monetary policies were no longer possible.33 More recently, the proposition has been the basis of the “two-corner solution theory” discussed in chapter 7.34 In Europe the paradigm of the inconsistent quartet pointed to the necessity of a single currency, while the OCA theory only referred to the single currency merely as a possibility. This explains perhaps why it acted powerfully in pushing toward the adoption of the euro and ceased to be debated after the launching of it. A careful reading of the Treaty of Rome suggests that its authors did not ignore the inconsistency, but dealt with it without tackling the heart of the problem, namely in radical institutional terms. For one thing, they foresaw the commitment to regard exchange rate policies as a matter of common interest and to coordinate economic policies. In addition they advocated gradualism in removing capital controls, hence softening one of the key prescriptions of the Treaty. Finally they allowed the temporary reintroduction of capital controls in the event of serious tensions. In practice, this approach proved ineffective. The prescribed coordination of national economic policies never took root, and the task to resolve the inconsistency thus fell on capital movement restrictions. The Treaty of Rome perceived the inconsistency, but it failed to resolve it and it took thirty-three years before this fundamental flaw was rectified. Between the dollar standard and the establishment of the euro, the anchor role was played, for about twenty-five years, by the strongest European currency, the Deutsche mark (DM). The DM regime began in 1972 with an arrangement called the “snake.”35 In 1979, the snake was replaced by the EMS, which included two “large” currencies (the French franc and the Italian lira) in addition to the small ones already pegged to the DM. Although all participants officially had the same status, the Deutsche mark, being the strongest and most stable currency, was the anchor and the monetary policy of the Deutsche Bundesbank, firmly oriented toward price stability, became the monetary policy of the whole area. This strongly contributed both to the fight against inflation and to the preservation of orderly trade relations within the European Union. And as convergence of

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individual macroeconomic performances was gradually restored, full implementation of the four freedoms, which in the early 1980s was still largely unfulfilled, gained new support. In the 1980s the contradiction between the four elements of the quartet, instead of producing a rolling back of European integration as it did in the 1970s, caused a movement forward. Seen in the light of the inconsistent quartet, the road toward the single currency looks like a chain reaction in which each step resolved a preexisting contradiction and generated a new one that in turn required a further step forward. The steps were the start of the EMS (1979), the re-launching of the single market (1985), the decision to accelerate the liberalization of capital movements (1986), the launching of the project of monetary union (1988), the agreement of Maastricht (1992), and the final adoption of the euro (1998). The difficulties inherent in the inconsistent quartet were aggravated by the fact that, in the course of the 1980s, the EMS became both increasingly rigid and increasingly exposed to tensions. On the one hand, countries that had succeeded in abating inflation to “German” levels (like France), or that still struggled to dis-inflate (like Italy), became less and less inclined to devalue. On the other hand, capital mobility had become so high that markets could mount huge pressure against a currency, even when costs and prices were relatively convergent. Finally the EMS was further strained and eventually blown up by a policy dilemma arisen from German reunification, which boosted growth in Germany while the rest of Europe was stagnant. Monetary policy was confronted with conflicting needs and the tightening decided by the Bundesbank on the basis of domestic considerations precipitated the crisis of 1992–93. The timing was such that the crisis did not interfere with the Treaty negotiation and only influenced the process of ratification. The whole episode was a striking confirmation of the paradigm of the inconsistent quartet. What determined the crisis was indeed the existence of a conflict about the course of monetary policy, against the background of a combination of fixed exchange rates with full capital mobility. The paradigm of the inconsistent quartet explains the crises of the Bretton Woods and the EMS regimes. Common to both is the emergence of a conflict between national and international interests after a prolonged period in which they had coincided. In both the domestic inflationary shock of a major political event (the Vietnam war for the US dollar, the reunification of Germany for the Deutsche mark) marked the passage from harmony to conflict. In both cases capital movements, albeit of a different size and speed, exacerbated the conflict.

The Roads to the Euro: A Historical Overview

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There were, however, also significant differences. The policy conflict that undermined the Bretton Woods system arose from an accommodative policy of the anchor country (the United States), which ran counter to the anti-inflationary preferences of other important players, such as Germany. In the EMS the policy of the anchor country—Germany—was too restrictive for its partners. More important, the exits were opposite. The international monetary system went to a floating exchange rate system, and Europe to the single currency. In terms of the recently expounded proposition that in an environment of capital mobility only so-called corner solutions work for exchange rates, one can say that the world and Europe moved to opposite corners. In conclusion, the economic road to the single currency has been one in which the gradual pursuit of the initial objective of the four freedoms was tenaciously pursued over the long run, despite pauses and temporary fallbacks. Along the road, one of its conditions, namely consistency between the economic and the monetary order, was initially fulfilled, then violated, then partially surrogated, and finally embodied in the single currency. The fact that the Treaty of Maastricht takes the form of an amendment of the Treaty of Rome is not a simple formality. It reflects the substance of the matter, in that it removes a fundamental flaw in the original Rome Treaty. 1.5

Central Banking: From Old to New Anchors

The third road to the euro concerns the history of central banks and monetary policy. Indeed, it just happened that the forty-year period between 1958 and 1998 was a key period in that history too, not only in the process of European integration. It was a coincidence, but a strategically important one. This section explains how this period in the history of central banking helped the move toward the euro and how its outcome was embodied in the Maastricht Treaty. Until about the last third of the twentieth century central banks were tied to two, not always mutually consistent, anchors. The first was the state, and the second was gold. As the holder of political power had always considered the striking of coins as its own prerogative, the right to print notes (what the jargon calls the “printing press”) was granted to central banks by the sovereign government itself. As to the gold anchor, since central banks were expected to stand ready to convert banknotes into gold on request, the amount of money they could create was, or should have been, dependent on the amount of gold in their vaults.

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Chapter 1

One anchor—gold—was not always tight, as it was technically possible to activate the printing press independently of the amount of gold on reserve. The other anchor—the government of the state—was not always wise, as its own vested interest (fighting wars, gaining popular support by increasing public expenditures, etc.) at times led to overcreation of money. Indeed, with the advent of banknotes, the main risk associated with the creation of money was no longer the scarcity of gold and hence deflation, for the growth in economic activity could be matched with enough means of payments. The main risk became, instead, an excessive use of the printing press and hence inflation. That the printing press embodied a dangerous temptation was clearly seen by the German poet and scholar Goethe in the early era of paper currency. In his most famous drama, Faust, it is Mephistopheles, the devil, who advises the emperor to solve his financial problems by simply issuing paper notes, supposedly backed up by the gold that is as yet unearthed in the soil.36 And, ironically, it was Germany that experienced, over a century after Goethe, the worst abuse of the printing press. In November 1923 a liter of milk cost 360,000,000 German Reichsmarks, one US dollar was worth 40,000,000,000, and the overall sum of cash in circulation reached the astronomical figure of 3,877,000,000,000,000, (or 3,877 trillion) Reichsmarks. In part, this explains the fierce concern with price stability of both the Bundesbank and the German people. The history of modern central banking can be looked at as a search for the optimal framework—institutional, intellectual, or operational—in which to set the newly discovered power to create value out of printed paper. This search explains a great deal of the successive migrations of the printing press from the sovereign government to a private institution, then back to the public sphere, and finally to an independent agency. The public policy need was to shelter the creation of money from the influence of whoever may have an interest in using it for self-financing at no cost. The temptation was to make money creation subservient to any interest other than the peoples’ interest to have a “sound currency.” The modern notion of an independent central bank corresponds to the principle that the central bank needs institutional protection from that temptation. As long as the principle held firm that public budgets should be balanced (or could only be violated in exceptional circumstances, as in wartime), a publicly controlled central bank was better sheltered than a private one. Pressure for excessive money creation was more likely to come from the private than from the public sector. For most of the twentieth century the

The Roads to the Euro: A Historical Overview

17

prevailing institutional model was increasingly one in which the central bank depended on the Treasury. Accordingly, those central banks that— unlike the Banque de France founded by Napoleon in 1800—were not state institutions from the start were nationalized in the course of the century. Others retained the form of a limited company (Banca d’Italia, National Bank of Belgium) but depended on the government for their policy decisions. With two notable exceptions—US Fed, and German Bundesbank, shaped on the US model—central banks were subordinated to the government for most of the second half of the twentieth century. When the Treaty of Rome was stipulated, this was not a real threat to monetary stability because fiscal discipline was prevailing in most countries and because currencies were still anchored to gold, via their link to the dollar and the latter’s link to gold. The three decades of the 1960s, 1970s, and 1980s witnessed the disruption of this consolidated setting. Driven by political and social change, the role of the state in the economy grew and the size of public budgets swelled. The welfare state enlarged through publicly funded pension systems, national health care, and expanded unemployment subsidies. Meanwhile the idea of deficit spending became widely accepted, intellectually and politically. Treasury-dependent central banks became increasingly exposed to political pressures to finance public deficits through monetary creation. With the advent of deficit spending in the 1970s the public sphere became an unsafe haven for central banks. Meanwhile, and partly under the pressure of the same forces, the Bretton Woods system collapsed and the last remaining link between money and gold was severed. A new framework for managing the currency had to be built. New anchors were needed. The break from gold permitted, and demanded, money to be managed entirely on the basis of human will rather than on Nature, that is to say, on policy decisions rather than the extraction of gold from mines. A new intellectual paradigm for the conduct of monetary policy became ever more necessary. The intellectual paradigm prevailing at the time, built on the foundations laid by Keynes, Hicks, and Modigliani,37 was that in an imperfect world with rigid wages, monetary policy could permanently affect real economic activity.38 Money was not neutral. There was a trade-off between inflation and unemployment, described by a curve (the Phillips curve, from the name of its inventor) where lower unemployment levels are associated with higher inflation rates.39 This allowed governments to achieve lower rates of unemployment by accepting a higher rate of inflation.

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The nonneutrality of money was, however, challenged by Patinkin, Friedman, and Lucas.40 In the 1970s the proposition that there was a natural rate of unemployment, from which monetary policy could not depart in the long-run, was supported by empirical evidence. In many industrial countries, the Phillips curve had shifted over time toward combinations of both higher inflation and higher unemployment. Today there exists a broad consensus about long-run neutrality of money, but views on the short-term effects remain divided.41 The rational expectations school takes a radical position and asserts that the public expects policy to respond systematically to economic developments so that only random and unexpected actions would have an effect in the end.42 At an empirical level, the evidence is mixed. It suggests that also systematic and expected changes in monetary policy may have short-term impacts on the real economy due to various frictions, adjustment costs, and information imperfections. Recognition of the long-run neutrality of money widened acceptance of a hierarchy of goals for monetary policy. A consensus developed that there is no significant policy alternative for central banks to focus primarily on the attainment of price stability, while leaving other policies (labor market policies, supply side policies, fiscal policies) to aim at full employment. In parallel with the evolution of ideas, the policy of central banks also evolved from an overly ambitious to a more sober view of what could actually be achieved through the conduct of monetary policy. In the United States, for example, monetary policy in the late 1960s and in the 1970s aimed at fostering high employment and often disregarded its consequences on prices until inflation had become high and publicly blamed. In those same years the United Kingdom and several continental European countries went through a similar experience. Only toward the end of the 1970s did attitudes change. In the early 1980s, under Paul Volcker, the Federal Reserve tamed rampant inflation by severely restricting monetary creation and changing market expectations.43 In the same period the Bank of England under the Thatcher government did the same.44 Germany was the notable exception to the inflationary experience of most industrial countries in the second half of the twentieth century, probably because the tragedy of hyperinflation after World War I had eradicated, from the mind of the people, the illusion that more money brings more prosperity. In designing the charter of the ECB, the Bundesbank model was adopted. The abandonment of the idea that central banks could, or should, choose between inflation and unemployment paved the way to a de-politicization

The Roads to the Euro: A Historical Overview

19

of monetary policy and hence to greater emphasis on the technical rather than political role of central banks. This in turn made it easier to accept the idea that monetary power could be transferred from member states to a common European institution, with the achievement of price stability as the common objective. In a nutshell, the period between 1957 and 1998 led from the signing of the Treaty of Rome to the single currency. It was also a period when people learned to manage an entirely fiduciary currency whose purchasing power is based on trust rather than intrinsic value. The Treaty of Maastricht sanctions principles of central banking and monetary policy that were identified through scholarly research and policy experience. These principles have gained growing support in the public opinion, and were finally adopted by a wide component of the political spectrum. In a sense, the Treaty embodies what was learned about central bank policies throughout the twentieth century. The three foundations on which the Treaty of Maastricht built the charter of the single European currency and its central bank are the outcome of the long search briefly summarized in this section. The first is the indication of price stability as the primary objective of monetary policy, the second is the guarantee of full independence of the central bank, and the third is the constitutional status of the charter of the central bank and the currency. In no other central bank charter are these three founding principles spelled out as clearly and strongly as in the Treaty of Maastricht. The Maastricht Treaty indeed represents the first constitution of money that entirely replaces old anchors with new ones. It has moved the printing press from the twin anchors of gold and the sovereign government to the anchor of a constitutional mandate complemented with institutional independence. This evolution could, of course, have happened in a setting other than the European Union. It is worth noting, however, that an important factor contributed to the meeting of the European and the monetary paths. An entity such as the European Union, which does not retain the traditional powers of the state, appeared to governments as a favorable ground on which to place a monetary power they were ready to abandon.

2

A Profile of the Eurosystem: The Newest Central Bank

In the history of central banking, the Treaty of Maastricht is a milestone comparable to the Federal Reserve Act of 1913 and the Bundesbank Act of 1957. The former created the first central bank with a federal structure and collegial decision-making. The latter led the way toward institutional independence. In this chapter, I present the new European central bank created by the Maastricht Treaty. I first examine its functions, structure, and organization (section 2.1), as well as the “center versus periphery” relationship (section 2.2). I then analyze its key institutional aspects: decision-making (section 2.3), independence, and accountability (section 2.4). I close with a reference to the wider context of the European Union (section 2.5 and appendix). 2.1

The Eurosystem

The Eurosystem is the entity that performs the central banking functions for the euro and the euro area. It is for the euro what the Federal Reserve System (the Fed) is for the US dollar and, until 1998, the Bundesbank was for the Deutsche mark. The name “Eurosystem” was chosen to indicate the construct formed by the European Central Bank (ECB) and the national central banks (NCBs) of countries that have adopted the euro. The Treaty of Maastricht gives no name to this entity and refers only to the wider European System of Central Banks (ESCB) that includes also the central banks of the EU countries not adhering to the euro, namely Denmark, Sweden, and the United Kingdom. However, the prospect of all EU member states—including the ten that joined in 2004—adopting the euro remains a remote one.1 Before illustrating the way the Eurosystem is organized, makes decisions, and relates to other EU institutions, it is necessary to cast its functions in

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the light of modern central banking. The discussions in subsequent chapters will attend to these functions in greater detail. Central banks originate from two fundamental changes in monetary systems over the past two hundred years. The first was, at the turn of the nineteenth century, the replacement of commodity currencies with paper currency. The second change was, about a century later, the development of commercial bank money (or bank deposits), which largely replaced notes and coins as a means of payment and store of value. To ensure the efficiency and safety of paper currency systems, most countries gradually entrusted one bank—which became the central bank—with the exclusive task of issuing banknotes. Today the general public considers central and commercial bank money (banknotes and bank deposits respectively) as equally safe and fully interchangeable. These two changes were innovations in the payment practices. However, they have been decisive in shaping the other two central banking functions that gradually developed over the last century, namely the supervision of banks and, later, the conduct of monetary policy. The control of commercial banks originated from the need to ensure full acceptance of bank deposits as the perfect substitute for banknotes. This in turn required central banks to assess the quality of the assets of commercial banks (for a qualification and wider discussion of this point, see chapter 5). As to monetary policy, which is today the foremost function of a central bank, it fully developed as the link between banknotes and gold was gradually loosened and eventually severed. Nowadays the total value of banknotes in circulation is quite small compared to total bank deposits. The overall stock of money is determined by the central bank, not by the availability of gold. In such a setting the confidence in the currency ultimately rests on two foundations: one is the convertibility of commercial bank money into banknotes at par at any time; the other is the ability of the central bank to manage the quantity of money in a way that keeps stable the value of the currency. In a modern market economy, based on exchange, division of labor, and a profit-driven banking industry, the triadic function of central bank— related to the payment system, banking supervision, and monetary policy—is crucial for the quality of money. The three functions are linked to three inseparable functions of money as means of payment, unit of account, and store of value. Operating and supervising the payment system refers to money as a means of payment; ensuring price stability refers to money as a unit of account and a store of value; pursuing the stability of banks refers to money as a means of payment and a store of value. These

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linkages explain why the three functions have most often been entrusted to the same institution, which is the central bank. The paradigm of the triadic function provides the key to reading the Treaty of Maastricht from a central banking point of view. In the following sections of this chapter, and in chapters 4, 5, and 6, the functions of the Eurosystem will not be presented in the order derived by the historical development just reviewed. Rather, a reversed order will be followed to reflect the fact that monetary policy is today the dominant function. The Treaty unambiguously assigns to the Eurosystem the task of conducting the single monetary policy. It states that its primary objective “shall be to maintain price stability” and also indicates that “without prejudice of the objective of price stability, the [Eurosystem] shall support the general economic policies in the Community.”2 In the field of payments, the Treaty gives the Eurosystem the task to “promote the smooth operation of payment systems”3 and states that “the ECB and national central banks may provide facilities, and the ECB may make regulations” to this end.4 As to prudential supervision, it is left to national authorities, but, in view of the link and complementarity between prudential supervision and other central banking functions, the Eurosystem is asked 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.”5 The ECB also has a consultative and advisory role when new legislation and regulation are adopted in the financial field. The Eurosystem, like any central bank, also conducts other activities related to the public interest of maintaining a sound currency, trusted by both the market and the general public. These activities include the exercise of operational and regulatory powers, relationships with other public authorities and the financial community, contacts and cooperation with other central banks, participation in international fora and institutions responsible for monetary and financial matters. 2.2

Center and Periphery

Being monopolists and being placed at the center of the monetary system, central banks have historically been characterized by a high concentration of power and a centralized organization. A central bank with a federal structure and a collective decision-making only appeared more than a century after modern central banks first took shape (Federal Reserve Act of 1913).

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The Treaty is unambiguous in ensuring the unity of the Eurosystem, in making it a single entity rather than a constellation of coordinated entities. It does so by means of two provisions. First, by attributing the central banking functions to the Eurosystem as such, not to its separate components. Second, by stating that the Eurosystem “shall be governed by the decision-making bodies of the ECB,” namely by casting it under a single command.6 The ECB is not another central bank operating alongside the NCBs, nor a competitor of them. Rather, it is the head of the system. Yet, when they have a federal structure, central banks always exhibit a combination of, and sometimes a tension between, centralized decisions and decentralized actions. The Eurosystem is no exception. Actually in the Eurosystem the combination is characterized, and the tension enhanced, by historical, constitutional, and organizational factors that determine a rather special “center versus periphery” relationship. These factors can be described as follows. The national central banks that on January 1, 1999, became part of the Eurosystem were not new entities created by the Treaty of Maastricht to serve as “components” of the new system. They were ancient institutions with long-established traditions and diverse charters. For many generations, each of them had performed the full range of central banking functions as a prominent institution of the nation-state. Public opinion perceived, and often still perceives, them as national entities. They were seen as the repositories of the people’s confidence in the currency, for which they were accountable to, and often dependent on, the political authorities of the state. Even after the euro, their tasks, organizations, statutes, and cultures preserve clear differences.7 Moreover, since they have retained tasks that the Treaty does not transfer to the European level,8 the NCBs combine a federal with a national role. From a constitutional point of view, NCBs are dual institutions: national, for tasks not attributed to the Eurosystem; peripheral to a federal institution, for the Eurosystem’s tasks. Two concepts—subsidiarity and decentralization—are relevant here. Subsidiarity is, in the European lexicon, the general criterion for deciding whether a policy function should be national or European.9 According to the Treaty, action is taken by the Community “only if and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States” and can be “better achieved by the Community.”10 Decentralization is the criterion the Treaty indicates to the Eurosystem for exerting the functions attributed to it, which are, by definition, European functions. In this respect the Treaty stipulates that “to

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the extent deemed possible and appropriate, the ECB shall have recourse to the national central banks to carry out operations that form part of the tasks of the [Eurosystem].”11 This distinction shows that the “center versus periphery” relationship has two features, both based on the Treaty. Following subsidiarity, NCBs perform functions that do not fall within the jurisdiction of the Eurosystem, and indeed remain rooted in national legislation.12 Following decentralization, they have a claim “to carry out operations” of the System, acting “in accordance with the guidelines and instructions of the ECB.”13 Subsidiarity and decentralization are quite different concepts and should not be confused. The constitutional decision, whether a particular policy— such as the prudential supervision of banks—should be national or European (state or federal in the US constitutional vocabulary) was made by the authors of the Treaty. It was not left to the discretion of the Eurosystem. On the contrary, the organizational decision whether “the operations” related to a particular Eurosystem (i.e., federal) function—be it the printing of banknotes or the management of foreign exchange reserves— should be carried out by the center or by the periphery was left to the Eurosystem. The Treaty recommends decentralization “to the extent deemed possible and appropriate,” but this recommendation of course does not impinge upon the European nature of that activity, which indeed remains directed by the ECB. In practice, defining the relationship between center and periphery is a crucial challenge for the Eurosystem at this early stage of its life. NCBs, specially the largest ones, tend to preserve the role, functions, and structure they had before the euro, and to operate outside the authority of the ECB. To this end they gear the interpretation of both subsidiarity and decentralization. Except for tasks directly related to monetary policy, they tend to read the Treaty as, first, conferring only minimal functions to the Eurosystem and, second, favoring decentralization over overall efficiency in the conduct of the conferred functions. The “possible and appropriate” formula used by the Treaty is thus interpreted extensively, and what is decentralized is often seen as still belonging to a national responsibility rather than a European one. The distinction between the constitutional and the organizational issue (i.e., between subsidiarity and decentralization) is thus often blurred, as numerous examples will show in chapters 5 to 8. In defining the working process of the policy-making, the Treaty of Maastricht uses three different words for successive steps: decision, implementation, and execution. It assigns decisions to the Governing Council

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of the ECB (ECB Council), implementation to its Executive Board (ECB Board), and execution to the NCBs and the ECB. The notion of decentralization is reserved to the execution of ECB Council’s decisions, not to the two other steps of the policy process. Although the Treaty does not provide an explicit definition of the three words, for monetary policy the interpretation of the “center versus periphery” relationship is rather straightforward. Decision concerns the strategy and instruments of monetary policy, the setting of interest rates, or the adoption of minimum compulsory reserves. The operations whereby monetary policy works in practice (e.g., buying and selling securities on the market) are directed by the ECB Board (implementation) and carried out by national central banks (execution). NCBs have no discretion about how to conduct them, although the proceeds affect their balance sheets. Thus implementation is centralized and execution decentralized. Paradoxically, the main reason for centralizing the implementation of policy is the multiplicity of money centers in Europe. Since so many central banks conduct, in different countries, monetary policy operations that are part of the same single policy, a strong direction from the center is imperative. In practice, every dealing room of NCBs receives direct orders and authorizations from the ECB headquarters in Frankfurt for each operation. It may be useful to compare the center versus periphery issue in the Eurosystem and the Fed, because the latter not only is the leading central bank in the world but also was the first to adopt a federal structure.14 The Board of Governors and the Federal Reserve District Banks are for the Fed what the ECB and the NCBs are for the Eurosystem. However, unlike the NCBs, the Fed’s District Banks did not preexist the creation of the System in 1913, nor do they have the dual character (state and federal, in the US terminology) described above for the NCBs. In both the Fed and the Eurosystem, monetary policy decisions are taken by a collegial body—the US Federal Open Market Committee and the ECB Governing Council respectively—which involves both the center and the periphery. In the execution of policy, the Fed operates through one District Bank only (the New York Fed), the Eurosystem through all NCBs. Partly as a result of that, larger discretion is left to the New York Fed in the actual conduct of operations than to the NCBs. Indeed the New York trading desk does not work under direct instruction from Washington. For other policy areas and for administrative and organizational matters the ultimate decision-making is an entirely “central” body in the Fed (the Board of Governors), while it is a “center plus periphery” one in the

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Eurosystem (the ECB Council). The authority of the Board of Governors includes oversight of the Reserve Banks’ services to, and their supervision of, the banks. Moreover each Federal Reserve Bank must submit its annual budget to the Board of Governors for approval. Within the Eurosystem, it goes the other way around because the ECB budget has to be approved by the ECB Council, where NCB governors constitute the majority. Meanwhile, in the Fed, the center does not operate directly, and attributes to some District Banks certain systemwide activities, such as functions related to payments, certain open market and foreign exchange operations, and information systems. In the Eurosystem, instead, the ECB has operational capacity (e.g., it has its own dealing room) while no systemwide activities are located in any of the NCBs. Important differences between the Fed and the Eurosystem derive from the fact that the former is a mature institution while the latter has just begun its life. In its early years the Fed’s periphery played a very large role and decades after its founding, the institution was still grappling with the “center versus periphery” issue.15 Only a very gradual process of rationalization led to the present setting. As to the Eurosystem, it is quite natural that just few years after the start, NCBs have the full central banking infrastructure they had when they were stand-alone institutions and try to favor slowness in the move toward a more integrated, systemwide organization. 2.3

Decision-Making in the Eurosystem

The ECB Council and the ECB Board are the two decision-making bodies of the Eurosystem. Both are part of the ECB and chaired by its president. Both derive their authority directly from the Treaty of Maastricht. The Board consists of six members (including the president and the vice president) appointed for a nonrenewable eight-year term of office.16 The Council is composed of the six members of the Board and the governors of all the national central banks that have adopted the euro. National governors are appointed according to national laws. The Council takes the decisions that are necessary to perform the tasks of the Eurosystem, notably to “formulate the monetary policy of the Community” and to “establish the necessary guidelines for [its] implementation.”17 The Board manages the day-to-day business of the ECB, prepares the decisions of the Council, and looks after their implementation. It has the charge to “implement monetary policy in accordance with guidelines and

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decisions laid down by the ECB Council.” Doing so means that the Board should give the necessary instructions to national central banks. In addition the “[Board] may have certain powers delegated to it where the [Council] so decides.”18 Decision-making was the stake around which the struggle for central bank independence developed over much of the last fifty years. For the ECB, as for any other central bank, it lies at the heart of the institution. Its credibility ultimately depends on its ability to make decisions that achieve the assigned objectives—price stability in the first place—and hence to convince the markets and the general public that the efficiency and stability of the currency are assured, and will continue to be assured. The Treaty provisions undoubtedly embody all the institutional preconditions for good decisions to be possible. The quality of decisions, however, depends on many more factors than just institutional provisions. Particularly for collective bodies, it depends on traditions, procedural rules, practices, “social” behavior, personalities, and so on. And if the institution is young and the tradition yet to be established, all outcomes, good and bad, are possible. Every episode or act may have a lasting constitutional influence, even those that in a mature institution would be immaterial. In central banking, independence has meant different things in different periods, depending from whence the main threat to achieving the public interest of a sound currency came. At an early stage of the debate over the single currency, the founders of the Maastricht Treaty understood that independence had to be safeguarded not only from such familiar contenders as the financial and business community, labor organizations, and fiscal and political authorities. Being the central bank of a group of countries with deeply rooted national—and sometimes even nationalistic—traditions, retaining their sovereignty in a number of relevant fields, the Eurosystem needed, first and foremost, independence from national interests or, more broadly, from national interpretations of the public interest. For the Eurosystem, “public” had to unambiguously mean the euro area, not just the interest of one nation, or some combination of national interests, each represented by a member of the ECB Council. In the Treaty, two important principles shelter the decision-making process of the ECB from the risk of becoming hostage to national interests being negotiated against each other. The first is that the ECB Council can act by a simple majority; the second is that each member of the ECB Council has one vote.19 From a conceptual standpoint, these look like obvious stipulations. Politically, however, they were not. Seen in the framework of the still nationally oriented EU institutions, it is remarkable

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that they were easily agreed upon in the preparation of the Treaty of Maastricht.20 As it will be explained in chapter 8, neither of the two principles have been challenged by the reform of voting modalities in an enlarged ECB Council. The majority principle marks the divide between a true union and occasional agreements, between a domestic and an international order. If a single policy line is only possible when all the parties involved agree on the same course of action, a “true union” does not exist. What exists under the unanimity rule is a “spurious union,” one formed on a case by case basis, in which only ex post can it be ascertained whether the preconditions for a single policy have been met. Rather than a better way to take all views into consideration, unanimity is a way to nondecisions or to decisions biased by the motivations of a minority or, possibly, a single member; two evils that any central bank should avoid. Like the Fed and any other central bank, the Eurosystem has been constructed to function on the basis of the majority rule. As to the principle “one person, one vote,” there is no doubt that with its adoption the authors of the Treaty took the decisive step in establishing the independence of the Eurosystem. To fully appreciate its fundamental significance, a distinction should be made between the motivation underlying two very different types of collegial decisions, which could respectively be called interest-based and wisdom-based. The former are collegial because different interests have to be reconciled and hence represented. The latter are collegial because— although all participants are entrusted with, and share, the same interest— the wisdom of more than one person is needed to reach the best decision. In an interest-based collegial body members have different objective functions and negotiate; in a wisdom-based collegial body all members maximize the same objective function and simply discuss how best to do it. In the former, people bring their problems to the meeting and there are as many problems as persons or interests. In the latter, there is only one problem and everyone is addressing it to the best of his or her judgment. At the decision-making table of an interest-based forum members are not, and should not be, independent from the interests they represent and to which they are accountable. As interests can be weighted, votes can, and indeed should, be weighted. No one would recommend, for example, the one person, one vote principle for the shareholders assembly of a listed company.21 In contrast, since wisdom cannot be weighted, each person has one vote in a wisdom-based forum. No one would imagine that the jury in a court could decide on a murder case otherwise than on the basis

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of that principle. If a jury is deemed necessary in a court, it is because one may not be sure that one single person has all the wisdom and independence required. Collegiality with the one person, one vote rule is a safeguard of independence also because a collegial body is much more difficult to influence than a single person. An individual can be put under pressure, be psychologically weak, or even be blackmailed; for a group of persons these dangers are more remote. A group can defend itself better than a single person from various pressures and influences, be they economic, political, psychological, or intellectual.22 According to these principles, the members of the ECB Council are mandated neither to defend a “local” interest, nor to secure the best compromise for their country. All are mandated, in an equal and same way, to serve the general interest of the euro area. When they meet in Frankfurt, national governors just happen to be the governors of a particular NCB, in reality they are members of the ECB Council, governing the whole Eurosystem.23 ECB Council meetings are organized accordingly. Members sit at the table by the alphabetical order of their names, with no distinction between national governors and Board members. Name tags do not carry the indication of countries or institutions (it was Hans Tietmeyer who requested, at the beginning of the first ECB Council meeting in June 1998, to replace Bundesbank with ECB on his name tag at the meeting table).24 The documentation for the meeting is prepared in the ECB, sometimes with the assistance of experts of NCBs. Documents look at the euro area, not a patchwork of national economies or systems, and hardly contain any country-by-country breakdown of the relevant information. The focus is on performance, structure, and efficiency of the area as a whole. Proposals are designed to achieve an optimum, not an average. The economic, not the political, map of euroland is considered. In the field of monetary policy cross-country comparisons are simply not relevant to the decision. By contrast, typical analyses of international organizations, such as the International Monetary Fund (IMF) or the Organization for Economic Cooperation and Development (OECD), are exercises in comparative economics. As far as the economic outlook is concerned, it should be further considered that economic situations are often highly heterogeneous within countries. Germany and Italy, for example, exhibit differences between regions (east versus west for Germany; north versus south for Italy) that are almost as pronounced as those between the richest and the poorest countries of the European Union. It would indeed be quite difficult, if not

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impossible, to trace the political borders separating countries within euroland by simply looking at an economic map. How to separate, for instance, Belgium from the Netherlands or the northeast of Italy from the southeast of Germany? Does the practice of ECB Council discussions conform to the principles described here? Indeed even sophisticated observers sometimes wonder whether the decision-making of the Eurosystem really passes this particular test of independence. Is it really true that governors leave their national hat in the wardrobe and let their hearts and minds only look at euroland when sitting in the ECB Council? The answer to this question is that the shift from an interest-based to a wisdom-based attitude has been accomplished in the monetary policy function, while it proves more difficult to achieve in other central banking fields analyzed in this book.25 The previous section reviewed the main factors influencing the “center versus periphery” relationship at this early stage of the EMU. Here it may be useful to explain why the emergence of a system-oriented approach is more laborious in nonmonetary than in monetary policy matters. Nonmonetary policy matters include a wide range of activities, like the printing of banknotes, the structure and operations of money transfer mechanisms, the management of the assets held in the balance sheets, the representation in international organizations and in foreign countries, the monitoring of the large banking institutions, the restructuring of the EU financial industry, and the policies concerning the international monetary and financial system. In all of these areas central banks generally have their own position, public message, and policy action, all proceeding from a single decision-making process. The Eurosystem, instead, is still in the transition from the pre-euro situation when each NCB used to define its own policy independently, referring to the national context. The move toward a single Eurosystem policy is relatively slower in nonmonetary than in monetary policy camps because in the latter the structural and organizational implications of a fast integration and rationalization of the System would be deeper. These are indeed the areas of activity that absorb most of the human and technological resources of a central bank. Moreover, having lost their role in monetary policy, central banks resist a further drain of their prerogatives. As explained in the previous section, this often leads to a far-reaching interpretation of the principle of decentralization and to attitudes, in the ECB Council, where the periphery is given more consideration than the total system. We will return to this theme in various chapters of this book and particularly in chapter 8.

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2.4

Chapter 2

Independence and Accountability

Over the last two decades the debate over monetary policy has resulted in a consensus that the central bank must be at the same time independent, accountable, and transparent. In this section attention will be confined to the first two of these notions which, unlike the third, identify the institutional profile of the Eurosystem and are therefore directly addressed by the Treaty. Although independence, accountability, and transparency interrelate and even overlap, their conceptual distinctiveness should not be ignored. Independence and accountability form a critical pair, the latter being the natural complement and counterweight of the former. As to accountability and transparency, they are often seen as interchangeable, disregarding that they originate from rather different requirements. Transparency will be discussed in chapter 4, devoted to monetary policy. In a society where the polity and the economy are based on the two principles of democracy and the market, the institutional profile of the central bank has to satisfy two different and even partially conflicting requirements: policy effectiveness and democratic control. Between them, the authors of the Treaty, like other legislators before, had to strike an appropriate balance. First and foremost, the Eurosystem had to be put in the position to effectively fulfill its mission to “safeguard the currency.”26 This postulates independence from politics. Independence should not imply the absence of democratic control, but the need to effectively fulfill the assigned policy tasks qualifies, and limits, the way in which democratic control is exercised. It should also be borne in mind that, until the 1990s, central bank independence was, in Europe and elsewhere, the exception, not the rule. In France, Italy, and Spain the central bank became legally independent only after the stipulation of the Treaty of Maastricht. The Bank of England was granted operational independence only in 1998, the Bank of Japan in 1997. The Treaty states that “neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a member state or from any other body.”27 In recognition of the specific requirements of policy effectiveness the Treaty thus removed monetary management from the realm of actions directly conducted by governments, and hence from the pressures of the day-to-day political process. Moreover, through its inscription in the Treaty, central bank independence was given the most solid constitutional basis. Its repeal not only would go

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beyond the power of individual member states, it would also have to pass the hurdles of the procedure designed for amending the Treaty.28 Independence is a means to a circumscribed end, explicitly assigned to the institution. Just as the military may be assigned a strategic objective and given discretion in the conduct of operations, so the specific decisions pertaining to the actual management of the currency can be considered as instrumental to the effective attainment of the assigned objective. The objective has been previously agreed upon in a constitutional process, when stipulating and ratifying the Treaty. The intellectual and political consensus on the primacy of price stability thus underpins the consensus on the independence of the central bank. It is not accidental that the two have emerged in parallel in the same historical phase. Independence would indeed be harder to justify if monetary policy, instead of being entrusted with the task of pursuing one primary objective, were given the power to balance two objectives, say price stability and full employment. In this case the decisions of the central bank would cease to be predominantly technical and would become eminently political. It would then be natural, and perhaps justified, for elected politicians to reserve those decisions to themselves. The above suggests that there is a nexus between the institutional arrangement and the economic paradigm underlying the action of the central bank. The era when central banks were not independent was indeed an era when it was deemed possible for monetary policy to promote effectively, and lastingly, growth and employment in ways other than by ensuring price stability. The current nexus could change again if the present consensus on the primacy of price stability were to vanish, and the old paradigm to come back. If this should happen, the ECB Council could be seen as a genuinely political body and the claim that monetary policy should be taken away from independent nonelected officials to be given back to the politics could regain ground. Independence has, as stated above, a counterweight in accountability. As a precondition for the successful pursuit of the given mission independence shields the Eurosystem from short-term political considerations, but it is by no means the same as the absence of democratic control. In a democratic system independence and accountability are two sides of the same coin. Accountability means that institutions with the power to affect the lives of the people are subject to the scrutiny by the elected representatives of the people. As such it is an essential and constituent element of our

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political order, and indeed this scrutiny is necessary also in those fields— such as central banking—where policy decisions are consciously removed from the day-to-day influence of the political arena. The entrustment of such momentous decision-making power to independent, nonelected central bankers could be considered legitimate only on the condition that a form of democratic control also be put in place. Thus accountability pertains to a civic and moral obligation inherent in the political order and is not exclusively related to the economic order. It is because it has been given a precise statutory mission and granted independence to pursue it effectively, that the Eurosystem has to be held accountable for the fulfillment of its mandate, and is obliged to explain and justify its decisions. Ultimately the Eurosystem is accountable to the European people at large. They are the ultimate addressee of accountability because they are the true interested party in the Eurosystem’s ability to “safeguard the currency” and to “defend their savings.”29 In practice, the provisions of the Treaty make the Eurosystem accountable to the European Parliament, because this is, in the EU political order, the only body that derives its role and legitimacy directly from the people. It is elected by a popular vote, and its deliberations are public. Unlike national governments or parliaments, it is mandated to pursue the interests of the people of Europe. Although the dialogue with the European Parliament represents the principal means to fulfill the duty to be accountable, the ECB is also engaged in a dialogue with other European institutions. Comparing the ECB with the Fed, one should note that the similarity of the two formal procedures for relating to an elected Chamber conceals a difference in substance. Compared to the US Congress, the EU Parliament lacks the power to change the charter and mandate of the central bank, a difference that makes the ECB more independent than the Fed (and, in the view of some, even too independent). Such difference depends on the nature of the political construct of the European Union, not on a deliberate choice concerning the status of the central bank. Accountability is thus limited today by the incompleteness of political union in Europe. Independence sets a limit to the role that can be played by the political bodies to which the central bank is accountable. If, say, the European Parliament could exercise a direct influence on specific monetary policy decisions, this would lead to a shared responsibility for the actual conduct of policy. Consequently the Eurosystem’s obligation to explain and justify its action would lose meaning, as the Parliament itself would have determined the actions for which the central bank is accountable to it.

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35

A Polity in the Making

From an economic and monetary point of view, the Eurosystem is the central bank of the euro and its “country” is the euro area. However, while the Eurosystem can be described and assessed entirely on the basis of the model of a modern central bank, the model of a sovereign state cannot be regarded as an accurate description of the European Union. The European Union is definitely not a state in the same way in which the United States are the “state of the dollar.” The expression “a currency without a state” indicates the special position of the euro with respect to the political and institutional entity to which it belongs.30 The European Union can be defined as a polity in the making; it is much more than a conventional international organization but clearly less than a full-fledged federal state. It is so much a sui generis political system that an entire branch of political science has developed, in the last decades, to deepen its understanding.31 To come to grips with it, it is necessary to look at what the European Union actually does, which powers it disposes of, how powers are distributed among its institutions, and how this compares to conventional political systems in federal states. While a brief description of the institutions of the “country of the euro” and of their tasks is given in the appendix to this chapter, here a few general remarks are made. The European Union’s tasks comprise the creation and management of the economic and monetary union, including its trade and competition policy, the embryo of a common foreign and security policy, a cooperation in justice and home affairs. The two chambers of the Union are the Council of Ministers and the European Parliament. Its main executive branch is the European Commission. Its Supreme Court is the European Court of Justice. The budget to which the ECB staff pays taxes is the EU budget. The “embassies” of the Eurosystem around the world are the representative delegations of the EU Commission. So described, the European Union seems clearly inspired from the classical constitutional order of a state. However, major elements, in both the tasks and the institutions, differentiate it from even the loosest federal state. As far as the tasks are concerned, the Union has no power to decide and act in the fields of internal and external security that are the very essence of any state. Moreover it lacks the power to “tax and spend.” Also it does not hold an autonomous power to allocate policy functions among the various levels of government (European, national, and subnational).

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As far as the constitutional design is concerned, the Union is still far from complying with key principles that form the heritage of western constitutions. First and foremost, the majority rule is not universally applied to decisions and actions required to pursue the objectives set for the Union.32 Second, it is still possible to adopt legislation without a positive vote by the only European body elected by the people (the Parliament). Third, equilibrium of powers is still lacking among the various institutions of the Union, with the Council of Ministers playing a predominant role, so that national interests often prevail over the common interest. The European Union today is a polity in the making and the move toward a single currency, important as it is, is by no means the final step in the process. The same Treaty of Maastricht that completed the economic and monetary union also marked the intended start of a political union, in the fields of foreign and security policy as well as in internal affairs. Further attempts were made with the Treaties of Amsterdam (1997) and Nice (2000). However, neither of these attempts led to meaningful results. In June 2003 the European Convention adopted a draft Constitution for Europe that was submitted for discussion to an EU Intergovernmental Conference.33 As long as further steps toward a genuine political union are not taken, the Eurosystem will be the central bank of a currency without a state, and hence be confronted with a challenge that no other central bank has. Through history the strength and success of a currency have been closely related to the strength and success of the economic, social, and political entity of which it was an expression, and not just to the skills and professionalism of its central bank. The Deutsche mark, for example, owes the international reputation it gained in the second half of the twentieth century to the dynamism of the economy, the stability of the social structure, and the good performance of the political institutions as much as to policies of the Deutsche Bundesbank. Applied to the euro area, this suggests that further progress toward the construction of a political union would, over time, be critical for the potential and ultimate success of the single currency. 2.6

Appendix: Institutions of the European Union

In this appendix we take a brief look at the quasi-state institutions that, mainly from Brussels, rule the European Union. These are the European Commission, the European Parliament, the EU Council of Ministers, and the European Council.

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The European Commission is composed of one commissioner from each member state (until November 2004 the large countries have two commissioners). The president of the Commission is chosen by the EU heads of state or government for a five-year term but can only take office after a vote of confidence of the European Parliament. The same applies to the full college of commissioners, all of whom are committed to act in the general interest of the whole Community and in full independence from outside instructions. The Commission plays the central role in making, maintaining, and developing the economic union. Legislation is entirely based on its initiative, as no European Union law can be passed unless proposed by it (called an “exclusive right of proposal”). Its primary executive functions consist in looking after the proper implementation of the common rules and in acting as the EU administration in such policy fields as the single market, external trade, competition, agriculture, regional policy. The Commission is also responsible for the execution of the EU budget.34 For other crucial noneconomic fields, such as foreign and defense policy or internal security, the Commission has only marginal functions. In the judiciary process, it promotes actions against infringements of Community law. Finally, it plays the key role in shaping EU policy by providing proposals, initiatives, and representation. The Commission is widely perceived as the embryo of the European government and its president as “Mr. Europe.” The European Parliament is an assembly of 732 directly elected representatives of the people. As such it is the depository of the European “popular will” and the basis of the European (as distinguished from national or regional) democratic process. Unlike the House of Representatives in the United States or most national parliaments, representation in the European Parliament strongly favors small states. In Germany it takes 820,000 citizens to elect a member of the European Parliament, while 770,000 are sufficient in France and 65,000 in Luxembourg. With the Council of Ministers, the European Parliament co-decides on a substantial proportion of EU legislation. Furthermore it exercises control over the European Commission and holds accountable other EU institutions, including the ECB. Even though the powers of the European Parliament have grown significantly over the past decades, there are still limitations that do not exist in any normal state. For instance, a large part of the EU budget (i.e., the funds dedicated to agriculture) are outside the scope of its budgetary competence. Only since 1993 has the possibility for the Council of Ministers to overturn a negative European Parliament vote on a legislative measure been abolished.

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The EU Council of Ministers brings together the ministers from all the member states and works under the rotating presidency of a member state. Like the US Senate, it comprises the representatives from the states. However, unlike the US Senate, and more comparable to the upper house of the German parliament (the Bundesrat), it brings together the governments of the member states. Moreover the diverse size of the EU member states is taken into account and embodied in provisions for weighted voting. Thus, unlike the Commission and the Parliament, the Council acts more as a body where national interests are represented and reconciled than as an institution truly entrusted with the “European general interest.” This is due not only to the fact that its members’ quasi-full-time job is to work, at home, on a national agenda but also to the still widespread inclination to base decisions on consensus. The Council has both legislative and executive functions. In operational terms, although it is a single institution, it works in many formations. For different policy areas respective ministers in charge (economic and financial matters, trade, agriculture, telecommunications, environment, etc.) meet, negotiate, and decide as the EU Council of Ministers. It is the upper chamber of a bicameral legislature, with the European Parliament representing the lower house. Beyond its role as legislator, the Council also fulfills substantial executive functions. The national heads of state or government and the president of the Commission form the European Council, which meets on average four times a year and acts as the principal guiding body of the Union. It provides the main strategic orientations for the political development of the European Union and has been, for more than twenty-five years, the principal driving force of European integration. It indeed constitutes the highest level of governance of the European Union. The European Court of Justice is akin to a Supreme Court for Europe. Its twenty-five judges and eight advocates general ensure that the law is observed in the interpretation and applications of the treaties and the provisions adopted by the EU institutions. It adjudicates, upon appeal, whether a European institution has overstepped the limits of its responsibilities or whether the public authorities or private undertakings in the member states fail to obey the EU rules. Its judgments take precedence over those of national courts. It has the power to impose fines and sanctions (e.g., payback of illegal state subsidies). The European Union has a budget of almost €100 billion (2004) to finance its activities. Some 80 percent of funds is spent on the common agricultural policy and aid for regional development, with the rest going

A Profile of the Eurosystem: The Newest Central Bank

39

to external development aid, administration, preparation aid for new member states, and so on. On the revenue side, the European Union disposes of so-called own resources, such as agricultural levies and customs duties collected at the EU external borders. In addition the member states transfer to the Union’s coffers 1 percent of their VAT revenue and a contribution calculated in proportion to each member state’s gross national product. Overall, however, the EU revenue is capped at 1.27 percent of EU GDP. In order to allow for better financial planning, the member states regularly agree—after much haggling—on a set of financial perspectives that map the Union’s revenue and expenditure for the next seven years. This appendix describes the institutional setup as laid down by the Treaty of Nice, which entered into effect on February 1, 2003. At that moment the so-called Convention for the Future of Europe was already preparing a fundamental revision of the legal framework of the European Union relative to the institutional setup. The draft Constitution that the Convention finally presented in June 2003 strengthened the powers of the European Parliament and restructured the European Commission and the Council. Several limitations on the budgetary controls of the European Parliament were removed and European Parliament’s role as co-legislator was reinforced. The Convention also proposed a reduction in the size of the College of Commissioners to fifteen, but allowed for the nomination of additional nonvoting Commissioners for those member states not represented in the College. Moreover, a reform of the current system of half-yearly rotating presidencies, was put forward, whereby the heads of state or government would elect a president of the European Council for a (once renewable) term of two and a half years. Individual member states would chair the different formations of the Council of Ministers of at least one year. Most decisions of the Council of Ministers would be taken by qualified majority defined not any longer on the basis of weighted votes, but as a majority of member states representing 60 percent of the EU population. Finally, the post of an EU foreign minister was introduced. The foreign minister also would be vice president of the Commission, chairperson of the Foreign Affairs Council, and member of the European Council.

3 Economic Policies: A Special Economic Constitution

In the years that preceded the introduction of the euro, the powerful incentive of the Maastricht process helped Europe restore macro stability in all respects but one, indeed a most important one, growth and hence unemployment. This is illustrated in an appendix to this chapter, which compares the European overall economic performance with that of the United States. For the “land of the euro” (often called euroland1, or euro area), the challenge for the years to come is not simply to preserve nominal stability but to couple it with sustained growth and the re-absorption of unemployment. To meet this challenge all the levers of economic policy will be called to action. Although the economic performance of a country or region is due to a wide number of causes, not all susceptible to economic analysis, the crucial importance of economic policy is undeniable. Economic policy, in turn, is crucially dependent on the institutional framework within which it is conducted. This chapter discusses whether the economic policy framework of euroland is a suitable basis to match, in the years to come, the economic dynamism that the American experience of the 1990s has proved to be possible even for a mature economy. The chapter starts with an illustration of the assignment of policy functions to different levels of government: European, national, and regional (section 3.1). Sections 3.2 and 3.3 are devoted to a discussion of the special interplay of policies in the euro area, namely the issue of policy coordination. In the four sections that follow (sections 3.4 to 3.7), I examine policies one by one: market, monetary and exchange rate, fiscal, and employment policies. My overall assessment concludes the chapter (section 3.8).

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3.1

Chapter 3

Policy Assignment

Why use the expression “economic constitution” to define the order created by the Treaty? The reason is that just as the constitution of a state, the Treaty provides the boundaries within which public authorities (central and local) exert their powers.2 The EU economic constitution is not the outcome of a single founding act, like the 1787 Philadelphia Convention, nor is it a complete social contract derived from the first principles of politics. Rather, it is built in the form of an international treaty and has taken shape step by step in a still ongoing process. Also it consists of a bulky text of over 300 articles and almost 30 protocols, going into many matters that normally constitutions ignore: for example, transport safety and vocational training of workers, interoperability of networks, and a campaign against poverty in developing countries. The Treaty stipulates, as is characteristic of any constitution, who does what in the area of economic policy. A matrix (table 3.1) is provided that connects the “what” with the “who” in a simplified manner that disregards the diversity of national constitutional structures. Five policies are identified: market, monetary, exchange rate, fiscal, and employment.3 Market policies—which are the founding element of the EU economic constitution—preside over the production and exchange of goods and services in a decentralized system of free economic decisions. Market policies concern not only the opening of national markets but also Table 3.1 Matrix of policies in the constitution of euroland Levels of government Policies

European

National

Subnational

Market Single market rules Other structural policies

¥¥¥ ¥

¥ ¥¥¥

¥ ¥¥¥

Monetary

¥¥¥

—

—

Exchange rate

¥¥¥

—

—

Fiscal

¥¥

¥¥¥

¥

Employment

¥

¥¥¥

¥

Note: Importance of the role played by various levels of government: — = no role; ¥ = low; ¥¥ = medium; ¥¥¥ = high.

Economic Policies: A Special Economic Constitution

43

the structure, regulation, and formation of the resulting single EU-wide market. The meaning of monetary and exchange rate policies is straightforward and requires no explanation. Fiscal policies embrace both the macroand the microeconomic aspects of taxing and spending activities. Employment policy—the actions (public and private) whereby the cost and the use of labor services are determined—ranges from wage determination, to prescriptions and restrictions on the use of manpower, to unemployment benefits. The five policy areas overlap. The tax system and public expenditures, for example, influence the functioning of markets for products and factors of production. Similarly employment conditions are affected by market policies. Exchange rate and monetary policy cannot be set independently. Employment policy has been singled out because it has in the member states unique social relevance. Instead of being determined by the representative of the people at large (i.e., by the legislative and executive branch of government), it is largely the outcome of agreements between representatives of workers and employers. Turning to the levels of government, the matrix includes European, national, and subnational levels (in the US terminology, federal, state, and local levels). However, no further distinction is shown between regional and municipal governments, because this is not relevant to the present discussion.4 In effect what the table does indicate is that in the European Union, (1) market policy is largely European but leaves room for national policies, (2) monetary and exchange rate policy are entirely European, (3) fiscal policy is national with a European macro constraint, and (4) labor arrangements are national. The EU economic constitution not only states who does what, it also indicates for what purpose. The goals of economic policy are declared by the Treaty to be “a harmonious, balanced and sustainable development of economic activities.” These are to be achieved by a high level of employment, noninflationary growth, a high degree of competitiveness, and convergence of economic performance.5 The economic policy it prescribes is one that operates on the principle of an open market economy with free competition. The guiding principles for the member states and the entire Community are stipulated to be stable prices, sound public finances and monetary conditions, and sustainable balance of payments.6 The economic goals just recalled accord well with the three categories of efficiency, stability, and equity mentioned in chapter 1. Indeed in the European Union, as in any society of interdependent agents, economic

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policy pursues high employment and the preservation of the purchasing power of money (macroeconomic stability), rational allocation of resources (efficiency), and “fair” interpersonal as well as interregional income and wealth distribution (equity, often called social justice). The fact that efficiency, stability, and equity are recognizable goals in the Treaty provisions is a reflection of the fact that they correspond to three human aspirations that modern democratic societies regard as socially valuable.7 A comparison with the economic constitution of an ordinary state shows some analogies mainly in the narrowly defined economic objectives. The differences are primarily of a political rather than economic nature. The similarities are found in the range of policies and assignments of certain functions to the highest level of government. Both EU and state economic constitutions contain a general formulation of objectives that recognize the end points of efficiency, stability, and equity. The differences lie in the EU policy’s peculiarity of a high dispersion and an ample sharing of responsibilities among levels of government. Policy functions are widely scattered across levels of government and the maximum concentration of power is at the national level. In a full-fledged state, on the other hand, policy functions are strongly concentrated at the top of the power structure, as they are predominantly, and often exclusively, performed at the level of the central government. The most important differences, however, are political, not economic. They derive directly from the fact that, first, the EU economic constitution is in the form of an international treaty and, second, the European Union is not a political union. Although the differences are political in nature, they do have major economic consequences. In the EU Treaty the very detailed formulation of objectives combines constitutional provisions with basic legislation and a program for further action. This approach, which is due to the desire to precisely define the limits of the transfer of power to the Union, has the important, albeit unintended consequence, of elevating to constitutional status policy actions and objectives that in most countries belong to the legislative and executive fields. For the countries adopting the euro, for example, it is a true novelty that the primacy of price stability and the independence of the central bank are given constitutional status. It is also a novelty that fiscal discipline is no longer one among many political options but a legal duty set above politics. As the European Union is not political, the responsibility for the main public goods, whose provision constitutes the very essence of a state, is the domain of the member states.8 The provision of goods like defense,

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45

security, stability, justice, and environmental conservation, for example, requires a sizable amount of resources. The member states, and not the Union, have therefore the budgets and the tax-raising powers to generate a macroeconomically relevant fiscal policy. This is the reason why fiscal policy and monetary policy are not at the same level of government. On purely economic grounds, this arrangement contradicts both the principle of subsidiarity and the very wording of the Treaty. If, following subsidiarity, each public good were assigned to the government level, which is competent for the domain where the good is “public,”9 there can be little doubt that, today, defense, security, environmental protection would be EU competences. Indeed, they are goods for which the jurisdiction of individual European states has become insufficient. The Treaty lists among the objectives of the European Union “to assert its identity on the international scene, in particular, through the implementation of a common foreign and security policy including the progressive framing of a common defence policy” (Article 2). The same Treaty, however, fails to endow the Union with the decision-making capacity and with the resources that would be necessary to pursue such stated objectives. Another major consequence of the European Union not being a political union is the fact that its procedures retain many of the characteristics and limits of the model of international organizations. The example that stands out is the unanimity requirement for taking decisions in many areas, which hampers the emergence of political union and also undermines the functioning of the economic constitution. Thus, although the EU economic constitution presents all the ingredients, and complies with the logic, of the model of an ordinary federal constitution, it falls quite short of the model. Only if what is still a polity-in-the-making moved to a full-fledged political union would the EU economic constitution become perfect. 3.2

Interplay

The overall performance of an economy depends not only on the assignment of policies to different levels of government, but also on their interplay and actual conduct. The interplay is the theme of this and the next section of this chapter. Generally, in the highly interdependent system of an advanced industrialized economy, where many public actors and many levels of government are involved, the overall economic performance is the outcome of countless decisions taken by different and often independent bodies

46

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with differing jurisdictions. Successful economic performance can only be obtained by virtue of an interplay—“coordination” is the word used—of such decisions. The constitutional question is how to shape the interplay in such a way as to have the best chance to produce a good overall economic performance. Euroland’s peculiarity, in comparison with ordinary states, is the widely dispersed shape of its policy matrix. Consequently the coordination problem is particularly complex. The entire matter of the EU economic constitution’s effectiveness hinges on the effectiveness of its policy coordination. Before presenting and discussing the specific features of policy coordination in euroland, a conceptual clarification is given of the meaning, rationale, and modalities of policy coordination. Two different meanings of the word “coordination” are often implied in different contexts. In a macroeconomic context, coordination is usually referred to the interplay between policy makers in charge of different policies (fiscal, monetary, etc.) or of the same policy for different countries. In a microeconomic context, coordination refers to the interplay between all sorts of private agents, be they individuals, firms, or households. In this context the market is the prime and most efficient coordinative mechanism. In euroland an adequate analysis of policy coordination has to involve both meanings because of the host of national or even subnational public economic agents that interact within a common institutional framework. As to the rationale, coordination is required whenever, due to interdependence, the actions of an economic entity (private or public) can be made more effective by cooperating with other entities. In the private, profit-driven production and exchange activities of a market economy the benefits of coordination are epitomized in the form of a contract, namely by the mutual advantage that a freely stipulated contract procures to each party. In public, policy-driven activities the rationale for coordination lies in spillover effects. By this we mean that each policy-maker tries to affect an economic system that is also affected by the behavior of other policymakers. In the case of euroland the scope for policy coordination is particularly large because the number of levels of governments is specially high and the concentration of power at the top specially low. Finally, turning to the modalities, the comprehensive notion of coordination suggested above leads to identifying the following four: Single institution Many decision-makers are replaced by a single one, which amounts to a full internalization of externalities and spillover effects.

䊏

Economic Policies: A Special Economic Constitution

47

Common rule The rule acts as a permanent constraint on independent decision-makers. This is sometime referred to as “hard coordination” as it effectively limits potential negative externalities. Consultative forum Independent actors meet in a forum where joint decisions are possible but not obligatory. This is often referred to as “cooperation” or “soft coordination.” Policy competition Policy-makers pursue the interests of their local constituencies and do not consider the wider interests of the entities of which they are a part. 䊏

䊏

䊏

From the point of view of the extent of coercion they entail for a dissenting party, the first two modalities are hard and the second two soft. In the European context there are often heard calls for separate actors to comply with joint decisions. This so-called “ex ante coordination” among separate policy actors may be identified, depending on the circumstances and the precise procedural arrangements, with either the single institution or the consultative forum. If rigorously interpreted, it ends up in the “single institution.” If loosely interpreted, it is a “consultative forum.” Either the coordinative procedure is so strong that the joint decision is always taken and implemented, in which case the many actors have effectively been replaced by a new, single, albeit collegial, one; or joint decisions are only taken occasionally, if and when consensus is reached. Because of its ambiguity and even contradictory character, ex ante coordination does not explicitly appear in the taxonomy. The proposed taxonomy does not suggest that the joint institution mode is always the optimal solution for the problem of interdependence. The reason is that there is no guarantee that the outcome of a joint decision will be superior to that resulting from separate and even competing decisions. 3.3

Coordination

In euroland, the need for coordination exists across countries, and across policies, because spillover effects may result within a given area (e.g., between fiscal and monetary policy) or between countries (e.g., between different employment policies in different countries).10 Table 3.2 shows the ways policy is being coordinated in euroland. As the table shows, the single institution mode applies first and foremost to market policy, where the European Union has the power to legislate the four freedoms, to enforce compliance, and to repress anticompetitive

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Table 3.2 Modes of policy coordination in euroland Modes of coordination Policies

Across countries

Market Single market rules Other structural policies

Single institution Policy competition

Monetary

Single institution

Exchange rate

Single institution

Fiscal

Common rule

Employment

Consultation

Across policies

}

Consultation

practices. It now also applies to monetary policy. The common rule mode is exemplified by the fiscal rules introduced in the Treaty of Maastricht and further specified through the so-called Stability and Growth Pact (SGP). The consultative forum mode is adopted for a number of structural policies, such as reforms of tax and benefit systems, and research and development, where nonbinding common positions are being taken.11 Last, policy competition plays a large role because of the many functions left to the national level. The four modes are not mutually exclusive. In market policies, for example, the common rules (called Directives) adopted through the single institution mode (the EU legislative process) leave wide room for competition among policies. A distinctive feature of the EU policy coordination scheme is that it is internally consistent. For many years the inconsistencies in free trade, capital mobility, stable exchange rates, and the autonomy of national monetary policies had hindered the full establishment of the four freedoms and relapse was an eminent threat to the integration already achieved. By explicitly recognizing that a single market could only be sustained by a single currency, a single monetary policy, and a single central bank, the Treaty of Maastricht corrected the lame constitution founded in Rome. This has put the edifice of European economic integration on two solid legs, “one market” and “one money.”12 The four modes outlined above represent the full set of possible approaches to policy coordination both within most countries and in their relationships with other countries. Within a country policy arrangements indeed combine a full set of these approaches to varying degrees: (1) central

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49

institutions are endowed with the power of command, such as a central bank or a central government, (2) rules exist to set limits on public spending, (3) nonbinding consultations exist between the government and the labor organizations, and even (4) policy competition is at work, for instance between regional or municipal governments. In the international sphere, the IMF Articles of Agreement lay down common rules governing international monetary and financial relationships while, at the same time, looser coordination operates, in the form of consultations among policy makers (in the IMF itself or in forums such as the G7). That said, the European Union has special features that place it in between a national and an international model. In general, the soft modes (consultative forum and policy competition) have a much wider application than in a domestic system. In particular, the scope of its policy competition is much wider than that of any single state. This feature requires some further explanation. In a typical domestic setting, competition is recognized as an efficient form of coordination for private, profit-driven, economic agents, whereas the field of policy is seen as the domain of monopoly, coercion, and concentration of power. In the field of international economic relations, where governments are driven by strategic motivations that resemble those of a large corporation, policy and competition are interlinked. Nevertheless, policy competition does exist in domestic spheres. The governments of California and Massachusetts were behind the development of high-tech centers in Silicon Valley and on Route 128, just as Bavaria and Hesse were behind the competing international airports of Munich and Frankfurt. In many countries local governments use economic incentives to attract businesses, good university teachers, tourists, and public works that are paid out of the national budget. Policy competition takes many forms, ranging from fair contest (cooperation) to unrestricted conflict (warfare). While the former produces economic benefits, the latter generates inefficiency and waste. In a consolidated domestic setting, where the singleness of the market is undisputed and the legal framework strong, policy competition is constructive and easily accepted. In an international setting, constructiveness is less straightforward and needs to be assessed case by case. Exporting copied products without recognizing the rights of intellectual property is undoubtedly economic warfare, but it would also be economic warfare for an advanced economy to bar access to its market to products of an emerging economy that are cheap because worker protection is low. Policy competition in the European Union today corresponds to the domestic model to

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a large extent, but not entirely. Member countries still pursue the strategic objective of self-sufficiency and hence protect national champions in many sectors, ranging from energy, to finance, to key industries. Often they use meetings in Brussels to implicitly or explicitly agree on delaying the full opening of their respective markets. The high degree of policy competition in the European Union is regarded by some as a fundamental weakness, the sign that the EU construct still falls short of the requirements of a typical “domestic economy.” There is ground, however, for a more balanced view. In general, competition provides a stronger incentive to optimization than monopoly, not only in the field of business but in that of policies as well. In society and communities, collective ambitions and community bonds are stronger on a local than on a continental scale. If this is the case in the United States, as one rises from county, to state, to national level, even more it is the case in Europe, where regional (or even town) loyalties have long roots and the nation-state a strong historical tradition. The overall quality of policies may thus benefit from an environment in which policies are set to compete and national ambition acts as an incentive. Policy competition also permits useful experimentation and corrections. As it is often difficult to design the “right” policy from the outset, and to avoid introducing perverse incentives, the simultaneous implementation of alternative approaches may trigger feedback from the market and thus help policy-makers. This applies to areas like regulation, taxation, incentives to business investments, and research. Policy competition is, on the whole, closer to the domestic cooperative model than to the international conflictual one. That said, the European Union is not immune from the inefficiencies and drawbacks of conflictual rather than competitive relationships. For example, the nurturing of national champions in public utilities, energy, public procurements, and financial markets is undoubtedly harmful to the consumer. It is still widespread and insufficiently discouraged by the European Union, which has only limited rule making and enforcement powers. In sum, the modalities of policy coordination in euroland exhibit, just as the assignment of policy functions discussed in section 3.1, a twofold characteristic. For one thing they are a blend of the same archetypes that can be found within an ordinary federal system. For another they reflect the fact that the European Union is only a polity in the making, lacking important functions and constitutional characteristics of a political union and retaining some features of an old model of strategic contest between independent states. Despite its limits and incompleteness, this framework

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does not suffer from fundamental inconsistencies; it provides a solid basis for the development of a unified market and for monetary and fiscal discipline. 3.4

Market Policy

This and the next three sections examine the policies one by one, focusing on their missions and on the interplay between different actors. We will see how, under their current design, these coordination mechanisms can contribute to the pursuit of the three goals of efficiency, stability, and equity. As we saw before, the responsibility for market policy is predominantly entrusted to the European Union, although national (and even subnational) governments also play a critical role. The European Union has the task of ensuring the singleness of the market, and the other levels of government are free to act within that constraint. In practice, the EU task has been defined and interpreted as requiring very detailed uniform EU legislation to avoid distortions in trade and the maintenance of nontariff barriers. Rules are enforceable by national courts. Since the market is one, the competition policy is a responsibility of the Union. For this reason the vast body of legislative and regulatory provisions concerning the production and exchange of goods and services now mainly originates from Brussels. Such provisions range from safety standards of electric appliances to brandname labels on wines and cheeses, to minimum periods of maternity leave. Despite the vast spread of EU legislation, the economic conditions of countries and regions in euroland continue to be largely influenced by national and local governments. In the first place national governments, in implementing EU rules can, by variously combining efficiency with equity considerations, enhance or undermine the competitive position of their economy.13 They have ample residual regulatory powers rooted in the principle of mutual recognition of national regulations, whereby any authorization or license issued by one country to a local producer grants access to the entire EU market.14 Mutual recognition of national regulations thus generates competition among rules, and rewards the countries and producers with the “best rules.” Over time this process raises the standards of all countries and producers, and gradually levels the playing field. Finally, and more generally, all national authorities—be they central, regional, or municipal—are free to “do what they want” provided that

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what they do is compatible with the EU framework. The levers thus left to them are sufficient to attract or, on the contrary, discourage new investment, businesses, workers, tourists, and students. Examples of such levers are the tax structure and the practices of national administrations or supervisory authorities, the planning of the territory and the efficiency of the judiciary in settling litigation, the preservation of law and order and the climate of industrial relations. In sum, EU market policy is firmly committed to the allocation efficiency in the Europe-wide single market. To achieve this goal, the EU economic constitution assigns the primary policy role to itself. National and local governments, however, retain significant discretionary power to shape business conditions within this policy and are free to pursue other objectives than pure allocation efficiency. Competition is the coordination mode that applies to the market policies of national and local authorities. The purpose of the Treaty and the single market is not to eradicate national ambitions but rather to channel them in a system of agreed rules, where competition replaces conflict and the animal spirits of private and public ambitions service wealth and prosperity. 3.5

Money and Exchange Rate

Monetary policy is an exclusive responsibility of the European level. While fiscal federalism is a possible, and indeed a recurrent, feature of most economic systems, the singleness of the currency leaves no room for monetary federalism. Monetary policy is indivisible and, by implication, exchange rate policy is also an exclusive responsibility of euroland. For monetary policy (which will be fully examined in the next chapter) the responsibility is entirely entrusted to the ECB. For exchange rate policy, both the central bank and the Treasury or the Ministry of Finance are involved, in euroland just as in all countries. There are two reasons for this shared responsibility. The central bank is the necessary operational arm of any direct or indirect action on the exchange rate, such as the buying and selling of foreign currency in the market or moving interest rates. The Treasury also traditionally has a say (and often the decisive say) on the exchange rate, both because the exchange rate has a strong influence on the external competitiveness of the economy and because the Treasury is often the owner of the reserves of the country. In euroland, the shared responsibility takes the form of a relationship between the ECB and the college of Ministers of Finance of the participating countries, which meets regularly in the so-called Eurogroup.15 The ECB

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has the exclusive responsibility for the operational side, namely for the buying and selling of foreign exchange, and cannot be obliged by the Ministers to intervene in the market even less to put exchange rate considerations above monetary policy considerations. The central bank thus plays a greater role in the European Union than in the United States and Japan, where the Treasury decides and the central bank only advises and executes. Concerning the policy objectives, the Treaty explicitly prescribes price stability as the priority, not only for monetary policy but also for exchange rate policy. It indeed stipulates that in all circumstances the Community will conduct an “exchange rate policy the primary objective . . . of which shall be to maintain price stability.”16 The Treaty also implicitly recognizes that in a large, relatively closed economy there is virtually no room for an independent exchange rate policy. It thus leaves to the ECB the task of integrating exchange rate considerations in the conduct of monetary policy, as well as the decision on whether and how to operate in the foreign exchange market. The Treaty, however, also envisages the possibility of more activist approaches to the exchange rate.17 In particular, it does not exclude such arrangements as a system of target zones, or the periodical formulation of coordinated exchange rate objectives by the authorities of the major currencies of the world. The European Council, however, after discussing these Treaty provisions, decided in 1997 and 1998 to leave the external value of the euro to be determined by the market. It declared the exchange rate of the euro to be “the outcome” of all relevant economic policies, rather than an independently set objective. It also decided that “general orientations” for the exchange rate policy of the euro area would only be formulated in “exceptional” circumstances, for example, in the case of clear misalignment.18 In sum, and again in terms of the objectives of efficiency, stability, and equity—monetary and exchange rate policies, which are an exclusive euro area responsibility, are both geared to macroeconomic stability. The EU economic constitution leaves no room for stimulating growth and employment through monetary expansion or currency devaluation. Moreover it recognizes that exchange rate policy cannot be set independently of, or in contradiction with, monetary policy. 3.6

Fiscal

In the fiscal field, the European Union sets a rule that limits the magnitude of public deficits and public debts, while national authorities decide

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about the size and composition of public budgets. This section will first describe such two-tier responsibility, then discuss its aptness to pursue the policy objectives set for the Union. The European budgetary rule results from the combined provisions of the Treaty of Maastricht19 and the Stability and Growth Pact of 1997.20 The rule orders that national budgets, which are the major component of the EU fiscal framework,21 to be “close to balance or in surplus” over the medium term, a period interpreted as the length of a business cycle. In the event of a recession, the deficit is allowed to grow to 3 percent of GDP.22 The ratio of public debts to GDP must be kept below 60 percent and, when in excess, reduced. To ensure that the rule is enforced, national fiscal policies are subject to a detailed procedure of multilateral surveillance, and specific sanctions apply in case of noncompliance.23 The political procedure is complemented by the disciplinary effect of the financial market, which differentiates, albeit in a muted manner, among sovereign borrowers.24 While subject to European rules, budgetary policy remains predominantly national. Because of their large size relative to other public budgets, national budgets provide for almost the totality of fiscal impulses. National authorities are also free to choose the overall dimension of their budgets and the structure of their expenditure and taxation.25 The Treaty emphasizes national responsibility for fiscal policy in various ways. There is a “no-bail-out-clause” that states that under no circumstances will the Union intervene in support of a country or other public body that fails to meet its financial obligations. It prohibits credit institutions from granting public authorities privileged access to credit, and it forbids any form of monetary financing of fiscal deficits by the Eurosystem.26 Will this fiscal structure meet the challenges facing the European economy? At this early stage of EMU, only a very preliminary assessment is possible, and only in terms of the three policy objectives of stability, efficiency, and equity. As for stability, the fiscal framework of the Stability and Growth Pact seems to be searching, in these early years of the euro, for an adequate combination of discipline and flexibility in the conduct of effective fiscal policies. In many countries fiscal discipline has worked in a fairly satisfactory way so far. At the end of 2001 seven of the twelve euro area members had reached the “close to balance or in surplus” condition prescribed by the Pact. In 2002 most countries remained below the 3 percent limit despite significantly lower growth. However, Portugal exceeded the limit

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in 2001, and so did Germany and France in 2002. The budgetary positions of Germany and France deteriorated further in 2003, leaving little prospects for a significant improvement before 2005. The disciplinary effect of the Pact is thus still uncertain. With regard to flexibility, the question is whether the EU rule grants sufficient compensation for the loss of national levers in the monetary and exchange rate fields. Additional fiscal flexibility is needed, for example, to stem inflationary pressures while the rest of euroland is faring below capacity. Such a shift from monetary to fiscal stabilization is undoubtedly permitted by the rules of the Pact. Indeed, once the transition is completed, the Pact allows a country to counter—within the 3 percent limit—cyclical fluctuations with automatic stabilizers as well as with discretionary measures.27 The Stability and Growth Pact has been intensely discussed by policymakers and within academic circles since it was proposed and negotiated in 1995 to 1997. In 2002, the slowdown in the EU economy and the consequent difficulty encountered by France and Germany in complying with the Pact opened a new round of discussion. Radical critics of the Pact, such as Wyplosz (2002), advocated a complete overhaul of the EU fiscal framework. Others, including Fitoussi (2002), de la Dehesa (2002), and Horn (2002) suggested replacing the existing rule—which targets the nominal overall budget balance—with one focusing on a cyclically adjusted balance or some form of a golden rule that computes the balance net of investment expenditures. After discussing these issues in some detail, the policymakers concluded that the rules of the Pact should remain unchanged. They also determined that the Pact should be implemented in a way that takes account of the effects of the cycle, the need for appropriate structural budget adjustment, and contingencies.28 The discussion was re-opened when, in November 2003, the ECOFIN Council decided not to follow the procedures foreseen in the Treaty and the Pact for bringing the deficits of Germany and France back below the 3 percent limit. Earlier that year the ECOFIN Council had issued recommendations to the two countries requiring them to correct their excessive deficits in 2004. When it became clear that these recommendations had not been fully complied with, the ECOFIN Council should have proceeded to the next step of the procedure. As this would have brought France and Germany only one step away from sanctions, the Council instead opted for the much softer approach. The Council “conclusions” adopted new recommendations giving France and Germany until 2005 to bring their deficits back below the 3 percent limit.

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The action taken by the ECOFIN Council led to immediate reactions of concern on the part of many countries, the Commission, and the ECB. The Commission even took the step of legally challenging the ECOFIN Council’s action before the European Court of Justice with the aim of establishing legal clarity. It also announced its intention to formulate new proposals to improve the Pact and its implementation, indicating that it was even considering a revision of the Pact itself. It is too early to tell whether the setback of November 2003 will mean a lasting weakening of the EU fiscal framework, or be just one episode in the life of an ambitious and difficult policy instrument. Turning from the country level to the euro area, it may be asked whether the Stability and Growth Pact should be complemented with a capacity to decide a concerted fiscal expansion if needed. This would correct an asymmetry that now exists between the hard-line disciplinary and the soft-line discretionary measures. There is, however, reason to believe that any attempt at proposing a binding procedure for areawide discretionary fiscal policies would meet serious constitutional and political difficulties. Any binding fiscal orientations that go beyond the Pact may raise questions of legitimacy. Whereas the policy requirements of the “sound money–sound finances” principle embodied in the Pact have a firm foundation in the Treaty, the foundation to sustain discretionary and binding EU-level fiscal decisions seems too generic.29 Moreover such new procedure would touch what in all countries is a high moment of the national political process. Any budgetary commitments made by the finance ministers in Brussels would be seen as an undue limitation of national prerogatives. Budgetary procedures are in fact so complex, lengthy, and fraught with uncertainty that no final decision can be fully controlled by all of the many parties involved. While the institutionalization of common fiscal decisions binding national policies may not be feasible, occasional coordinated responses to shocks symmetrically affecting the area may be possible and even desirable. Already the practice of frequent meetings and informal discussion among finance ministers has led to a progressive “internalization” of euro areawide concerns, and allowed the European perspective to be strengthened in national political discourse. Another crucial issue concerns the interaction between fiscal and monetary policy. Critics of the EU policy framework see the lack of coordinative procedures as an impediment to the achievement of an appropriate so-called policy mix. Along the same lines, the Commission and the European Parliament have from time to time advocated a “right policy mix” between monetary and fiscal policies.30

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Joint decisions on fiscal and monetary policy used to be taken in countries such as the United Kingdom or France, when both policies were in the hands of their Treasuries. This is not the case wherever central bank independence is in place. The division of responsibilities in euroland does not differ from what we find in pre-euro Germany, the United Kingdom, the United States, or Canada. In these countries, just as in the European Union, neither mutual public commitments on either side, nor bargaining processes, nor joint decisions are part of policy-making. Although the lack of hard coordination between fiscal and monetary policy is not specific to euroland, there are aspects that are unique. First, the singleness of monetary policy is not matched by anything like the budgetary procedure of a country.31 Moreover the ECOFIN Council or the Economic and Financial Committee are not really suitable bodies for the confidential, but often effective, consultation between monetary and fiscal authorities that normally exists at the national level. Compared to the quiet weekly breakfast of the Chairman of the Fed with the Secretary of the Treasury, euro area meetings can be quite chaotic. There are a great many people in the meeting room, the machinery for preparing the meetings is too heavy and too formal, and there is too much media exposure. Thus, even if there were to be a more structured euro area fiscal policy, an appropriate “consultative forum” procedure to facilitate the discussion of monetary and fiscal policy in an effective, nonbinding manner would still have to be developed. All in all, the Eurosystem is missing the fiscal and political counterpart that usually mediates for a central bank. This harbors the risk of the Eurosystem being seen as the only macroeconomic policymaker in euroland, and hence to be held responsible for any adverse development in the European economy, not only inflation but also unemployment and slow growth. So far we have dealt with fiscal policy from the point of view of the pursuit of macroeconomic stability. Historically, however, public budgets were created, and grew in size, to produce public goods and to help the needy with resources of the wealthy. These are the allocation and redistribution functions of fiscal policy, respectively, related to efficiency and equity. The two functions are—like stabilization—mostly left to the jurisdictions of the member states and thus subject to their national political processes. This, in turn, has implications for the overall policies and economic performance of euroland. As for allocation, a rational approach to policy-making should distinguish among European, national, and local public goods, following the principle of subsidiarity, and assign each to the respective level of government

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and budget. Correspondingly, there should be local, national, and European taxes. Deviations from the assignment guided by subsidiarity would entail losses in terms of both effectiveness and efficiency. The strong concentration of budgetary functions at the level of member state is the legacy of the political and military history of Europe, where power was concentrated in the hands of national governments and military strength was a major objective. Most, if not all, public goods were “public” for the jurisdiction of the state, not for the various regions or for the continent. In a constitution based on the principle of subsidiarity, a number of functions would be shifted up to the EU budget and down to regional and municipal budgets. A more rational allocation of resources would allow for a more satisfactory overall economic performance throughout euroland. In Europe the redistribution, or equity-oriented, function, represents a sizable portion of the public budget, much larger than that in the United States or other parts of the world. These redistribution functions— pensions, health care, unemployment benefits, and so on—are largely concentrated in national budgets. There are reasons for the budgetary functions aimed at equity—unlike those aimed at the production of public goods—to remain largely entrusted to national or regional levels of government. Social solidarity develops within communities. The smaller the community, the tighter are the bonds of compassion and the disposition to accept giving part of one’s income in order to help the needy: indeed, charity begins at home. The higher and more distant levels of government, up to the whole European Union should only be in charge of redistribution from wealthier communities (rather than persons) to more indigent ones. This is in effect the purpose of the structural funds and the Cohesion Fund mentioned in chapter 1. Although these funds are small in size (only 0.3 percent of GDP), their importance is significant for the receiving countries and regions. Should the overall configuration of fiscal policy in the European Union be held responsible for the disappointing economic performance of Europe in the last decade? The answer can hardly be encapsulated in a single sentence. First, if EU-driven fiscal consolidation has temporarily dampened growth in Europe, this is to be regarded as a fair price for a highly desired objective. As the fiscal rule embodied in the Treaty and the Stability and Growth Pact was introduced only in the 1990s, it is too early to gauge how it will be interpreted and managed in a steady state that has not yet been reached.

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Only time will tell if policy-makers will be able to avoid both excessive laxity and excessive rigidity. Second, so far the allocation and redistribution of resources have remained predominantly national functions that are being performed in ways that do not foster economic efficiency and growth. For one thing, certain classic public goods, such as security or protection of the environment, have not been moved from the national to the European domain, entailing a duplication of resources. For another, the traditional continental European strata of politically active society, with only minor variations, deliberately forgoes even a quantum of efficiency and growth in favor of greater equality and social protection. EU economic and monetary integration has extended the scope of competition from private to public agents, from products, services, and factors of production to policies and, more generally, administrative, political, and legal systems.32 To the extent that slow growth depends on structural rigidities rooted in the social, political, and cultural tradition of Western European nation-states, it can be said that European integration has been a corrective factor. With more determined implementation of both subsidiarity and policy competition, some dynamism might be imparted to the European economy. As for the EU budget, only a new transfer of policy tasks from the member states may in time increase the size and make it a suitable instrument for macroeconomic policy. For example, in time internal security and defense may become EU responsibilities, requiring common budgetary resources. In the case of equity and solidarity, the existing EU regional and structural funds may be increased or a system of intercountry fiscal transfers, comparable to the German Länderfinanzausgleich, may be created.33 Historically public budgets were not created to make macro fiscal policy possible but to provide goods and services recognized as “public” by a given political community. Their usability as macroeconomic policy instruments came as a by-product. There is no reason to think that the European Union will follow a different path. 3.7

Employment

The fourth and final policy area is employment policy, namely the actions (public and private) whereby the remuneration and the use of labor services are determined. In the European Union this policy is overwhelmingly national, largely entrusted to the social partners (employers and labor unions) and subject only to a consultative European framework.

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In most European countries negotiations between employers and labor unions determine wages and salaries, as well as the main nonpecuniary aspects of labor contracts. Negotiations can occur at various levels, from government to firm or factory, with the former still retaining a strong role. The agreements stipulated between workers and employer organizations are generally maintained by force of law. Parliaments and governments intervene through social legislation and regulation, as well as by taxes and spending. Normally, however, they use their powers only after extensive consultations with social partners and refrain from open confrontations with them, a practice that further extends the influence of social partners on employment policy. This largely consensual model, often termed corporatist,34 significantly distinguishes Europe from the United States. The corporatist model also applies at the EU level. Labor unions, employers, and trade associations, for example, are represented in the EU Economic and Social Committee,35 which is consulted on many aspects of European legislation. The Treaty itself contains a social policy chapter that allows the Community to undertake “complementary actions” in fields such as social protection of workers, representation and collective defense of both sides of industry, as well as vocational training. The Treaty also provides for a social dialogue between labor and management at the EU level, including the possibility to accord the status of European law to the contractual agreement reached. In reality this EU framework is much weaker than it looks, and almost nothing is determined at the European level in a binding way. In employment policy, EU procedures are of the soft “consultative forum” type described in section 3.2. Despite the stated common objective of a high level of employment, the EU economic constitution leaves employment policies almost entirely to the discretion of national and subnational entities. The fact that monetary policy is European and employment policy national has been criticized as an potential impediment to the smooth functioning of EMU.36 Wage settlements and other arrangements affecting labor costs (whether detailed in labor contracts, in regulations, or in ordinary legislation) are indeed likely to be the principal remaining source of country-specific inflationary shocks. In a monetary union such shocks, which were previously corrected by devaluation, can prolong unemployment and lead to economic decline. The antidote is, and can only be, an alignment between the dynamics of labor cost and that of productivity. This requires agreements that keep

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the cost of labor close to the production unit. By contrast, industrywide and countrywide stipulations when uniformly applied to diverse production units inevitably generate an excess supply of, or an excess demand for, labor; the result is unemployment or price increases. Only with a very flexible labor market can employment policies avoid generating asymmetric shocks that monetary policy cannot cure. The need for labor market flexibility is all the more strong in the European Union, where significant cultural and social barriers limit geographical mobility of workers. If wage bargaining processes in the various countries, regions, sectors, and firms closely reflected disparities in productivity among workers, regions, and sectors, then geographical mobility would be less needed for the proper functioning of monetary union. Euroland wage bargaining for a single wage rate is being sometimes advocated. This, however, would aggravate, not alleviate, the unemployment problem. The high unemployment in southern Italy, the Mezzogiorno, and in eastern Germany is largely due to such premature wage equalization.37 The allocation of employment policy to sub-federal levels means that, in this field, policy competition is the predominant coordination mode. This does not preclude, however, useful cooperation among EU policymakers in the present soft mode, combining the benefits of discretion and flexibility with those of peer review and emulation of best practice. Common policy objectives may be set, time tables given, and progress jointly monitored also to push through unpopular reforms.38 As part of this cooperation, the European Council, meeting in Lisbon in March 2000, has set the objective to raise the labor force participation rate in the European Union from 63 percent in 2000 to 70 percent by 2010.39 3.8

While the Jury Is Out

In sum, the special features of the EU policy constitution are the strong emphasis on macroeconomic stability, the ample role left to subfederal levels of government, a practice of guidance through consultation forums, and an unusually large scope for policy competition. Euroland has emerged from a decade of mixed results. Success in reducing inflation and fiscal deficits has been countered by defeat in fostering growth and employment. The question is whether the EU economic constitution embodied in the Rome–Maastricht Treaty is conducive to the policies needed to combine price stability with growth. The jury is still out. The EU constitution is too recent for a considered judgment to be possible. Like any constitution it will be shaped through

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years of interpretation and practice. The potential effects of the innovations it has brought about, particularly, the single currency, need time to unfold. As economic constitutions leave ample room for discretion in the conduct of policy, it may not be easy even years from now to assess how much of the performance was due to constitutional framework and how much to practice of policy. Indeed, no economic constitution can ensure the precision with which its stated goals are met. Unforeseen events, the free democratic spirit of the people, and the discretion necessarily left to future policy-makers prevent arranging an automatic pilot that sets the economy on a golden path and keeps it there thereafter. In the long run the economic performance of any country or region is only in part amenable to the influence of economic policy. Yet, there are good and bad economic constitutions. And the good quality of the constitution, albeit not a sufficient, is undoubtedly a necessary condition for a good economic performance. While the jury is out, we can, thus, try an assessment on the basis of what we know today. The structure of policy instruments, the design of the institutions, and the assignments of tasks to various levels of governments are, in the European Union, rather different from the model of other large modern economies. In many ways it is a system of incentives that can be equally, and even more, effective than the one of other federal systems. However, for the constitution to operate successfully a change in policies is needed. To reduce unemployment and raise growth potential calls primarily for the proper functioning of the labor market, and also for a removal of remaining rigidities in product, services, and capital markets. In areas where national responsibility and even policy competition prevail, cooperation among the member countries can deliver value added by raising the growth potential of euroland as a whole. While a mere consultative method without a powerful European economic policy actor may appear as a weak and insufficient policy process, it sets in motion a learning process. Participants are guided to internalize the requirements of a monetary union, and their awareness is raised of the euro dimension of national policies. This structure is gradually conferring to the table of cooperative action topics that used to be jealously guarded prerogatives of national politics, such as the design of tax-benefit systems, the structure of public pension systems, and the financing of public healthcare. While it may be neither efficient nor politically feasible to design uniform solutions, regular exchanges foster a convergence of ideas. The result may be adoption of common guidelines or, at some point, even binding rules, in accordance with the Community’s legislative process.

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No doubt, in time the articles of the Rome-Maastricht constitution will undergo amendments. The example of the US Constitution shows how, on the basis of a single constitutional clause (granting freedom to interstate commerce), a transformation of the activities of the federal government in the economic realm can develop. 3.9

Appendix: Euroland’s Economic Structure and Challenges

Comparisons help our understanding of reality. The facts and figures for euroland are in this appendix matched with those of the United States. While the two economies are broadly similar in economic size and structure, some immediate noteworthy differences are recognized (table 3.3). Euroland and the United States have populations of 308 and 289 million, respectively, and account, respectively, for 16 and 21 percent of world GDP, converted on the basis of purchasing power parities.40 Average per capita income in the euro area, calculated in purchasing power parity terms, represents 71 percent of the US level.41 The industrial sector of the euro area is somewhat larger (27 against 23 percent of GDP) and the service sector (70 against 76 percent) smaller. In euroland agriculture produces 2.3 percent of GDP and occupies 5.2 percent of the labor force, against 1.6 percent and 1.7 percent, respectively, in the United States. The government sector presents significant disparities between the two economies, reflecting differences in history, tradition, social structure, and attitudes toward the role of the state. Total public expenditures amount to 48 percent of GDP in the euro area, against 34 percent in the United States, reflecting the fact that the role of government in the economy is considerably larger in the former than in the latter.42 The financial sector in euroland is mainly centered on banks: bank deposits and loans amount, respectively, to about 81 and 107 percent of GDP in the euro area, significantly more than the shares in the United States (63 and 52 percent). In contrast, debt securities amount to only 99 percent of GDP, while in the United States the same ratio reaches 156 percent. In the United States stock market capitalization, in relation to the GDP, is around double that in euroland, where it reaches around 51 percent. Looking at the external sector, we see that both euroland and the United States are relatively closed economies, with openness measured by the average of exports and imports of goods and services relative to GDP. Within euroland, Germany accounts for about 30 percent of the area’s output, followed by France (22 percent), Italy (18 percent), and Spain (10

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Table 3.3 Structural comparison of euroland with the United States Euroland

United States

307.7

288.6

GDP per capitab

15.7 23.8

21.1 33.4

Sectors of the economy Agriculture, forestry, and fishery Industry (including construction) Services

2.3 27.3 70.4

1.6c 22.8c 75.6c

General government sector Total revenue Total expenditure Net lending (-) or borrowing (+) Gross debt

46.0 48.3 -2.3 69.0

30.8 34.2 -3.4 61.4

99.4 51.5 81.1 107.5

156.3 103.0 63.5 51.8

0.9 14.6

-4.7 11.7

Demography Population (millions) Gross domestic product GDPa

Financial sector Amounts outstanding of debt securitiesd Stock market capitalizatione Bank deposits Bank loans External sector Current account balance Opennessf

Sources: ECB, European Commission, OECD, BIS, IMF-WEO, Federal Reserve, International Federation of Stock Exchanges. Note: 2002; unless otherwise stated, figures are expressed as a percentage of GDP. a. As a percentage of world GDP, converted at purchasing power parities. b. In thousands of euro, converted at purchasing power parities. c. 2000 figures. d. Issued by residents in national currency. e. January 2003 figures. f. Average of exports and imports of goods and services.

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Table 3.4 Euroland and US performance over the long term Euroland

United States

Real GDP (average annual growth) 1951–1990 1991–2002

4.2 1.9

3.5 2.9

Real GDP per capita (average annual growth) 1951–1990 1991–2002

3.5 1.5

2.3 1.7

Population (average annual growth) 1951–1990 1991–2002

0.7 0.4

1.2 1.2

Net job creation (millions) 1950–1990 1991–2002

18.3 8.9

65.5 21.7

Employment rate (average) 1961–1990 1991–2002

63.1 62.3

69.7 79.4

Sources: European Commission, OECD.

percent); the two smallest economies are Portugal (1.8 percent) and Luxembourg (0.3 percent).43 Germany, France, and Italy are members of the Group of Seven (G7) leading industrial nations.44 Economic and structural differences exist also within countries, for example, between western and eastern Germany or between northern and southern Italy. Moreover cross-country differences have declined over time. Actually, in many respects, the euro is the currency of an entity that is not significantly less homogeneous than some of its members were before its introduction. The economic policy challenges with which euroland will be confronted in the years ahead become more visible when moving from photographic stills to cinematography. If one compares the behavior of the euro area and the American economy over the last decade, a sharp difference in dynamism stands out. While, during the 1991 to 2002 period, the United States grew at an average annual rate of 2.9 percent, euroland has only achieved 1.9. In per capita terms, the difference is smaller but still exists (1.7 and 1.5 percent, respectively). Over the same period 22 million new jobs were created in the United States, against 9 million in the euro area (table 3.4).45

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If one looks farther back, however, it is clear that the 1990s mark a pause in a four-decade-long trend that followed World War II. From the early 1950s to the early 1990s, the European economy performed as well as, and sometimes even better than, the United States in terms of GDP per capita growth. In purchasing power parity terms, euroland’s GDP per capita was at 41 percent of the US level in 1950, when a remarkable catch-up phase started, reaching 70 percent in 1991. Since then the gap in GDP per capita terms has remained broadly constant, as it stood at 71 percent in 2000.

4

Monetary Policy: As Strong as the Deutsche Mark

This chapter is devoted to monetary policy in euroland, its framework and implementation, and the debates it has raised. In the 1990s the slogan “A euro as strong as the Deutsche mark” was used to indicate the ambition the Eurosystem should set for itself. For the German people, who were reluctant to abandon their highly stable currency, the slogan was a promise of continuity. For people of other countries, it was a promise to finally eradicate the inflation that had plagued them for years. Germany had undoubtedly been most successful in learning how to manage a fiduciary currency, as its average inflation was 2.9 percent for a half-century (in the years 1949–1998: 4.0 percent in the United States, 5.7 percent in France, 6.2 percent in the United Kingdom). The Deutsche Bundesbank’s institutional independence, concentration on price stability and on the medium term, and tireless education of the public opinion became the features of a monetary policy that gradually spread over Europe and eventually became the model for the EMU. Nevertheless, euroland is not Germany, and the Eurosystem is not the Bundesbank. The German legacy can only be used as a reference, and not as a blueprint. When the ECB Board and Council met for the first time, in June 1998, they were confronted with a meagre seven months for setting up the regulations, analytical instruments, statistical apparatus, technical infrastructure, decision-making practices, operating procedures, communication protocols that constitute the indispensable basis of any policy-making.1 By the end of December 1998 the ground was laid for a single monetary policy. The subsequent five years became a critical, albeit short, testing period. In this chapter the various aspects of euroland’s monetary policy are discussed. Sections 4.1 to 4.3 are devoted to the mandate and strategy of the Eurosystem. In sections 4.4 to 4.6, the operations, transmission, and communication of policy are reviewed.

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Chapter 4

Mandate, Strategy

The Treaty of Maastricht leaves no doubt as to the direction in which the compass needle should steer the course of monetary policy. The primary objective is price stability. Only insofar as price stability is not endangered, is the Eurosystem mandated to support the general economic policies in the Community, aiming at growth and employment. Although the Treaty recognizes that monetary policy is part of a broader set of policies, this clear order of priority bars the ECB from disregarding the compass, and governments from influencing the ECB. In October 1998, just a few weeks before the start of the euro, the ECB adopted its strategy for a monetary policy. This consisted of (1) an interpretation of the mandate imparted by the Treaty and (2) an analytical framework for fulfilling the mandate, which is based on two pillars. This became known as the “ECB two-pillar strategy” for monetary policy.2 The interpretation of the mandate consisted in a quantitative definition of price stability: “a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2 percent,” complemented with the proviso that monetary policy would maintain price stability “over the medium term.” With this definition, the ECB indicated not only the upper threshold beyond which price stability is no longer in place but also its intention to oppose symmetrically inflation and deflation (hence the choice of the word “increase”). The focus on the medium term allowed the ECB to hedge the impossible, or undesirable, “instantaneous” enforcement of price stability. The logic was clear in this regard. Monetary policy’s impacts upon the economy come with long and variable lags.3 It was at the same time also undesirable, because the cost of immediately countering certain price shocks hitting the economy can result in disproportionate effects overall. For example, the desirability to offset an adverse temporary supply shock (such as an increase in the price of oil or other primary commodity) has to be assessed on the basis of its intensity, tendency to influence price and wage-setting behaviors, and thus tendency to perpetuate itself. The ECB gave no elaboration for the Treaty’s provision to “support the general economic policies of the Community” (Article 2 of the ECB Statute), in order to retain flexibility in the interpretation of this part of its mandate. On the one hand, the ECB recognizes that money is neutral only in the long run, and that the effectiveness of monetary policy rests on its ability to produce effects on the real economy. On the other hand, the ECB has declared itself unwilling to engage in policy activism because

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of the risk entailed in attempts at overexploiting the trade-off between growth and price stability in the short or medium run. Turning to the analytical framework, a forward-looking assessment was made of two elements, or pillars: a prominent role for money and a wide range of indicators of future prices. The variables used for the two pillars were respectively nominal and (mainly) real variables. The first pillar consisted primarily of an assessment of the current and prospective behavior of monetary aggregates, and in particular, of M3,4 for which the desired rate of growth was treated as a reference value for the monetary policy. The dynamics of the monetary aggregates provided useful information about future prices given the long-term neutrality of money. That is, any prolonged or persistent deviation of the actual rate of M3 growth from its reference value is likely to mean that the monetary policy is out of line with the requirement of price stability.5 The argument that prices respond proportionately to changes in money in the long run goes way back to Hume in 1752. As Robert Lucas has emphasized in his Nobel Lecture, it has received ample validity over hundreds of years and in many places.6 The second pillar consisted in a range of indicators of the current and prospective state of the economy to assess the outlook for price stability. The variables included the dynamics of economic activity, the components of aggregate demand, surveys of business and consumer confidence, fiscal developments, price indexes, prices of oil and other standard commodities, the exchange rate, and the prospect of forthcoming wage negotiations. Such variables have a more immediate and direct impact on prices than money supply. Periodic staff projections of GDP growth and consumer price inflation, which in December 2000 started to be published twice a year, are part of the information set used by the ECB. The two-pillar strategy was designed to ensure that, at the moment of taking decisions, the ECB organized the use of all relevant information about economic, monetary, and financial conditions.7 To help readers form their own views, it may be useful to compare the ECB strategy with some alternative approaches to monetary policy adopted by other major central banks over the last two or three decades prior to the launch of the euro. The approaches can be traced back to four archetypes, three of which are characterized by an explicit and public posting of a single variable as the target of policy, and one by discretion, namely by the central bank “letting its actions speak.” In the first three approaches the exchange rate, the stock of money, and the inflation rate are the variables by which monetary policy is committed

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to pursue a quantitative target. The target is sometimes set by the central bank itself, as in 1975 to 1998 in Germany. In other cases the government assigns the objective to the central bank, as in the United Kingdom for the inflation target.8 In the EMS, the Ministers of Finance collectively decided the central rates. In the fourth approach—largely followed, among others, by the US Fed over the last decades—the monetary policy is not to post a single variable nor formulate an explicit and formal strategy. Among these monetary policies, all of which were adopted at differing times by the G7 countries in the quarter-century that preceded the euro (a total of 175 years of policy), discretion emerged clearly on top in terms of the frequency of distribution (90 years), followed by exchange rate targeting (39 years), money targeting (32 years), and inflation targeting (14 years) (table 4.1). Table 4.1 Approaches to monetary policy in the G7 countries in 1974 to 1998 Exchange rate

Money

Inflation

pegging

targeting

targeting

Discretion

—

1974–78 1983–98 21

United States

1979–82 —

Number of years

4

Japan

1974–98 —

—

—

Number of years

25

Germany

1975–98

Number of years

— —

France

1979–98

1974

24

— — — —

1 1974–78

Number of years

20

— —

United Kingdom

1990–92

1980–83

1993–98

Number of years

3

4

6

1974–79 1984–89 12

Italy

1979–92 1997–98 16

— —

— —

1993–96 9

1991–98

1974–90

Number of years

— —

— —

8

17

Total years

39

32

14

90

Number of years

5

1974–78

Canada

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In the view of some, counting years of policy may give too much weight to the past and not do full justice to more recent developments in policymaking and academic research. In particular, it does penalize inflation targeting, which, since its introduction by New Zealand in 1989, has been adopted by about 20 countries (depending on how strictly one defines inflation targeting), has gained the support of academic consensus, and is actively recommended by the IMF to many countries. One should, however, not underestimate the value of a strong long-term record as well as the uncertainties inherent in an approach like inflation targeting that has not yet withstood the test of time.9 (We will return to inflation targeting in the next section.) Against this background it is possible to assess the choice made by the ECB in 1998. The exclusion of exchange rate targeting should be no surprise. Since the collapse of the Bretton Woods fixed exchange rate system, no leading currency has subordinated its monetary policy to an external anchor. For the ECB the exchange rate is merely one of several indicators in the second pillar, given the information it offers about future price developments. As to money targeting, inflation targeting, and discretion, it may be said that while not choosing any of these strategies, the ECB drew something from each. It did not choose money targeting, but recognized in the first pillar the prominent role of money in the preparation, transmission, and communication of decisions. Likewise, while not pursuing an inflation forecast that is conditional on a certain (usually constant) policy rate time path, the ECB adopted a quantitatively defined objective of price stability, one of the key features of inflation targeting. As to discretion, the ECB rejected the unwillingness to publicly disclose a decision-making method but nevertheless took much of the analytical substance. The ECB strategy may effectively be seen as one that combines two views. The first is avoidance of tying monetary policy to a single variable as the decision driver. The ECB recognizes in this way the merits of the rather eclectic approach prevailing over a quarter century among leading industrial economies and notably preferred by the US Fed. Indeed, the nature of the ECB strategy (i.e., the role attributed to a wide range of nominal and real variables) is primarily supported by the desire to base monetary policy on a broad set of indicators, rather than on a restricted number of pre-selected indexes. Inflation expectations, in particular, which are the dominant driver of policy decisions in inflation targeting, were not seen as sufficient to exhaustively depict the state of the economy. Furthermore, to secure the robustness of monetary policy actions, the ECB felt that

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monetary policy decisions should be taken on the basis of a plurality of models, not a single model or paradigm. Finally, the Bank regarded as desirable to retain a margin of flexibility to cope with exceptional circumstances. All these arguments led to favor wide discretion over a simple rule. The second component of ECB strategy is the recognition of the merits of making explicit the intellectual framework underlying the policy deliberations. Historical, political, and intellectual arguments led the ECB to rule out the option of not formulating and publicly announcing any approach. The new central bank came to life at a time when the intellectual climate was adverse to the undisclosed style traditionally followed by the experts of the discretionary view. Moreover nondisclosure was not the method of the Deutsche Bundesbank, the central bank whose legacy was taken by most as the benchmark against which to judge the ECB. Nor was it what the public, markets, and analysts were overwhelmingly hankering for. Coupled with the lack of track record, a nondisclosure method would have made ECB actions almost impossible to read and interpret. For a novel and rather special central bank such as the ECB, the choice of the strategy had to be seen also in the light of the internal functioning of the institution. In order to shape the monetary policy process of euroland rapidly and effectively, the deliberations of the new, collective policymaking body needed the discipline of an agreed discussion method. The strategy thus served the purpose of organizing an orderly discussion within a Council largely formed by governors coming from heterogeneous backgrounds and different monetary policy frameworks. 4.2

Debates on the ECB Strategy

The ECB policy strategy stirred a debate that is still ongoing. Both criticism and appreciation have been voiced.10 Appreciation was expressed for the breadth of the assessment on which policy decisions are based and for the ample communication. Key features of the strategy have received positive recognition. First, market reactions to the establishment of the new rules of the game were swift, a sign that the new monetary policy environment was perceived as transparent and operational. For example, since 1999 overnight rates have limited their fluctuations on the dates of monetary policy announcements to less than five basis points on average, a sign that policy was reasonably predictable.11 Second, the ECB’s systematic avoidance of short-term economic finetuning has been found consistent with a renewed interest in the academic

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debate for less activist approaches to monetary policy. The idea behind these approaches is simple. The more drawn out the central bank’s reaction to a given shock, namely the more persistent its compensating reaction to the original perturbation, the quicker private expectations— discounting this persistent reaction—will adjust to the shock in an equilibrating direction. As private expectations are incorporated in long-term yields, and demand conditions are influenced primarily by changes in long-term interest rates, persistence in monetary policy strengthens the central bank’s leverage on the economy via an expectation channel.12 Third, the notion that price stability should be maintained over the medium term has made some headway among other central banks, once committed to shorter and more rigid forms of quantification concerning the horizon relevant for policy.13 Having to compensate adverse shocks to inflation over the medium term allows a more measured response to the original source of disturbance, which avoids injecting unnecessary volatility into economic activity. Finally the important but not all-encompassing role assigned to inflation forecasts within the strategy has gathered consensus among those observers who are more alerted to the risks of elevating a single summary indicator to the sole guide for policy (e.g., see Vickers 1999). Along with this appreciation, criticism has persisted and, to some extent, intensified. In one way or another, the failure to opt for full inflation targeting seems to have constituted in the eyes of some observers the fatal sin in the ECB’s original experiment in mechanism design. It should be recalled that the ECB strategy was adopted at a moment when both the academic consensus and the choice of central banks were heavily leaning toward inflation targeting. This source of criticism has taken various forms and has been articulated at various levels. At a less fundamental level, the ECB has been accused of imprecision in the communication of those elements of its strategy that it shares with inflation-targeting central banks. For example, the quantitative definition of price stability has been described as “ambiguous and asymmetric” and less than effective in anchoring expectations if compared with the numerical targets adopted by inflation-targeting central banks. Likewise the lack of precision in the characterization of the time horizon over which monetary policy ought to restore price stability has been found incompatible with the best practices of inflation targeting. These would impose a binding form of commitment to a detailed time frame for action. Lars Svensson, in a series of interventions, has heralded this technical form of dissatisfaction among academics.14

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But the dissonance in reasoning that has emerged between the ECB and sympathizers of strict inflation targeting has a deep-seated origin. It was the ECB’s idea, embodied in the dual-pillar approach, that monetary policy needs a diversified (as distinguished from unified) analytical framework. The underlying fact is that there exists a great deal of uncertainty regarding the correct specification of the transmission mechanism of monetary policy. Because of uncertainty about which specification best reflects the true structure of the economy and the true transmission mechanism of monetary policy, a unified reference model to inform policy decisions was considered to be hazardous. Hence arose the need for a diversified perspective of the economy. It is precisely this diversification that many critics reject. They see no justification for it and seem to opt for a unified-perspective approach. Jordi Galí, a prominent contributor to the unified-perspective model, has been a representative voice expressing scepticism about the ECB strategy.15 One could venture to say that the unified-perspective approach uses as its reference model of the economy a re-interpreted version of the traditional Keynesian IS-LM-plus-Phillips curve model that was the fundamental analytical workhorse in macroeconomics for much of the postwar period.16 To be sure, the framework advocated by ECB critics such as Lars Svensson and Jordi Galí differs from its postwar predecessor in one important respect. Unlike its original Keynesian prototype, the new Keynesian model is fundamentally forward-looking. Indeed, the model derives its structural conditions for demand and supply from the optimizing choices of a representative agent and a representative firm, both of which entertain expectations about the future and over time smooth out demand and production decisions accordingly. This forward-looking dimension lends the model a center of gravity, which the old Keynesian version lacked: the natural rate of unemployment. In other words, the model allows a shortterm form of nonneutrality of monetary policy, in the sense that a nonsystematic (i.e., unexpected) monetary policy impulse can have an impact on real activity in the short term. Nevertheless, the model has a tendency to return to a long-run equilibrium situation, which is independent of the monetary policy. This means that the model incorporates neutrality in the long run.17 This is, of course, an important difference with respect to the old Keynesian model, which assumed that the structure of the economy was essentially static, that expectations about the future (including future policy moves) played no role in determining the private economy’s behavior in the present. This assumption, joined with the wide conviction that the

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economy could be moved around toward the most preferred equilibrium by systematic policy intervention, is now considered responsible for the most severe policy mistake that economic history has recorded since the Great Depression: the Great Inflation of the 1970s.18 By systematically prolonging expansions and checking contractions in a quest for “maximum employment,” monetary policy resulted in an upward drift in prices. By contrast, the new version of the Keynesian model has a built-in natural attractor, namely a maximum amount of resources that is compatible with inflation being constant at the level targeted by the central bank. The economy cannot depart from this so-called natural level of activity except in the short run, and at the cost of generating pressures on prices and inflation expectations. So, if the vintage Keynesian framework was, in a sense, a standing invitation for policy action (and thus possibly policy excesses), the present generation’s model has a built-in mechanism that warns policy-makers against being too ambitious about fine-tuning the economy through monetary impulses. Furthermore, within the new version of the model, unlike the old one, discretionary policy is constrained by a clear objective, involving inflation stabilization around a target and output stabilization around a level, which is consistent with the maximum amount of resources that represents the natural attractor of the economy. This can indeed remove one of the primary causes which promoted the large policy mistakes of the 1970s: the erroneous attempts to “buy a little bit more employment” in exchange of “a little bit of inflation.” But, that being said, the two model vintages share a fundamental common feature. They both reflect the primacy of real sector forces in the determination of spending decisions and price-setting behaviors. The new version of the model even goes a step further in this direction, as it provides monetary policy with a “rule” that prescribes policy action entirely as a function of the current state of the real economy.19 Such a rule would have the central bank change the short-term interest rate in a manner that tracks at every moment, and as closely as possible, the so-called natural equilibrium real rate of interest. This is the real interest rate that would prevail in the hypothesis of an output consistently at its long-term “natural” level. Now the primacy of real sector forces in the determination of spending and pricing decisions in the structural model, and the predominance of real sector indicators as drivers of policy decisions in the prescribed policy rule have one important implication and one risk. The implication is that by stressing solely real sector forces, alternative channels of monetary

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policy transmission may be overlooked. In fact data prove to be consistent with models in which money quantities play an important role as determinants of price developments. But this evidence, establishing a close link between liquidity conditions and price inflation, cannot be entirely explained by the new-Keynesian paradigm.20 The risk is that a successful outcome of policy is made exceedingly dependent on getting “right” the natural equilibrium real interest rate— that is, the level that can be maintained in the long run without giving rise to an accelerating rate of inflation. This is a particularly hazardous condition because this variable, like the so-called natural level of output, is not directly observable to the central bank. It has to be estimated by various statistical techniques that may err in one way or another in real time. Actually some observers have argued that the Great Inflation of the 1970s was made possible, among other things, by a severe real-time mismeasurement of the natural level of output.21 Seen from this perspective the unified new-Keynesian framework, the reference model for many critics of the diversified strategy of the ECB, provides no insurance against real-time misperceptions about fundamental parameters of the economy, which policy is nevertheless advised to target in the short run. A diversified approach to macroeconomic analysis is preferable. By putting less emphasis on one set of indicators, on one particular sector of the economy, on one single perspective over the workings of the transmission mechanism, the ECB’s diversified strategy is designed to avoid major policy mistakes. In conclusion, large part of the dispute over the ECB strategy can be traced to a differing appreciation, of the ECB and some of its critics, as to whether monetary policy should rely on a diversified, or else a unified, allencompassing model of the economy. The rationale for a discretionary policy label, such as that widely used in the quarter century before the start of the euro, is not only for a simple desire to be free at the moment of policy decisions, it is also in recognition of the risk associated with an unconditional adoption of a single model without conclusive evidence that it is the best model. Discretion, which implies some eclecticism, in turn confers some robustness to policy-making. More generally, the debate has been pervaded by a lack of clarity, and a lack of agreement, on what an adoption of a strategy, or a policy rule, really means. Policy-making may be likened to a process whereby an initial set of degrees of freedom is gradually being “spent” until, at the instant of the decision, the set is empty.22 Most of the academic debate about monetary policy can be seen as a debate about how and when those degrees of freedom

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should be spent. The adoption of the ECB strategy in 1998 was just one step into that process. It was preceded by the stipulation of a mission in the Treaty and followed by the monthly preparation of documents by ECB staff, their discussion and approval by the Board, the discussion, and finally the decision, by the Council. Seen in this way, a strategy is not a tool that mechanically links action to information, thereby exhausting the set of degrees of freedom. Even “tighter” policy rules, such as the unified model approach of inflation or monetary targeting, do not mechanically make such a link. They leave degrees of freedom, that is, room for discretion, up to the moment of action. For example, judgment enters in the specification of the relevant behavioral relations that best describe the working of the economy. Judgment and discretion also guide the assumptions concerning the exogenous variables, namely those economic variables, like foreign demand, that are considered as given in a policy simulation exercise. Finally judgment is crucial in the interpretation of the results and, in particular, in the assessment of risks. A strategy, useful as it is for good decisions, does not yield decisions. Its role is to identify relevant information, help interpret it, and connect it with possible actions, but not to mechanically produce a decision. Ultimately this is due to the fact that a decision is an act of will, not an act of knowledge.23 No strategy can change the voluntary nature of decisionmaking. An act of will is not only required by imperfect knowledge, nor is it only a remedy to ignorance and risk. It is the very nature of a decision on any matter. After all, just as scholars debate about research issues, policy-makers debate about policy issues. No matter the field, humans hold different views, and they also weigh arguments differently and rarely adhere to a conclusion without some residual doubt. In areas of policy the questions of how to act and when to act are not, and cannot be, unambiguously prescribed by a rule. The strategy of the ECB leaves room for discussion, judgment, and disagreement, and it would be insufficient if it did not. If information were as perfectly connected to action as it is sometimes hoped, why involve a decision-maker, and why create a council, where differing views, based on shared adherence to a strategy, can be aired to consent to an action? A final point to be stressed before concluding this section is that in the monetary policy field, the deliberation style of the ECB Council fully corresponds to that of the collegial decision-making that led to the Maastricht Treaty and described in chapter 2. From the very start, in hammering out a single monetary policy, each participant brought to the table his or her

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own view of how best to effect price stability in euroland, and not the particular needs of his or her country of origin. The dynamics of prices of course, is not the same in every euro country, just as it is not the same in every region of a country. It was thus tempting for a national central bank governor of a country with lower than average inflation to resist an interest rate hike that might be called for by the overall state of the euro economy. Indeed, we will see, in other chapters, that, in areas other than monetary policy, national or “periphery” considerations still very much influence the Eurosystem’s deliberations. That this is not happening in the exercise of monetary policy, which is the central and foremost function of the System, is all the more remarkable. The collective view by now established is that an introduction into a discussion of national bias would be very badly received by the peers gathered at the table. This is a significant achievement in this early stage of the new institution. 4.3

Practice and Evaluation of the Strategy

In December 2002 Willem Duisenberg, the then president of the ECB, announced that a “serious evaluation” would be made of the monetary policy strategy of the ECB. The announcement created an expectation of substantial change. In fact the evaluation was decided as a matter of good maintenance, and not because of the need for change. Being an innovative design, it had to be evaluated for its effectiveness, like a motor vehicle going back to the shop for a tune-up after four years of running on a road on which no vehicle had ever traveled. From the start, the strategy was to reconcile the different biases and intellectual inclinations that coexisted in the ECB Council. The strategy was used to organize the documentation and analyses presented to the policy meetings to impart order and consistency to the deliberations, and to structure the communication and explanations of the ECB decisions. In the January 1999 to February 2004 period, monetary policy had been on the ECB Council agenda in 98 meetings. Until October 2001, the ECB Council discussed monetary policy twice a month, thereafter only once a month. The interest rate was changed 15 times (compared with 19 times by the Fed over the same period). In four years out of five the annual inflation rate went above the critical threshold of price stability as defined by the ECB: 1.1 percent in 1999, 2.1 percent in 2000, 2.3 percent in 2001, 2.3 percent in 2002, and 2.1 percent in 2003. Also the 41/2 reference value for the growth of M3 was persistently exceeded, with 5.6, 4.9, 5.4, 7.2, and 8.0 percent growth for the

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five years. In the ECB’s view the specific causes of both of these trespasses were such that no specific corrections were needed. Inflation had been pushed up by a rather unusual sequence of supply price shocks in 1999 to 2003.24 The notion that price stability is “to be maintained over the medium term” had been expounded precisely to acknowledge that monetary policy cannot be expected to counter the first round effect of a supply shock. With regard to M3, the main cause of the very high expansion was found to be protracted portfolio shifts. Investors showed a sustained preference for liquidity because of the high uncertainty in financial markets and in the general macroeconomic outlook. Over the first four years, a gradual change occurred both in the conduct of monetary policy and in communication. First, in early 2002, the ECB ceased to claim that it was aiming at an inflation rate “safely below 2 percent.” It can be observed today that initially the aim reflected the special circumstances of the economy during the second part of the 1990s, when inflation was exceptionally low and no fears of deflation or a liquidity trap had yet plagued any of the major economies, with the exception of Japan. Second, month-to-month monetary policy decisions became increasingly related to the real sector analysis of the indicators of future price developments as captured by the second pillar of the strategy, instead of to the dynamics of monetary aggregates. The ECB had to consistently explain why failing to react to money growth above 41/2 percent, albeit prolonged in time, did not contradict its belief that “money matters.” However, the Bank did show, in both words and deeds, that the analysis of the first pillar was more a controlling device than an operational guide for short-run decisions. Third, the consideration of the important role of money was gradually broadened beyond M3, to include a full range of indicators of the liquidity conditions of the economy, in the form of money and credit aggregates. The 2002 re-evaluation concentrated on the quantitative definition of price stability and the role of money. As to the former, three main concerns arose from the experience of the early years, and they were amply debated in the course of the re-evaluation. First was the concern that an underlying, or core, inflation should be preferred to the HICP. In its favor was the argument that if one removes the more volatile components of prices, the core inflation provides a better assessment of the trends. Second was the concern that a less ambitious upper threshold than 2 percent should be adopted. As 2 percent had been chosen at a moment when inflation was particularly low in many European countries, and shortly after the Bundesbank had lowered from 2 percent to the 1.5–2.0 percent range

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its stated “price norm,” it was below the long-term average inflation in Germany (2.9 percent in 1949–98) and had been repeatedly exceeded in the early years of the euro. Third was the concern that the 1998 definition, which lacked the explicit indication of a lower bound, was asymmetrical and ill-suited to deal with the risk of deflation. From 1998 to 2002 several critics had claimed that the ECB seemed to wish an inflation rate as low as possible in the zero to 2 percent range and that it was insensitive to the difficulty of conducting monetary policy in such a very low inflation environment. The second focus was on the role of money. Here the critique was based both on the instability shown by the money demand function in the early years and on a recent trend in academic literature that considered money to be largely irrelevant as an indicator of inflationary pressures. In these theoretical models the transmission mechanism was shown to operate primarily through aggregate demand (e.g., see Svensson 1999). With the announced outcome of the evaluation in May 2003, the ECB affirmed again the importance of HICP to the definition of price stability based on its transparency and reliability, but it indicated that measures of core inflation were to be used as indicators in its policy-making. The Bank also expanded its 1998 definition of price stability (“below 2 percent . . . to be maintained over the medium term”), but at the same time specified that it will aim to maintain inflation rates close to 2 percent. It confirmed that its monetary policy will continue to be based on two pillars, but at the same time specified that monetary analysis would mainly serve as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications coming from economic analyses. Moreover, the ECB announced a new structure of the monthly Press Statement, whereby the economic analysis would be presented first and the monetary analysis second (figure 4.1).25 All in all, the re-evaluation did not lead to a change in strategy, but rather to a clarification, which made explicit the evolution occurred in the early years. All along the issue whether the strategy needed a change or a clarification was debated extensively within the ECB. Of course, a change in strategy would have been effected if the ECB Council had felt that by a different strategy better decisions could have been taken in the previous years. Rightly or wrongly, the ECB did not have such regrets, which of course does not preclude the fact that better decisions could have been taken with the given strategy. The Council thus did not see any compelling reason for change; it only found the need for clarification.

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Primary objective of price stability

ECB Council takes monetary policy decisions based on a unified assessment of the risks to price stability Economic analysis Analysis of economic shocks and dynamics

Monetary analysis Cross-checking

Analysis of monetary trends

Full set of information Figure 4.1 Monetary policy strategy

The change versus clarification issue, however, had also deeper implications. Just as legislation operates as a blend of written law and jurisprudence, so the policy profile of every central bank is a combination of a posted strategy and a track record. Depending on the history and practice of each institution, the two components weigh in different proportions. In the case of the Fed, for example, the track record has traditionally had the dominant role, with the exception of the 1979 to 1982 Volcker years when, partly to correct the negative track record of the previous decade, a monetary target was adopted to halt inflation. In contrast, because the ECB had no track record, it had to rely almost entirely on a posted strategy from its start. In part the ECB borrowed the track record of the Bundesbank by the adoption of some features of its strategy (M3 in particular), the Frankfurt location, and by relying on some of its high officials. When the re-evaluation took place in 2003 a track record, though of only four years, did exist, and it was very positive to the point of curbing the early scepticism from many quarters. What is truly remarkable was that long-term inflation expectations, as measured both by Consensus Forecast and the ECB Survey of Professional Forecasters, have been consistently below 2 percent since the start of the euro, and that this was achieved despite the actual figures often exceeding 2 percent (figure 4.2). Moreover, from the distribution of the inflation rates across countries in the euro area, it was clear that the first years of single monetary policy had

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5.5

5.5

5.0

5.0

4.5

4.5

4.0

4.0

3.5

3.5

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 HICP inflation (y-o-y rate of change)

Upper bound definition of price stability

Long-term inflation expectations

Figure 4.2 Euro area inflation expectations since 1990. Sources: Consensus Forecasts; ECB calculations.

not induced any noticeable increase in the dispersion. Since the start of the euro, the degree of inflation dispersion in the euro area countries has remained in line with that of US regions where the common currency has had the benefit of centuries of experience (figure 4.3). Clearly, any change in strategy would have meant a restart of the jurisprudence and hence some waste of the little, and all the more precious, capital of a track record built in the early years. Had the ECB Council been convinced that the strategy was flawed, a change would have no doubt imposed itself. Since, however, this was not the case, continuity was seen as a positive factor. A segment of the academic community was disappointed to see the ECB willing only to clarify, and not alter, its strategy. In view of the large intellectual support for inflation targeting, that segment of academe had wished the ECB to follow its preferred approach and abandon the two pillars. As I explained in the previous section, the divide between the Bank and this academic group ran deep, and beyond a purely scholarly dispute. The Bank has maintained its approach not so much, and not only, because of a difference as to what might be the “right” model, but rather because of

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7

6

Euro area (12 countries)

5

4

3

2

1

0 1990

Stage I of EMU

Stage II of EMU

Stage III of EMU

United States (14 MSAs)

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Figure 4.3 Dispersion of annual inflation across euro area countries compared with fourteen US metropolitan statistical areas (MSAs). Note: Data up to February 2003 for the euro area and to January 2003 for the US MSAs. Sources: Eurostat and US Bureau of Labor Statistics.

an unwillingness to abandon its diversified approach in favor of tying itself to a single model. Ultimately, this is and remains a difference of view on the robustness of what the scientific laboratory can offer to the practitioner. The press, the market, and the general public were much less critical of the results of the re-evaluation. They understood that the re-evaluation had led to no fundamental change, but just, as one put it, to “aligning words with actions.” For most recipients this was neither a surprise nor a disappointment. Markets, in particular, had already well understood that M3 and other monetary or credit aggregates were not main triggers of policy decisions and that the “safely below” had been replaced by “below, but close to.” 4.4

Operations

Central bank operations—the term of policy that follows the mandate and the framework—is where NCBs come into play. Like the framework, operations were decided in 1998, just before the start of the euro. They consist of (1) the operational target, (2) the instruments, and (3) the mechanics of policy implementation and execution.

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The operational target is the economic variable monetary policy seeks to control, the closest to its end of the transmission process. For the Eurosystem this is the overnight rate, meaning the rate of interest at which banks— for one working day—borrow and lend euro held on the accounts of national central banks. For the ECB, choosing to control a price (an interest rate) rather than a quantity (bank reserves) was relatively easy,26 because all NCBs—like most central banks throughout the world—had for many years adopted the same approach. Yet the choice is not quite trivial, nor is it a once-and-for-all affair, because there are circumstances in which the control of bank reserves may be a more effective policy tool. This may be the case where monetary policy is confronted with a protracted deflation, interest rates have reached a historical minimum, and the provision of an extra stimulus to the economy overrides any other objective.27 To achieve the desired overnight rate, the ECB uses three instruments: open market operations, standing facilities, and a reserve requirement. Open market operations mainly take the form of repurchase agreements conducted by means of weekly tenders.28 Through these operations the banking system borrows from the Eurosystem an amount of euro that satisfies its transaction and liquidity needs and, at the same time, is deemed by the ECB apt to keep the overnight rate on target. The second instrument—two so-called standing facilities—allows each commercial bank to deposit its surplus of liquidity with (deposit facility), or to borrow liquidity from (marginal lending facility), the Eurosystem on an overnight basis, at its own initiative, and without limits. This provides the banking system with a simple and demand driven tool for the management of liquidity.29 The third instrument is a reserve requirement, meaning the obligation for credit institutions to hold a certain amount of funds on accounts with the Eurosystem. Minimum reserves are fully remunerated, as their purpose is not to “tax” the banking system but first and foremost to stabilize shortterm rates.30 The stabilizing role of minimum reserves is key in allowing the Eurosystem to conduct open market operations only on a weekly basis. The choice of instruments just described was not straightforward. Due to a diversity of traditions, and perhaps more important, of financial environments, there was no homogeneity across NCBs prior to the euro.31 The third and last step in setting up the operations of monetary policy concerned the mechanics, meaning the arrangements to act in practice. The execution of policy is mainly done by NCBs. Unlike the two other steps, the mechanics of central banking entail no policy decisions. Entering into an operation with a particular bank is a systemwide decision independent

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of the location of the bank. The central bank counterparty of a bank established in Italy is Banca d’Italia, while, for the same operation, it is the Finnish central bank for a Finnish bank. It is often asked whether the implementation and execution of monetary policy in euroland are as “single” as the framework and the decisionmaking. The answer is unambiguously positive. There is in fact no single instrument of policy left to the discretion of national central banks. In this way the Eurosystem is more integrated than the Fed.32 In the weekly tender, as in occasional operations, national central banks act as collectors of the bids and formal counterparties of commercial banks, but they cannot add to, subtract from, nor change the distribution of the liquidity provision decided in Frankfurt.33 It is at the ECB that the allotment is distributed after ranking the bids in a single ordering, which disregards the national origin and location of the bidding banks. The singleness of the operational phase results—ex post—from the fact that there is a single overnight rate across euroland.34 The decentralization of the mechanics has had, so far, no negative implication for the effectiveness of monetary policy. Indeed, in the few instances experienced so far, in which an extra provision of liquidity had to be urgently decided, the Eurosystem has operated as effectively and promptly as the Fed (e.g., in the aftermath of 9/11). Yet decentralization may complicate the logistics and bring some extra cost. For example, the monitoring of the overall liquidity situation requires a potentially cumbersome aggregation, in the early hours of each working day, of twelve (and, in the future, up to twenty-seven) national central bank inputs. That the execution of policy operations is done via the NCBs reflects not only the principle of decentralization but also the fact that despite the singleness of the currency, euroland is still a fragmented area. It has many financial centers, and still largely country-based banking communities, that relate to the Eurosystem through the local central bank and via local channels of communication in which the national language is essential. The legal and technical instruments required to settle the operations remain national. It should also be noted that decentralization of policy execution is not unprecedented in central banking, nor is it an exclusive characteristic of a central bank with a federal structure. In the past decentralization was practiced in many countries, where discount operations were decided by the local branch of the central bank. In its early years the Deutsche Bundesbank fully decentralized the execution of policy. On the operations of the Eurosystem, the Statutes set another, and potentially a more important, constraint than just decentralization. They

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require the Eurosystem to “act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources.”35 This implies, among other things, equal access to the operations of the central bank, which means that all credit institutions fulfilling certain standards are eligible counterparties of the Eurosystem. Such an approach contrasts with the operating procedures of other central banks, among them the Fed and the Bank of England, that select a limited set of counterparties on a discretionary basis. Similarly the Treaty forbids the Eurosystem from granting privileged financial treatment to public issuers, and this implies that in its credit operations, the Eurosystem must accept a very broad range of assets as collateral, issued by both public and private bodies. In shaping monetary policy operations, the role of the financial environment is not less important than the charter. In the United States, for example, the Fed can implement monetary policy by trading a small range of securities with a limited number of counterparties, and this function derives directly from the US financial structure.36 In euroland a complication came from the fact that the structure of financial markets, and in particular, the money market, was not precisely known at the time the operational framework had to be decided. Indeed, while the introduction of the euro could be expected to—and actually did—foster an unprecedented consolidation of the financial system, the pace and the scope of that process could not be fully comprehended in advance. 4.5

Transmission

The effectiveness of monetary policy ultimately depends on the way central bank impulses are transmitted to the economy. Unlike the framework and the operations discussed earlier, the transmission mechanism is received, rather than created, by the central bank. Although the Bank may influence it in time, in the short run it can only strive to understand its workings and to utilize it to the best advantage. The Eurosystem could, of course, draw from a rich body of theoretical knowledge and empirical evidence about the transmission mechanism in member countries prior to the euro. None, however, refers to that special and newly created “country” that is euroland. In the textbook case, based on the one-to-one correspondence between countries and currencies, the economy exhibits a high cohesiveness of the social, economic, and financial structure. This is the outcome over a nor-

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mally very long period during which economic, social, cultural, political, and legal life develop within a single state. Cohesiveness is the crucial factor because, in the economy as in any other field, “transmission” from one part (in this case the central bank) to the whole (the economy) presupposes, by definition, a “sticking together” of the parts. In the case of euroland the transmission mechanism is complicated by the fact that cohesiveness, and hence the transmission mechanism, is in a process of change, partly due to the advent of the euro and the single monetary policy. The special features of policy transmission in euroland can be better understood by taking a closer look at two of its aspects concerning the financial and the real side of the economy respectively. Consider financial aspects first. Prior to the euro there were significant cross-country differences in the way movements in central bank rates produced changes in the overall structure of interest rates. In Germany, for instance, where the Deutsche Bundesbank used to set its rates very much in the same way in which the ECB does today, interbank interest rates directly reflected changes (and expectations of changes) in the main policy rate. By contrast, in France, the most relevant rate for banks, corporations, and households was not the official policy rate but the overnight rate, which was tightly controlled by the central bank and usually different from the official rate. In Italy the deposit and lending rates of commercial banks continued to respond to changes in the official discount rate, so that the liquidity and rate conditions on the money market, determined by the daily operations of the Banca d’Italia, had little bearing on the real economy. Likewise in Finland a large proportion of bank loans were indexed on an interest rate set administratively and not relevant to monetary policy operations. Important diversities appear also for the business and household sectors. Across Europe, for example, investment decisions are unequally dependent on external finance and hence unequally responsive to monetary policy due to the diversity of the balance sheet structure of firms. The importance of credit rationing, namely the tendency of credit institutions to set quantitative limits to the credit supplied to individual clients, depending on their standing, was high in certain economies and low in others. In Belgium or Italy, where households were large holders of government securities, the wealth effect produced by the central bank via changes in the price of government bonds was more sizable than elsewhere. Similarly a highly indebted household sector is more responsive to a change in monetary and credit conditions than a balanced one.

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Different patterns of household savings and debts also result in different responses to monetary policy impulses. In France, for instance, households traditionally held a large part of their savings in the form of money market funds, so part of their income was positively correlated with monetary policy rates. Meanwhile French households typically finance home purchases through long-term, fixed-rate loans, so this part of their liabilities was not directly sensitive to movements in official rates. By contrast, in Ireland, Spain, and Finland, where residential mortgage rates are indexed on short-term rates, monetary policy decisions have a direct impact on households’ wealth.37 Over time the features described above can be expected to converge, partly as a result of the euro itself. In these early years, however, monetary policy has to cope with a financial structure that lacks the cohesiveness typical of mature unions. The second peculiarity of the transmission mechanism concerns the real aspects of the economy. It lies in the fact that the domain of the single monetary policy does not correspond to the one in which many decisions that strongly influence the inflation rate are taken. While the former is euroland, the latter is still predominantly national. With some simplification one could say that price-setting decisions in the economy are taken in two different modes that correspond to a competitive and a noncompetitive paradigm. Both modes are normally present in any economy, albeit in proportions that vary from country to country. In the competitive mode all prices, including the interest and the wage rates, result from the “atomistic” interactions of profit-maximizing firms, workers, consumers, and savers. Here the chief mechanism by which monetary policy ensures price stability is the effect of interest rates on spending (investment and consumption) decisions. In the extreme case, where a whole economy functions in this mode, no economic agent would be a price setter and all price decisions would be completely impersonal. The key variable monetary policy seeks to influence—the consumer price index, which is a statistical abstraction—would be entirely made of individual prices that “no one” sets. Monetary policy would not need to speak to anybody, and money would be neutral not only in the long but also in the medium or even short run. In the noncompetitive mode there is an identifiable decision-maker, with ample power to influence the market price of many goods and services. A single decision taken by the supply side of the market, or through a collective bargaining process, sets a price that is then adopted in a wide range

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of individual transactions and exchanges. Wage setting is the foremost, but by no means the only, case where such mode applies. Other prominent examples are prices of mass-produced goods or services (air or train transport, cars, computers, books, newspapers, food, etc.), administratively set prices, tariffs set by professional orders or public utilities. Of course, the fundamental economic laws of scarcity and self-interest that preside over the competitive mode also work, over time, for the part of the economy where the noncompetitive mode applies. Over time, the level at which the price is set triggers responses in terms of quantities sold or produced. In the short or medium run in which monetary policy works, however, the distinction between the two modes is relevant. In the first mode, monetary policy tends to work through markets that act and react relatively quickly. In the second mode, it must address itself more directly to price setters in an effort to influence them before their decisions are taken, knowing that rigidities and inertia make corrections slow and costly. In the first mode, the central bank could simply act by buying and selling assets in the money market. In the second mode, it must also speak, persuade, scare, be credible. Both modes are reflected in the economic literature, and indeed, differences of views as to the role of monetary policy largely depend on the relative importance attributed to the two modes.38 The intellectual paradigm of the first mode is general equilibrium with perfect competition, game theory is the paradigm of the second. The general equilibrium paradigm rests, first, on the assumption that every quantity and economic variable has an impact on all other variables. Furthermore it assumes that economic agents are unable to exert an impact on the formation of prices. This model of the economy, known in its essentials since Walras (1874), has received a systematic treatment in Debreu (1959).39 Game theory reverses the assumption that agents are atomistic and formalizes the strategic behavior of “big players” who interact and influence each other. Unlike in the general equilibrium paradigm with perfect competition, here the issue is whether, in making their economic decisions, agents internalize the expected reaction of their counterparts to their moves. Game theory was inaugurated in a celebrated book by von Neumann and Morgenstern (1944) and has since blossomed into one of the main fields of theoretical economics. Its emphasis on strategic interactions has made this framework of analysis particularly amenable to the study of situations where a large economic institution (e.g., a central bank) makes policy decisions in a context in which another large player (e.g., trade unions) can influence the final outcome of that policy.40

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Any economy—and euroland is no exception—is a blend of the competitive and noncompetitive modes, and this is why any central bank acts and speaks, is simultaneously engaged in hard action and in the game of influencing collective behavior. Prior to the euro, the most successful countries in maintaining price stability were not necessarily those where the competitive mode prevailed over the noncompetitive one. Brilliant performances were achieved where the game played between the central bank and the collective price setters was cooperative rather than disruptive. This is why the rigid and largely corporatist structure of the German economy has not been an impediment, and might have even been conducive, to price stability. Where the speciality of the euro lies is in the fact that the competitive mode is largely euro area wide, while the noncompetitive mode is still predominantly national. The most important price set in the collective mode, namely the price for labor services, is set—as explained in the previous chapter—through negotiations between employers and labor organizations whose outcome applies nation wide. The same is true for the services of public utilities such as energy, transportation, and telecommunication. Even the price of such mass products as cars, laptops, dishwashers, spaghetti, and mineral water—each offered to the whole euro area by a relative small number of mass-producers—today is often uniform within a country and diversified only across countries. Although suppliers are overall fiercely competing, they are able to exploit a market power that differs from country to country. At the start of the euro, the economy of euroland was in an intermediate position, in which integration had gone too far to allow a plurality of currencies and monetary policies but not far enough to exhibit the financial, economic, and social cohesiveness of a mature single economy. Euroland is thus characterized by an uncommon relationship between the central bank and the price-setting mechanism. On the one hand, the central bank (the Eurosystem) is facing a plurality of national price setters. On the other hand, the national price setter, be it the labor union or a large public utility, is no longer confronted with, and disciplined by, a national central bank endowed with the countryspecific instruments that were used, or threatened, before the monetary union. The challenge involved in the adoption of a single currency is twofold: first, to firm up the part of the integration process that had already occurred, and second, to foster the process by means of the single currency, thus reaping additional benefits. Success requires a number of long-run

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strategies, of which some pertain to the Eurosystem, some to nonmonetary—national and European—actors. For the Eurosystem it is crucial to be conscious of the peculiar features of its mission and to actively follow all useful paths. The policy challenge transcends the normal task of a central bank in the pursuit of price stability. It extends to the structural transformation that the euro area economy has still to accomplish, partly as a result of the very adoption of a single currency. Beyond monetary policy this challenge embraces—as we will see in the next two chapters—the other central banking functions, related to the financial and payment systems. Because the various aspects of central banking form a single whole, it would be illusory to think that over time the Eurosystem could adequately perform its monetary policy function while neglecting the other aspects. Moreover the Eurosystem must mobilize all of its components, notably its NCBs, to the task of overcoming and compensating the peculiarity of the transmission mechanism it faces. The policy message accompanying monetary decisions must be consistent throughout euroland, but need not, and should not, be phrased identically everywhere. It is for national governors to give country specific warnings where public administrations are about to increase publicly set prices above euroland’s inflation rate, or social partners to stipulate excessive wage increases, or governments to deviate from the Stability and Growth Pact. In the past, national governors used to flash the threat of refusing monetary accommodation to discourage decisions incompatible with price stability. Today, they can explain that collective price decisions running counter to the overall economic conditions and monetary policy stance of the area would, by definition, not be accommodated and hence would inevitably produce competitive losses and decline in employment. Other strategies pertain to nonmonetary actors, along the lines reviewed in the previous chapter. Indeed, at the national level the loss of monetary policy requires more active use of other policy levers, both micro and macro. As to the former, economies where competition is wider are better equipped to cope with a single monetary policy. It is therefore an implication of the euro that the area of the noncompetitive mode should be reduced, which largely amounts to a reduction in structural rigidities. As to macro aspects, the desirable strategy is full preservation of budgetary discipline (mainly based on compliance with the Stability and Growth Pact requirement for a budget “close to balance or in surplus”), coupled with increased flexibility in the structure and size of budget revenues and expenditures. This is indeed the condition that allows a country to respond

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with fiscal instruments to disturbances that were previously corrected with monetary policy. 4.6

Transparency, Communication

While the decision, the operations, and the transmission of monetary policy form a temporal sequence, transparency and communication run parallel to the whole sequence. They are probably the most controversial aspects of the Eurosystem activity. The background is the 180-degree change in the approach to transparency that has occurred over the short span of one generation. For decades, silence, secrecy, opaqueness, and surprise were praised as the pillars of central bank wisdom.41 The general public had very limited interest in monetary policy, and even financial markets were not watching the central bank on a continuous basis. Such an old world is not so distant if we consider that until 1994 the Fed did not announce its target interest rate, leaving the markets to find this out. All has changed. Like most public institutions, central banks have come under close scrutiny by the general public, professional observers, and the media. Higher living standards, demographic trends, and the spreading of private pension systems have made financial developments crucially relevant for the masses. Innovations allow millions of individuals to directly manage their savings, shifting funds from bank accounts to fixed income or to equities. In the name of openness, transparency, and predictability central bankers are under a continuous and insatiable request to “say more.” The request is sometimes so strong that the central banker’s only defense is to deliberately choose words that are hard to decipher.42 Yet monetary policy itself has an interest in transparency, which was fostered by an increasing awareness of the game-theoretic aspect of the transmission mechanism described in the previous section as well as by a strand of academic research highlighting the importance of rational expectations. Communication has thus become an indispensable tool to improve the transmission of monetary policy by managing expectations in financial markets and guiding the behavior of wage and other price setters. For some central banks, direct communication with, and support from, the general public has also been a way to counterbalance subordination to government. For others, it was a way to honor an acquired independence status. The present practices of the ECB can be summarized as follows. Once a month the president holds a press conference, which consists of an introductory statement explaining policy decisions, followed by a questions and

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answers session. The transcript of the press conference appears on the ECB Web site. The ECB also publishes a monthly bulletin, containing an analysis of economic and monetary developments as well as longer-term studies and other background information. Quarterly the ECB president appears before the European Parliament. Twice a year staff forecasts on inflation and growth are published. The president and other members of the Board speak frequently in public and, occasionally, on television. Through their own publications, speeches, and interviews, NCBs explain monetary policy to a national audience in the national language. There are differences between the ECB and other main central banks of the world, the Fed, the Bank of England, and the Bank of Japan. The Eurosystem provides real-time information that no other major central bank offers today. The day of the meeting, the Fed and the Bank of England issue a brief press release without meeting the press. The Bank of Japan holds a press conference one to two days after the second monetary policy meeting of the month. On the other hand, minutes of meetings and individual voting behavior are published by the three other central banks but not—for the reasons explained below—by the ECB.43 Macroeconomic forecasts are published quarterly by the Bank of England in an inflation report. They represent the “best collective judgment” of the Monetary Policy Committee and staff. Consistent with the fact that the policy-making body takes responsibility for the inflation forecast, the Bank of England is required by statute to publicly justify—in a letter to the Treasury—marked deviations from it.44 For the ECB the projection of growth and inflation rates, which is published twice a year, does not involve the responsibility of the Board or the Council and is merely an element in the second pillar of the strategy. As to the Fed, it treats the subject as very confidential and refrains from publishing either forecasts or the underlying models, while members of the Federal Open Market Committee members are not entitled to witness the process by which the staff forecast is derived. If monetary policy is dubbed as an art rather than as a science or a technique, this is largely due—in our days—to the difficulty and nature of its communication. The never equal circumstances, the multiplicity of purposes, its unavoidable personalization, the diversity of channels and addressees make it an arduous task for any central bank and for the Eurosystem in particular. In the euro area both the sending and the receiving side of communication are still in the process of learning the features that differentiate them from ordinary countries and central banks.

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As to the receiving side, the general public in Europe is still divided in national segments, accustomed to different languages and types of messages, and focused on different concerns. Moreover traditions differ across countries in the way the central bank relates to the government. For example, the Banque de France has been strictly dependent on the Treasury until the eve of the euro, whereas the Deutsche Bundesbank and the Banca d’Italia had a large degree of independence. Such segmentation persists, but at the same time money and financial markets rapidly consolidate and react to ECB communication in an integrated way. Another feature of the receiving side is its still rudimentary information about the euro and the Eurosystem, clearly inferior—as surveys show—to the pre-euro standard. Even such sophisticated media as wire services, for example, have continued for some time to give wide coverage to declarations of regional presidents of the Bundesbank, well after they had ceased to have any say in monetary policy. Turning to the sending side, the Eurosystem is the only major central bank operating with a plurality of (eleven) official languages. Moreover, even when perfectly translated, one and the same message often carries different meanings and is perceived differently in the various national contexts, due to differing traditions and conventions. For example, the German public has been educated by the Bundesbank to be continuously warned against the risk of inflation and would perhaps take a change in communication practice as a disquieting sign that, with the euro, price stability has become less important for the central bank. In other countries, with a price stability record only slightly inferior to the German one, the style of communication of the central bank was less grim, and the adoption of the Bundesbank style might raise inflationary expectations rather than reassure the public. Given the two-sided nature of the communication process, it is not always easy to establish whether possible misunderstandings depend on the sending or on the receiving side. A foremost example concerns the “one voice versus many voices” issue. In the case of the US Fed or the Bank of England, a free expression of multiple—and sometimes diverging—views tends to be perceived by the markets and the media as a positive sign. It indeed reassures that in policy-making a wide spectrum of points of view is considered, which is conducive to better decisions. By contrast, in the case of the Eurosystem even small differences in tone and wording by members of the ECB Council have often been criticized as signs of confusion and lack of a clear policy line. In fact the inherited traditions of the NCBs, the plurality of languages and communication

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protocols, and—last but not least—the nature of the policy transmission process described in the previous section actually compel the Eurosystem to speak with many voices. In euroland communication cannot be as concentrated onto the person of the president as it is onto the chairman of the Fed for the United States or the governor of the Bank of England. When discussing “how central banks talk,”45 it should be borne in mind that communication serves both transparency and accountability, or, in other words, both policy effectiveness and democratic control, two noncoincident, and at times even conflicting, objectives. Utterances aimed at effectiveness need to be forward-looking and easily understandable to economic agents and financial markets. The optimum does not consist in maximizing the amount of information but rather in a targeted selection of messages and clear command of the interpretative keys used by the receivers. If appropriately managed, the communication of intentions can raise policy effectiveness enormously. Utterances aimed at democratic control, in turn, have a mainly backward-looking content, need primarily to explain how the institution has fulfilled its mandate and how its actions relate to the interest and welfare of the citizens.46 Always central banks must speak the language of ordinary citizens and beware that elected politicians have only recently renounced conducting monetary policy themselves. Meanwhile, in weighing the requirements of transparency and accountability, namely in assessing the respective roles of political control and policy effectiveness, the Eurosystem has, quite understandably, decided to take no risk on the side of policy effectiveness. Of course, since effectiveness and democratic control do not use specialized channels of communication, information, analyses, and comments provided by the central bank are interpreted interchangeably in the light of both purposes. This is reinforced by the fact that a truly European public opinion is slow to emerge and the European Parliament is not widely perceived by the people as the key democratic body that represents them. Two much debated issues highlight the difference between transparency and accountability: the release of the minutes of policy meetings, and the publication of economic forecasts. In both cases the request to increase disclosure is often supported with mixed, and even opposite, arguments. For example, parliaments ask for the publication of forecasts in the name of accountability, while analysts request the disclosure of voting behavior in the name of transparency. In the light of the distinctions above, the publication of forecasts should be related to policy effectiveness, rather than political control.

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Correspondingly the release of the minutes of policy meetings can hardly be justified with the need for effectiveness. An example shows how accountability and transparency may occasionally conflict. If minutes with attribution of opinions to individual participants were to be released some weeks after the meeting, it could become more difficult to agree on an elaborate press statement on the day of the decision. The reason is that the discussion of this statement, which is necessarily brief, could preempt the subsequent lengthier discussion of the precise wordings of the minutes. Also in view of this possible dilemma, the Eurosystem has deemed more useful to offer to the market and the general public a “same day” extended statement and a candid “questions and answers” session. Indeed, delayed publication of extensive minutes and voting records would not help markets and the general public to take informed decisions in the immediate aftermath of ECB meetings. Meanwhile publishing detailed minutes with attribution of statements and votes would encourage an interpretation of the ECB Council as a collection of “national factions” and expose some of its members to the risk of undue political pressure.

5 Financial System: The Euro as Unifier

Banks are the creators of the largest component of the money stock and the main providers of payment services. Together with financial markets, they play a key role in central bank operations and in the transmission of monetary policy. Crises in banking and finance may disrupt both the economy and monetary policy. These are the reasons why, as described in chapter 2, financial stability is an integral part of the tasks of central banks. The Eurosystem can be no exception. However, the task is specially challenging for it because of two, potentially conflicting, developments triggered by the advent of the euro. On the one side, euroland’s financial markets and institutions are receiving an impressive impulse to consolidation, prompted by the disappearance of currency segmentation. On the other side, at the very moment in which such impulse is imparted, national competence is preserved in the field of prudential supervision. This chapter reviews both market developments and policy arrangements. After an explanation of why currency specificity is crucial to identify a single banking and financial system (section 5.1), in section 5.2, I outline the features of the continental European model and in section 5.3 the impact of the euro. In sections 5.4 and 5.5, I then examine the existing arrangements for financial regulation and supervision and in section 5.6 the role of the Eurosystem. For the purpose of this chapter, I define the financial system as encompassing all financial intermediaries and markets, as well as the market infrastructures and the regulatory and supervisory system impinging on their functioning. 5.1

Single Market and Currency Segmentation

Conceptually, economically, and geographically the single market and the single currency are two distinct entities. The distinction is particularly relevant when discussing the financial system, since a frequent error is to

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argue that all that really matters for the policies concerning the financial system is the single market, and not the single currency. In January 1999, at the launch of the euro, the single market had already produced many of the intended effects. From the 1980s onward the financial system had gone through a massive legislative change and reorganization. Already before the euro, capital could move freely across the European Union and financial institutions were allowed to provide services in all member states, with a single license and under the sole supervision of the home-country authority. However, harmonization of rules and lifting of barriers to entry in national markets were not enough to create a single “domestic” market. The permanence of different currencies was a powerful factor preserving national segmentation. Currency segmentation prevents neither the free movement of capital nor the free provision of financial services across national frontiers. Yet, for financial intermediaries and markets, the currency is a crucial element in the organization of activities. In fact in the single market financial activities remained segmented by currencies even within a single bank, and institutional investors used to allocate their global portfolio to currency lines. Accordingly financial centers were specialized in financial products denominated in their national currency. With the advent of the single currency and the Eurosystem, this segmentation started to fade away. The extensive restructuring of the financial system in euroland—the wave of mergers and acquisitions and, what is more important, the reorganization of activities at an areawide level within large financial groups—is a major demonstration that currency segmentation mattered. The introduction of the euro also affected the currency composition of the business undertaken with residents outside the euro area. While at the beginning of 1999 dollar denominated assets of euro area financial institutions towards non–euro area counterparts were almost twice as large as euro-denominated ones, the gap narrowed substantially by end-2002. Significant effects are also visible in those segments of the European financial market where issuance in US dollars was dominating (the so-called euro-dollar market). For instance, in the European commercial paper market the share of euro-denominated debt instruments increased from less than 20 percent at the beginning of 1999 to almost 50 percent in 2003, while the dollar-denominated share fell from almost 60 percent to less than 30 percent in the same period. Regardless of the empirical evidence, it might be argued that, at least for banks, the very creation of the Eurosystem has ipso facto determined the

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emergence of a unified system. Why is it appropriate, in the case of banks, to refer to a “system” while no one would dub the steel or the chemical industries as “systems”? All the answers to this question have to do with the singleness of the currency and the central bank. First, banks are interconnected through payments. As I will further show in chapter 6, this undoubtedly constitutes a system, linking participants in a network that is also a vehicle for quick propagation of risks. Second, banks have collectively the function of channeling liquidity to the rest of the financial sector and to the economy as a whole. In performing this basic task, they are strictly dependent on the access to central bank liquidity. Third, confidence in the currency and the central bank influences all parties operating in a single currency area. The financial market may remain segmented, but if a liquidity need emerges in a segment of the financial industry, it is always the central bank that bears the ultimate responsibility for it. Hence the shared framework for accessing central bank liquidity ties together the banks and, through them, the other components of the financial system. The singleness of the currency is indeed, more than it is usually recognized, the factor that justifies the notion of a system in banking and finance. This applies, as we will see, to euroland, but it also applies to any other country. In the United States, for example, even when interstate banking and branching still faced strict limitations, the financial system was a single entity. A single monetary policy and a single regulatory framework implied that the structural trends and systemic disturbances cut across state borders. The jurisdiction of the central bank by itself defines the geographic borders of the financial system. 5.2

The Continental European Model

The blurring of frontiers between financial contracts, intermediaries, and approaches to regulation and supervision have somewhat attenuated what used to be the distinctive features of a continental European model. The internationalization of finance has further harmonized the financial features of the major industrialized countries. Nonetheless, due to a degree of path dependency intrinsic in structural developments, some specific aspects of financial intermediation that took shape in the past still affect the present, not only in Europe but also in the United States. The salient characteristics of the continental European model are (1) the dominant role of banks, (2) universal banking, (3) bank-assurance, (4) public ownership, and (5) a “hands-on” approach to regulation and supervision. I will briefly review these characteristics.

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In continental Europe banks have traditionally played a dominant role in channeling savings toward investment opportunities. In the United States and the United Kingdom market-based finance, namely the issuance of securities by the investing sectors, has traditionally played a much larger role. The recent deepening of securities markets in Europe has changed, but not suppressed, the bank-based feature of the European financial system. Euro area stock markets developed steadily during the 1990s, and notwithstanding the significant drop in stock prices since 2001, the ratio between stock market capitalization and GDP is still more than double than in the early 1990s. Issuance of corporate bonds also grew remarkably for several years, before the recent slowdown of primary market activity. The deepening of securities markets has proceeded hand in hand with the widening role of institutional investors. And this role is bound to grow further with the gradual move from pay-as-you-go to funded pension schemes.1 Developments of the last decade, however, did not marginalize banks in the euro area. Either directly or through closely controlled entities, banks still play the leading role in the provision of services for the issuance of securities and in the asset management industry. This reflects their “universal” nature. Universal banking is the term used to define the ability of banks to engage directly in the full range of securities activities and to establish close links with nonbank firms, through equity holdings or board participation. Even though universal banking was, and still is applied, in many countries around the world, it surely is a most prominent feature of banking in continental Europe. The difference between the United States and euroland can be best understood by referring to the boundaries of what banks can do. Both jurisdictions define banks as institutions that couple deposit taking with the supply of loans. However, this shared notion of the core function of banking is accompanied by a clear difference in the range of activities that a bank is allowed to conduct. In the United States, banking has been essentially limited to the core function, with a very narrow range of additional activities. The EU banks, while holding an exclusive license to perform the core function, do not face major restrictions of the range of further financial services they are allowed to offer.2 In the United States the traditional barriers separating banks from securities and insurance were partially released only with the Financial Holding Companies Act of 1999. Also Japanese

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banks’ activities are limited to core functions, but a wider range of financial services may be provided by a banking group by means of subsidiaries. Bank-assurance, the third distinctive feature, may be viewed as a further extension of the universal banking model. Operational linkages between banks and insurance companies have traditionally been more developed in Europe than in either the United States or Japan. Ownership linkages between the two sectors used to be subject to several constraints in Belgium, France, and the Netherlands, but the restrictions were generally alleviated at the beginning of the 1990s and also previously they did not prevent the establishment of close operational relations. More recently close linkages between banking and life insurance have further developed in fully integrated groups providing the whole range of financial services, the so-called financial conglomerates. The freedom enjoyed by European banks in developing their business beyond traditional deposit taking and lending was often balanced by the strong involvement of government in the financial sector, through both public ownership and a “hands-on” regulation and supervision. In continental Europe, public ownership of banks is rooted in history and predates the industrial revolution and the development of modern market economies. It originates from the often nonprofit and charitable nature of lending and pawnbroking. Public ownership was further extended in the last century as a way to rescue banks that failed in the crisis of the 1930s, or, later, as part of nationalization programs implemented by leftist governments.3 In many European countries the widespread presence of central or regional governments in the ownership structure of banks was also seen as a way to alleviate the risk of systemic instability in the financial system. In the last decade of the twentieth century, public ownership of banks became less relevant in Europe and privatization programs were adopted. This reflected a change in prevailing economic ideas as well as the creation of the single market, which dismantled regulatory barriers, tightened competition rules, and eroded the “game reserves” of public banks, usually endowed with special charters.4 Admittedly, however, privatization does not per se create a smoothly functioning market for corporate control, where inefficient owners and corporate governance structures are replaced through shifts of control rights, such as via a takeover bid. The ownership structure may be engineered in such a way as to prevent shifts in control, and public authorities may continue to interfere to some extent with moral suasion or other instruments.

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The last distinctive continental European feature of the financial system is the “hands-on” approach to regulation and supervision. This feature has been only partially corrected by the trend toward a more market-friendly approach that has emerged worldwide at the end of the last century. This trend has developed also in Europe, where the creation of the single market has fostered a lighter regulatory and supervisory approach. However, the distinct “hands-on” features of the continental European approach have persisted. The recent wave of financial and technological innovations has actually revived the difference between the continental European attitude and the “hands-off” approach typical of the US tradition. Following this latter approach, which can be traced back to the free banking regime of the nineteenth century, recent technological developments can be seen as depriving banks of the special features that justified extensive prudential rules.5 Financial institutions should therefore be treated as any other corporation and any entrepreneur should be left free to enter the industry, without public regulation influencing their behavior and ability to innovate. Thus bank regulation should not prevent the private, nonbanking sector from trying out new solutions, with a greater role to be played by self-regulation.6 The continental European approach maintains, instead, that the public policy concern generated by the core function of banks is not wiped away by the fact that it can be conducted by means of new technologies. All entities performing such function therefore need to be under the safety net consisting of prudential controls, deposit insurance, and access to emergency liquidity in case of distress. This is why a strict licensing procedure has to be in place, so that all entities engaged in banking activities are subject to the same rules and controls.7 5.3

The Shock of the Euro

The disappearance of currency segmentation brought about by the euro was a shock to a European financial system already pressed to change and in search of a new equilibrium. Has a unified market for banking and other financial services already emerged? Although, as argued above, the jurisdiction of a central bank by itself defines the borders of a system, a more concrete review of recent developments is necessary to fully answer this question. It is frequently argued that a single system will only emerge if and when cross-border mergers among financial institutions occur.8 This assertion

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identifies the domain of a market with the ownership structure of the firms operating in it, and fails to adequately consider the integration of activities. In reality the ownership structure has only a modest significance for assessing the degree of market integration. For example, in key manufacturing industries, which are undoubtedly competing in a European-wide market for much longer, only few cross-border mergers have taken place. That cross-border mergers are not the decisive indicator of the emergence of a single industry, is also suggested by the US experience. After the removal of barriers to inter-state banking in 1991 mergers and acquisitions mainly took place within states, while concentrations across states were rare and generally confined to neighbouring states.9 Only at a later stage did nationwide operations become more frequent. This resembles what is happening in Europe today, with a large number of intrastate mergers and very few interstate cross-border mergers between banks in close proximity to one another (e.g., in Scandinavian countries and in the area including Belgium, the Netherlands, and Luxembourg). To assess whether the removal of currency segmentation has unified the market, attention should focus on financial products and services, rather than on the ownership structure. To this end, the simple, most frequently used, criterion is the so-called law of one price, stating that if the same product is sold at different prices within a competitive market, arbitrage activities will eliminate price differences.10 A market is thus identified as the space where, under the forces of competition, the same good or service is sold at the same price. In the field of finance, however, the law of one price is—for two reasons—of limited help. First, finance is a field where a given product is often not sufficiently homogeneous for its price to be equalized through arbitrage. Quality competition—as distinguished from price competition—is crucial for most financial products and services. Second, in finance there is a plurality of products and services, ranging from asset management to insurance policy, from loans, to mergers and acquisition (M&A) services, to privatization.11 This implies that markets where different products and services are exchanged differ in size and geographical span. These features make it very difficult to apply the law of one price and, more generally, to find a unifying empirical measure of the degree of integration of the market. To overcome the difficulty, the discussion of overall financial activity will be divided in three main categories—wholesale, capital market, and retail—to be considered separately. Wholesale activity is the one where the two sides of the transaction are not the end users—say, households or firms—but financial institutions. It

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constitutes the inner core of the monetary and financial system and also the part closest to the central bank. It is the main channel for transmission of both monetary policy and potential financial instability. In this segment of the system product standardization is high and the law of one price can be applied. The key component of the wholesale market is the transfer of liquidity among banks, which takes place mostly in the market for unsecured deposits (almost 50 percent of total interbank activity).12 In this market the law of one price began to work almost immediately after the launch of the euro, on January 4, 1999, when interest rates became virtually identical in all countries, signaling that market segmentation had disappeared. Market integration was somewhat less prompt for secured transactions, where legal discrepancies and practical difficulties in the cross-border management of collateral tend to obstruct the arbitrage mechanism.13 The second set of products and services comes under the heading capital market activity. It is so denominated because the counterparty of the financial institution is the capital market. This activity—constituting the essence of investment banking—comprises corporate finance and asset management services. The former consists of services offered to firms, which are in a position to tap capital markets, such as bond and equity issuance, privatization, syndicated lending, mergers and acquisitions, and corporate restructuring. The latter relates to managing asset portfolios of savers, which can be individuals, corporations, pension funds, or other institutional investors. It should be noted that the management of assets is kept distinct from the distribution of the products to final investors (i.e., the collection of savings), which is a retail activity, to be considered below. In capital market related activity, quality competition is very strong, since the reputation of the intermediary and its relationship with other market participants—for example, in terms of placing power—play a major role. Hence the law of one price applies only to a limited extent. Bond issuance is the field of corporate finance where both prices and amounts show that the unification of the market has come about rather quickly after the start of the euro. Indeed, the volume of funds denominated in euro raised by private entities (i.e., nongovernmental, but including banks) doubled in the first year of EMU and international operations grew consistently more than domestic ones. This reflected the fact that international bonds could be issued in the debtor’s own currency, the euro. The spreads narrowed significantly, demonstrating increased liquidity. More difficult is to gather evidence for other corporate finance services such as underwriting services, syndicated lending, structured finance for

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start-ups, and the various advisory services relating to mergers and acquisitions and corporate restructuring. However, it should be noted that, since these services are highly sophisticated and clients large in size, the market was already tending toward a high integration before the euro. Turning to asset management, important economies of scale and benefits from spreading risks push toward the concentration of actual management of assets and trading activity, while enhancing international diversification. To show how fast asset management has moved away from purely domestic investments, suffice it to recall that from 1997 to 2002 the share of domestic stocks in European equity mutual funds fell from 49 to 29 percent. Both in corporate finance and asset management services, currency segmentation has been an impediment to exploiting the high potential for economies of scale. The advent of the euro has thus triggered a significant movement toward consolidation. More than twenty of the largest forty banks in euroland have been involved in important mergers as the euro was being introduced, between 1998 and 2000. While rarely on a crossborder basis, mergers were largely triggered by the fact that markets—in particular, capital markets—were no longer national in any meaningful sense. For the financial system of the euro a particular aspect is the role of London. Not surprisingly a bulk of wholesale and capital market activities in euro, involving euro area investors, issuers, and intermediaries takes place in London, which is the prime financial place in Europe as well as the center where most US and other non-European institutions are located. For example, large value interbank flows are about equally shared between London and Frankfurt, and even many large euro area banks conduct investment banking activities through specialized subsidiaries located in London. Strong cooperation between the Eurosystem and the Bank of England alleviates the anomaly that a significant portion of financial business denominated in euro takes place outside the area of jurisdiction of the central bank issuing that currency. The third set of products and services goes under the heading of retail activity. This is the most visible part of the financial system and the one that reaches the largest number of clients, mainly households and small firms. The retail market maintains a strong geographical segmentation because, with counterparties scattered and not very mobile, the crucial factor is proximity. The high visibility of retail banking contributes to the erroneous impression of a persistent division of euroland into national markets. It is interesting to note that euroland and the United States have

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similar features. According to a survey conducted by the Fed, more than 90 percent of banks’ clientele is located within a distance of less than 20 miles of the banks’ premises.14 Proximity is an intrinsic characteristic of the retail market, which remains relatively unaffected by the single currency. The significant market integration already achieved does not warrant the conclusion that no relevant impediments remain. First, there are obstacles, which are a historical legacy rather than the making of private agents or the effect of deliberate policies. The very existence of eleven languages, for example, still makes euroland a sharply divided economic space and makes the emergence of truly transnational undertakings rather difficult. Traditions in corporate culture and management styles are quite different across countries. The still predominantly national dimension of labor contracts is another factor. Moreover some relevant differences in legislation still exist, which are the outcome of the incompleteness of the European Union. For instance, there still is no common regulatory framework on takeover bids, while legislation defining the statute of an EU company, as distinct from nationally based undertakings, has been only recently introduced after a long debate. Private agents too may interpose obstacles to market integration. Intermediaries, or managers of market infrastructures, that enjoy, individually or in agreement with other firms, monopolistic rents in domestic markets will strongly oppose integration. They may also put in place anticompetitive practices, for instance, through local mergers or agreements. Finally, and not last in importance, there are the attitudes of national authorities, which naturally favor and support their domestic marketplace just as the regional governments of Bavaria or Cataluña support the fortunes of Munich or Barcelona within Germany and Spain. A “local” public authority (whether regional or national) pursues the quite legitimate goal of maximizing the welfare of “its” constituency. In the financial field it does so by favoring the access to funding by local corporations and by maintaining or increasing sources of income and employment for local intermediaries. As was noted in chapter 3, competition among national policy authorities is an integral part of the EU economic constitution and a beneficial factor to foster efficiency and growth oriented regulation. To the extent that emulation produces a spreading of best practices, it also contributes to the harmonization of regulatory approaches, which in turn facilitates the integration of the market. Economic contest ceases to be beneficial and becomes outright protectionism when efficiency is sacrificed to an “unwarranted” strategic objec-

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tive.15 In the pursuit of such strategic objective, a “tax” is imposed upon consumers or other producers in the form of inferior quality of the service, higher prices, and barriers to entry, for example. The effect of competition is higher overall efficiency, increase in the consumer surplus, and further integration of the market. The effect of protectionism is the opposite of all that. For the benefit of policy competition to be reaped, therefore, a line has to be drawn separating competition from protectionism, allowing the former and sanctioning the latter. This in turn requires a strong arbiter, superior to the contenders, regardless of whether they are private or public. Here is where the limit lies in the analogy between the national and the regional use of a local power in the competitive arena. In member states the central arbiter has much more power over regional governments than the European arbiter over national players (be this arbiter the European Commission in Brussels or the ECB in Frankfurt). National authorities retain the instruments and the mentality of a time in which the economic contest between nations looked more like a conflict than like a game. It may thus happen that the preservation of a strong nationally owned banking industry, or of a “local” capital market, is seen as a strategic rather than economic objective. Self-interested objectives, such as favoring national control over financial institutions or preserving jurisdiction on major domestic intermediaries, is persistently presented as an objective on its own right, regardless of the benefits for the users of the service. Similarly, in a not distant past, self-sufficiency in food or steel production was regarded as a vital safeguard of national independence. Several tools can be, and indeed are, activated to pursue national objectives, ranging from fiscal instruments to moral or political pressure, to the preservation of public ownership, to a distorted use of authorization powers. If national policies or private actions substantially hinder market integration, the European Commission—in its capacity to maintain a level playing field in EU competition rules—should have the strength and the instruments to intervene and undertake corrective action.16 5.4

Regulation and Supervision

To the extent that a single system is emerging, public control through financial regulation and supervision also becomes a euro area issue. This section illustrates the regulatory and supervisory system that euroland inherited from the single market and reviews the debate that has recently developed on the subject. This debate was largely triggered by the start of the single currency, but other factors contributed to it, such as the reform

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of regulation and supervision in the United Kingdom, and the rapid pace of change of the financial industry. Before entering the subject, a clarification in the terminology may be useful. Regulation and supervision are the two words commonly used to name the intervention of public authorities in the financial system. Regulation consists in issuing rules for banks, other intermediaries or other market participants. Such rules can be written in national or EU law, or in so-called secondary legislation, namely in norms issued by technical committees or agencies. Supervision is the activity aiming at ensuring compliance with the rules. It has an executive and judiciary (as distinguished from legislative) nature and is concerned with implementing and enforcing— often with a large degree of discretion—the rules. The two main public interests pursued through regulation and supervision are financial stability (for which the comprehensive term of prudential controls is often used) and protection of the investor. Depending on institutional arrangements, regulation and supervision may be entrusted to the same authority or be assigned to different authorities. Against this background, the regulatory and supervisory framework set up for the single market of banking and other financial services was based on coupling European regulation with national supervision. More specifically, the following four arrangements were adopted: (1) essential EUharmonized regulation; (2) mutual recognition of nonharmonized, national, rules; (3) national competence for supervision in the implementation and enforcement of the rules; and (4) close cooperation among national authorities. Of the four, the first two are the general arrangements that preside over the whole structure of the single market. They were adopted in the mid1980s to accelerate the program of establishing freedom of circulation of goods, services, capital, and persons in the European Union. Taken together, they have permitted to combine a simplification of the legislative program required to launch the single market with the benefits of policy competition. According to the third principle—national competence for supervision— every financial institution (which has the right to do business in the whole area on the basis of a single license) operates under the authority of the country where the license was issued. This principle, called home-country control, allows the unambiguous identification of the supervisor responsible for each institution. Cooperation among national authorities is the fourth and last principle. Clearly, in an integrated market that retains a plurality of “local” (national)

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supervisors, only active cooperation can safeguard, on a EU rather than only on a national scale, such public goods as openness, competition, safety, and soundness of financial intermediaries. EU directives state the requirement of such cooperation and remove the legal obstacles that professional secrecy in the conduct of supervision could pose to the exchange of confidential information among national authorities. It should be noted, however, that removal of obstacles is not the same thing as creating a firm obligation or an institutional arrangement that makes such cooperation happen in practice. The framework just described was inherited by euroland from the single market, for which it was designed. The question is whether it is sufficient to cope with the enhanced regulatory and supervisory requirements of a single currency area. Today the almost unanimous answer is that the framework is not quite adequate. Outside observers, representatives of the industry, national governments, the EU Commission, and the ECB agree that there are persisting discrepancies and inconsistencies in both national rule books and supervisory practices, as well as differences in the legal standing, organization, and professional expertise of national supervisors. Some also argue that the discretion of supervisors is too often used for protecting local markets or institutions. Even when it does not undermine safety or soundness, this situation deprives end users of better services and increases the burden for groups operating at an areawide level, especially in terms of costs of compliance. Thus it is widely agreed that an overhaul is needed, although the debate is open as to its extent and direction. The debate has proceeded in waves, touching in turn different sectors of the financial systems (banking and securities in particular) and different aspects of the framework (regulation, supervision, and the structure of public agencies). The field of banking attracted attention shortly after the start of the euro. A first appraisal was marked by a rather conservative attitude of the parties involved. Fearful that the move to the single currency could trigger a transfer of competence also in the field of prudential controls, national supervisors—particularly when they were central banks—mounted a strong defense of the status quo. In 2000 a report to the Economic and Financial Committee (the so-called Brouwer I report) basically blessed the framework inherited from the single market. The report acknowledged remaining differences in national supervisory practices and only advocated enhanced cross-border cooperation, with greater convergence in supervisory practices and more exchanges of information.

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A second wave of the debate focused on securities, a field where little preparation had preceded the launch of the single market. Here differences in regulation and supervision were found particularly pronounced because—much more than in banking—national rules had been only mildly harmonized and no clear structure for cooperation among national supervisors was in place. Moreover, as most of the rules were carved in the stone of EU directives rather than in the clay of secondary legislation, regulation could hardly adjust to the rapid pace of financial innovation.17 Furthermore, where general principles had been harmonized, the implementation often preserved wide differences across countries. These multiple shortcomings—which had the twofold consequence of thwarting the integration of the market and imposing an extra burden on the regulated entities—led the Ministers of Finance to set up a committee of experts called the “Committee of Wise Men” with the task of proposing ways to improve the situation. The consequent report (known as Lamfalussy report) in 2001 proposed a new approach for regulation and supervision respectively.18 As to regulation, it recommended that the directives be made more flexible by inscribing in them only principles and leaving to secondary legislation (entrusted to an ad hoc committee, composed of high level representatives from member states) more detailed provisions. This would make it possible to more easily update regulation to keep pace with changes in the marketplace. As to supervision, the report recommended that cooperation be improved among national authorities (by way of another, more technical, committee) to allow more homogeneous implementation and enforcement of common rules. The report argued that if this approach did not prove effective in removing regulatory obstacles to securities market integration within a reasonable time horizon, a change in the Treaty should be considered, possibly attributing more responsibility to the European level. What came to be called the Lamfalussy approach started to be implemented in 2001, when the two ad hoc committees were created. The agreement reached in the field of securities opened a third phase in the debate, which concerned the other sectors of finance, namely banking and insurance. The orientation is to fundamentally stick to the four principles described at the beginning of this section and simply to improve their functioning. To this end regulation would be made more flexible (along the lines suggested by the Lamfalussy report), cooperation among national authorities would be enhanced, and the configuration of existing committees would be completed and streamlined. The process for establishing the new regulatory and supervisory committees for banking and insurance has been lengthy and full of contro-

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versy. The delicate institutional balance between the European Parliament and the European Council by which to delegate powers to the new regulatory committees is yet to be completely settled. Also the issue of the composition and location of the supervisory committees proved to be controversial. Eventually the decisions were made and the new structure is almost completely operational at the time of writing. The arrangements will be subject to very important tests. Both in banking and in insurance the regulatory framework for capital adequacy is being extensively revised, and a major effort is needed to ensure consistent implementation and enforcement in the single market. European institutions have set up a monitoring framework in order to ensure that the new arrangements are effectively delivering a regulatory and supervisory environment adequate for an integrated currency area. 5.5

The Institutions of Supervision

As indicated earlier, a much debated issue triggered by the euro was the structure of supervisory agencies or, in simpler terms, “Who does what.” In some ways this was the hardest and most complex part of the whole debate, because not a single, but a cluster of often entwined issues was involved and because any assignment of policy functions stirs hot controversy. In the background there was the fact that the institutions of supervision differ widely from country to country (see table 5.1) and that no conclusive theoretical argument points to a single optimal setup. Transformation of the industry called, at any rate, for a reconsideration of existing arrangements. Moreover the adoption of a quite new approach by such a major financial center as London in 1998, and the active efforts to sell the formula around the world undertaken by the new UK agency, have further moved the spirits.19 Giving Europe a single currency and a single central bank naturally leads one to ask whether supervision should remain national or become itself European. This was the question explicitly addressed in 1988 to 1992 when EMU was designed and inscribed in the Treaty of Maastricht. In recent years two other issues were added to the debate on the institutions of supervision. To see the overall picture, let us begin by adumbrating these other questions. The first question is whether the various sectors of the financial system— banking, securities, and insurance—should be supervised by a single agency or by separate agencies. Advocates of the creation of the Financial Services Authority (FSA) as an all-purpose supervisor stressed that sector segmentation is increasingly disappearing. Critics emphasize that the

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Table 5.1 Institutional arrangements for supervision in euroland Number of supervisory authorities

Supervisory modela

Role of the central bank

Belgium

1

Single

Some operational involvement

Germany

1

Single

Some operational involvement

Spain

3

Sectoral

Full responsibility for banks

Franceb

6

Sectoral

Some operational involvement

Greece

3

Sectoral

Full responsibility for financial intermediaries

Irelandc

1

Single

Full responsibility for all financial intermediaries

Italy

3

Twin peaks

Full responsibility for banks and some nonbank financial intermediaries

Luxembourg

2

Sectoral

No operational role

Netherlands

2

Twin peaks

Full responsibility for the prudential supervision of all financial intermediaries

Austria

1

Single

Some operational involvement

Portugal

3

Sectoral

Full responsibilities for banks and some nonbank financial intermediaries

Finland

2

Sectoral

Some operational involvement

a. “Sectoral” denotes authorities with sectoral responsibilities; “single” denotes single authority for the whole financial sector; “twin peaks” denotes responsibilities divided by objectives (i.e., prudential controls versus enforcement of conduct of business rules). b. Close cooperation and administrative support exist between the supervisory authorities and the central bank. Additionally the chairman of the Commission Bancaire is the deputy governor of the Banque de France. c. The Irish Financial Services Regulatory Authority is a constituent but autonomous component of the Central Bank and Financial Services Authority of Ireland.

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requirements and approaches to prudential controls still differ widely across sectors and that Chinese walls as well as internal coordination are also needed within a single organization. Conflicts of interest may arise between the stability-related tasks and investor protection activities, namely the enforcement of disclosure and conduct of business rules.20 The second question was whether supervision (in particular, of banks) should be located inside or outside the central bank. Advocates of separation observe that concerns on the profitability and solvency of the banking industry may—in certain circumstances—lead monetary policy to excessive softness in fighting against inflation. They also point to the risk of moral hazard, since banks may take up excessive risks in the belief that the central bank would support them in case of difficulties.21 In the opposite sense, the information-related synergies between supervision and other central banking functions are arguments for concentrating the two functions in the central bank.22 In general, there are no conclusive theoretical or empirical arguments showing that a separate agency is a better supervisor than the central bank. Both approaches can function effectively or fail, depending on how they are managed. In the specific case of the Eurosystem, however, the balance may shift in favor of a continued, and even reinforced involvement of national central banks. With the introduction of the euro, the interbank market, the securities and derivatives markets, and the payment, clearing, and settlement infrastructures—which are the most relevant channels of contagion—have become euro area wide. Meanwhile the potential conflict with monetary policy should no longer be a concern, because the two functions are assigned to different levels and distinct decision-making bodies. The third question was whether supervision should be a national or a European competence. We have seen above that the combination of European regulation with national supervision, chosen for the single market, has been confirmed in the Maastricht Treaty. We examine here briefly the arguments for and against the appropriateness of this approach. If we rely on the experience of the past, in which there was coincidence among the geographies of currencies, supervisors, and financial institutions, the creation for a supranational, areawide agency would seem imperative. In fact the case of a unified financial system, where supervisory responsibilities are split among a large number of local authorities, is almost unprecedented. In the United States, banking supervision, albeit divided among different federal and state authorities, attributes to federal agencies (the Fed and the Office of the Comptroller of the Currency) the

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responsibility for large banks and financial groups with a nationwide business. It is somewhat surprising, then, that the transfer of supervisory competencies to the euro area level has not been put forward more strongly in the recent debate. The drawbacks associated with a plurality of national supervisors go from slowness in responding to problems, to use of national discretion for the protection of the national industry, to aggravation of the regulatory burden. It is not by accident that in past historical experience, a single currency area with a single financial system has almost always been complemented with a single supervisor.23 For large intermediaries with significant cross-border business a “one-stop only” relation with public authorities significantly reduces the costs of compliance. Also the changing dimension of systemic risk speaks in favor of shifting supervisory competence to euroland. Indeed, financial institutions are increasingly exposed to shocks originating outside national boundaries, while channels for contagion imply enhanced cross-border spillover effects in case of crises. Individually, national supervisors—which by construction lack the whole picture of the industry—may neglect important developments in the risk profiles of the entities they supervise. Collectively they may fail to provide an optimal control of systemic risk. On the other hand, defenders of national competence observe that since the final responsibility to decide whether to intervene with taxpayers’ money in case of a crisis lies with national governments, a supranational agency would lack clear lines for reporting and accountability. They also stress the benefits of proximity to the financial institutions, which grants supervisors a closer access to information and market rumors. Furthermore they observe that some policy competition between national systems may favor experimentation and comparison of different approaches. Finally they maintain that a European agency could hardly function without further harmonization of the legal and regulatory framework. This should include, in addition to traditional prudential rules, such fields as company laws and corporate governance rules, judiciary system for appeals against supervisory decision and settling controversies. Only time will tell whether the chosen approach will meet the euro areawide public interests generated by the emergence of euroland’s financial system. At this stage it can only be observed that a time measurable in years, not in months, will be needed for amending the existing framework. This requires redrawing the dividing line between primary and secondary legislation, which in turn involves rewriting the existing directives (there are about forty of them for the various sectors of finance) and, after that,

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adopting a whole new body of secondary legislation. Such a bulky undertaking would only be worthwhile if the resulting revised framework were kept in use for many years. This means that what is planned today is the regulatory and supervisory framework for a decade or more, a period in which the EU financial system is bound to undergo a substantial transformation and even face situations in which its stability may be under stress. Combining the preservation of national supervision with a rapid process of financial integration thus means accepting a major challenge and even taking a risk. Therefore one may wonder whether going for a refurbishment rather than for a new construction is the best approach. Few indeed deny that in the end a single market with a single currency requires a single supervisor, not just harmonized regulation. In this matter the principle of subsidiarity assigns the onus of the proof to the advocates of a supranational agency. Thus the capability of national authorities to establish a close network through cooperation and to deliver a unified functioning of the present institutional framework should be fully tested before considering any transfer of responsibilities to an EU (or euroland) supervisor. A single supranational agency could and should at any rate preserve, as far as possible, proximity to the supervised entities as well as the variety and richness of present structures. 5.6

The Eurosystem and Financial Stability

This final section deals with the specific role and concerns of the Eurosystem, the central bank that identifies the financial and banking system of euroland. Past and recent systemic crises show that financial strains developing outside the banking field can only be overcome if banks are capable of supporting the liquidity needs of other intermediaries, letting the insolvent ones face their own destiny and countering the risk of the whole financial system collapsing. As to the central bank, it has to be in a position—as “last” lender to banks—to ascertain the real financial conditions of its counterparts and to actively intervene if needed. Having a responsibility for the stability of the system as a whole, the central bank must carefully assess the impact of bank insolvency. This is why all central banks monitor the state of health of the financial system and strive to prevent adverse developments. Since, in case of a crisis, they are the ultimate line of defense before bankruptcy, central banks are subject to come under strong pressures to intervene and bail out ailing institutions and markets. For this reason they need

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to be assured that prudential controls are effective enough to make this occurrence as remote as possible. Thus there exists an unavoidable “central bank track” to financial stability, ultimately stemming—as explained in chapter 2—from the need of central banks to preserve the store of value and means of payment functions of money. This track is strictly intermingled with the “supervisory track” even when the latter is entrusted to a separate agency. Historically the two tracks were one, born with the failures of the free banking era, which showed the inability of private clearinghouses to effectively provide emergency liquidity to banks under stress and to monitor their behavior on a regular basis. The central bank track to financial stability is expounded in the Treaty, which asks the Eurosystem to “contribute to the smooth conduct of policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.”24 Given the separation between monetary and supervisory jurisdictions, this provision is clearly intended to ensure a smooth interplay between the two.25 The Treaty approach establishes a double separation—geographical and functional—between central banking and banking supervision. Functional separation holds even in countries where the supervisor is the national central bank, because the latter no longer controls money creation. Geographical separation is, as noted in the previous section, a not uncommon arrangement. It should be noted, however, that the Treaty also establishes a simplified procedure to entrust specific supervisory tasks to the ECB without recourse to the burdensome procedure of Treaty amendment.26 This is a “last resort clause,” which might be activated one day if the present arrangements proved ineffective. The Treaty thus implicitly indicates a preference for banking supervision to be entrusted to the central bank rather than a separate agency. Of course, activation of such a provision would make both the geographical and the functional separation disappear at once. Like any central bank without direct responsibilities for prudential supervision, the Eurosystem needs to monitor the banking and financial system in its jurisdiction. Similarly it needs to follow developments in the regulatory and supervisory policies and practices. Naturally the Eurosystem would have a role to play in the management of a crisis. Coordination mechanisms between the Eurosystem and supervisors must ensure efficient exchanges of information and contribute to an agreed stance on financial stability issues of common interest.27 Crisis management is the issue on which most of the criticism of the present arrangements has concentrated in the early years of the euro. It

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has been argued that in euroland responsibilities to manage a banking (or, more broadly, financial) crisis are neither clearly assigned nor openly disclosed, and that the sheer number of authorities potentially involved would make the efficient provision of emergency liquidity unmanageable.28 A crisis—just when cooperation between central banks and prudential supervisors is most needed—is the situation where the double separation arrangements of euroland may prove most problematic.29 When assessing the existing mechanism for crisis management, it should be borne in mind that lending-of-last-resort (i.e., the provision of central bank money) represents just one solution to a crisis.30 Two other solutions are the provision of taxpayers’ money into ailing or insolvent financial institutions and the injection of private money by banks or other market participants. These three solutions must not be confused and should be considered one by one. The private money solution is market based and is the preferable option, not just to save public funds but also to reduce moral hazard. For it to materialize, public authorities often have to play an active role, since private parties may otherwise be unable to act for lack of information or coordination. In the euro area the coordinators would normally be national supervisors and central banks. The Eurosystem and the relevant supervisory committees would become involved whenever the crisis had relevant cross-border dimensions. The taxpayers’ money solution comes into play in case of a significant insolvency. Politically liable Ministries of Finance may feel that the failure of a large portion of a country’s banking system, or of a single large institution, would cause too negative macroeconomic and social consequences and hence may decide to provide support from the public budget. Crisis management procedures involving taxpayers’ money are left practically unaffected by the introduction of the euro. The European Commission would be directly involved, since any state aid must be compatible with the Community’s competition legislation. Central banks usually play a role in such cases, either because bridge finance is needed while the rescue gets organized, or, more generally, because they sometime intervene in the market place helping in ring-fencing the ailing institution, thus preventing contagion. Only the central bank money solution is the specific lender-of-last-resort function, a notion dating back more than 120 years and referring to emergency lending to institutions that, although solvent, suffer a rapid liquidity outflow due to a sudden collapse in depositors’ confidence, such as a classic bank run.31 Nowadays, in our industrial economies, such classic runs

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are to be found more in textbooks than in reality, because of the many antidotes developed since the late nineteenth century.32 Deposit insurance, the regulation of capital adequacy and large exposures, improved licensing and supervisory standards, all contribute to the preservation of depositors’ confidence and minimize the probability that a modern bank is solvent, but illiquid, and at the same time lacks sufficient collateral to obtain regular central bank funding. What if this rare event was nevertheless to occur and cause a systemic threat? The answer is that national arrangements would continue to apply, including those concerning the access of central banks to supervisors’ information. National central banks would bear the responsibilities and the costs for such operations. In case the amount of liquidity creation required was significant, the ECB Council would be involved. Full exchange of information should ensure that any potential liquidity impact is managed in a manner consistent with the single monetary policy. The provision of emergency liquidity to a bank is not the only case where central bank money may have to be created to avoid a systemic crisis. A general liquidity dry-up may also be caused by a gridlock in the payment system or a sudden drop in stock market prices. The actions of the Fed in response to the stock market crash of 1987 or those jointly conducted by the ECB and the Fed in the aftermath of September 11 are examples of a successful central bank operation used to prevent a dangerous marketwide liquidity shortfall. These actions are close to the monetary policy function. That the Eurosystem is prepared to handle this kind of market disturbance has already been proved on some occasions, such as the operations in the aftermath of September 11, 2001.

6 The Payment System: The Plumbing of Euroland

The payment system consists of the set of instruments, networks, rules, procedures, and institutions that ensures the circulation of money. It is a vital infrastructure for the proper functioning of a market economy, much like the legal or the transport system. It is also a key component of the transmission mechanism of monetary policy. Its safe and smooth operation is indispensable for the stability of the currency, the financial system, and the economy in general. To show the importance of what Gerald Corrigan, former president of the Federal Reserve Bank of New York, once called the “plumbing” of the monetary system, consider January 4, 1999. This was the first day the euro was introduced as a medium for transactions in the money and securities markets. Had the newly built euroland payment system failed to function, the whole world would have sniggered and scornfully concluded that the much-celebrated project of a single European currency was a bust. The metaphor of the “plumbing” is appropriate because it hints at the circulation of liquidity, but also because it refers to the humble back-shop of logistics rather than to the noble realm of policy. After providing a general background in sections 6.1 and 6.2, I present the key issues of making euroland a single payment area in section 6.3. These issues are further explored for the three fields of retail payments (including banknotes), large-value payments, and securities settlement systems (sections 6.4 to 6.6). I end the chapter with a review of the challenges looming ahead (section 6.7). 6.1

Historical Background

Payment practices are as old as the exchange of goods and services among human beings. Since ancient times their evolution has been driven by the search of ever more efficient ways of organizing trade, leading from barter

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to monetary exchange, namely to invent and perfect a special good called “money.” Money has taken many forms, going from stones, to salt, and to shells before gold and other precious metals took over about 2,600 years ago.1 Then quite recently, about 200 years ago, commodity (metal) currencies were gradually replaced by paper currency, and thus started the development of modern monetary systems. Still more recently, about a quarter of a century ago, paper gave way to electronics. In the early years of paper currency, any bank, and even commercial enterprise or shop, used to issue paper notes, as promises to convert them, on the bearer’s demand, in an equivalent amount of metal currency. This situation generated confusion and instability, as it was very difficult to gauge the reliability of the promise without knowing the issuer. The value of paper currency could therefore collapse whenever doubts arose about the solvency of a major issuer. Moreover, since different notes had different values depending on the issuer’s creditworthiness, there were exchange rates between them. In sum, those were not single currency systems. To overcome the precariousness of such systems and firmly maintain the public’s trust in paper currency, the state made the right to issue notes an exclusive prerogative granted to a particular bank. This was the central bank, or bank of issue. Banknotes became legal tender, that is to say, the sole settlement means that market participants are legally obliged to accept.2 The finely designed banknote, printed in chalcography on watermarked paper, carrying the effigy of revered national figures and the profile of historical monuments or famous landscapes of the country, certified by the signature of the central bank governor, became the epitome of money. Despite the expanding role of its various substitutes, the banknote still is a fundamental instrument of economic life. Touched repeatedly every day by almost every person, it is, by far, the most universally handled manufactured good in society. Being an intrinsically worthless piece of paper that everyone accepts from a stranger in exchange of worthy goods and services, its circulation testifies, more than any other social habit, the bonds of confidence that tie together the members of a community. Like the flag, the House of Parliament, or the color of military uniforms, the banknote is, par excellence, an expression of the modern state. For reasons of safety and convenience, banknotes came to be increasingly deposited at commercial banks, which stood ready, on demand by the client, to convert the deposit back into banknotes. The transfer of such deposits (i.e., of entries in the books of commercial banks, also called

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commercial bank money) thus gradually replaced—for a number of relatively large value transactions—the physical handover of notes. As commercial bank money developed, the value of money became again dependent on the solvency of the depository banks. In theory, following the same evolution as paper money, the issuance of deposits could have been progressively entrusted to one bank only, as a way to maximize the safety and efficiency of the system. This path, however, was not taken and the total stock of money thus became a composite aggregate, formed by the central banknotes and the demand liabilities of the commercial banks. Payments between commercial banks became a necessary part of the payment circuit whenever the payer and the payee were not depositors of the same bank. They were made in legal tender, meaning in central bank money rather than commercial bank money. In order to economize the holdings of non-interest-bearing banknotes, so-called multilateral netting and clearing procedures were devised, as well as institutions called clearinghouses.3 In clearinghouses payments due to, and to be received from, each bank were canceled out and an actual transfer of notes only took place to settle net balances. Moreover the transfer of deposits with the central bank gradually replaced the physical handover of banknotes. An essential feature of a payment system is its currency specificity, the fact that it comprises the circulation of one and the same money. This in turn means that the various components of the money stock are completely fungible throughout the plumbing; that is, they share the same nominal value and are accepted as fully interchangeable forms of one and the same currency. Indeed, one of the key public interests associated to the monetary system is precisely the preservation of fungibility as a sine qua non condition for keeping its unitary, or system, character. The central bank is the institution to which this mission is entrusted. To sum up, the technology of payments in place at the beginning of the twentieth century can be summarized as follows. The stock of money was made of notes issued by the central bank and deposits with commercial banks. The transmission of money occurred through physical handover for the former and, for the latter, via an order (in the form of a check or a socalled giro) given by the depositor to the bank to settle with the payee. Orders to banks were mainly written on paper, the handwritten signature was the authentication, and the mail was the dominant instrument to transmit them at distance. Multilateral netting and settlement in central bank money were the key features of that model. This technology remained basically unchanged through most of the twentieth century, despite an increasing use of electronic data processing

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in the second half of it. The payment system became gradually a nonstrategic front for central banks, an area rarely looked at by governors or board members. 6.2

New Risks, New Technologies

The long standstill ended in the 1980s, mainly as a result of two developments. The first was the growing risk of a collapse in netting systems due to the exponential increase in the number and value of financial transactions; the second was the advent of new money transfer techniques combining electronic data processing with telecommunication technology. In traditional netting systems the problem posed by a participant’s inability to settle at the end of the day used to be solved by excluding from the netting the payments due by the defaulter and recalculating net balances. As the total volume of payments grew much faster than the amount of central bank money necessary to settle it, this solution (called “unwinding”) became unworkable. The exclusion of one participant increasingly risked changing the net position of other participants, thus triggering a chain reaction of defaults. Settlement risks became liable to cause financial crises. Central banks were concerned by these developments because the increased vulnerability of netting arrangements—so-called systemic risk4— was a potential threat for the orderly functioning of the monetary system. In 1990 efforts to improve the resilience of netting systems led the major central banks to set minimum standards for their functioning. Netting systems were asked to adopt provisions ensuring that the settlement phase would be completed even in the case of the failure of the participant with the highest debit position.5 Following this initiative, most systems amended their operational rules and procedures. Meanwhile a historical change was made possible by the revolution in information and communication technology (ICT). By allowing to transfer money in real time from one account to another, ICT increased almost without limit the velocity of circulation of central bank money. This dramatically reduced the need to economize holdings of fruitless balances in central bank money, namely the rationale for using netting procedures. Settlement in central bank money on a “gross” basis, namely by ensuring immediate finality of each and every payment, became economically possible, and thereby eliminated the intra-day balances between banks and radically reduced systemic risks.

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The move from net to gross settlement started with a pathbreaking initiative of the Fed, which in the 1980s upgraded Fedwire to make it an integrated, electronic system.6 In the 1990s all EU member states followed that example and developed electronic real-time gross-settlement (RTGS) systems. With RTGSs the “ubiquitous presence of unsecured and sometimes uncontrolled credit in net settlement systems” was substituted by the provision of intra-day credit by the central bank.7 For central banks, the developments of the last twenty years have given rise to a new function called payment systems oversight. While sharing the objective of financial stability with prudential supervision, oversight looks at systems rather than institutions. It spans from setting standards to monitoring systems and assessing compliance. In the 1980s the oversight function developed mostly on a nonstatutory basis. Later it became recognized in law. As shown in chapter 2, the issuance of central bank money is the seed from which all the functions of central banks stem. Although, in all modern economies, the total stock of money has become a composite of commercial and central bank money, the latter has retained a superior combination of safety, availability, efficiency, neutrality, and finality, which ensures it a unique position in the monetary system.8 As we saw above, the payment system has evolved into a sort of layered pyramid, with the central bank at the top, commercial banks in the middle, and end-users (households and firms) at the bottom. In this construct central and commercial bank money coexist in a delicate equilibrium, where they are substitutable and complementary at the same time. Substitutability is what makes the singleness of the currency. If central and commercial bank monies were not perfectly fungible, the monetary system would not be one, the public’s confidence would not be sustained, and financial stability would be permanently at risk. Two substitutable goods normally compete. Yet the degree of competition here is limited by the convention that central banks refrain from competing with commercial banks. This generates the dichotomy between banknotes, which are available to all, and central bank accounts, which are available only to some. While most segments and functions of the monetary system are not entered by central banks, others are reserved to them. Hence the requirement that certain systems systemically important for the economy should settle in central bank money. Here is where complementarity meets substitutability. Central bank money complements commercial bank money because the trust created by

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the central bank refers to the totality of the money stock and the entirety of the monetary mechanism, and not just to the parts the central bank directly issues or runs. In a regime of fiduciary currency, where both the money and the payment services are simultaneously supplied by a public interest-driven central bank and by profit-driven commercial banks, trust and stability rest on the complementary and mutual reinforcing character of the two roles. Against the historical and functional background described in this and the previous section, the rest of this chapter will illustrate the issues and challenges the Eurosystem is facing in the field of payment systems. It will consider in turn the three components into which modern payment systems usually are classified, namely retail, large-value, and securities settlement systems. Between retail and large-value payments the distinction should be made on the basis of the entity making or receiving the payment, rather than on the size of the payment. Retail payments concern the circuit of consumers and businesses, while large-value payments are mainly exchanged between banks. Since the respective requirements are different, these two categories of payments have different architectures and supporting systems. In particular, payments between banks have to be settled on a specific day, and increasingly even in a specified time slot of the day, in order to allow for the settlement of interdependent operations. Retail payments are less time critical. As to securities settlement systems—used to discharge the mutual obligations assumed by market participants when buying or selling bonds or equities—they provide for the final delivery of securities from the seller to the buyer and of money from the latter to the former. They are the “plumbs” on which both securities and cash flow. Due to the phenomenal pace at which financial transactions have grown, both in volume and number, they have become, in the last three decades, a critical area where risks, as well as the requirement of a speedy and reliable service, have risen at the same pace.9 6.3

One Currency, One System

In the course of the 1990s, prior to the launch of the euro, payment and securities settlement systems underwent fundamental changes everywhere in the European Union, under the financial and technological impulses described above. Central banks played a key role in promoting and guiding the change; they restructured and modernized their own operations, promoted cooperative arrangements among market participants, introduced

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Table 6.1 Key indicators on payment instruments in euroland and the United States, 2001 Euroland

United States

Volume

Value

Volume

Value

(million)

(billion euro)

(million)

(billion US$)

Banknotes and coinsa

—

Cashless payment instruments Checks Credit/debit cards Credit transfers Direct debits E-money

240.3

—

584.9

39,438

202,899.4

77,041

794,205

5,871 9,413 13,597 10,453 104

6,122 522.1 189,898 6,356.9 0.4

41,223 29,543 3,890 2,385 —

38,909 2,086 744,578 8,632 —

Sources: Payment and securities settlement systems in the European Union (Blue Book), Addendum incorporating 2001 figures, ECB, September 2003. Statistics on payment and settlement systems in selected countries (Red Book), figures for 2001, BIS, April 2003. a. In circulation outside credit institutions.

regulatory requirements for the minimization of systemic risk, and developed national RTGSs. Throughout this reform and modernization process, and despite further economic integration, the organization of payment services in Europe remained country based. On the eve of the euro, the payment landscape was still a patchwork of national systems, reciprocally segmented by their currency specificity. In no sense was euroland a single payment area. Although the term is still used to refer to payments across national boundaries, within a single currency area the very notion of “cross-border” payment has lost economic relevance. A payment in euro between Milan and Brussels is “domestic,” while it is “cross-border” between Milan and London, as long as the United Kingdom is not in euroland. Thus for euroland to be a single payment area the cost, speed, and safety of a payment between, say, Milan and Brussels had to be the same as between Milan and Rome. We can call this a “condition of indifference.” At the start of the euro in January 1999, euroland was quite far from meeting the condition of indifference. Surveys showed that retail money transfers between countries of the euro area were structurally, and often sensationally, more expensive, slower, and less reliable than transfers within countries. As to large value payments, the TARGET system ensured

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the transferability of central bank money in real time across euroland, but the condition of indifference was not met either, as the price of a transfer was very different from country to country. Euroland was largely segmented in twelve country-specific components, with seventeen large-value payment systems, twenty-three securities settlement systems, and countless overseers. This compares with two large-value payment systems, two securities settlement systems, and two overseers in the United States. Only with the advent of the single currency have the conditions, the incentives, and the need arisen for the emergence of a single payment system for euroland. As shown in the previous sections, the first and foremost condition is the singleness of the currency. The incentives consist of the enormous increase in economies of scale and network externalities offered by the move from a high number of systems of limited size to a single, huge, euro areawide space. The need is strong for the private sector, which requires payment services to be rapid, safe, and inexpensive. Moreover there is a need from the point of view of the public interest, because a single and efficient system is part of the Eurosystem’s mandate and a condition for the efficient transmission of monetary policy.10 This is the background against which to assess the strategies and perspectives of euroland’s payment system. Despite the needs and the incentives, and despite the provisions of the Treaty, in the early years of EMU the movement toward a single, efficient, and secure payment area for the euro has been slowed by difficulties and impediments. One could wonder why market forces did not smoothly lead to the optimal configuration. Historically the evolution of payment systems has never been driven by competition alone, but by a peculiar combination of cooperation, public action, and competition. Moreover cooperation among market participants rarely materializes without the public authorities actively playing the catalyst role. And the task of drawing the boundaries between the respective camps of the three driving forces has rarely been fulfilled by the invisible hand of market forces. Now, while none of this would be a problem in a “normal” country, it is one in euroland, where the initial segmentation of financial systems and infrastructures is strong and the vested interests defending the status quo are often as powerful as the advocates of change. An efficient and safe single payment system of euroland would immensely benefit all the users, but it would advantage only some of the service providers now operating in the field. Even in a positive sum game there may be losers. The payment industry is not made of a mass of small operators individually unable to influence market conditions. It is made of powerful entities, often semi-

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public in their ownership structure and capable of influencing private sector decisions. In these circumstances only great determination and powerful initiatives by the Eurosystem could promote change at the speed required by the interests of often voiceless end users. Given their dual profile, however, national central banks themselves are caught in this tangle. While the ECB Council is mandated to optimize the single overall system of euroland, and national central banks, as components of the Eurosystem, are “governed” by the ECB Council, as national institutions they tend to be defenders of the status quo. All this makes their position awkward. 6.4

Banknotes and Other Retail Payments

The efficiency and safety of the medium of exchange function of money in everyday life is, for the general public, an integral part of the quality of money. Slow, unsafe, cumbersome, or technically faulty money transfers undermine confidence in the currency just as inflation does. In the European Union the free movement of goods, services, capital, and people would not yield all its potential benefits if individuals could not receive and send money within the whole area as rapidly, reliably, and cheaply as within any member state. Making euroland a single retail payment area, namely a “normal” country from a monetary point of view, implies the accomplishment of three circumstances. First is replacing all national notes denominated in the pre-euro currencies with a single stock of notes and coins denominated in euro (the so-called cash changeover). Second is making the cost and speed of a money transfer indifferent to national borders, namely by achieving the condition of indifference. Third is preserving fungibility, that is, making the various forms of money used for retail payments fully interchangeable. While, prior to the start of EMU in January 1999, European central banks devoted all effort in the field of retail payments to the preparation of the new banknotes, after that date payments in commercial bank money drew increasing attention.11 The cash changeover was a huge logistical operation that started on December 16, 1995, when the European Council decided that “euro” would be the name of the new currency and ended on February 28, 2002, when national notes and coins were no longer legal tender.12 Once the name was chosen, the preparation went on with the planning of the new notes and coins, their denomination, subject, design, colors,

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security features, type of paper, and metal. It continued with the decision of the amount to be printed and minted, and then with the actual production. Around 14.9 billion banknotes and 51.6 billion coins were produced. Banknotes were produced in fifteen printing works, of which five are owned and run by central banks. Complex quality control procedures were put in place to ensure that the same, say, 10 euro banknote produced in fifteen printing works would be identical. On a given banknote there are no recognizable signs allowing the bearer to understand whether it was printed in Italy, or Finland, or any other country. Prior to, or immediately after, the actual changeover over two hundred thousand cash dispensers and about ten million so-called vending machines (supplying food, gasoline, train or parking tickets, and other goods or services against cash) had to be converted to the euro. Moreover notes and coins were pre-distributed to banks and retailers for them to be adequately supplied from day one. Since national currencies also circulated abroad, an important cash changeover had also to be organized outside euroland. It was estimated that between 30 and 40 percent of the total Deutsche mark currency in circulation was outside Germany. In some countries or territories, like Bosnia or Kosovo, the Deutsche mark was the legal tender. Other national currencies such as the Austrian schilling, the French franc, and the Spanish peseta also circulated outside the respective countries, albeit in much smaller proportions. The changeover implied a change in unit of account, not only in the medium of exchange. Indeed, although goods and services could have been priced in euro as of January 4, 1999, for goods and services widely traded by the general public the new pricing (unit of account) came only with the change in payment practices (medium of exchange). Although less visible, the logistics of the change in unit of account was a not less complex operation than the change of notes and coins, as it required millions of producers and shopkeepers to convert accounting practices, computer programs, forms, price lists, and so on. Even more subtle is the change in unit of account that has to occur in the mind of every person (be it a consumer, a retailer, an industrialist, or a Minister of Finance). Indeed every person—including the author of this book—carries in his memory a sort of price list for a vast number of goods, services, and magnitudes. On the basis of such list reflexes have been trained to gauge the adequacy of a price or the realism of a figure. The “changeover” of this human memory from the old to the new unit of account is slow and presumably still far from completed.

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After years of preparation the final act (the actual replacement of notes and coins), initially planned to spread over a six-month period, then shortened to two months, was consummated in a matter of days if not hours. In a majority of countries the changeover was virtually completed in the first days of January 2002. By the end of January national currencies had practically disappeared from everyday use. In all countries ordinary people proved keen to enter the new standard as rapidly as possible. In the foreign exchange market, in monetary policy, in stock exchanges, in the denomination of public debts, national currencies had ceased to exist three years before the cash changeover. For economists and central bankers the euro had started then. Yet, in the imagination and psychology of the people, the much talked about single currency became a reality only when it could be seen and touched in the form of notes and coins. That was a moment of enthusiasm and emotion, marked by the popular sentiment that a major step in the half century long process of constructing a united Europe was then accomplished. Turning to the condition of indifference, the second requirement for a single payment area, while for central bank money this was achieved in early 2002, it was still unfulfilled for commercial bank money. The speed and fees of transfers of deposits remained grossly different depending on whether the transfer was made within or across countries.13 This is despite the fact that the banking industry was given the opportunity to run ahead of the central bank with its own form of money. As the spontaneous play of market forces failed to provoke any perceptible movement toward the formation of a single payment area, the ECB gradually stepped up its pressure, acting as a catalyst for change rather than getting operationally involved. In 1999 it set as an objective for the year 2002 that in parallel with the introduction of the new notes and coins, the banking community should substantially improve cross-border payment services in terms of cost and execution time. Since the situation was not improving, by mid-2001 the European Commission proposed a Regulation on Cross-Border Retail Payments in euro, obliging banks to bring their cross-border charges down to the level of domestic ones. Only then did banks present a proposal for a stepwise elimination of the additional charges for cross-border credit transfers. The Regulation was nevertheless adopted in December 2001. As to the third accomplishment—the preservation of fungibility—the challenge did not come from the advent of a single currency in euroland but from innovation brought about by new technologies in the field of retail payments. The 1980s had seen the spreading of automated teller machines,

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debit and credit cards, point-of-sale terminals, and home banking. Transaction costs in commercial bank money shrank, and the share of cashless payment instruments grew at the expense of banknotes and other paperbased instruments. However, important as these developments were, the retail payment industry did not modify its fundamental feature of being based on commercial bank money. More recently the challenge of innovation has come under a new form— called electronic money or e-money—whereby, for the first time, money can circulate independently of any book entry in the banking system in a form differed from notes or coins. Electronic money can in fact be defined as a payment instrument allowing monetary value to be electronically stored on a technical device; the amount stored is decreased or increased whenever the owner uses the device to settle a transaction. This new form of money has the potential to become an attractive alternative to both bank deposits and banknotes. The spreading of its use could change substantially the traditional structure of retail payments based on commercial bank money. It could also challenge the provision of payment instruments and settlement services by banks. Although its spreading has so far been slow, the use of e-money could accelerate, once a critical mass is reached. If redeemability of e-money into commerical bank money and central bank money were not guaranteed, monetary systems would go back to where they were before a single issuer of banknotes was established. If the same path is followed, multiple units of account would emerge, competition between them would give rise to excessive circulation, leading to the collapse of the value of the overissued currencies, crises of public confidence, and systemic contagion through the rest of the financial system. A policy to address these concerns was set out by the ECB in 1998. The core of this policy was that issuers of electronic money should stand ready to redeem e-money in commercial bank money or in central bank money at par. The ECB urged that to ensure this, only credit institutions should be entitled to issue e-money. This requirement became the cornerstone of the new Community regulatory framework proposed by the European Commission in 2000.14 6.5

Large-Value Payments

In the field of large-value payments, two conditions had to be fulfilled for EMU to start: the existence of a single, area wide RTGS system and the safety of the other systems which were also to process large-value payments in euro.

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TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) is the system that satisfies the first condition. By linking together all national RTGS systems of the EU member states, it constitutes de facto a euro areawide RTGS. As such it provides an overall infrastructure for the processing of both domestic and cross-border payments in euro. Without TARGET, the euro area money market would remain segmented in national markets, interest rates would differ across financial centers, and the single monetary policy would stumble at the first step of the transmission mechanism. The Eurosystem needed a mechanism to transfer liquidity between the books of the NCBs just as the Deutsche Bundesbank or the Fed had previously done for the Landeszentralbanken (regional central banks) or Federal Reserve District banks. TARGET has the unique feature of being open to EU central banks not participating in the euro. These are the central banks of the United Kingdom, Denmark, and Sweden, and of the ten new members of the Union. Although justified by the special features and circumstances of the EMU, this was a possibly pathbreaking decision, because it was the first time that a central bank allowed its own currency (the euro) to be offered for settlement facilities by central banks issuing different currencies.15 Given the special circumstances justifying the decision, the ECB complemented it with a confirmation of the general rule, according to which, as in other monetary systems, central bank money in euro can only be created by the central banks of the Eurosystem. The second condition to be met before the launching of the euro concerned the netting systems operating in parallel with TARGET. There were five such systems in 1999, with only three processing significant amounts. They all had to be made compliant with the minimum standards set in 1990 by the G10 governors. TARGET started its operations on January 4, 1999. The average daily volume of payments represents about 55 percent of the volume and 100 percent of the value processed by Fedwire, which is the equivalent US system. In 2002 TARGET processed about 85 percent of the value of the interbank payments in euro and served as the settlement vehicle for other systems. The rest of interbank payments were made via net settlement systems. In the mid-1990s, when TARGET was designed, the single currency was still a distant and somewhat uncertain event. As the main focus of each central bank in Europe was to develop a national RTGS, it was decided not to build a common infrastructure but simply to connect national systems, subject to a minimum harmonization. Satisfactory as it may have been for the early years of the euro, TARGET is not a sustainable arrangement over

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Table 6.2 Evolution in the value of transactions in euroland and the United States, 1990–2001

Euroland Large-value payment systemsa Mixed payment systems Retail payment systems Total

1990 (billion ECU)

2001 (billion euro)

Increase, 1990–2001

46,387 76,691 5,898 128,976

440,152 NAb 15,392 455,544

849% NAb 161% 253%

1990

2001

Increase,

United States

(billion US$)

(billion US$)

1990–2001

FEDWIRE CHIPS Retail payment systems Total

199,100 222,100 17,815 439,015

423,867 311,707 32,855 768,428

113% 40% 84% 75%

Sources: For euro transactions: Payment systems in EC member states, Committee of governors of the member states of the European Economic Community, September 1992. Payment and securities settlement systems in the European Union (Blue Book), addendum incorportating 2001 figures, ECB, September 2003. For US transactions: Payment systems in the Group of Ten countries. BIS, December 1993. Statistics on payment and settlement systems in selected countries (Red Book). Figures for 2001, BIS, April 2002. a. Included TARGET. b. Not applicable. Because of a methological change in statistical collection, payment systems from 1999 are distinguished into large-value and retail.

the longer run. From a technical point of view, composed as it was of fifteen national systems and as many devices to interconnect them with each other, it was bound to encounter more frequent difficulties than an organically designed system. From an economic point of view, the system was not cost effective and very few of its national components recovered a reasonable fraction of their expenses. The future of TARGET was also brought into question by the approaching widening of its area of jurisdiction. Ten countries were to join the Union in 2004, and many of them were likely to adopt the euro before the end of the decade. The expansion of TARGET would have exacerbated the current efficiency and cost problems and accelerated the search of innovative solutions for the system as a whole. Not long after the start of the euro, it thus became clear that TARGET was confronted with a hard trilemma. Either it continued to fail meeting

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the condition of indifference described above for retail payments, as fees were widely different from country to country. Or, it moved toward a uniform fee, which would entail over- and/or underpricing compared to costs. Or else, it adopted a rather odd model of full-fledged competition among national RTGSs, namely among its very components. As none of these routes was really viable in the long run, and since, at any rate, technical obsolescence was approaching, the second generation of TARGET was planned on the basis of a new approach.16 The trilemma was overcome in fall 2002 when the ECB Council designed a second-generation TARGET, with a new technical infrastructure and a new set of rules and pricing criteria. It was decided that a single shareable platform would be developed, with all NCBs free to join it or to continue running an own platform. NCBs would maintain their business relationships with their banks. A uniform set of services and a single fee structure would be adopted. Cost recovery would become mandatory for all components. In the field of large-value payments the Eurosystem, just like the Fed, is also confronted with new developments concerning the settlement of foreign exchange transactions. Because the two currencies involved in any such transaction flow through different systems, the participant paying out one currency has no guarantee to receive the other currency in return. This risk is known as “Herstatt risk,” from the name of the bank that defaulted in 1974 and materialized it for the first time. In 1996 the central banks proposed that the banking industry should provide multi-currency services.17 The response of the industry was to develop a so-called continuous linked settlement (CLS) system, whose purpose is to eliminate Herstatt risk by ensuring the simultaneous settlement of both currencies linked to a foreign exchange trade.18 CLS started to operate in September 2002. 6.6

Securities Settlement Systems

In recent years securities settlement systems have become the most dynamic component of the overall payment system and a major concern for central banks. As the final settlement of the securities leg and the cash leg of a transaction increasingly tend to become simultaneous (so-called delivery versus payment), payment flows generated by securities transactions are part of the banks’ intra-day liquidity management. If securities are not delivered, or not delivered on time, payments are equally delayed, and ultimately a gridlock can arise.

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The Eurosystem is a regular user of securities settlements systems because the provision of liquidity is conditioned to the prior or simultaneous delivery of adequate collateral (which normally takes the form of securities). If securities settlement systems were not available or were not functioning efficiently, the Eurosystem would not be ready to implement its monetary policy operations, nor would it be ready to provide the intra-day liquidity needed for the smooth functioning of RTGS systems. In the area of securities settlement systems, as in retail and large-value payments, the central issue facing the Eurosystem is the transformation of euroland into a single “domestic” payment area, with a degree of effectiveness, efficiency, and safety equivalent to mature currency areas. This process of change is driven, but at the same time hindered, by a combination of market and policy forces. Securities settlement systems have some features of natural monopolies, such as network externalities, economies of scale, and economies of scope, which have led, in most countries, to consolidation into one or two systems only, often established by the law. Euroland, instead, retains a highly fragmented infrastructure, inherited from pre-EMU time, when the natural domain of the monopoly was the national jurisdiction of the currency and the central bank. Although the single currency denomination for all securities makes euroland a single securities market, an integrated settlement system for securities denominated in euro is still struggling to emerge. For one thing the advent of the euro and economies from information technology have enhanced competition between national systems and financial centers in a way that could lead to sharp consolidation. The competitive process, however, has encountered obstacles, in both the private and the public sphere. There is no competition, for example, when endusers cannot freely choose which system to utilize. Free choice could only be provided by an open architecture, where the use of a particular clearing or settlement facility would not be compulsory for the users of a particular trading platform. Similarly trading platforms should not prevent trades concluded on other platforms from accessing their own clearing and settlement systems. Interoperability should allow a Spaniard and an Italian trading BMW shares on the Deutsche Börse to settle the accounts they hold in Iberclear (the Spanish SSS) and Monte Titoli (the Italian SSS) under the same conditions as if they were trading, clearing, and settling in their own domestic system(s). The Eurosystem has so far remained neutral in the competition between systems, financial centers, and categories of users. However, as the central

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bank of euroland, the Eurosystem has a strong interest in the achievement of a coherent “domestic” (i.e., euro area) securities infrastructure for the euro. Such an infrastructure is actually necessary to ensure an efficient transmission of monetary policy, to achieve efficiency in securities markets, and to address liquidity problems that may be triggered by payment, clearing, and settlement systems.19 The Eurosystem operates to foster a safe and efficient securities infrastructure. In 1998 it defined standards from a user perspective. An integrated regulatory and oversight framework is now being developed. At a global level the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) developed, in 2001, “Recommendations for securities settlement systems” from an oversight perspective.20 The ESCB and securities regulators of the European Union are in the process of adapting and implementing these standards. 6.7

Main Challenges

The move to the single currency has not produced, in the payment system field of central banking, the sharp break in continuity that has characterized monetary policy. While an instantaneous regime shift occurred in monetary policy on the night of December 31, 1998, in the financial system and in payment services change has been much slower and even uncertain. In the field of payments, the Eurosystem is now facing a specific challenge, unlike other challenges it shares with other central banks of the world. This challenge consists in shaping itself as a single—albeit decentralized and federally structured—central bank, reaching the highest standards of effectiveness, efficiency, and safety. To successfully meet this challenge, years, rather than annual quarters, will be needed. We have seen in the previous sections how the Eurosystem is dealing, in the early years of its life, with this challenge, which is specific to the peculiar nature of its charter and of the “country of the euro.” At this historic juncture the Eurosystem also faces more general challenges, which it shares with other central banks in the world. Four of them are particularly relevant. The first arises from privatization. Most monetary and financial systems are encountering a rising trend to shift the dividing line between the public and the private sector toward an enlargement of the latter area. Systems that used to be seen as public utilities have been transformed into privately

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owned, profit-driven service providers. Banks that used to be owned by the state have been privatized in many countries. More generally, the idea has gained ground that public bodies should refrain from a number of their regulatory and operational functions, which were for long considered their prerogative. A second challenge is consolidation. Pushed by competition and technical progress, financial institutions and markets strive to increase the scale of their operations. In payment and settlement systems this is leading, for example, to the progressive concentration of correspondent banking in a few large banks acting as quasi-central banks as well as to the consolidation of securities settlement systems. This may progressively reduce the need for central bank money and at the same time increase systemic risk. A third challenge comes from e-money. For the first time a type of money appears, that the central bank (and, in the view of some, even commercial banks) does not issue. To the extent that e-money might replace a significant and increasing portion of banknotes, a fundamental prerogative of central banks could be eroded. Fourth and last, these three challenges arise in the context of globalization, which entails the emergence of global systems operating in multiple currencies. In the absence of a global institution, no central bank alone can cater the needs of a global system; each bank can, in principle, only provide settlement in its own currency. Each of these challenges has specific technical features and needs a specific policy response. Every central banker is nowadays already dealing with each of them in its currency area, while cooperating with fellow central bankers in the relevant international forums. Taken together, however, the four challenges raise a more general and fundamental question of whether there can be central banking without central bank money or, even more radically, a monetary system without a central bank.21 Where does the central banking community stand in this debate? One certain point is ruled out: the two polar solutions of either no central bank money at all or only central bank money. Beyond these extremities different blends are conceivable to define an optimum as an intermediate solution. One strongly rooted solution is the so-called AngloAmerican tradition, which leans toward letting the market decide, and avoids the risks of policy interference in profit-driven choices and in the innovation process. Implicit in this approach is that public intervention should occur ex post and only after market failure in order not to distort private incentives. This way, if alternatives to central bank money exist, the market should—in the first instance—be free to use them. Another pos-

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sible solution, one closer to the traditions of continental Europe and Japan, leans toward setting up ex ante a firm regulatory framework within which market forces are free to play. It is based on the conviction that the payment and settlement services, the rules, and the oversight offered by central banks are indispensable to the smooth functioning of the economy and cannot be supplied by the market alone. The harmful effects of market failure have been sufficiently experienced in the past and cannot be allowed a chance to recur. The Eurosystem brings to the debate its continental European tradition, which is based on two components: the distinct role of central bank money and the strict requirement of a license to conduct banking business. A look at past monetary systems without central banks may help in discerning the future. As we saw earlier in this chapter, the plumbing was a factor from the start of modern monetary systems. In Europe, central banks developed when the production and management of a new medium of exchange—paper currency—was recognized as a public function and entrusted to an institution oriented to the public interest rather than profit making. Earlier experiences indicate that in a free banking regime the payment system overtakes the other central bank functions, including monetary policy and banking supervision. In the absence of a formal central bank, the plumber becomes the governor.

7 The Eurosystem in the Global Arena: A New Actor in a New Play

The Economic and Monetary Union was not conceived to address an external challenge. The challenge was rather intra-European. It meant complementing the single market with a single currency, setting price stability on a EU basis, and bringing forward the unification of Europe. Preparations for the single currency were inwardly focused and the euro came to life without program, ambition, or doctrine for its international role. Yet the implications of EMU go well beyond the borders of Europe. This chapter is devoted to the international role of the euro and the Eurosystem in the current global architecture for monetary and financial cooperation. After assessing the quantitative relevance and the policy issues related to the role of the euro as an international currency (section 7.1), I move to exchange rate relationships, which—as the primary link between currencies, economies, and countries—constitute the main theme of the chapter. Four sections deal, respectively, with the performance of the euro in the foreign exchange market in the first years (section 7.2), the exchange rate relationships between the three key world currencies (section 7.3), and the role of the euro for those third currencies, which seek an external anchor (sections 7.4 and 7.5). In the final section (section 7.6), I discuss cooperation for financial stability. 7.1

The Euro outside Euroland

The role of an international currency may be assessed by the extent to which nonresidents use it as a store of value, medium of exchange, and unit of account (table 7.1). And since public authorities and market participants are driven by different motives, it is convenient to distinguish nonresidents into official and private. When examining the international use of a currency, one should also bear in mind that, unlike its domestic use, the international one entirely

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Table 7.1 Functions of international currencies Use by residents of an area other than where currency is issued Functions of money

Private use

Official use

Store of value

Investment and financing currency

Reserve currency

Medium of exchange

Payment/vehicle currency (1) in exchange of goods and services (2) in currency exchange

Intervention currency

Unit of account

Pricing/quotation currency

Pegging currency

Source: ECB.

lacks an institutional underpinning. While the domestic use of money is fundamentally determined by institutional arrangements, the international use is driven by habit and reflects political as well as economic considerations. For the international use the pace of change is the normally slow pace at which market practices and network externalities change. Thus the British pound still had an important international role decades after the United Kingdom had ceased to be a global economic and political superpower. The international use of a currency is driven neither by decrees, nor by institutional arrangements. Growing liberalization and globalization of financial markets further limit the bearing policy makers could directly have on such a use. Precisely because it is habit-driven, the international use of a currency does not evolve at the same speed for the three functions, nor for the two categories of official and private users. Evolution is slowest for the unit of account function, as this is most dependent on the inconvenience of changing standards of measurement. At the opposite extreme, the store of value function can move at the same high speed at which portfolio decisions are taken and reviewed. Official holders outside euroland use the euro, as indicated above, for the three purposes of reserve currency (store of value), external anchor (unit of account), and intervention vehicle (medium of exchange). As to the first, at the end of 2002, the euro accounted for 18.7 percent of the world foreign exchange reserve assets. This share is close to that observed for the national currencies prior to the introduction of the euro (mainly the Deutsche

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mark) and compares with 64.8 and 4.5 percent for the US dollar and the Japanese yen. As to the anchor role, at the end of June 2003 about fifty countries in the world had an external anchor where the euro played some role, a fact that will be further analyzed in section 7.5. Finally the intervention role is mainly related to the anchor role, although, also for currencies not pegged to the euro such as the Japanese yen, the euro was partly used for intervention purposes. Turning to private users, they have been quite active in borrowing or investing in euro, namely in the store of value function. Since it holds a total amount of financial assets far exceeding official reserve holdings, and since it usually adjusts its asset and liability positions more frequently than central banks, the private sector exerts a dominant influence on market developments. In 1999 to 2002 the average share of the euro in bond issuance by nonresidents was around 28 percent, while pre-euro currencies had a share of 19 percent in the period 1994 to 1998. The key driver of this expansion has been the greater liquidity of the euro-denominated bond market arising from the pooling of demand from the twelve member states as well as the desire by non–euro area borrowers to enlarge their investor base for the euro. In the same four years the performance of the euro in the issuance of paper on the international money market has been even stronger.1 As to investors, at the end of 2002 the euro accounted for an estimated 26 percent of bond portfolios of major global asset managers (against 51 and 14 percent for the US dollar and the Japanese yen respectively). At the same date, equity holdings accounted for 22 percent (52 and 8 percent for the United States and Japan).2 Turning to the uses as a unit of account and medium of exchange, the available evidence suggests that, at the global level, the euro currently plays a more limited role. Internationally traded goods and services are predominantly priced and paid in US dollars, regardless of their origin or destination. Foreign exchange operations between not widely traded currencies are largely conducted via the US dollar, namely by splitting the trade in two transactions against the US dollar. The predominance of the dollar is unshaken, mainly because of inertia in market practices, network externalities, and economies of scale. What is the Eurosystem policy concerning the international use of the euro? Part of the public opinion frequently holds the view that the international role of a currency is the result of a deliberate strategy. To many people around the world, the dollar is the very epitome of the American

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superpower. To many Europeans, the adoption of a single currency was seen as a means “to match the might of the dollar.” Despite this popular view the reality of today’s world is that there is no deliberate policy behind the expansion or the contraction of the international use of a currency. The international use of a currency is mainly “demand driven,” determined by independent decisions of private end users. Even if the Eurosystem wanted, it could neither directly foster nor directly hinder the international role of its currency in a significant way. Both public policies and politics, however, do have an indirect influence. Market participants and official authorities of third countries take the economic and financial policies of a country into account when considering denominating their liabilities, allocating their portfolios among different currencies, or invoicing external trade. Moreover they do look at political and strategic factors. At the technical end of the spectrum, measures promoting an efficient and fully integrated financial market are likely, if successful, to make the euro more attractive to international borrowers and investors, thereby increasing its role as a store of value. At the political end of the spectrum, progress—or lack thereof—toward EU political union influence private and public decisions taken outside euroland about the euro. Clearly, if the People’s Bank of China increases the proportion of the euro in its reserve holding, it is on the basis of a political, not only of a financial, decision. The Eurosystem’s attitude toward the internationalization of its currency can hardly be compared with that of other countries in the past, because historical and political factors are so different. The rise in the international role of the pound sterling and the dollar was inseparably linked to the rise of United Kingdom, first, and the United States, later, to the status of leading global power. After the Second World War, in particular, the dollar was formally assigned the pivotal role in the Bretton Woods system and the United States enjoyed the benefits of, and bore the responsibility for, that role for more than twenty-five years. As to the Deutsche mark, the development of its international role followed a completely different path. On a global scale, Germany resisted the internationalization of its currency for reasons that were both political and economic. Politically, it was because of the low profile attitude taken by Germany after 1945 in international relations, as a consequence of the disastrous events of the previous years. Economically, it was for fear that the internationalization of the national currency would interfere with the conduct of its price stability oriented monetary policy. This reluctance, however, could not prevent the Deutsche mark from becoming increas-

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ingly used internationally by virtue of the excellent domestic performance and the growing role of Germany as a trade partner. Nor did it make Germany unwilling to let its currency play the anchor role for a large portion of Western Europe. None of these past examples fits euroland’s case. The political factors that played so strongly in those other historical experiences are not there today, and at the same time, the economic size of euroland is such that the international role of the euro is both hard to avoid and unlikely to unduly influence domestic stability. The Eurosystem is concentrated on the successful implementation of the price stability mandate imparted to it by the Treaty and regards the internationalization of the euro not as a policy goal but, if anything, as a reward of a good domestic performance of the currency. On the one hand, the fact that a widely used international currency grants extra seigniorage to the issuer and facilitates the financing of external deficits is not an inducement to foster the internationalization of the euro. On the other hand, there is no ground, for the Eurosystem, to inherit the traditional Bundesbank mistrust toward an international role of the currency, for fear that this could thwart a price stability oriented monetary policy. 7.2

Fall and Rise of the Euro

Well before the launch of the euro, its exchange rate developments started to attract some interest among both the specialized and the general public. Among specialists, speculations abounded about the most likely course of the euro and a widespread view was that the exchange rate would have appreciated in its early years, mainly because international portfolios would have been diversified from US dollars into euro.3 The general public was led to share this expectation. To many ordinary people the promise of “a euro as strong as the Deutsche mark,” to which we referred in chapter 4, was interpreted as the promise of a strong exchange rate. Actual developments rapidly contradicted these expectations. For an initial period of about seven quarters, the euro declined, losing 23 percent in nominal effective, trade-weighted, terms between January 1, 1999, and October 26, 2000. The decline vis-à-vis the US dollar—which accounts for 25 percent of the trade-based basket used to calculate the effective exchange rate of the euro—has been, over the period, in the order of 30 percent (figure 7.1). The long descent of the euro produced wide disappointment. When the euro went below parity to the US dollar on January 27, 2000, part of the

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1999q1 = 100

USD/EUR

125

1.5

120

1.4

115

1.3

110

1.2

105

1.1

100 1.0

95

0.9

90 85

0.8

80

0.7

75 1975

0.6 1980

1985

1990

1995

2000

Euro real effective exchange rate (lhs)

(average 1975–2003)

Exchange rate vis-à-vis the US dollar (rhs)

(average 1981–2003)

JPY/EUR

1999q1 = 100

350

125 120

300 115 250

110 105

200 100 95

150

90 100 85 80 1975

50 1980

1985

1990

1995

2000

Euro real effective exchange rate (lhs)

(average 1975–2003)

Exchange rate vis-à-vis the Japanese yen (rhs)

(average 1978–2003)

Figure 7.1 Exchange rates. Sources: ECB and BIS.

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press and analysts talked of a scorching defeat of the new currency by the market. Put on the racetrack, the announced winning horse did not seem fit to run. The unsophisticated public considered that the promised strong currency was not being delivered. It is not quite surprising that perceptions about the strength and quality of the new currency have been—and to some extent still are—strongly influenced by the exchange rate. In most European countries the general public used to consider the exchange rate as the prime indicator of overall stability and strength of the national currency. Moving from the Bretton Woods regime, to the snake, to the EMS (see chapter 1), most countries in Europe—the relevant exception being Germany—had lived almost permanently in a world of fixed exchange rates. Because of the very large size of the external sector compared to the overall size of the national economy, the price dynamics of most countries was largely determined by the exchange rate. In most European countries, a devaluating or depreciating currency was considered a sign of general weakness, a defeat, an event associated with inflation, often coupled with wage restrictions and budgetary austerity. The transition to the single currency should have wiped out these “open economy” or “fixed exchange rate” instincts, which were no longer substantiated by the new economic reality of euroland, much less open than its component states. Not surprisingly, however, the change of instincts did not come immediately, as entrenched habits and the absence of a floating exchange rate culture could hardly be corrected in a few quarters. The early reaction also explains the asymmetry between European and American attitudes. The concerns for the weak euro indeed failed to be matched by an equivalent concern for the strong US dollar, although the US economy was running a sizable external deficit, while euroland was in balance, and despite the similarities between the two economies. Europeans look at the external value of their currency much more closely, and even anxiously, than the Americans. For Americans “a dollar is worth a dollar.” For a French or an Italian citizen a franc or a lira used to be worth, first, “that many dollars” or, since the mid-1970s, “that many Deutsche marks.” In the host of explanations brought forward while the euro weakened, the one to which analysts and market participants returned most frequently was the actual and expected growth differential in euroland and the United States.4 However, also fancier arguments were put forward, such as the claim that an “invisible currency,” meaning a currency that did not circulate in the form of notes and coins, could not generate confidence

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among the people and was therefore bound to fall. In a similar vein it was suggested that the decline came from sales of stocks of illegally held and earned, or simply circulating outside euroland, banknotes to be converted in dollars for lack of euro notes.5 It was also noted that the decline of the euro was magnified by the fact that euro started from a position that, compared with its average over 1997 and 1998, was relatively high in nominal effective terms.6 In spring 2000, Wim Duisenberg, the then president of the ECB, publicly commented that “The exchange rate of the euro does not reflect the ongoing improvement in domestic fundamentals in the euro area economy.” In less diplomatic language, this could be interpreted as meaning “the market is wrong,” in more academic language that the market was “overshooting.”7 The view that the market was going too far was repeated by the ECB in subsequent months and was widespread also among analysts and observers, although most did not expect the trend to reverse soon. The Treasuries and central banks of the G7 took the same view in September 2000 and jointly intervened in the foreign exchange market, buying euro and selling other currencies, at the end of that month. A second round of intervention was made by the ECB at the beginning of November 2000. Seen in retrospect, part of the decline of the euro appears just as another episode of exchange rate overshooting, a type of event periodically exhibited by the post–Bretton Woods floating regime. That the market “overshoots” does not mean, of course, that it has no story to explain its behavior, nor that its story is factually false (in the case of the euro, as we noted, there were quite real differentials in income and productivity growth). Rather, it means that the story is partial; it overlooks factors that over time do concur in the determination of the exchange rate but, for some reason, are temporarily disregarded. Market participants are often the first to be aware of their “partiality,” but they also know—or believe—that putting their money on a bet with stronger and more complete analytical foundations would cause a loss. It is thus not surprising that the “traditional” determinants of exchange rate developments—focusing on fundamental and permanent factors of influence—did not succeed in providing a satisfactory explanation. For example, compared to the United States, the euro area had better price stability and no significant macroeconomic imbalances like the exorbitant accumulated US external debt and deficit.8 Similarly several econometric models, tested to link the exchange rate to a range of macroeconomic fun-

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damentals, were generally unable to account for the full decline of the euro.9 The long descent of the euro ended shortly after the concerted G7 intervention, in the fall of 2000. The descent was followed, for about five quarters until spring 2002, by a prolonged stability in a range comprised between 0.85 and 0.95 to the US dollar, a level that most analysts still judged “low.” In April 2002 the euro started to move sharply up vis-à-vis the US dollar and passed the parity on July 15, 2002. Over a period of fifteen weeks— between April 1, 2002, and July 15, 2002—it gained 6 percent in nominal effective terms and 14 percent to the US dollar. Following another phase of relative stability, the euro strengthened again between November 2002 and January 6, 2004, when it reached its historical record at 1.2858 against the US dollar. One could say that with the rise back above parity the euro had come of age. Its movements are now likely to be seen as those of a normal currency, not as indicators of whether or not it was a good idea to adopt a single currency, whether or not euroland is a success story. Markets have accepted that a currency, rather than being the expression of a full-fledged state construct, can be issued and managed by the central bank of what in previous chapters I called a polity-in-the-making. It should be recalled, once again, that measuring the success of the new currency on the yardstick of the exchange rate is a misconception. The adoption of this yardstick was a prolongation of the fixed exchange rate mentality that had characterized most euro area countries before the single currency, and also reflected the desire of the media and communication system for a daily indicator. However, it was not the yardstick used for major international currencies, including the Deutsche mark prior to EMU, which in the 1980s had fallen well under the low level later reached by the euro. Nor was it a goal set by the Treaty. 7.3

Three Floating Currencies

For a largely accidental reason, the advent of the euro coincided with a new round in the international debate over the appropriate exchange rate regime among the main international currencies. The debate was triggered in the fall of 1998 by the German Finance Minister Oscar Lafontaine. Tighter exchange rate arrangements among the US dollar, the euro, and the Japanese yen were proposed, in the form of so-called target zones,

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namely predefined fluctuation bands. Rates would move freely within the targeted zone, but action should be taken to prevent them from trespassing. The proposal was discussed and eventually discarded.10 The key arguments that won the case can be recapitulated as follows: Establishing a formal scheme would require the leading industrial countries to agree on desirable exchange rate levels, which would prove extremely difficult, in view of the lack of strongly based criteria for estimating equilibrium exchange rates. Indeed, while for price stability (the value of money in terms of goods and services) there exists a sufficiently precise and widely accepted quantitative measure, for the value of money in terms of another money there is no reliable compass. Assessing the equilibrium exchange rate on the basis of the underlying fundamentals is difficult and controversial.11 Moreover, while there is little disagreement about the desirability of stable prices, exchange rate variations are regarded by many as a useful, even indispensable, adjustment mechanism for an economy. Perhaps more important is the argument that none of the leading central banks—mandated as they are to pursue domestic objectives for which they are accountable to their domestic constituencies—would now be willing to forgo domestic policy objectives in order to keep the exchange rate within the agreed range. The experience with what, in chapter 1, I have called the inconsistent quartet (i.e., the incompatibility between free trade, capital mobility, stable exchange rates, and independent monetary policies) has repeatedly indicated that conflict can hardly be avoided. Difficult to reach, an agreement on the level of the exchange rate would be even more difficult to enforce in today’s highly integrated international capital markets. In theory, the system could function if all countries agreed to give one of them the anchor role, as it happened under the Bretton Woods and EMS regimes. Such a hierarchy, however, would be economically unfeasible and politically unacceptable in today’s circumstances. This is why both the Eurosystem and the US authorities expressed serious reservations about any scheme to enforce stability between the three main currencies. That early debate has shown that the advent of the euro is unlikely to lead to new attempts to take back from the market—to which it has been entrusted in the early 1970s—the task of determining the exchange rates of the key currencies. Yet this conclusion, which tends to be accepted with greater or smaller satisfaction depending on one’s degree of “market optimism,” does not cross out exchange rates from the list of policy concerns. Nor does it exonerate monetary authorities and economists from the task

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of reflecting about the strengths, weaknesses, and possible improvements of the present regime. Several questions have to be addressed. The first question is: Will the exchange rate of the key currencies continue to exhibit the high variability of the past twenty-five years?12 A conclusive answer is difficult to formulate because different arguments point in opposite directions. European attitudes toward exchange rate developments could become more detached because euroland is a far less open economy than its national components were.13 In the opposite sense, however, the relatively new fact that all the three leading economies— United States, euroland, and Japan—clearly gear their monetary policies toward medium-term price stability could favor more stable exchange rate relations. The proposition that price stability should lead to nominal exchange rate stability is far from accepted in theory and, in practice, is not supported by the experience of the early years of the euro. As in the past the foreign exchange market seems to remain prone to episodes of over- and undershooting like the one observed for the euro in 1999 to 2000 and, before then, for other currencies. All in all one could hardly expect, for the years to come, a significant decline in exchange rate variability, in the form of both short-term volatility and—what is more important—prolonged misalignments. This leads to a second question: Should persistent exchange rate variability be a cause for concern? In my view, the answer is yes. Although little can be done to avoid them, the costs and damages that high exchange rate variability inflicts on economic activity, financial stability and the climate of international relations can not be denied altogether.14 Large and prolonged misalignments negatively affect macroeconomic stability, generate uncertainty, distort the allocation of real and financial resources, determine shifts in competitiveness, and foster trade conflicts and pressures for protectionism.15 Thus, a third question arises: Are there policy remedies to excessive exchange rate variability? Here is where the main difficulties are. If the exchange rate is unlikely to become an objective for the major economic players, international cooperation can only pursue exchange rate stability indirectly, and the instruments available to this end are limited. When inadequate macroeconomic or structural policies are seen as the cause of large exchange rate movements, international cooperation may try to mount peer pressure for adoption of the corrections needed to restore stability. When misalignments are seen to arise from market uncertainties or misperceptions of actual or future policies, cooperation may be used to

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try correcting market perceptions by way of coordinated information and communication. Stronger measures, aiming at building more stability into the market mechanism, such as through restrictions on capital movements, are much harder to design and their effectiveness is at best doubtful. Thus, for the undesirable exchange rate variability that will persist even if no fundamental policy mistakes are made, only symptomatic cures are available, in the form of declarations and occasional interventions. This is indeed what key industrial countries have resorted to since the collapse of the Bretton Woods regime, and it is fair to say that such symptomatic cures, while producing some effect on some occasions, have not fundamentally corrected the imperfections of the market mechanism. In conclusion, and looking at the years to come, the relationships between the dollar, the yen, and the euro are likely to remain left to market determination, with only occasional and limited interference by public authorities. As there are no signs that other currencies will soon achieve the status of international currency, the world will remain one of three floating currencies, with a clear ranking between the three. All in all, the policy side of the present exchange rate relationships is quite limited, it has no rules, and is largely handled by the G7. Whereas the Bretton Woods system was based on a combination of firm rules with an institution empowered to ensure their implementation (the IMF), in today’s exchange rate relationships the IMF does not play a significant role any longer. Discussions on the three key currencies and their respective economies take place within the small circle of the G7. In that group no formal decision-making procedures exist and the IMF is relegated to the role of a technical secretariat. The agreed G7 communiqué rarely modifies policies that would have been followed anyway. Implementation of the conclusions is voluntary. This very soft governance of the three key currencies and areas is consistent with the “hands-off” attitude of today’s public authorities. Such attitude, in turn, results from a combination of factors like the overwhelming power of the private sector, the dominant intellectual paradigm of market optimism, and the strong reluctance of national powers to share sovereignty internationally. Obviously no mechanism of this kind would be effective if its ambition was to effectively influence exchange rates, as it lacks the basic decision-making procedures and action tools that constitute the very essence of any policy-making. The mechanism hardly functions otherwise than as an instrument for crisis management, because only a crisis or a near-crisis provides the extra incentive to reach agreements that go beyond exchanges of views and information.

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In the foreseeable future, the configuration of major players, institutions, market structures, cooperation practices, and intellectual paradigms described here is unlikely to change. If, however, one looks beyond the so-called foreseeable future (whose length nobody knows), it cannot be excluded that the present configuration may suddenly come under discussion. The absence of the IMF from any meaningful role in policy discussion can be hardly justified. The composition of the G7 fails to correspond to monetary realities. The allegation that the market is always right and always stronger than the policy-maker is just an allegation. The affirmation that wide misalignments are impossible to assess and do little harm is pervaded by complacency. Moreover new changes may be incubating. As countries like China, India, and Russia become more open, more market oriented, and more financially relevant, the number of key currencies can be expected to increase. Market structures and practices could evolve toward greater instability and volatility. The pendulum of academic and expert opinion might swing away from the pronounced market optimism that has prevailed in the last two decades. The question of how to manage a more complex multi-currency system could thus be reopened, although it is very hard to speculate about the direction a “return to policy” could take. Our conclusions on the exchange rate debate are therefore permeated with awareness that the future is open. 7.4

Pegs and Corners

Besides the three countries discussed so far, many of the nearly two hundred countries remaining have a good many reasons to pursue an exchange rate objective. These reasons range from the size and openness of the economy, to the quest for credibility, to the strong trade links with, and financial dependence on, a large neighboring country. For many decades the instrument most frequently chosen to integrate the exchange rate objective in the monetary policy strategy consisted in anchoring or “pegging” the national currency to a major currency, generally the US dollar.16 The instruments used to this end included setting domestic interest rates, buying and selling the national currency against the anchor currency, and imposing restrictions on foreign exchange transactions. Of course, in a wider sense, all domestic macro- and microeconomic policies contribute to the determination of the exchange rate and hence to sustain, or to undermine, the pegging strategy. With a large global financial market, capital easily flows into, and out of, countries, in pursuit of high returns but retreats as soon as it detects

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default in the debtor. Obviously, the countries that offer high return are precisely those for which the risk of default is sizable, so-called emerging or transition economies. The former seek to take off as fast growing, exportoriented economies, and the latter seek to construct a market economy after the collapse of the Soviet system. Both types rely heavily on external trade, both are capable of high-growth performances and prone to sudden crises, given their fragile economic and political institutions and the weak and weakly regulated financial system. In such circumstances pegging the national currency to another currency is no longer the simple and powerful strategy that it used to be when the international financial market was small, and various restrictions on foreign exchange transactions worked effectively. Indeed, in the last decade, financial crises such as those in Mexico (1994–95), East Asia (1997–98), Russia (1998), Brazil (1999), Turkey (2001), and Argentina (2001–2002) have shown that the requirements for sustaining pegged exchange rates have become increasingly demanding. A pegging strategy is under the constant risk of defeat because, in the present world, the policy-maker often lacks the instruments to win the confrontation, and pegging is, relative to the market, considerably weaker than it used to be under Bretton Woods.17 It should be pointed out that what is said here for a pegging strategy applies also—albeit in a lesser degree—to other strategies in which, monetary policy, while retaining a degree of discretion, pursues an exchange rate objective and adopts an external anchor. Among such strategies are the so-called crawling pegs, exchange rates within crawling bands, and managed floats.18 All of these strategies fall under the rubric of intermediate strategies, however. Recently the view has gained ground that intermediate strategies are very vulnerable and so should be avoided in all circumstances. Policy-makers must therefore restrict themselves to free floating currency or completely abandon any idea of monetary sovereignty, that is, to implicitly or explicitly adopt a currency of another country (so-called hard pegs in the form of currency board arrangements, dollarization, or euroization). This view has become popular in academe, and in some international circles, where it is termed “corner solution theory.”19 Corner solution theory invokes the same inescapable logic as that behind the “inconsistent quartet” proposition illustrated in chapter 1 of this book. It is undeniable that in a world of capital mobility, intermediate strategies, which are harder to sustain, should be handled more carefully and may not be practicable in all the cases in which they were successful in

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the not so distant past. The merit of intermediate regimes, however, for many countries still is that a float is often seen as too destabilizing and a hard peg as unacceptable.20 Mainly a floating strategy can incur perverse cycles of bubbles and bursts caused by the alternating over- and undershootings to which markets are prone.21 This is the reason behind a so-called fear of floating present in many emerging markets experiencing weakness, and it cannot be disregarded. Openness of the economy, hence key role of the external sector in promoting both economic activity and price stability, and the risk of too rapid financial integration with the outside world are reasons to reject the option of pure float. Moreover, as exemplified by euroland and the European Union vis-à-vis other European and Mediterranean countries, regional integration of neighboring countries may determine the emergence of a predominant trade partner with a stable currency, which may induce countries with free floats to move to a peg. The complete surrender of a national currency and monetary policy, however, may be economically unsound and politically unacceptable. Many countries are too large and their economies too dependent on endogenous impulses for blind adoption of a monetary policy designed for a different economy to be a rational solution. Even when a country is very open and foreign-dependent, there may be no single outside economy to which it is so tightly integrated for the currency and monetary policy of that outside economy to be the optimal choice. Argentina is a case in point. Short of completely adopting the name and the banknotes of another currency—a process called dollarization—no hard peg may be hard enough to prevent a crisis. It also suggests that for a medium-sized country dollarization—or euroization—can be politically and technically bad for either side.22 What is unavoidable, or works, for Panama or Monaco is not necessarily good or applicable for Brazil or Russia. Not many countries are ready to surrender monetary sovereignty altogether and accept an external anchor. While there may be the claim that a “hollowing out” of the middle range of the fixed-flexible continuum in favor of extreme solutions is the trend, this is only partly borne out by evidence. The majority of studies of actual regimes have discredited the notion that the middle ground has been abandoned, and that exchange rate policies are shifting outward from the middle of the continuum. Especially in East Asia, many of the countries declaring to pursue a float policy in fact manage, in varying degrees, their exchange rates.23 The discussion of country attitudes toward exchange rate strategies should not minimize the importance of a change in strategy or, as it is

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called, a “regime shift.” In the moment of crisis, a strategy can be abandoned because of an inconsistency with other policies, because it led to the evils being experienced, or else because a better strategy is on the horizon. Any of these motives can, and actually do, appear in any crisis and under any exchange rate strategy. Rarely does this imply that a strategy alone is the cause of a crisis. When economic policy and economic behavior are not sound, no strategy is sustainable indefinitely. At the moment a crisis erupts, it must be changed. Often it is not the intrinsic quality of the new strategy but the drama associated with change that catalyzes the political will, for lack of which the tensions and the crisis originated. A peg, even a hard one, may not survive the pressures of the market. However, as the experience of Brazil in 2002 shows, also a float may not be sustainable, for countries that float currencies are not per se immune to macroeconomic instability. In such situations the shift to a harder regime may help import credibility and restore stability. In sum, exchange rate strategies must be viewed in terms of overall policies as they also influence the design and effects of such policies. This intergrative aspect of policy should dispel the fallacy that the exchange rate is a kind of automatic pilot, that once a regime is adopted the policy-maker is exonerated from the task of attending to its route. No single formula ever meets the needs of all countries at any one time. A strategy has to be consistent with country-specific characteristics, in the main, the size of the economy, its trade and financial linkages, the extent of liberalization of capital movements, and the maturity and soundness of its financial sector. 7.5

The Euro as an Anchor

Euroland and the Eurosystem are not only (with the United States and Japan) part of the triad of key currencies and economies, they have also engaged bilateral relations with a wide range of other currencies and countries, both inside and outside Europe. The exchange rate has special importance for the Eurosystem as it is the prime monetary link to these other countries. For the reasons explained in the preceding section, many countries still choose an intermediate regime, hence entered the role for the euro as anchor. In the spring of 2004, about fifty countries world wide had an exchange rate regime involving the euro (see table 7.2.). These countries were distributed over a well-defined part of the world, which covers Europe, the Middle East, and Africa, and comprises around 100 countries, not counting the 25 EU member states. It can be named as the European

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Table 7.2 Exchange rate regimes involving a link to the euro

Exchange rate regime Exchange rate arrangements with entitlement to use the euro as the official currency

Number of countries/ territorial communities 2

3

Countries/territorial and overseas communities French territorial communities of Saint-Pierre-et-Miquelon and Mayotte The Republic of San Marino, the Vatican City, the Principality of Monaco

Euroization

3

Andorra, Kosovo, Montenegro

Currency board arrangements

4

Bosnia-Herzegovina, Bulgaria, Estonia, Lithuania

Peg arrangements (including pegging to the SDR and other currency baskets including the euro)

20

Pegging to the euro only: Cyprus, 14 African countries of which the CFA franc is the legal tender, French Polynesia, New Caledonia, Wallis and Futuna, Cape Verde, Comoros Pegging to the SDRa: Botswana, Jordan, Latvia, Libyan Arab Jamahiriya, Morocco, Vanatu Pegging to other currency baskets including the euro: Israel, Malta, Russia, Seychelles

6

4

Managed floating with the euro used as a reference currency

7

Total

49

Burundi, Croatia, Czech Republic, FYR Macedonia, Slovak Republic, Slovenia, Yugoslavia

a. Since January 1, 2001, the euro has accounted for 29 percent of the SDR basket.

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hemisphere since, for virtually all of them, the European Union is by far the largest trading partner, the base of their financial systems, and is counterparty to important agreements in the fields of trade. It also is the source of technical assistance and support for economic development. To the extent that these countries have sought an external monetary anchor, the euro has become the natural choice. The anchorage strategies range from very close or even full links—such as through currency boards, euroization, or formal entitlement to use the euro as legal tender—to loose forms—such as pegs, crawling pegs, or managed floating. What is remarkable is that no such comparable regional clustering is observed around the United States, and even less around Japan, in their respective parts of the world. In the American hemisphere, regional cooperation is still at an early stage, and mainly confined to trade arrangements. So far only a loose institutional structure exists and does not involve binding legislation or supranational decision making. The US dollar, of course, plays and will continue to play a strong role, although differently than in the European hemisphere, where adoption of the euro has become the aspiration of medium-sized economies such as Poland. In the American hemisphere only very small countries (e.g., Ecuador and El Salvador) have opted for full dollarization thus far. As to the East Asian and Pacific region, the prospects for the Japanese yen to play the role of a reference currency are still remote, despite some progress already being made in regional integration in that part of the world.24 The present attitude of the Eurosystem toward the euro’s role of anchor is cautious and even reluctant. The euro may be an anchor currency due to unilateral decisions by third countries, but not as a result of any contractual relationship with the ECB. This attitude arises from different concerns, and is partly rooted in the historical misgivings of the Bundesbank about any form of external commitment. The main concern that the objective of price stability could be weakened by any constraint deriving from a contractual relationship is pushed to the point of shying away from any such relationship. The culture of floating rates of the Bundesbank is much more in line with the present prevailing view over exchange rate regimes than the traditional French attitude, which was much more inclined to see the advantages of enacting policy discipline over exchange rates. Such concerns, however, should not be blown out of proportion as the experience of postwar Germany bears little resemblance with today’s world. The Eurosystem is incomparably stronger and even more independent, and the euro area incommensurably larger, than any European predecessor. Hence the ECB is more equipped to cope with the euro’s increased

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role as an anchor currency. Today the aggregate GDP of countries anchored to the euro is small, less than 4 percent of world GDP and 16 percent of euroland GDP. Euro anchoring has therefore virtually no bearing on the transmission mechanism of monetary policy, and should be mainly considered from the perspective of the potential net benefits in the overall relationship between euroland and the anchoring country. 7.6

Cooperation for Financial Stability

For many long years monetary policy through exchange rate relationships was virtually the only policy field where international cooperation was firmly established. Over time, however, the two other central banking functions described in chapter 2—financial stability and payment systems—became relevant internationally as a new international monetary system emerged out of the collapse of the Bretton Woods regime. This section traces the profile of such a system and shows how the Eurosystem participates in the related policy functions. Understandably, as the world has moved rapidly toward global capital mobility, global regulation has lagged behind. The asymmetry between the market, which is world wide, and policy making, which is national, reflects the fact that with Europe excluded, economic and political realities have not evolved in parallel. Such an asymmetry can impair financial stability, and therefore calls for increased cooperation. Unlike the Bretton Woods regime, the present global system is neither the outcome of a formal conference nor does it correspond to a grand design. It has evolved unplanned, driven by continual interaction between policy decisions and market forces. Although it has often been dubbed a nonsystem, it can be better defined as a market-led system, unlike the previous system, which was government led.25 The benefits of the market-led system can hardly be underestimated. World economic relations have been freed from the macroeconomic inconsistencies that undermined the fixed exchange rate regime with the advent of capital mobility. Greater efficiency has been gained in the international allocation of resources. The practice of financial repression, used to shelter domestic economies from competitive pressures and national policies from market discipline, has been largely discarded. Such a system, however, has also brought with it new challenges and new requirements. The dominant forces of the market in both the determination of exchange rates and the international allocation of savings has extended from the national to the international arena the whole range of

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public policy concerns associated with monetary and financial activity. First and foremost is the challenge to the stability of the global capital market and banking system. It is not by accident that a series of financial tensions and crises has hit industrial and emerging economies, from the early 1980s onward, after almost four decades of substantial stability.26 Financial stability has thus become a key item in the international agenda of ministers and central bankers, often a more prominent item than the traditional topics of monetary and exchange rate relations. The risk of instability has been heightened by a combination of inadequate supervision and contagion effects.27 The response has been international cooperation in various fields of financial regulation and supervision, as well as in payment systems. The areas of policy reviewed in chapters 5 and 6 have gradually complemented monetary and exchange rate matters on the international agenda. It can be said that in today’s market-led system, the restrictions to capital movements, characteristic of the Bretton Woods era, have been replaced by the promotion, at the international level, of financial stability. Cooperation in the supervision of banking started in the mid-1970s. For many years it was driven almost entirely by central banks and conducted under the aegis of the Bank for International Settlements (BIS), which is Basel based and owned by the central banks of major countries around the world.28 Over time, this cooperative arrangement spread to other fields of finance and to the payment system. The emphasis has progressively shifted from crisis management to what is known as crisis prevention, and the involvement of forums and institutions other than the BIS has grown. The financial tensions, or crises, that have periodically hit the market-led system were a powerful incentive to more cooperative effort.29 By the end of the 1990s international cooperation in the field of financial stability had reached a configuration that can be described as follows. In the extent of coverage, international cooperation is active in virtually all fields of finance where public policy actions are undertaken at the domestic level.30 Besides banking, these include securities, insurance, payment systems, accounting standards, and more specialized fields such as derivatives or primary markets. The relevant groups are normally composed of representatives of the national agencies in charge. Their composition, size, organization, and authority vary widely from field to field. Cooperation has a three-level framework. Political impulse is provided mainly by the G7. This Treasury-dominated forum takes the key decisions in time of crisis, sets the agenda for global cooperation, and monitors the overall process. Rule making and standard setting is generally made by spe-

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cialized committees and organizations, arising out of the relevant branches of the financial sector. Implementation and enforcement of international rules and standards are mainly promoted by the IMF and the World Bank, whose charters and special knowledge ensure influential contacts with virtually every country of the world. International coordination works—to use the terminology used in chapter 3—in the “soft mode,” whereby decisions cannot be taken unless consensus is reached, and even then are not legally binding. This soft mode is not supranational but international in nature. On the basis of this description, the validity of the present system of cooperation for financial stability and the role of the Eurosystem can be assessed. Cooperation for financial stability—developed over years of ad hoc decisions driven by needs and opportunities—has undeniably achieved important results. The repeated financial crises of the last two decades have been managed and overcome. Several fundamental regulatory instruments have ceased to be purely domestic and, after some harmonization, have become internationally agreed standards. The system of rules has begun to spread from the restricted circle of the leading industrial countries to the whole world. Recent encouraging signs suggest that the global financial system has become more resilient and less prone to contagion. The system has produced useful results because, over local interests and entrenched practices of regulatory laxity, have prevailed such positive factors as the compelling need for an international discipline, the leadership of the key countries, the desire of national authorities to be credible outside their borders, and the aspiration of financial institutions to gain international reputation. Cooperation for financial stability has also enhanced, in recent years, the role of the IMF and the World Bank. The former has complemented its traditional macroeconomic surveillance with a periodic review of financial systems, and a regular monitoring of compliance with international codes and standards for financial regulation and supervision. These positive results, however, should not obfuscate the congenital weaknesses of the present system. One of them is a cumbersome structure whose logistics is difficult, and not all the countries are present in all the roles. As a result frictions are bound to arise. Table 7.3 shows the present composition of the main groups, organizations, and institutions involved. Another weakness is the lack of a strong, transparent, and accountable institutional structure. Unlike the European Union or the IMF, the G7 is a self-appointed body led by a group of Treasury officials and, within it, by

G10 countries, Spain and Luxembourg (central banks and other institutions with banking supervisory responsibilities), FSF

Observers: ECB, European Commission

1974

Committee in regular meetings

Members

Other participants

Year of establishment

Decision-making body

Presidents’ committee

1983

Affiliate members: 7 international organizations and 53 national organizations (mainly stock exchanges)

84 countries, with ordinary or associate member status (securities commissions)

Securities firms and markets

Securities Commissions)

Banking Supervision)

Internationally active banks

Organization of

(Basel Committee on

Area of work

(International

BCBS

IOSCO

Table 7.3 Standard-setting bodies in the financial field

Association in General Meeting

1994

Observers: 60 including international organizations, industry and professional associations, companies, consultants

Over 100 jurisdictions (insurance supervisory authorities)

Insurance companies

Insurance Supervisors)

Association of

(International

IAIS

Committee in regular meetings

1990

Non-G10 central banks are associated on an ad hoc basis

G10 countries, Hong Kong SAR, Singapore, ECB (central banks)

Payment and settlement systems

Settlement Systems)

Payment and

(Committee on

CPSS

Board

2001, as a result of the restructuring of IASC (established in 1973)

—

14 accounting experts, whose selection is not based on geographical criteria

Accounting

Standards Board)

Accounting

(International

IASB

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Working groups; task forces; network of regional committees Large General Secretariat located at the BIS (Basel)

4 meetings per annum, on a regular basis

Setting regulatory standards; exchanging information; encouraging the adaptation of banking regulation at the national level; cooperating with other regulators

Basel Capital Accord (1988, amended in 1996; a new Accord is expected to be finalized in 2004) Core principles for effective banking supervision (1997)

Other bodies and secretarial resources

Frequency of the general meetings

Main areas of work

Main achievements

Capital Adequacy Standards for Securities Firms (1989) Objectives and principles of securities regulation (1998)

Setting standards; exchanging information; surveillance of international transactions

Annual conference

Executive Committee; four regional Standing Committees Large General Secretariat located in Madrid

Insurance supervisory principles (1997) Principles for the conduct of insurance business (December 1999)

Setting standards; promoting cooperation; providing training; cooperating with other regulators

Annual conference

Executive Committee; several committees, working groups and task forces Small Secretariat hosted by the BIS (Basel)

Real-time gross settlement systems (1997) Core principles for systemically important payment systems (2001)

Setting standards; coordinating oversight functions of central banks; monitoring developments; cooperating with other regulators

3 regular meetings per annum

Subgroups and working groups Small Secretariat located at the BIS (Basel)

International accounting standards

Setting standards; cooperating with national rulemakers to achieve convergence in accounting standards around the world

“At such times as the IASB determines” (usually monthly)

Trustees; Standards Advisory Council; International Financial Reporting Interpretations Committee Large Secretariat located in London

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the United States. Ineffective in the traditional monetary and macroeconomic field, where deliberations virtually never influence policies, the G7 in recent years has fostered some positive results in financial stability. However, a number of problems and shortcomings remain. Treasury officials lack the statutory authority and the technical expertise to make difficult decisions whenever a lack of willingness or a lack of consensus emerges in the sectoral groups and organizations. Moreover the G7 has no authority over non-G7 countries.31 The crux of the matter is that as economic and financial interdependence deepens, the global financial system is increasingly being confronted—just as Europe has been on a regional scale—with a new challenge. The logic of growing interdependence calls for a gradual transition from the issues, needs, and procedures typical of international relations to those that are typical of a domestic setting. This was indeed the path consistently, albeit not entirely, followed by the European Union, up to the major step of creating a single currency and its own central bank. The way forward is easy to see but extremely difficult to follow. It consists in hardening the soft mode by strengthening the authority of international standard-setters, deciding even when consensus is lacking, providing adequate instruments to act, organizing a more acceptable representation to all countries of the world, and enhancing rule enforcement and inter-agency cooperation. This is an extraordinarily difficult task when applied to a multitude of about 200 sovereign countries. Implementing such a design, for which only limited inspiration can be drawn from national or even regional constitutional models, is politically arduous because effectiveness can only be obtained by accepting some limits to national sovereignty. What is the role of euroland and the Eurosystem in this complex and rapidly changing framework of policy cooperation? It is potentially significant but in point marginal. It is potentially important because of the economic and financial size of euroland, the stability of its overall macroeconomic position, the soundness of its financial system, the high level of technical expertise, and the large network of contacts and relationships with countries around the world. It is factually marginal because neither euroland nor the Eurosystem have been willing, so far, to pool their forces and to act as a system. In the groups, committees, and organizations constituting the threelevel policy process described earlier neither euroland nor the Eurosystem normally participate as such, and when they do, they do so in an observer capacity.32 In terms of substance, the national governments of euroland are

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unwilling to adopt the stringent decision-making procedures that would be required to systematically adopt a single position on the key issues on the agenda of G7 or IMF deliberations. National central banks of the euro area are themselves keener to act as parts of a national constituency than as parts of the Eurosystem. The latter thus fails to play the role of catalyst of a single policy platform that would otherwise be possible and consistent with its institutional interest.33 In sum, the very same characteristic of the Eurosystem we have encountered in the policy realm (other than monetary policy) examined in earlier chapters can be found in the field of cooperation for financial stability. In these early years neither the Eurosystem has acted as a full-fledged central bank nor euroland as a “country.” The latter still lacks the constitutional structure to do so. The former is endowed with such structure but has not yet enlivened its charter with the necessary determination and political will. The result is that in the global arena an important player is missing from the field and another—a “central bank without a state”—stays on the field but does not fully play.

8 The Trials Ahead: From Infancy to Maturity

At the age of five an institution is, like a human being, just out of infancy. It is impossible to predict how the adult will turn out and how he will look back on his early years. To shape the adult, childhood and adolescence are as important as infancy. How the euro and its central bank will mature over time will depend greatly on factors and events that are outside the control of the Eurosystem. Economic developments in euroland, personalities at the top of the ECB and the national central banks, the further constitutional change of the European Union, the overall evolution of the state of the world, are among such factors. The euro and the Eurosystem have overcome the risky trials of infancy in a matter of weeks and months. The design of the strategy and operational framework for monetary policy, the construction of a euro areawide payment circuit, the road test of these arrangements, the production and distribution of the new banknotes, are among the things that could have gone wrong at the very beginning with catastrophic consequences. Predicting the future is impossible, but looking ahead is necessary for both the analyst and the policy-maker. This final chapter is an attempt to look ahead on the basis of the few things we know. We know that the euro and the Eurosystem are only children. We know that it is an unprecedented experience for which no ready-made manual exists. We know that the forthcoming trials will take years or even lusters, not just weeks or months. We finally know, or presume to know, what the main trials for the years to come are likely to be, although we do not know precisely what conduct of affairs will permit to win. The following five sections review the trials I regard as most decisive for the years to come. 8.1

Price Stability and Growth

The foremost standard on which the ECB and the Eurosystem will be judged in the years to come will continue to be the ability to maintain

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price stability. On the other hand, the success of EMU and euroland will be judged on a different and more ambitious standard: the combination of price stability with growth, and the creation of enough new jobs to reabsorb unemployment and reach the forefront of economic and technological progress. The problem lies in the fact that the noncoincidence of these two standards represents, in itself, a challenge and a potential risk for the Eurosystem. In the 1990s the United States showed to the world that growth rates of the order of 4 percent a year are not the preserve of catching-up economies but can be achieved by the leading countries.1 By contrast, we saw in chapter 3 that the same decade was, overall, disappointing for Europe despite the success stories of some countries. Is a golden decade within Europe’s reach? Pessimists point to the rigidity of the social structure, the high unemployment benefits, the generous provisions of the social safety net, the ageing population, the high cost of the welfare system, the overexpanded role of the state, the persistent economic nationalism, and the defense of inefficient national industries. Under the influence of these factors—they say—the old continent has lost its drive and its economic energies have atrophied. Only with a thorough change in mentality, economic incentives, and social institutions can old Europe emulate young America. Optimists think that a substantial improvement in the overall European economic performance is possible without changing the nature of the European model, and perhaps is not so far away. They point to the fact that all the factors recalled by the pessimists were already in place in a not distant past, in which the European economy outperformed the American economy. If anything—they say—the last ten or fifteen years have been marked by substantial, albeit admittedly insufficient, structural reform that may bear more fruits. Rigidities in the labor market were generally stronger in the 1980s and early 1990s than today in most countries. The launching of the single market, the adoption of the euro, and the structural correction of public budgets were, after all, no small structural reforms. To enter a golden path the Europeans do not have to adopt an American model any more than the Americans had to copy the Japanese model in the early 1980s—as some suggested at the time—in order to redress the fortunes of their economy. The debate is inconclusive because knowledge over the ultimate determinants of economic growth is not sufficiently complete for economists to predict—and for policy-makers to engineer—the growth process of a country or region. What matters here, however, is to explain why keeping

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the rate of price increase consistently “below 2 percent over the medium term” is to be regarded as a necessary, but not as a sufficient, condition for the new institution to feel comfortable. Major real imbalances do disquiet a central bank also when its statute unambiguously ranks price stability as the top objective. The reason is that if a current account deficit, or a fiscal deficit, or the unemployment rate reach such a large dimension as to be unsustainable, the adjustment that will eventually be set in motion is likely to have adverse implications for the central bank and its policy. Adjustment of any imbalance of course will involve in the first place the economic variables that were out of equilibrium. However, it will normally also involve key economic variables whose values looked previously in good shape, and may even reach institutional arrangements, policy orientations, and political processes. Inflation, for example, may shoot up, if, for too long, the market mechanism had been repressed or the exchange rate held artificially stable. Similarly the exchange rate may collapse and capital may take flight out of the country, when the market suddenly realizes that the external debt had gone too far. Or, a perverse combination of current account deficit and high unemployment may arise in a country that had for long insulated itself from international trade and competition. Unemployment can also soar as a result of a privatization process. Popular and political support for fiscal discipline may vanish if public services are too deficient and economic activity stagnates. The unsustainable imbalance from which euroland has been suffering now for many years is high unemployment with slow growth. And, if such imbalance were to persist, risks for the Eurosystem would grow regardless of its ability to maintain price stability. The ultimate reason is that the state of health of the currency cannot, in the end, fundamentally diverge from the state of health of the economy. For the central bank the risk with insufficient growth and prolonged unemployment is functional and institutional. On a functional ground, a chronically weak economy is one in which expectations deteriorate, investments stagnate, and spending declines. Structural unemployment also increases the risk of a deflationary spiral because a longer than expected duration of unemployment may lead households to respond more conservatively to a deflationary shock. And we know that monetary policy is much less effective in countering deflation than it is in countering inflation. The most insidious threat, however, arises on the institutional ground, through a possible chain of causation involving social, economic, political, and cultural factors. Attitudes of society respond to economic

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situations and policies, which in turn are influenced by economic ideas. Institutions, on their part, respond to attitudes of society. The Great Depression lastingly changed both the course of economic thought and the practice of policy. Similarly the pain of prolonged inflation in the 1970s and 1980s molded consensus about the value of price stability and central bank independence. It cannot be taken for granted that such a consensus would last if high unemployment and slow growth in euroland lasted for many more years. Nor can it be taken for granted that the position of the central bank would remain unchanged if that consensus faltered. What can the Eurosystem do to pass the trial of slow growth and high unemployment in euroland? The answer is “very little,” because there is no miraculous medicine that monetary policy can provide to these two evils. The Eurosystem faces the risk that in the future its mission may not receive, from the public, governments, and parliaments, the same strong support which resulted from two decades of high inflation. Since unemployment is what concerns the voters and youth most, it may be very difficult for the central bank to convince a future generation of the benefits of stable prices if it has not directly experienced the cost of inflation. The Eurosystem must also be sensitive to the fact that a new environment may offer less forgiveness for excessive monetary restriction than the inflationary environment of the past two or three decades. Independence does not mean infallibility. The central bank could find itself in an awkward position if it should appear to seek a ceiling for growth rather than for inflation. Instead, it has to make it clear that it welcomes, and is ready to accommodate, any rate of noninflationary growth, the higher the better. 8.2

A Perfect Central Bank

The word “perfect” evokes both completeness and excellence. If the Eurosystem is in future years to become a perfect central bank, it is in this double sense of the word. The road to perfection is long and the Eurosystem, like every newly founded central bank of the past, will need years to reach its destination. We saw earlier (chapter 2) that modern central banks originated from fundamental changes in the technology of payments. We also saw that the three central banking functions related to monetary policy, financial stability, and payment systems, (chapters 4 to 6) have most often been entrusted to the same institution. This is because they are inextricably

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linked and refer to the roles of money as means of payment, unit of account, and store of value.2 In performing its functions the central bank exerts operational and regulatory powers, interacts with other public authorities, practices a special magistery over the financial community, intervenes in crises, works with other central banks, and cooperates in international monetary and financial matters. Each central bank does all that in one way, with one style, under a single command, and not in a variety of ways across its organization. From the point of view of the perceptions of people and markets all such activities refer to one and the same public good, called confidence. In a modern market economy confidence, rather than intrinsic value, is the foundation of the value of money. The textbook on central banking, and not the Treaty, should be the road map to perfection. It would be unrealistic to expect a full and satisfactory guide solely from a legal interpretation of the charter. Past experience of international organizations have shown that the narrowly legalistic course can be a paralyzing trap. Although ECB decisions must comply with the Treaty, whose statutes provide the foundation of its activities, those who must manage the euro and be accountable for its stability have long been aware how the vague wording of the central bank statutes compares historically with the actual workings of a central bank. In the end the test of the Treaty’s effectiveness will be in the accomplishment of the basic mission within the paradigm of central banking functions. Against this background two leitmotivs have run through the book. The first is the need to establish and assess the Eurosystem as a single central bank across the whole spectrum of functions, interests, and activities that characterizes a full-fledged central bank. The second is the need to achieve these objectives and do so at minimum cost, that is, to become efficient as well as effective. While we can conclude from the preceding chapters that in the field of monetary policy perfection is already within reach, in most other activities the Eurosystem is still striving to fully establish itself. In the effort to reach perfection, it is imperative that the Eurosystem does not fall short of the classic paradigm of a central bank. The public, the markets, and international institutions and organizations would not understand. However, the road to perfection is not only imperative, it is also arduous, because the steps required are multiple and complex from both a conceptual and a practical point of view. Moreover, they meet resistance within the system itself. So far most components of the Eurosystem have kept in place the full infrastructure of a stand-alone central bank and are keen to keep it active. Each NCB has its own banknote printing process, each has a proprietary

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system for transferring central bank money in real time across its banking community, and each maintains its own dealing room and foreign exchange reserve management capacity. Each NCB offers (or can offer) to other central banks around the world to manage their reserves in euro, each entertains (or can entertain) its own representative offices abroad, and each defines its own position in the main international forums. These activities are neither shared nor pooled. Each NCB is confronted with a problem of excess capacity. The Eurosystem is thus a very special federal and decentralized central bank.3 The structures of national central banks, historically designed to perform the full range of central banking functions, underwent only modest changes when they became integrated in the Eurosystem. Selfsufficiency is still the style. We could call this the “one-to-onecorrespondence” between member countries and central banking infrastructures. Seen from the angle of the Eurosystem, this situation generates simultaneously insufficiency and redundancy. Redundancy (i.e., lack of efficiency, or excessive costs), because many of the activities that are multiplied across the system involve high fixed costs and economies of scale, that could only be removed by abandoning the one-to-one correspondence. Insufficiency (i.e., lack of effectiveness, or inadequate performance), because the present segmentation sometimes leaves out what could be called “the whole.” For example, there is no comprehensive and integrated picture of the main financial institutions operating in the euro area. Because of confidentiality concerns the central banks are reluctant to regularly pool information about their individual institutions. While unavoidable at the start, the one-to-one-correspondence model will likely prove to be unsustainable over time. In many cases it entails not only a duplication of tasks and coordination problems within the Eurosystem, but also a creeping competition among central banks as well as the risk of giving contradictory signals to the outside world. Different national central banks have different practices in such areas like procurements, outsourcing, and market relationships. Eventually with the present configuration the Eurosystem will suffer a loss of credibility in its attempts at efficiency and structural reform in the EU economy. A traditional central bank is a monopolist, it holds an exclusive franchise for supplying a range of goods and services. Today’s Eurosystem is, instead, an archipelago of monopolists. As for the ECB, to which the Treaty entrusts overall authority over the system, it is understandably hesitant on the course to take as a way to unify the system.

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Conceivably the ECB could protract indefinitely the present archipelago, with its multiple of centers of activity. Another design may be for the ECB to actively manage top down transformation of the Eurosystem into a single monopolist, which is as perfect as a modern central bank could be. A third design may be to allow a clear and transparent competition to emerge among national central banks and thus trigger a bottom-up rationalization process. It is becoming evident that the ECB will need to make a clear choice on its direction. However, the evidence points to only a middle course, a managed rationalization that addresses the fragmentation and duplication of NCB services and allows the system to perfect itself. The present configuration of the Eurosystem maintains segmentation and differentiation that contradict the precept that euroland is a single monetary area. As many services are de facto subsidized, this contradicts the basic recommendations that the Eurosystem dispenses on the economy to governments in favor of efficiency and structural reform. Conceptually appealing as it may appear, the competition among the NCBs is unrealistic. Competition is a game in need of rules and a strong arbiter. The Eurosystem cannot be imagined to either take this role or be ready to accept guidance from the European Commission, which in the European Union is the authority in charge of competition. Competition has winners and losers, and it is hard to imagine that one NCB ceases to exit, while another will take its place. Therefore outright competition among NCBs is not a viable solution. Rationalization of the Eurosystem is a task for the system’s managers, and not for the invisible hand. The Eurosystem has no choice but a managed rationalization, whereby the one-to-one-correspondence is phased out in an orderly fashion, in a way other than full centralization. At the time of writing, managed rationalization has just begun in the Eurosystem. It is too early to assess whether it has progressed with the necessary energy and what form the solution will ultimately take. While a temptation to prolong the present archipelago of central bank services is always lurking, the need for rationalization pops up with increasing pressure and in a growing number of areas, several of which were mentioned in this book. To a large extent there is no single across-the-board formula, and the optimal approach may be to tailor a solution for every type of activity. Some criteria, however, can be identified. Centralization of activity at the ECB whenever economies of scale would speak in favor of a single center of production, for example, the printing of banknotes or the management of third countries’ foreign exchange reserves is both unlikely and

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undesirable. It would be hardly acceptable by the ECB Council. It would also pose very complex implementation problems, and would run counter to the very architecture of the Eurosystem as well as against the decentralization principle stated by the Treaty. A middle position between centralization and one-to-one-correspondence seems clearly preferable and is in the process of being developed. In large-value payments it may mean shifting to a TARGET configuration made up of fewer RTGS systems than member states. In the printing of banknotes, it may mean reducing, successively, the number of factories where euro banknotes can be printed. The break-up of the one-to-one-correspondence does not mean that the duplicated activities of the central banks involved will cease at once, nor does it mean that the changes will be obligatory. It may be gradual, voluntary, and guided by rules and incentives rather than command. The force of reality may lead small and large central banks to different choices. To the extent that economies of scale are a factor, the incentives and the constraints cannot be identical across peripheries. In the end the process cannot be expected to bring the Eurosystem into a far-reaching uniformity. Diversity is a positive factor and it has always been valued as an attractive feature of Europe. The crucial institution for enacting the change is, of course, the ECB and, at its top, the Board and the Council. The ECB Council is not only the highest decision-making authority, but also the institution that exemplifies the “center versus periphery” tensions and the dilemmas involved in the road to perfection. National governors are those who have to resolve the conflict between the local interest they pursue as heads of NCBs and the Eurosystem’s interest which they are called to serve in sitting on the ECB Council. For many decades, national central banks were accountable to, and sometimes dependent on, national politics. Public opinion identified them as national entities, and to some extent continues to do so. The “public interest” to which they were referring was the “national” interest. Significant differences exist in their tasks, organizations, statutes, traditions, and cultures. The ECB Council will need to be quite a powerful melting pot to produce the amalgam that is to shape the Eurosystem into a single strong central bank. 8.3

Incoming Countries

A third impending trial for the Eurosystem is the accession of ten countries to the European Union and subsequently to the euro.

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European integration was never intended to be restricted to the original six countries. The Paris Treaty of 1951 contained an implicit “accession entitlement” that provided for any European state to apply to accede to the Treaty.4 For the first half of its five-decade history, the Community was confined to the six founding members; for the second half, the number was continually expanded as nine new members were acquired in four successive “enlargements”.5 From 1998 to 2002 twelve countries of central, eastern, and southern Europe (Bulgaria, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, the Slovak Republic, and Slovenia) negotiated membership, and ten—the exceptions are Bulgaria and Romania—joined the Union in 2004. This fifth enlargement was a special case as it involved a large number of new entrants. The number of member states has consequently almost doubled. The largest increase in the past was three countries at one time. The recent history of the new entrants also differs markedly from that of the current member states. They were countries that had reclaimed their identities from communist dictatorships with planned economies, prolonged misallocation of resources, and no market rules or institutions. Excluding Poland because of its size, the last wave of enlargement brought into the European Union rather small states. Luxembourg apart, in population, eight of the twelve countries joining are smaller than the smallest EU member, Ireland. Again, Luxembourg apart, in GDP, all but one joining country are smaller than the smallest of EU member, Ireland. For all these reasons the enlargement of the European Union presents a much bigger institutional and political challenge than ever before. Already in 1993 in Copenhagen, in recognition of the difficulties that could arise from such unprecedented historical change, the EU heads of state or government established some preconditions for EU membership.6 First, candidate countries must have in place stable political institutions that guarantee democracy, the rule of law, and human minority rights. Second, they must have in place a functioning market economy capable to cope with competitive pressure from a single market. Third, they must have the ability to take on the obligations of membership including adherence to the aims of political, economic, and monetary union.7 All new member states are committed to adopt the euro, and no “opt-out” clauses, such as those stipulated by the United Kingdom and Denmark, are accepted. Once a country has joined the European Union, the Treaty dictates a transformational sequence of its monetary regime in

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three stages. These are the very stages that the current members of euroland experienced over the forty-year history of the European Union. In a first stage, which is entered on the day of accession, the new member state agrees to regard its exchange rate policy “as a matter of common interest”8 and participate in the procedures of policy coordination (described in chapter 3). In a second stage, membership is acquired in the exchange rate mechanism (called ERM II), which provides a framework for monetary cooperation with the euro area and prepares the state for the adoption of the euro.9 At the third and final stage comes membership in the euro, which is obtainable only after at least two years of tension-free membership in the ERM II and proven compliance with the other convergence criteria set by the Treaty. Within this general framework of EU enlargement, the Eurosystem is being confronted with an important trial in the first decade of its life. The challenge has to do with economic and policy-making aspects, and also, more important, with the functioning and organization of the institution itself. The economic problem due to enlargement lies in the discrepancies in income and price levels between the new member states and the euro area. These discrepancies are of a type and magnitude not observed in previous experiences. On average, GDP per capita in the new member states is, in terms of purchasing power parity, around 46 percent of that of the European Union. The least wealthy country that joined the Union in the past (Greece in 1981) had a per capita income of 62 percent of the community average. The catching up process required to close this gap is set to be a difficult one and will involve a profound transformation of both the economic system and the price structure in the incoming countries. Given the limited growth differentials between them and the euro area, it will likely be a lengthy process. In the monetary field, the countries in a march to catch up and interact in the process toward adopting the euro face unknown economic risks and policy problems. From the point of view of the euro area, the equalization of income and price levels is not a prerequisite of an effective integration of new countries in the single currency. Indeed, the relatively small economic size of the group of prospective members suggests that euroland and the ECB should not see enlargement as a threat to their overall economic and monetary equilibrium. Suffice it to consider that at the moment of German reunification, Eastern Germany represented, in terms of GDP, 10 percent of Western Germany, whereas for the ten new entrants, the proportion to euroland is 7 percent.

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In contrast, from the point of view of the entrants, it is desirable that as much progress as possible is made, before they join the euro, both in raising living standards and in converging toward a market-based economic structure. During the catching-up process their economies will undergo changes in their price structures, which participation in the euro may render especially difficult to manage. The process will in fact demand increases not only in real income levels but also in price levels. While statistically the swelling of price levels carries the name of inflation, it can hardly be seen as a pathological phenomenon. It is, much more, a physiological component of the catching up and, as such, should not be repressed. Moreover it may require periodic revaluations of the exchange rate to partially offset the price rises, which early adherence to the euro would preclude. A further complication is that these are the very countries that will be probably struggling to prevent their inflation rate from rising over and above the threshold associated with catching up. Their main concern and their true fight is for price stability, which is why, quite understandably, these countries see early entry in the euro as a guarantee of monetary stability. The debate around the optimal trajectory toward the euro has to weigh these arguments. In this debate, which goes under the title of “real and nominal convergence,” the ECB is called to play a role because, even before the incoming countries become members of the European Union, the ECB was seen as their future command post as well as their advisor and senior colleague. For the ECB the trial consists in helping in a constructive and competent way the new countries and their central banks’ approach to the euro. For the Eurosystem, enlargement further raises institutional and organizational issues. One concerns the decision-making process in the ECB Council. Under the present Eurosystem Statute this college, today of eighteen, could reach, owing to the enlargement, up to thirty-three members. The enlargement may encumber the logistics of the meetings so as to make the deliberations of the Council inefficient. Suffice to think that a simple tour-de-table in which every Council member speaks, on average, for four minutes would take more than two hours. Moreover the large proportion of very small countries among the new entrants could lead to decisions supported by only a small fraction of total euroland, which, in the view of some, would render the Council a less credible decision maker than it is today. To avoid such drawbacks, a reform of the Eurosystem Statute was approved in 2003, whereby the number of voting members in the Council would be capped at 15. At the time when the number of euro area

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countries exceed 15, the voting rights in the ECB Council will be shared among governors on a rotation scheme.10 The reduction in the number of voting members of the ECB Council will leave unchanged the right to attend meetings and speak in them, so the amelioration would be modest. Other changes are needed in the working and deliberation procedures of the Eurosystem. Such changes could be autonomously decided by the ECB Council and could address both the rules of procedure for the conduct of the meetings and the division of labor between the Council and the Board. Another issue concerns the organization of the Eurosystem and the “center versus periphery” concept. As was argued in the previous section, the present system, characterized by self-sufficiency and one-to-onecorrespondence between members and central bank infrastructures, is an already cumbersome structure. The enlargement with a large number of small countries aggravates the problem and makes rationalization of the Eurosystem all the more urgent. In fact almost all of the ten new members have such small size, and such overall scarcity of national resources, as to make the costs of a full-fledged infrastructure even more heavy to sustain than for old members. Challenges may, of course, be viewed as opportunities. For the Eurosystem the very trial consists in making challenge an opportunity. The accession of new members simply makes more acute an already present need for institutional and organizational reform. While today some members of the Eurosystem wax nostalgic over past splendors of unrestricted national monetary sovereignty and decry the ambition of perfecting the Eurosystem as the strong, efficient, authoritative, globally influential central bank of the European Union, enlargement may compel the young institution to shrug off reticence and to accelerate its coming of age. 8.4

A Reluctant Global Actor

The advent of EMU not only involves the development of an international role for the euro and the Eurosystem, it also affects global policy cooperation. The trial confronting euroland and its central bank is to improve the system taking inspiration from its own regional experience in international governance. As was noted in chapter 7, since the collapse of the fixed exchange rate rule of Bretton Woods, international monetary and economic relationships have evolved in an unsystematic fashion, mainly under the pressure of market forces that had overtaken the might of policy makers. Despite the disappearance of the rule, the institutional arrangements remained those

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laid down between the 1940s and 1960s, only modestly complemented with ad hoc additions suggested by specific events and urgencies. These arrangements have coped with the challenges of a number of crises, but have fallen short of the need to complement the development of a global market with global, effective, and legitimate governance. What in chapters 3 and 7 was called the “soft mode” of cooperation, namely voluntary and nonbinding statements of policy, is still predominant and severely limits effectiveness in international governance. The introduction of the euro brings three concomitant elements to the existing institutional arrangements: simplification, complication, and a potential for innovation and reform.11 The simplification consists in reducing to three (United States, euroland, and Japan) the number of key players, a change that makes international macroeconomic debates more efficient and possibly facilitates the formulation of agreements.12 It also contributes to achieving more balanced relations among the three players. A complication that looms over the positive effect is the difficulty of fitting the euro into the present pattern of international representation and institutional arrangements for policy cooperation. Such a pattern was appropriate decades ago, when a policy–government–country nexus prevailed and the responsibility for economic policy was almost entirely concentrated in the hands of the central governments of nation-states. In those years no supranational European power existed and central banks were generally dependent on their own Treasuries. Although the gradual loosening of the nexus had started before13 the advent of a common currency, the euro, represents a major step in the loosening process. Instead of a country, euroland is a regional entity and has a dispersed matrix of policies (as was shown in chapter 3). The international representation of euroland and the Eurosystem has been handled so far in a way that adds to the composition of existing groups and bodies, without attempting at redesigning them.14 The role of the European Commission has been downgraded, although it is the body in charge of EU interests. Only minimal adjustments were adopted to make existing arrangements compatible with the charters and internal rules of the relevant international institutions, organizations, and committees.15 It is somewhat paradoxical that, in the process of stipulating ad hoc arrangements on who should speak or act on behalf of euroland, the main advocates of a minimalized role were the Europeans themselves. There were more divisions among them than between them and the Americans. Paradoxically, a unified—and hence potentially more influential—

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representation was requested by Washington, while the Europeans clung to their largely symbolic and ineffective individual seats in the various organizations and committees. Formal representation was clearly preferred to actual influence. There is little doubt that full accommodation of EMU in international relations requires radical reforms, going well beyond the arrangements put in place so far. Complications of an already complex architecture, rather than simplification and reform, have so far characterized the coming of the euro and the Eurosystem on the international arena. The trial for the coming years is to reverse this trend. And this is not only a matter of representation or composition of the relevant organizations, it is much more a matter of taking inspiration from the EU experience to improve the governance of international interdependence. Indeed, in the second half of the twentieth century Europe invented and implemented, through its own integration, principles of international governance, whose validity outdistances the time and space horizon within which these principles were experimented. The provision of international public goods cannot be expected to automatically result from the spontaneous interplay of market participants and national governments, for the same reason for which, inside an economy, the market cannot produce public goods. The self-centered behavior of individual agents (be they businesses or governments) is bound to ignore the externalities that arise at the international level, and international organizations or groups exist precisely to deal with these externalities. The European experience shows that despite the entrenched idea of unbounded power of sovereign countries, a degree of supranationalism is feasible and that it does not represent the twilight of national policy, allegiance, nor loyalty. Supranationalism may be in fact the sine qua non for an effective provision of international public goods, just as a national power is indispensable for the provision of national public goods. Another key principle concerns the alignment of market freedom with enforceable rules. The market system is known to be a legal, social, and institutional order, and not merely an economic one. It is well recognized that markets need a strong set of public arrangements to function effectively at the national, or domestic, level, but this is still insufficiently recognized—and often even denied—at the international level. The European experience shows how private and public that compose the market system can be developed jointly, in a balanced way, not only within a country, but also for a group of countries. Finally, the European Union and the euro suggest that a regional level of integration may complement and strengthen, rather than endanger, the

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multilateral character of the overall system of international relations. Regionalism in organizing relations between countries is a precious intermediate layer in a world where the number of sovereign countries has grown to almost two hundreds. Indeed, following the EU experience, attempts are now made in other parts of the world to promote the regional dimension of international cooperation.16 It may be hard for Europe to actively contribute to international reforms otherwise than in parallel with the further development of its own union, both in the economic field and in the move from the economy to the polity. The more euroland and the Eurosystem are consistent in applying such methods to themselves, the more they are in the position to improve governance on a global scale. 8.5

Policy, Politics, Polity

We could define the fifth and last trial for the Eurosystem as the practice of an appropriate relationship between policy, politics, and polity.17 It consists, in other words, in coping with the lack of a full political union. Whether monetary union can be achieved despite the lack of political union has been central in the European debate prior to the Delors Committee and the EMU negotiation in 1988 to 1991. Although throughout this book the European Union has been defined mainly as a “polity-in-themaking,” the expression “lack of political union” is also so often used that a clarification is needed. It would be a misconception to assert, without any qualification, that political union is lacking altogether in Europe today. It is not because the content and the competence of the European Union are mainly economic, that its nature and historical role are not political. Even before the single currency, EU competence extended over virtually the whole body of economic legislation, from the establishment of “the free movement of goods, persons, services and capital” (the four freedoms proclaimed by Article 3 of the Treaty) to external economic relationships. To understand how very political these issues are, it should suffice to consider the place they take in the US political debate today, or have taken in the politics of our countries before the creation of the European Community. Moreover the institutional architecture of the European Union is entirely that of a political system, not that of an international organization based on soft cooperation: a legislative capacity that prevails over that of member states, a judicial power, a directly elected—albeit with limited power—Parliament. Also it would be a misconception to assert that Monetary Union has devel-

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oped as the outcome of a technocratic process removed from politics. Quite the contrary is true. The single currency has been achieved because of the strong political determination of elected governments over a full decade (from June 1988 to May 1998). Central bankers have “only” provided expertise, from the drafting of the blueprint to the preparatory work for the actual start of the system. For the rest they have accepted the limits of their role and recognized that the ultimate decisions have belonged to elected politicians.18 The advent of the euro is a quintessentially political event in its genesis, and a profound social and cultural change in its nature. Economists and even central bankers pay limited attention to notes and coins, a minor and endogenous component of the money stock almost irrelevant for monetary policy. On the contrary, for many politicians monetary union meant little else than the change in banknotes and coins, described in chapter 6. More than economists and central bankers, they saw that for the people money has to do with the perception of the society to which they belong and, ultimately, with their culture. As such, money goes well beyond the economic sphere of human action. As we have argued before, the act whereby a person agrees to provide goods or services to an unknown person in exchange for pieces of paper that have no intrinsic value is perhaps the most significant and widespread testimony of the social contract that binds people. This is why coinage and money printing have always been a prerogative of the state. Nevertheless, it remains that Europe lacks political union. The European Union is not the ultimate provider of internal and external security, the two utmost functions of the modern state. EU institutions fail to comply with the key constitutional principles that form the heritage of western democracies: foundation of the legislative and executive functions on the popular vote, majority principle, equilibrium of powers. Why does the lack of political union constitute a trial for the Eurosystem? In the short span of less than thirty years two anchors of money were abandoned: metal and the sovereign, namely gold backing and dependence on political power. It is true that central banks have struggled for years to free the printing of money from the influence of politics, as they struggled in the past to free it from the influence of private interests. It is equally true that the present independent status of the Eurosystem is exceptionally strong in this respect. However, only superficial thinking could view the lack of political union as strengthening the central bank and making it freer to fulfill its mission. It would be unfortunate if independence were to be confused with loneliness.

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Ultimately, the security on which a sound currency assesses its role cannot be provided exclusively by the central bank. It rests on a number of elements that only the state or, more broadly, a polity can provide. When, for example, we say that a currency is a “safe haven,” we refer not only to the quality and credibility of its central bank but to the solidity of the social, political, and economic order to which it belongs. Historical experience shows that when that order appears to weaken, the currency weakens, regardless of the actions of the central bank. A strong currency requires a strong economy and a strong polity, not only a strong and capable central bank.19 The problems posed by the coexistence of a single currency with a still unachieved polity will influence both practical and intellectual activity in the coming years. Such problems will have implications for both the central banker and the politician. In the realm of politics the implication is that the decision to move ahead with the euro in advance of political union contains an implicit commitment to the completion of the polity. In the conduct of monetary policy and other central banking tasks, the implication is a need to adapt to a composite and still changing institutional architecture. This deprives the central banker and its policy from the simple and well-ordered polity and gives an additional dimension to its relationship with the political process. The central banker should be prepared for the further evolution of the institutional architecture to which the Eurosystem belongs.

Abbreviations

ASEAN Benelux BIS CPSS CAP CBA CHIPS CLS DM EC ECB ECOFIN Council ECSC EDC EEC EIB EMI EMS EMU ERM ESCB EU or Union Euratom Fed FOMC FSA FSF

Association of Southeast Asian Nations Belgium, the Netherlands, Luxembourg Bank for International Settlements Committee on Payment and Settlement Systems Common Agricultural Policy Currency board arrangement Clearing House Interbank Payments System Continuous Linked Settlement Deutsche mark European Community European Central Bank Council of the EU Ministers of Finance and Economic Affairs European Coal and Steel Community European Defence Community European Economic Community European Investment Bank European Monetary Institute European Monetary System Economic and Monetary Union Exchange Rate Mechanism European System of Central Banks European Union European Atomic Energy Community Federal Reserve System Federal Open Market Committee Financial Services Authority Financial Stability Forum

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Abbreviations

G7

Group of Seven (includes United States, Japan, Germany, France, Italy, United Kingdom, and Canada) Group of Ten (includes G7, Belgium, the Netherlands, Sweden, and Switzerland) Group of Twenty (includes G7, Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Republic of Korea, Russia, Saudi Arabia, South Africa, Turkey, and European Union) Gross domestic product Harmonized index of consumer prices Information and communication technologies Intergovernmental Conference International Monetary Fund International Organization of Securities Commissions Long-Term Capital Management Mercado Común del Sur North Atlantic Treaty Organisation North American Free Trade Agreement National central bank Optimum currency areas Organization for Economic Cooperation and Development Real-time gross settlement Stability and Growth Pact Securities Settlement System Trans-European Automated Real-time Gross settlement Express Transfer

G10 G20

GDP HICP ICT IGC IMF IOSCO LTCM MERCOSUR NATO NAFTA NCB OCA OECD RTGS SGP SSS TARGET

Notes

Chapter 1 1. Jean Monnet (1888–1979), French businessman and politician, was the main architect of European integration in the twentieth century. He was deputy secretary general of the League of Nations in 1919, and during World War II the chairman of the committee coordinating Franco-British war production. He also inspired, and became the first president of the European Coal and Steel Community (1951). In 1955 he created, and led until 1975, the Action Committee for the United States of Europe, that promoted most of the initiatives taken by governments in the field of European integration. Altiero Spinelli (1907–1986), Italian politician, was a member of the European Commission (1970–76), member of the European Parliament (1976–1986), and founder, in 1941, of the European Federalist Movement. He coauthored the 1943 “Ventotene Manifesto,” which sought the establishment of a European Federation to supersede the nation-states that had led Europe into internecine wars twice within thirty years. Jacques Maritain (1882–1973), French philosopher and theologian, had already in the early 1940s advocated the unification of Europe and the reconciliation between enemies of the two World Wars as the only way to establish justice and peace in Europe. Luigi Einaudi (1874–1961), Italian economist and politician was governor of the Banca d’Italia (1945–1948) and the first president of the Italian Republic (1948–1955). In 1918, and again in 1943, he advocated the creation of a federal European state and a single European currency as the solution to the problem of war and economic disorder in Europe. Helmuth James Graf von Moltke (1907–1945), German lawyer and resistance fighter against the Nazi regime, founded the “Kreisauer Kreis,” a group of German intellectuals. Together they worked in the 1930s and early 1940s toward the overthrow of Hitler and the development of a European postwar order based on a FrancoGerman understanding. 2. Robert Schuman (1886–1963), French lawyer and politician, was born in Clausen (Grand-Duchy of Luxembourg) in a family whose roots were in Lorraine. He was a German national, and then a French national after 1918 when Lorraine reverted to France. On May 9, 1950, as minister of foreign affairs in the French government,

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Schuman proposed to Germany that it should join on an equal footing a new body responsible for the joint management of coal and steel. In 1958 Robert Schuman, member of the Christian Democrat parliamentary group, was unanimously elected the first president of the Joint Assembly (EEC, ECSC, Euratom), now the European Parliament. Konrad Adenauer (1876–1967), a German politician, was opponent to the Nazi regime. As chancellor of postwar Germany (1949–1963), he reconstructed the country and led the process on European integration. Alcide de Gasperi (1881–1954), an Italian politician who contributed to the material and moral reconstruction of his nation after World War II, was the chief architect of Franco-German reconciliation after World War II. In foreign affairs he strove to restore an influential role in international politics for Italy. During his government Italy entered the NATO. A leading proponent of the formation of a federation of democratic European states, he helped organize the Council of Europe and the European Coal and Steel Community (1951). 3. Implementing the freedom of circulation of goods, services, capital, and persons (the so-called four freedoms) was a very far-reaching objective, going well beyond the creation of a free trade area or a customs union. To appreciate its importance, suffice it to say that when the Treaty was stipulated, the four freedoms were not fully in place within the countries that decided to establish the freedoms among themselves. In the 1950s, for example, there were countries where customs duties had to be paid to move goods within national boundaries. Until late in the 1970s, the provision of banking services was subject to territorial restrictions inside some countries. 4. Charles de Secondat, Baron de la Brède et de Montesquieu (1689–1755), was a French lawyer and philosopher. He developed the thesis of “sweet commerce” in his most important book L’Esprit des lois (1748). He not only pointed out that the pursuit of profit-making serves as a countervailing bridle against the violent passions of war and abusive political power but also identified the interdependence inherent in trade relations as a fundamental force for peace, stating that “Two nations who traffic with each other become reciprocally dependent; for if one has an interest in buying, the other has an interest in selling; and thus their union is founded on their mutual necessities.” 5. In the so-called Schuman declaration of May 9, 1950, when he proposed to place German and French coal and steel production under a joint authority, Robert Schuman said: “In this way, there will be realised simply and speedily that fusion of interest is indispensable to the establishment of a common economic system; it may be the leaven from which may grow a wider and deeper community between countries long opposed to one another by sanguinary divisions.” 6. Many European institutions and bodies are located and work in Brussels, so that Brussels has as its synonym the “capital of Europe.” Outside Brussels are located the official seat of the European Parliament (in Strasbourg), which holds in Brussels most

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of its working sessions, the European Court of Justice, the Court of Auditors, the European Investment Bank (in Luxembourg), and the European Central Bank (in Frankfurt). 7. Most of the national leaders who created the EEC had little expertise in the economic field and were predominantly interested in political and strategic objectives. On some occasions they even acted against the advice of their economic experts. For example, German chancellor Konrad Adenauer strongly pressed for the stipulation of the Treaty of Rome despite the negative advice of Ludwig Erhard, his influential and highly reputed minister of economics. Ludwig Erhard (1897–1977), German politician, economics minister (1949–1963), and chancellor (1963–1966) of the Federal Republic of Germany, is widely acclaimed as the father of the German “social market economy” and the postwar “economic miracle.” Erhard, as a fervent advocate of global free trade, was originally opposed to the establishment of a European common market that was limited only to its six founding members, fearing that this would force the export-dependent German economy into a protectionist corset, especially given the exclusion, at that time, of the United Kingdom from the Community. 8. Charles de Gaulle (1890–1970), French general and politician, played a leading role in twentieth-century French politics. In 1930 he warned, without success, that France should adopt a professional army and a military strategy based on tanks and movement instead of defense and trenches. In 1940 his appeal to the French people after German occupation helped create a French government in exile that allowed France to rank among the victorious allies of World War II. After a brief period as prime minister, he retired from power in 1946 but continued to act as a staunch critic of European integration, contributing to the defeat of the EDC Treaty by the French Parliament in 1954. He returned to power in 1958, in the middle of the war Algeria was fighting to gain independence. He adopted a new constitution, granted independence to Algeria, withdrew from NATO, fought against projects of further European integration, as part of an attempt to restore a leading role for France in world politics. He retired in 1969. 9. In a customs union, tariffs and quotas are abolished for imports from participating countries. In addition all members of the customs union apply the same duties and other commercial regulations to trade with nonmembers, which implies, in practice, a common external tariff and trade policy. It therefore represents a step beyond a free trade area where the tariffs and other restrictive regulations of commerce are eliminated between the participating countries, but where each partner retains its national tariffs and quotas vis-à-vis third countries. A common market comprises an area with no obstacles to the free movement of goods, persons, services, and capital, which is accompanied by a range of common policies, such as trade and customs policies, and competition policy.

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10. This practice followed the so-called Luxembourg compromise, which was stipulated in 1966. This compromise did not have formal legal status but was only a political text in which the member states essentially agreed to disagree. France insisted that whenever important national interests were at stake, a unanimous decision should be sought. The other (at the time) five member states only conceded that they would “within a reasonable time” try to reach unanimity whenever very important interests of one or more member states were at stake. If unanimity proved elusive, they would insist on qualified majority. Over the years, however, the French reading of the Luxembourg compromise came to be accepted, as also other members states invoked the veto right. 11. The 1965–66 crisis was an episode that was to go down in history as the “empty chair crisis,” deriving its name from the refusal of the French government representatives to participate in meetings of the Council of Ministers. 12. Under this amendment to the Treaty all customs duties on products imported from non-member countries, all levies on agricultural imports and resources deriving from value-added tax go into the coffers of Brussels. In accordance with the century-old democratic maxim of “no taxation without representation,” the budgetary powers of the European Parliament were progressively strengthened. In addition a Court of Auditors was established in 1977 as a full-fledged Community institution. 13. The EMS was based on the so-called exchange rate mechanism (ERM). Within the ERM currencies had to be kept within a fluctuation band of plus or minus 2.25 percent around fixed central rates. Countries were committed to unlimited interventions in the foreign exchange market once their currencies had reached the limits of the band. Central rates could not be changed unilaterally but had to be agreed upon by the partners. A number of mutual credit facilities were established among central banks to assist participating countries in fulfilling their obligation to intervene. 14. Helmut Kohl (1930–), German politician, was chancellor of the Federal Republic of Germany between 1982 and 1998. He was the chief architect of German reunification in 1990 and a forceful and consistent promoter of European integration. François Mitterrand (1916–1996), French politician and president of the French Republic from 1981 to 1995, was, together with Kohl, the main driving force behind the progress made by European integration in the 1980s and early 1990s. 15. Jacques Delors (1925–), French politician. He was French minister of finance from 1981 to 1984 and president of the European Commission from 1985 to 1994. During his tenure at the European Commission he was, with Kohl and Mitterrand, the chief driving force of European integration. The so-called Delors Committee (Committee for the Study of Economic and Monetary Union) was created in June 1988, and the Committee presented its report in April 1989. It was formed by the

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twelve governors of the EEC central banks and three independent members. The author of this book was co-secretary of the Committee. 16. The Single European Act was adopted after the European Parliament had, in the years 1981 to 1984, elaborated a new treaty transforming the, still mainly economyoriented, EEC into a full-fledged political union. As the European Parliament lacked the constitutional power to implement it, this project had no direct consequences, but it created the political climate that paved the way to the Single European Act. 17. Complementing the progress toward the four freedoms, Germany, France, and the Benelux countries entered in 1985 in the Luxembourg town of Schengen into an international agreement (i.e., outside the Community’s treaty framework) that abolished all border controls for people traveling between their countries. By 1997 the “Schengen agreement” had been incorporated into the EU Treaty, and today it covers thirteen member states (the United Kingdom and Ireland having been granted an exemption). 18. Giulio Andreotti (1919–), Italian politician, was prime minister in 1972–73, 1976–79, and 1989–91. From 1988 to 1992 he played a decisive role in the preparation and stipulation of the Maastricht Treaty. Felipe Gonzalez Marquez (1942–), Spanish politician and lawyer, was prime minister of Spain from 1982 to 1996. He is widely regarded as having been a key proponent of the institutionalization of the concept of European citizenship in the Maastricht Treaty. 19. For Kohl, at least, monetary union was not simply about pushing forward, it was about making integration irreversible, about creating a barrier against a possible rollback of integration, and more fundamentally, as a kind of “insurance policy” against intra-European wars. 20. Unlike the other member states of the European Union, the United Kingdom and Denmark are not subject to the general obligation to adopt the euro once they fulfill all the necessary conditions. Specific provisions included in protocols annexed to the Treaty of Maastricht allow these countries to “opt out” of economic and monetary union. 21. The Treaty had in fact set two dates: an earlier one for January 1, 1997, on condition that a majority of member states fulfill the criteria. If that condition was not met, monetary union would start on January 1, 1999, even if only a minority of member states was ready. 22. There was also a one-off devaluation of the Irish punt in early 1993. 23. Ratification was completed in October 1993, when Germany—after a ruling of its Constitutional Court—signed the Treaty. In most member states, ratification was the occasion for a profound political debate about the relationship of the country with Europe and the issue of national sovereignty. Political issues, more than economic or monetary ones, were at the center of these debates and decisions.

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24. The Convention on the Future of Europe was a body of 105 members, which brought together European parliamentarians and members from the national governments and parliaments of current EU member states as well as from thirteen countries expected to join the European Union in the future. The Convention prepared and submitted to the EU governments a draft “Constitution for Europe.” At the time of writing, this draft was still discussed in view of a final approval by an Intergovernmental Conference. A first attempt to draw negotiations to a conclusion failed in December 2003. Among the contentious issues that divided member states, the definition of the voting modalities in the European Council featured most prominently. 25. Treaty of Rome, Article 124. 26. Treaty of Rome, Article 99. 27. Bretton Woods is a small town in New Hampshire where, in July 1944, an international conference was held to design the key features of the international monetary and financial system to be established after the end of World War II. Under that system, participating countries agreed to keep their currencies pegged to the US dollar at rates that could be adjusted, but only to correct a “fundamental disequilibrium” in the balance of payments. The US dollar, in turn, was convertible into a fixed amount of gold. The Bretton Woods conference also decided to create the International Monetary Fund (IMF) and the World Bank. 28. The structural funds (mainly, the European Regional Development Fund and the European Social Fund) allow the European Union to grant financial assistance to address structural, economic, and social problems. The European Investment Bank finances investment projects that contribute to balanced growth in the European Union. The Cohesion Fund finances projects linked to the environment and transport infrastructure of member states whose GDP per capita is less than 90 percent of the European average. 29. The Bretton Woods regime collapsed as confidence in the convertibility of the US dollar into gold eroded in the 1960s due to inflationary policies in the United States and the accumulation of external deficits by that country. The pressure on the system became such that the United States decided, in 1971, to abandon the convertibility of the US dollar into gold. The IMF then established a regime with central exchange rates and wide fluctuation margins (the so-called Smithsonian Agreement), but that regime was abandoned in 1973. 30. Eichengreen (1990) notes that the literature on the optimum currency areas does not provide a formal test through whose application the hypothesis that a group of countries form an OCA can be accepted or rejected. Tavlas (1993) notes that it is still difficult to weigh and reconcile all OCA properties. 31. After the pioneering contributions of the 1960s, in the 1970s several other authors brought up several additional OCA properties including the similarity in

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inflation rates, fiscal and political integration, and the similarity of shocks. In the 1980s and early 1990s several theoretical and empirical advancements led to reassess the main benefits and costs from monetary integration. The long-run ineffectiveness of monetary policy was asserted. The issue of credibility came to the fore. The effectiveness of exchange rate adjustments was questioned. It became clear that there are lower costs from the loss of autonomy of domestic macroeconomic policies and more benefits, for some countries at least, due to credibility gains. The view on currency unions improved, and their borders could be drawn larger than by mechanically testing for the sharing of OCA properties. A lot of this research was catalyzed by the very influential One Market, One Money report by the EU Commission, which was completed in 1990 and published in 1992. In the late 1990s a new debate started on the effects of monetary integration, namely on whether currency unions would bring about an “endogeneity of OCA,” meaning that the fulfillment of the OCA properties could take place ex post even if some properties were not satisfied ex ante (Frankel and Rose 1998 and Rose 2000). The intuition is that sharing a single currency is “a much more serious and durable commitment” (McCallum 1995). This line of thinking is still being scrutinized and is being weighed against other forces. 32. The Mundell-Fleming model was the first to integrate international capital flows into macroeconomic analysis. In the early 1960s the model had foreseen the importance of these flows in determining key macroeconomic variables, such as real national income, unemployment, price level, and the interest rate. By extending the standard macroeconomic model—the IS-LM model of the Hicks-Hansen synthesis— to the open economy, Mundell (1963) and Fleming (1962) developed, inter alia, the basic macroeconomic principle usually named as the “impossible trinity.” With perfect capital mobility, they argued, only fiscal policy affects output under fixed exchange rates, while monetary policy serves only to alter the level of international reserves. In Padoa-Schioppa (1982) this trio has been turned into the “inconsistent quartet” by adding a fourth element, free trade, which is a pillar of the Treaty of Rome. As Henry C. Wallich has observed, the incompatibility of these elements is “a fact well known to economists but never recognised in our institutional arrangements or avowed principles of national policy” (Wallich 1972). 33. Krugman suggested (1987, p. 139) that “as a simple matter of feasibility, Europe cannot have at the same time (a) stable exchange rates, (b) integrated capital markets, and (c) independent monetary policies. The experience of the post-1973 period seems to indicate that (a) is not something that can be dispensed with. Given the already close integration of European markets for goods and services, large exchange rate fluctuations associated with divergent monetary policies seem to be unacceptable. Thus creation of a unified capital market will also require adoption of a common monetary policy.” 34. Given a range of possible outcomes (e.g., the different possible values at which the exchange rate can stabilize in the long run between two extreme values), a

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“corner solution” is one that involves either one of the two extremes and excludes any intermediate solution. In the context of exchange rate regimes, which can span an interval between full flexibility and irrevocable fixity, a corner solution is either the abandonment of any exchange rate arrangement or the move toward a currency union. For more references, see Eichengreen, Masson et al. (1998), Mussa et al. (2000), and Fischer (2001). 35. The term “snake” is due to the fact that that arrangement resembled a snake moving within a “tunnel,” the tunnel being the larger fluctuation band vis-à-vis the dollar. Planned for all European currencies, the snake was soon reduced to the currencies of some small open economies pegged to the Deutsche mark. By March 1979 only the Dutch guilder, the Danish krone and the Belgian/Luxembourg franc had remained in the snake. 36. Johann Wolfgang von Goethe (1749–1832), German poet, scholar, geologist, painter, and politician, became together with Friedrich Schiller the intellectual figurehead of the classical period of German literature. In his most important oeuvre, Faust, Goethe produced a drama of remarkable poetic skill, philosophical depth, and even political vision, including a premonition of the dangers of unbridled proliferation of paper money. The latter is suggested by Mephistopheles: “Der Zettel hier ist tausend Kronen wert, ihm liegt gesichert, als gewisses Pfand, Unzahl vergraben Guts im ganzen Land” (Faust, part II, lines 6057–6062). [Who hath this note, a thousand crowns doth own. As certain pledge thereof shall stand vast buried treasure in the Emperor’s land (trans. George Madison Priest).] 37. John Maynard Keynes (1883–1946), a British economist, is widely considered one, if not the most, influential economist of the twentieth century. His General Theory described how an economic system may fail to coordinate on an equilibrium in which all available resources are efficiently used. John Hicks (1904–1989), a British economist, made contributions ranging from the theory of consumer choice to welfare economics to the systematization of Keynes’s macroeconomics in a coherent analytical framework, which came to be known as the IS-LM model. The IS-LM model is still in use. Franco Modigliani (1918–2003) was an American, Italian-born, economist. He was a leading figure in the so-called neo-classical synthesis, which established itself in the 1950s as an attempt at reconciling Keynes’s ideas about the rigidities at work in the actual economies with the theory of efficient market and rational choice by agents. His main contributions were to the theory of consumption and savings. He worked on the first-generation family of the large macroeconometric models, which are still used in the assessment of policy and for forecasting purposes. 38. The result that money could have permanent effects on the economy—namely that money can be nonneutral even in the long run—was driven by the concomitant assumptions that (1) the economy was originally in a state in which factors of production were not fully employed (i.e., there was equilibrium unemployment) and (2) expectations did not play a major role in shaping agents’ behavior. If expec-

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tations are rigid and the economy is not operating at full employment, then an increase in money supply would help finance the employment of idle resources and would not put pressure on prices. 39. Although several people had made similar observations before him, Alban W. H. Phillips, a New Zealander economist, published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly and, when unemployment was low, wages rose rapidly. 40. Don Patinkin (1922–1995), an American-Israeli economist, was one of the main contributors to the theory of money and monetary policy, which was to become central to the economic debate since the 1970s. Milton Friedman (1912–), an American economist, is the recognized father of modern monetarism, the theory that has emphasized the role of central banks’ (mis)management of money supply as the primary cause of short-run volatility in output. He has argued that monetary policy, while effective in the short run, can in the long run only affect inflation. Robert E. Lucas (1937–), an American economist, is the father of the so-called rational expectations revolution in macroeconomics. His work has proposed a new model formalizing the way economic agents form expectations of the future. 41. In an influential paper, George T. McCandless Jr. and Warren E. Weber (1995) examine data for 110 countries and 30 years. They find that there is an almost-unity correlation between the rate of growth of money (in three alternative definitions) and the rate of inflation, but there is no correlation between the rate of growth of money, on the one side, and real output, on the other. They conclude that: “First, the fact that the correlation between money and inflation is close to one implies that we can adjust long-run inflation by adjusting the growth rate of money. . . . Second, the fact that the growth rates of money and real output are not correlated suggests that monetary policy has no long-run effects on real output. . . . If the long run effect of monetary policy on real economic activity is truly zero, then any shortrun successes in reducing downturns can only come about at the expense of reducing upturns” (p.6). 42. Contrary to previous models, the rational expectations literature builds on the premise that agents know the basic structure of the economy and solve the “true” model when constructing their anticipations about key macroeconomic variables. This has been proved (by Lucas) to imply that only unanticipated changes in policy can affect economic decisions and thus real economic variables. 43. Paul Volcker (1927–), an American economist, was chairman of the Fed from 1979 to 1987. 44. Margaret Hilda Thatcher (1925–), a British politician, led, as prime minister of the United Kingdom from 1979 to 1990, the so-called Thatcher revolution that

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strongly turned the country to more market-oriented policies and less intervention of the state in the economy. Chapter 2 1. Two present EU members (United Kingdom and Denmark) have an “opt out” clause, and the first attempt to remove it was defeated by the Danish voters in 2000. (Sweden, where adoption of the euro was rejected by referendum in September 2003, does not qualify, as it does not meet the exchange rate and legal criteria defined in the Maastricht Treaty.) As to the new EU members, from central and eastern Europe and the Mediterranean Sea, they will join the euro only some years after joining the EU. As long as the Eurosystem and the ESCB do not coincide, the latter will remain a scarcely relevant entity, because neither does it refer to the single currency area nor does it have significant policy tasks. 2. Treaty of Maastricht, Article 105.1. 3. Treaty of Maastricht, Article 105.2. 4. ECB Statute, Article 22. 5. Treaty of Maastricht, Article 105.5. 6. ECB Statute, Article 8. 7. A discussion of how the national central banks of the Eurosystem may still differ in their tasks, organizations, and cultures would go much beyond the scope of this book. One can, however, give a few examples. Within the Eurosystem, not all central banks are in charge of supervising the banks. The number of branches in relation to total population differs considerably from country to country. Some central banks provide services that are private in nature to the general public, the financial markets, or the public authorities; others do not. This is reflected in the varying degrees of involvement of the central bank in, or outsourcing of, matters such as banknote printing, the level of banking services provided to the government, and retail payment services. 8. For example, national central banks may act as the fiscal agent or debt manager for their government or they may collect statistical information that is not related to the tasks of the Eurosystem. 9. The principle of subsidiarity was elaborated by political philosophers in the late Middle Ages and adopted by the European Union to decide the assignment of policy responsibilities to different levels of government. In the central banking field, the most important function that the authors of the Treaty decided to keep at the national level is banking supervision. 10. Treaty of Maastricht, Article 5.

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11. ECB Statute, Article 12.1. 12. This is so unless the ECB Council finds that such functions conflict with the objectives and tasks of the Eurosystem. Article 14.4 of the ECB Statute lays down that “national central banks may perform functions other than those specified in this Statute unless the Governing Council [of the ECB] finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB.” 13. ECB Statute, Article 14.3. 14. The field of competence of the central bank differs in the United States and Europe mainly because the Fed, contrary to the Eurosystem, has a key responsibility for prudential supervision. 15. Friedman and Schwartz (1971). 16. They are appointed by “common accord” of the EU heads of state or government, on a recommendation of the EU Council of Ministers after it has consulted with the European Parliament and the ECB Council. 17. ECB Statute, Article 12.1. 18. ECB Statute, Article 12.1. 19. ECB Statute, Article 10.2. 20. In major policy fields—be they defense, foreign policy, or fighting international crime—the EU still sacrifices its capacity to act to the rule of unanimity, even when the solution to problems no longer lies at the individual country level. And where the majority rule is accepted, the choice of the criterion for vote weighting still stirs the hottest controversy. The EU system works on the basis of a “qualified majority.” Each member state is given a number of votes, ranging from 29 for the largest member states (Germany, France, Italy, United Kingdom) to 3 for the smallest (Malta). A decision is adopted if a simple majority of the member states support it, and if this majority also represents a certain threshold number of votes (around 72 percent). Since the latest Treaty revision, there is a third requirement: upon the request of a member state, it has to be verified whether the assembled majority represents at least 62 percent of the total EU population. If not, the decision is not adopted. 21. For patrimonial decisions concerning, inter alia, the capital of the ECB, the transfer of foreign reserve assets to the ECB, and the allocation of net profits and losses of the ECB, the votes in the ECB Council are weighted according to the national central banks’ shares in the ECB capital. 22. In the International Monetary Fund, which is not in charge of a single policy in the way the Eurosystem is, voting power of the member countries is allocated in proportion of financial contributions, not on the basis of “one country, one vote.”

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23. In the European Monetary Institute (EMI), which operated between 1994 and 1998 to prepare the technical and organizational foundations of the Eurosystem’s policy framework, unanimity was required for any binding decision. Institutions and countries (rather than persons) were sitting at the table, and meetings were negotiations rather than deliberations. After the most influential central bank, the Bundesbank, had firmly stated its position, the course of the discussion was set. 24. Hans Tietmeyer (1931–) was president of the Deutsche Bundesbank from 1993 to 1999. 25. Admittedly there is, beyond the word of an insider such as the author of this book, little hard evidence that national interests do not prevail in the field of monetary policy. It has to be considered, however, that the opposite contention, made by some outsiders, also lacks hard evidence. One may argue that publication of the minutes of the meetings of the ECB Council could resolve the doubt and settle the issue. The reasons why the ECB has decided not to publish those minutes are explained in chapter 4, section 4.6. 26. “To safeguard the currency” (“die Währung zu sichern”) was the primary function of the Bundesbank, as laid down in the Bundesbank Act of 1957. 27. Treaty of Maastricht, Article 108. 28. Amendments to the EU Treaties have to be unanimously agreed by national governments and subsequently ratified by all national parliaments. Moreover in many countries a national referendum is also required. 29. “Defend their savings” derives from the statutory tasks of the Banca d’Italia, which is “la difesa del risparmio.” 30. Padoa-Schioppa (2000a). 31. There is a plethora of academic texts on European integration studies. A useful overview of various theoretical approaches is contained in Rosamond (2000). The history, institutions, procedures, and policies of the European Union are well explained, inter alia, in Nugent (2002), Dinan (1999), and Wallace and Wallace (2000). 32. Perhaps the crucial element that makes the European Union a statelike construct rather than a conventional international organization is the increasing (albeit still partial) recourse to the majority principle in decision-making. When adopting majority voting, and only then, there is full acknowledgment of a common interest that supersedes the national interests of member states. Conversely, the unanimity rule and right to veto decisions mark the gulf that separates the European Union from a full-fledged union. 33. An Intergovernmental Conference (IGC) is an ad hoc conference of representatives of the governments of the member states. After agreement in the IGC, the Con-

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stitution needs ratification in all member states in accordance with their respective constitutional requirements. 34. In 2004 the EU budget amounted to 99.7 bn euro, or 1 percent of the EU GDP. Chapter 3 1. For so long have currencies been associated with countries that, as soon as the advent of the euro became certain, a name was invented for the country of the euro. Euroland was the name chosen by the media, “euro area” the name more often used in official documents of the ECB. The Académie Française, since 1635 the custodian of the purity of French lexicon, was concerned that “Eurolande” could sound too much like a true country and opted for “zone euro.” In the following, the terms euroland and “euro area” will be used interchangeably to refer to the economic area formed by the EU countries (twelve at the moment of writing this book) that have adopted the euro as their currency. 2. The Treaty provides, so stated the European Court of Justice in 1963 in the Van Gend and Loos judgment (Case 26/62, Van Gend en Loos v. Nederlandse Administratie der Belastingen), a “new legal order for the benefit of which the States have limited their sovereign rights, albeit within limited fields.” The “limited fields” essentially refer to the economy. In the same judgment the Court also established the principle that certain provisions of Community law—if they are unconditional and sufficiently precise—are directly effective in that they create “individual rights which national courts must protect” without there being any need for further implementing legislation in the member states (often referred to as the doctrine of “direct effect”). This direct impact of the Community is also evidenced in particular by the “establishment of institutions endowed with sovereign rights, whose exercise affects member states and also their citizens. On the basis of the legislative capacity created by the Treaty, an ample body of European legislation has been produced. Directives, regulations, and decisions are the types of legally binding EU acts produced by the European Union, depending on whether they are applicable directly and in their entirety in all member states of the Community, or are binding with regard to the result to be achieved, but allow each member state to choose its own means of implementation, or are directly binding, but only on the individual(s), enterprise(s), or member states to which they are addressed. EU legislation is enforced by the European Court of Justice and by national courts. From the 1960s onward a jurisprudence of national constitutional and ordinary courts has stated the supremacy of European law over national law. 3. Alternative taxonomies could of course be considered, such as a classification by objectives (e.g., efficiency, stability, equity) or one by instruments (e.g., taxation, expenditure, regulation, money printing). They would, however, be less suited to describe a constitutional order in which objectives as well as instruments are, to a certain degree, entrusted to more than just one level of government.

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4. The Treaty disregards the internal constitutional structure of member states, leaving them free to decide whether they should be organized in a federal or centralized way. In fact the member states of the EU present a variety of approaches ranging from the highly centralized constitutional structure of France to the federal structure of Germany. Over the decades since the start of European integration, most states have progressively decentralized their organization. 5. Article 2 of the Treaty. 6. Articles 4.1 and 4.3 of the Treaty. 7. It is interesting to note that the three goals of efficiency, stability, and equity also underlie the system of international cooperation developed after World War II. Indeed the World Trade Organization, the IMF, and the World Bank can be seen as the three global agencies to which the three objectives are respectively assigned, with the United Nations acting as the overall political structure. Article 1 of the IMF Articles of Agreement refers to purposes like “expansion and balanced growth of international trade,” “promotion and maintenance of high levels of employment and real income,” and “to promote exchange stability.” A similar threefold involvement can be traced in the stated goals of agreements for regional groups of countries, like NAFTA (for North America), ASEAN (for Southeast Asia), and MERCOSUR (for Latin American countries). In international settings, however, the institutional arrangements created to pursue those goals are softer and looser than in national systems, where the full power of the state is available. Thus, although efficiency, stability, and equity are often stated as common objectives, the decision-making capacity, the resources, the direct reference to the citizens, the legal system, and the enforcement power that characterize international institutional frameworks are weak and often missing altogether. 8. These features are common to all sovereign states. They are most pronounced in the highly centralized states that took shape in Europe over the last three centuries (particularly in France, United Kingdom, and Spain). They are also present in federally structured states, such as the United States, Canada, and Switzerland. 9. Attribution to a higher or lower level would involve inefficiencies. Each function should be allocated to the lowest level of government at which the expected welfare gains can be reaped. Only indivisibility, economies of scale, externalities, and strategic requirements are acceptable arguments to lift powers to higher levels. 10. A number of studies have considered the theoretical rationale for policy coordination in EMU. See, for example, Buti and Sapir (1998), and Jacquet and Pisani-Ferry (2001). 11. Deliberations occur in several bodies such as the ECOFIN Council, the Eurogroup, the Economic and Financial Committee. The Eurogroup is an informal body within which the Finance Ministers of the euro area meet to discuss issues connected with their shared responsibility for the single currency. The Commission

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and the ECB are also invited to participate. The Economic and Financial Committee is comprised of two senior officials from each member state (one from the finance ministry and one from the central bank), the Commission and the ECB. It plays an advisory role and helps prepare meetings of the EU Council when the latter is to discuss economic and financial issues. For these occasions the EU Council brings together the specialized Ministers of Economy and Finance and is then referred to as ECOFIN. 12. Emerson and Gros (1992). In examining the costs and benefits of a single currency, the Commission pointed out that, with the completion of the single market, continuing with a peg but adjustable exchange rate system (what it called the “1992 + EMS” scenario) would not be a stable alternative to economic and monetary union. This was because “complete capital liberalization requires virtually a unified monetary policy if exchange rates are to be stable.” This argument was captured in the phrase “one market, one money.” 13. For instance, in Italy workers receive unemployment insurance payout for six months after becoming unemployed, whereas in France and in the Netherlands such transfers can continue up to sixty months. 14. This principle was formally adopted in the mid-1980 to ensure the singleness of the market in a way that would both avoid overextending EU harmonized legislation and impede discriminatory action by national authorities. The principle of mutual recognition was first applied in a famous ruling of the Court of Justice of 1979 (the Cassis de Dijon ruling of Case 120/78, Rewe-Zentrale v. Bundesmonopolverwaltung für Branntwein), stating that “[t]here is therefore no valid reason why, provided they have been lawfully produced and marketed in one of the member states, alcoholic beverages [i.e., Cassis de Dijon for this case, but, by extension, applicable to all kinds of products] should not be introduced into any other member state.” Based on the logic of mutual recognition, the Commission presented a “New Approach” to lawmaking in 1985, which sought to restrict the harmonization measures (necessary for the completion of the single market) to “essential requirements” (e.g., consumer safety), thereby avoiding the need for excessively detailed rules. 15. Prior to the start of the euro the Treasury–central bank relationship differed between the countries that now form euroland. In France, for example, decisions were taken by the Treasury, with the Banque de France in charge of an execution role. In Germany and Italy, by contrast, the key role was played by the central bank. 16. Article 4.2 of the Treaty. 17. In particular, Article 111 of the Treaty contemplates two so-called arrangements and sets ground rules for the Treasury–ECB shared competence. The first type of arrangement is “formal agreements on an exchange rate system.” An adjustable peg or a target zones system—under which exchange rates can move freely but only within predefined fluctuation bands—would fall into this category. The second type is the formulation of more ad hoc, less structured “general orientations” for

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exchange rate policy. With regard to the latter, however, the Treaty itself stipulates that they should be without prejudice to the primary objective of the Eurosystem to maintain price stability. 18. Resolution of the European Council on “Economic policy coordination in Stage 3 of EMU and on Treaty Articles 109 and 109b,” annexed to the Presidency Conclusions of the Luxembourg European Council of December 12 and 13, 1997. 19. Article 104 of the Treaty states that “Member States shall avoid excessive government deficits.” 20. The idea of a “Stability Pact” was first presented by German Finance Minister Theo Waigel in 1995. It aimed to ensure that the member states continue on the path of fiscal discipline (and avoid lapsing into the old profligate behavior of earlier decades) even after they had reached the 3 percent deficit target set by the convergence criteria for entry into EMU. The Stability Pact was to become an essential complement to monetary union since it represented an “insurance policy” against negative spillovers on all countries sharing the euro that might arise if overspending governments generate pressure on the common interest rate. Legally the later renamed (on French insistence) “Stability and Growth Pact” consists of a European Council Resolution stating the member states’ commitment to the rules and objectives of the Pact and two Council Resolutions laying down the precise details for multilateral surveillance and speeding up the Treaty procedure to deal with excessive deficits in particular member states. 21. National public budgets play the largest role in the EU fiscal framework. They account for about 97 percent of the totality of public expenditures from all levels of government. The macroeconomic relevance of the EU and the subnational budgets is, instead, quite negligible. The EU budget is subject to a stringent upper limit (presently of 1.27 percent of the aggregate GDP of the Union), which can only be raised through a lengthy and difficult procedure, while deficit spending is precluded. As to subnational budgets, they vary in size and importance, depending on the constitutional set up of each country, but are generally small relative to those of central governments. 22. The Pact also states that in case of a “severe economic downturn” with an “annual fall of real GDP of at least 2 percent,” this limit would not apply. 23. According to this procedure, member states of the euro area submit every year so-called stability programs, where the envisaged development of national public finances for the years to come are set out. The programs are received and analyzed by the European Commission, then discussed by national Treasury officials in the Economic and Financial Committee, prior to formal deliberations by the ECOFIN Council. In the event that the fiscal policy of a member state is seen as incompatible with the Pact, the Council can adopt a recommendation, and make it public. Member states are also obliged to transmit the relevant data of national public

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accounts (budget deficit, overall public debt) twice a year to the European Commission in order to assess actual—as opposed to merely intended—conduct of national fiscal policies. Governments failing to respect the upper deficit limit can be subjected to the payment of fines of up to 0.5 percent of the offending country’s GDP. 24. Despite a universal AAA rating small, but persistent, spreads are quoted by the market among sovereign borrowers. For example, Italian ten-year bond yields were on average around 20 basis points over the German benchmark in the first half of 2003. 25. This freedom is subject to the sole condition of complying with European macro rules and with some micro restrictions related to the single market. An example of the latter is the provisions for harmonized taxation. In 1992 the EU Council agreed on a revised VAT directive which, among other things, sets a minimum standard VAT rate of 15 percent for all EU countries (though reduced VAT rates can continue to apply to a commonly agreed list of specific products and services). 26. Article 102 of the Treaty states that “Any measure, not based on prudential supervision, establishing privileged access by Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions, shall be prohibited.” Article 101 of the Treaty states that “Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.” 27. Allowing the automatic stabilizers to operate means that little or no action is taken to counteract the shortfall of tax revenues and increase of government spending on social benefits which occurs naturally during a downturn. Examples of discretionary measures are social security spending, lower taxation, and public spending on infrastructure. 28. A useful overview of the different views and proposals made in the context of the discussion on the Stability and Growth Pact in 2002 can be found by consulting the briefing papers prepared for the exchange of views between the ECB president and the European Parliament’s Economic and Monetary Affairs Committee on December 3, 2002. While some of the briefing papers, including those prepared by Guillermo de la Dehesa (Centre for European Policy Research, CEPR), Charles Wyplosz (CEPR), Jean-Paul Fitoussi (Centre for European Reform, CER), and Gustav Horn (Deutsches Institut für Wirtschaftsforschung) went in the general direction of

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making the Pact more flexible, other papers, including those prepared by Sylvester Eijffinger (CEPR), Giampaolo Galli, Daniel Gros (Centre for European Policy Studies, CEPS), and Niels Thygesen argued that the rules of the Pact needed to be strengthened. As far as policy-makers are concerned, the proponents of a more flexible Stability and Growth Pact have included, notably, the British government and Commissioner Mario Monti. 29. To use the words of Article 2 of the Treaty, the goal of economic policy is to promote “a harmonious, balanced and sustainable development of economic activities.” 30. For example, the European Commission (2002) Communication “The Euro area in the world economy—developments in the first three years” mentions that “the aggregate policy mix of the euro area is what matters for the rest of the world.” Recital 9 of the European Parliament’s Report on the 2001 Annual Report of the ECB states that “a right ‘policy mix’ between monetary and fiscal policy presupposes sound public finances.” 31. The Broad Economic Policy Guidelines and the Excessive Deficit Procedure are the two EU procedures. The so-called Broad Guidelines of the Economic Policies of the Member States and of the Community are adopted by the EU heads of state or government on an annual basis. They contain a joint analysis of the current economic situation and set out the main orientations for the conduct of economic policies for the coming year, including country-specific recommendations that clearly identify the policy measures that each national government needs to take in order to remedy specific economic deficiencies. The Excessive Deficit Procedure regulates how the EU governments act collectively in the event that a member state breaches the upper deficit limit of 3 percent of GDP. Over the period of a year, the procedure foresees a gradual buildup of collective pressure on the offending country to mend its ways, starting with warnings and policy recommendations, which—in order to maximize their disciplining effect—can be made public. They can ultimately lead to the imposition of sanctions, including the payment of fines of up to 0.5 percent of the respective country’s GDP. 32. In reality, EMU has enhanced not only competition but also cooperation in the field of budgetary policies, largely because, by cooperating, national budgetary authorities, and specially Finance Ministers, can better overcome political and social resistance to structural reforms. Thus, in addition to the monitoring of the macroeconomic profile of fiscal policy, a practice has been started to assess the quality of national budgets. The structural features of revenues and expenditures are jointly examined, so as to learn from each other how best to address longer-term challenges, like the budgetary impact of aging populations. 33. The German Länderfinanzausgleich (Regional Financial Compensation) is a scheme that provides for a limited redistribution of fiscal revenues between the more prosperous and less prosperous German regions.

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34. Corporatism, in this context, refers to a form of social partnership between the government and centralized interest groups (usually employers and organized labor) giving the latter a privileged role in economic and social policy making. In return for favorable policies, the leaders of labor unions and employers’ organizations undertake the implementation of policy by delivering the cooperation of their members. Even though generally in retrenchment in Europe since the 1960 and 1970s heydays, this kind of tripartite negotiation also has recent examples, such as the 1998–2002 “Alliance for Jobs” between the German government, employers, and trade union organizations or recurrent tripartite agreements under the Italian “Patto Sociale,” or the (until recently) usual consultation between the Spanish government and Social Partners on most major social and economic policy initiatives (e.g., changes to the labor laws or pension reform). 35. The Economic and Social Committee is an organ of the European Union that offers advice to the EU institutions on the potential economic and social impact of pending legislation. It consists of 344 part-time members who are appointed by national governments and who represent employers, trade unions, consumers, and other interested groups. 36. The single currency deprives national policy-makers of the key exchange rate instrument that, until recently, was used to gain (or regain) competitive advantage and sustain employment. So there will be no way to correct the consequences of inconsistent labor cost dynamics in different countries (e.g., see Feldstein 1997). There is, however, disagreement in the literature as to whether EMU would be conducive to labor market reforms that could reduce the risks of lost competitiveness. Some authors suggest that once the easy option for an EMU country to devalue its currency is lost, it will have no alternative but to proceed with labor market reforms (Bean et al. 1998). Others, however, worry about the risks of open-ended transfers within the euro area, which could serve to stabilize but may finance regional nonadjustment indefinitely (Obstfeld and Peri 2000). 37. See, for instance, Decressin and Fatas (1995) and Boeri, Layard, and Nickell (2000) 38. In the run-up to monetary union, the European Union has set up a number of so-called processes to develop this consultative mode in the fields of employment and structural policies. Specifically, a new chapter on Employment has been inserted into the Treaty in 1997, which provides for the elaboration of annual Employment Guidelines. These Guidelines set out recommendations and priority areas of action, especially with regard to labor market reform, development of labor skills, and job creation through the encouragement of business start-ups. National Employment Action Plans transpose these orientations into policy proposals operable at national level, taking into account the specific conditions of the country. Together with the regular exchanges of views and the reciprocal learning from good as well as bad experiences, this has become known as the “Luxembourg process,” given its elaboration at the European Council meeting in Luxembourg on November 20–21, 1997.

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39. The labor force participation rate is the percentage share of the economically active (employed or unemployed) population over the total population. 40. As GDP figures are usually expressed in national currencies, it is necessary to convert them to a common denominator for cross-country comparisons. In the figures cited in this appendix, and in line with the convention used, for example, in the World Economic Outlook, published by the IMF, this is done on the basis of purchasing power parities (PPP), which measure the real amount of goods and services that can be bought with one unit of each currency. This conversion corrects for differences in national price levels as well as exchange rate fluctuations. When converted at market exchange rates, the respective shares of world GDP are somewhat higher than in PPP terms, namely 21 percent for the euro area and 33 percent for the United States. 41. At market exchange rates, GDP per capita in the euro area was at 61 percent of the US level. This higher gap in exchange rate terms rather than in PPP terms reflects essentially the relatively high valuation of the US dollar exchange rate in the reference year (2002). 42. A few examples may be indicative of the difference. In euroland the public sector pays almost 75 percent of total health care expenditure, whereas in the United States only 45 percent is carried by the public sector. The respective roles of the government and the private sector also differ substantially with regard to the educational system, especially university education, for which the sector bears around 87 percent of the costs in euroland against 47 percent in the United States. 43. In cross-country comparisons it appears that the lowest income per capita (Greece) is at 67 percent of the euro area average, while income per capita reaches 123 percent of the areawide average in Ireland and even 190 percent in Luxembourg. Total government expenditures are 34 percent of GDP in Ireland and 54 percent in France; public debt ranges from 6 percent of GDP in Luxembourg to 107 percent in Italy. 44. The G7 consists of seven major industrial countries—Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States—that meet annually at the level of heads of state or government. In addition the ministers of finance and central bank governors of the G7 hold regular meetings on economic and financial matters. The presidency of the Eurogroup and the ECB participate in those parts of the meetings devoted to multilateral surveillance and exchange rate policies. 45. The strong economic performance of the United States in the 1990s can be attributed to a combination of growing employment with strongly increasing productivity. Over the period 1991 to 2000, productivity increases in the United States were above those in the euro area, especially when measured in terms of total factor productivity (1.2 percent in the United States against 0.9 percent in the euro area).

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Chapter 4 1. This was quite a different situation from that of any other financially sophisticated industrial economy, where this highly complex and integrated basis is the outcome of a long process of trial and error, known to market participants, well understood by analysts, and familiar to the general public. It is true that the ECB Board and Council greatly benefited from the preparatory work conducted by the EMI over the three preceding years. However, since the EMI had virtually no decision-making power, almost no concrete steps had been taken before June 1998. For a description of the differences between the setup of central banking and monetary policy prior to the start of the single currency, see Padoa-Schioppa and Saccomanni (1994). 2. “Two-pillar strategy” soon came to characterize the monetary policy strategy of the ECB. Interestingly this catchphrase, which was widely used by the ECB in its publications, was actually coined by a journalist in a question to the ECB president when the strategy was first presented. Of course, the phrase fails to indicate that the components of the strategy are in fact three, and not two. 3. The reason why the lag is long is that while monetary policy has a relatively quick impact on very short term interest rates, it takes time for this impact to be transmitted to the entire structure of interest rates and, through this channel, to consumption and investment decisions. The lag is variable because the institutional setting (bank regulations, various provisions on financial markets, etc.) may change over time, thus having an impact on the flexibility of financial intermediaries in response to policy stimuli and on the sensitivity of other agents vis-à-vis changes in the interest rate. 4. M3 is a broad money aggregate that includes currency in circulation, overnight deposits, deposits with agreed maturity of up to three years, deposits redeemable at notice up to three months, repurchase agreements, money market funds and units, money market paper, and debt securities with maturity of up to two years. 5. For M3, which is the key variable selected to look at the relationship between money and prices, a quantitative reference value of 41/2 percent annual growth, to be re-examined every year, was announced by the ECB in October 1998. The reference value is identified as the M3 growth rate that would be consistent with price stability in the medium term. It is derived from a simple quantity relation, linking money growth to price stability, potential output and changes in the velocity of money. 6. Lucas (1996). 7. For a more in-depth discussion of the reasoning behind the formulation of the monetary policy strategy (e.g., see Issing et al. 2001; ECB 1999).

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8. In 1997 the newly elected British government (led by Prime Minister Tony Blair) introduced a major institutional reform of monetary policy and financial regulation and supervision. As a result of this reform the Bank of England was given operational responsibility for setting interest rates in order to meet the Treasury’s stated inflation target that had been introduced following Britain’s departure from the Exchange Rate Mechanism in 1992. With the same reform, the competence for banking supervision was taken away from the Bank of England and transferred to a new institution (the Financial Services Authority), where all the competencies for financial regulation and supervision of individual financial organisations in all sectors of finance were concentrated. However, the Bank of England continues to have statutory responsibility for the stability of the financial system as a whole. 9. See, for example, Bernanke et al. (2001), Loayza and Soto (2002), and Bernanke and Woodford (2003) for further reading on the conceptual issues of inflation targeting, as well as an implementation and evaluation of inflation targeting. 10. See, for example, the annual reports in the series “Monitoring the European Central Bank” by the Centre for Economic Policy Research (CEPR) in London, or the reports by the Macroeconomic Policy Group of the Centre for European Policy Studies (CEPS) in Brussels. In addition Buti and Sapir (2002) provide a collection of contributions by academics and policy-makers that assess the early years of EMU. 11. See Gaspar et al. (2001) and Hartmann et al. (2001). 12. Some recent studies have focused on optimal policy frameworks for a smooth and measured response to shocks by the central bank; see, for example, Woodford (1999). 13. The Policy Target Agreement between the treasurer and the governor of the Reserve Bank of New Zealand has recently adopted the notion of ‘over the medium term’ when specifying the time horizon over which the Reserve Bank has to guarantee price stability. 14. Svensson (2002) questions the alleged lack of clarity over the ECB’s inflation objective and suggests to specify a point value within the 0–2 percent region indicated by the ECB as consistent with its definition of price stability. In his opinion, having a point target is more important than the precise level of the target. See also Svensson (1999) for an early critical appraisal of the monetary policy strategy of the ECB, as it was originally conveyed to the public in 1998. 15. See Galí (2003) for a complete description of this position. 16. The Keynesian theory of demand determination was cast into an analytical framework for policy analysis and became widely known as the IS-LM model. Hicks (1937) published the original version of the model. During the 1960s and 1970s this model was enriched by a condition for price determination, which in the original version had been left unspecified. By this additional condition, which came to be

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known as the Phillips curve (after a 1958 empirical study by A. W. Phillips), wage inflation, and implicitly, price inflation, was postulated to be determined by the prevailing situation in the labor market; high unemployment was associated with low wage inflation, and vice versa. A very influential article by Samuelson and Solow (1960) interpreted the evidence as indicative of a persistent trade-off between unemployment and inflation, which the policy-makers could exploit. In their own words: “In order to achieve the non perfectionist’s goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead” (p. 192). 17. This nonneutrality in the short term but neutrality over the long term of the reference model is reflected in the Phillips curve, which has a finite slope in the short term but drifts in the long run as private expectations adjust to the monetary policy. Over the long run as adjustments are made to a higher expected rate of inflation, the intercept of the Phillips curve drifts upward, and the trade-off between inflation and unemployment disappears. 18. See De Long (1997) for a colorful discussion of the attempts to stem high inflation in the 1970s in the United States. In his view, it was the happy reception of the Samuelson-Solow conception of an exploitable Phillips curve within the political circles surrounding President Nixon that introduced in 1969 the permanent upward bias to inflation. 19. Interest rate rules of this kind are now proliferating in macroeconomics. One such rule was proposed by John Taylor in 1993. The so-called Taylor rule prescribes that the short-term real interest rate be set to equal the “natural rate,” on average, and to deviate from it in response to deviations of inflation from the central bank’s target and output from the level that is sustainable in the long run. 20. Gerlach and Svensson (2002) and Trecroci and Vega (2001) find, for example, that a “real money gap,” which is the difference between the actual level of real money balances and the level that would be consistent with a long-term equilibrium money demand, helps predict future inflation in a way that cannot be explained on the basis of the new-Keynesian real sector model. 21. Orphanides (2000) argues that the high inflation plaguing the 1970s in the United States was caused by a severe mismeasurement of the economy’s productive capacity. The dramatic fall in productivity that took place in the early 1970s was misread by the Federal Reserve as a fall of output below its “natural” level and thus responded by a reflationary policy. 22. At the two extremes of the “rules versus discretion” spectrum, in the “decisive” (or decision-making) meeting, the set is, respectively, empty or full.

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23. Due to the postulate of rationality, the difference between knowledge and will is not recognized in theoretical economic research. It is, however, a distinction that is well known in the fields of psychology and philosophy. 24. The exogenous price shocks included an oil price shock in 1999 to 2001 (more than 60 percent increase in the average oil price of 2001 relative to 1999), the “mad cow” and foot-and-mouth diseases in late 2000 and 2001 (7.2 percent increase in unprocessed food prices in 2001), the 1999–2000 depreciation of the euro (16.6 percent in nominal effective terms), the freeze in January 2002 (plus 8.4 percent increase in the price of unprocessed food), the cash changeover in early 2002 (an estimated effect of up to 0.3 percent increase in the total euro area HICP), the increase in indirect taxation in 2003 (sources: ECB Monthly Bulletin and Annual Report, various issues; Eurostat). 25. For more information on the outcome of the evaluation of the monetary policy strategy, see the ECB press release “The ECB’s monetary policy strategy” of May 8, 2003. A number of background studies prepared by ECB staff, which served as input into the Governing Council’s evaluation of the strategy, were also made public at the same time. These background studies are available on the ECB Web page (www.ecb.int). For additional information, see also the article entitled “The outcome of the ECB’s evaluation of its monetary policy strategy,” which appeared in the June 2003 issue of the ECB Monthly Bulletin. 26. Bank reserves are held by the banks at the central bank for the purpose of meeting the minimum reserve requirement (see below) and for the clearing of interbank balances. With the control of bank reserves, the central bank sets a target for the amount of bank reserves and is ready to accept whatever interest rate is needed for the banks to absorb that amount. With the control of the interest rate, the central bank sets a target for the level of short-term interest rate and stands ready to supply the market with the amount of bank reserves needed for the market to clear at that level of the interest rate. 27. A case in point is the decision, taken by the Bank of Japan in 2001, to target the amount of bank reserves rather than a short-term interest rate. 28. The interest rate applied to open market operations is the most important policy rate of the ECB. The weekly frequency of the operations, lower than that customary to several national central banks prior to the euro, and the practice of full publicity were chosen to enhance the strength and clarity of the signaling effect. Repurchase agreements are reverse transactions whereby the central bank purchases a given amount of admissible instruments on the understanding that these will be repurchased by the counterparty at a specific price on a future date or on demand. 29. The deposit and the marginal lending rates constitute, respectively, the floor and the ceiling for the overnight interest rate in the money market. 30. Since compliance is determined on the basis of the average of the daily balances of the banks’ accounts with the Eurosystem over a so-called maintenance period of

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one month, the reserve funds act as an automatic buffer for liquidity shocks, and hence as a stabilizer for very short-term interest rates. Banks can postpone the constitution of their reserves in the event of a temporary shortage of liquidity at any point of the maintenance period; they can also front load the constitution of their reserves in the event of a temporary surplus. 31. The most obvious example is the situation of countries that followed a stable exchange rate policy. For those countries the day-to-day control of the interest rate was key, so they had a practice of daily operations. The Banque de France, for instance, used daily fine-tuning operations that allowed a tight control of the overnight interest rate. Another example is that of Portugal, where for historical reasons the central bank had accumulated massive amounts of domestic assets, gold, and foreign exchange reserves. Accordingly there existed a large liquidity surplus and the central bank implemented monetary policy by withdrawing liquidity (issuance of debt certificates). See Borio (1997). 32. While the charter of the Fed allowed the Federal Reserve District Banks to provide extra central bank money to the economy via rediscount operations, the Eurosystem has fully centralized all decisions that have an impact on the overall liquidity. Originally each Federal Reserve District Bank set its discount rate independently, to reflect banking and credit conditions in its own district. Over the years, reflecting the integration of regional credit markets into a national market, the discount rate has become homogeneous across the country. Today the discount rate used by all Reserve Banks is identical, except for the days around a change, as not all Reserve Banks implement the change on the same day. The decision to provide liquidity at the discount window remains at the discretion of each Reserve Bank. The collateral accepted is also decided independently by each Reserve Bank. However, Regulation A of the Federal Reserve Board of Governors, which defines the conditions under which the discount window is to be used, specifies that “the lending functions of the Federal Reserve System are conducted with due regard to the basic objectives of monetary policy and the maintenance of a sound and orderly financial system.” In May 2002 the Board of Governors published a proposed amendment to Regulation A. Under this proposal, each Reserve Bank would retain its discretion over (1) the type of collateral used and (2) whether it accepts to lend to bidding banks. See Madigan and Nelson (2002) and Borio (2001). 33. As it will be further explained in chapter 5, each national central bank remains responsible for the provision of emergency liquidity if a credit institution belonging to its jurisdiction runs into a crisis. Even in this case, if the liquidity to be created is of an amount that can influence the stance of monetary policy, the ECB Council will be involved. 34. Dispersion of short-term interest rates in euroland has been negligible from the very first days of EMU. 35. ECB Statute, Article 2.

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36. Two features of the US financial structure are relevant in this respect. The first feature is the huge depth and liquidity of the repo markets in which the operations are conducted, and the second is the depth and organization of the market for bank reserves, which ensures that central bank money attributed to few institutions is channeled efficiently through the entire system. 37. See Angeloni, Kashyap, Mojon, Terlizzese (2001). 38. The importance of central bank credibility was first introduced by Kydland and Prescott (1977), who stressed the tension between ex ante and ex post optimal monetary policy, and pointed out the importance that central banks are able to precommit to policies. Their key result—and of Barro and Gordon (1983)—is that discretionary monetary policy (i.e., when a central bank can freely alter its policy) is time inconsistent and that it therefore produces an inflation bias. In essence, this problem arises because in a low-inflation environment there may be an incentive for a discretionary central bank to unexpectedly pursue an expansionary monetary policy in the short term. This incentive, however, will be known by the public, which will adjust wages and prices accordingly, thereby introducing an upward bias in inflation without any positive effects on output. Calvo (1978) focuses on a closely related credibility problem due to the incentive of increasing inflation in order to obtain revenue from the private sector in the form of seignorage. In subsequent development of the literature, the importance of the central bank’s reputation has been stressed. In particular, the possibility that the central bank will suffer a loss to its reputation if it deviates from its announced low-inflation policy has been suggested as a potential solution to the inflation bias problem, since a loss of reputation will entail significant future costs (e.g., see Backus and Driffill 1985). Alternatively, Rogoff (1985) suggests that the inflation bias problem may be solved by appointing an independent “conservative central banker” to conduct monetary policy. This central banker should be conservative in the sense of having more than society as a whole preferences placed on maintaining low inflation. Because the public will realize that this type of central banker has little desire to pursue an expansionary monetary policy, it will also expect inflation to be low in the future. Walsh (2003) provides a more detailed overview of the academic literature on the inflation bias and possible solutions to it. 39. The general equilibrium mode of representing the workings of the transmission mechanism of monetary policy is dominant in today’s macroeconomics. For a comprehensive treatment, see Woodford (2003). 40. This is a “game” in which there may be two solutions (i.e., two different, though plausible outcomes): one in which the rate of growth of money is low, and wage and price inflation are low; and the other one in which wage inflation is set at a high level and the central bank accommodates wage claims with a high rate of money growth, thus yielding high inflation. A “tough” central bank, meaning a central bank that is consistently committed to an objective of stable prices and is not prepared to deviate from it under any circumstances, can be shown to coordi-

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nate expectations (and thus wage claims and inflation) on the low-inflation equilibrium. See, among others, Horn and Calmfors (1985). 41. This was epitomized by such expressions as “le silence de la monnaie” (the silence of money) or “Rumore” (noise) used by Jacques Rueff and Luigi Einaudi respectively. Jacques Rueff (1896–1978), one of France’s most influential liberal thinkers and economists of the twentieth century, owes his reputation to his career in public administration (director of Treasury, vice-governor of the Banque de France, magistrate of the Court of Justice of the European Communities) and his persuasive talent. The formula “the silence of money” attributed to him has been used for years in France to epitomize the appropriate noncommunicative behavior of those in charge of monetary policy. In his 1960 article “Rumore” (Noise) Luigi Einaudi (see endnote 1 in chapter 1) stated that, rather than acting through policy decisions visible to the media and the markets, a good central bank governor should seek to influence monetary conditions through informal advice to bankers on whether to expand or to constrict credit. 42. This can be illustrated by the following two quotes of what Chairman Greenspan is reported to have said: “I know you believe you understand what you think I said. But I am not sure you realize that what you heard is not what I meant.” And, on another occasion, “If I say something which you understand fully in this regard, I probably made a mistake.” 43. The Fed and the Bank of England publish the minutes with a delay of respectively around six and two weeks, the Bank of Japan in the week after the next meeting of its monetary policy committee. 44. The justification is required if for two consecutive quarters the forecast deviates by more than 1 percent from the inflation target set by the Treasury. 45. Blinder, Goodhart et al. (2001). 46. As Blinder (1998, pp. 69–70) puts it: “In a democratic society, the central bank’s freedom to act implies an obligation to explain itself to the public. Thus, independence and accountability are symbiotic, not in conflict. The latter legitimises the former within a democratic political structure. While central bankers are not in the public relations business, public education ought to be part of their brief.” Chapter 5 1. Pay-as-you-go pension schemes envisage direct transfer of workers’ contributions to pensioners, while funded schemes entail the investment of the provisions in financial markets, through pension funds. 2. The harmonized regulatory framework set out in the Second Banking Coordination Directive combines a general definition of banking with a list of activities that licensed banks are allowed to conduct. While the definition is narrow, the list is

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broad. Banks are thus defined, much in the same way as the US legislation does, as institutions that couple deposit taking with the granting of loans. Meanwhile the list of activities comprises other financial services, including among others the trading of financial instruments for own account and for account of customers, participation in securities issues and provisions of related services, portfolio management and advice, financial leasing and advice to undertakings on capital structure, industrial strategy, mergers and acquisitions. See Articles 3 and 18 of the Directive 2000/12/EC (so-called consolidated banking directive). 3. The responses by the United States and some continental European countries to the banking crises of the 1930s are another sign of the difference between two intellectual and policy traditions. While Europe largely responded by extending public ownership, the United States responded by strictly limiting the scope of banking activities and by introducing Federal Deposit Insurance. After the Great Depression, the belief prevailed that the combination of banking and securities business created much room for conflict of interest and made banks more vulnerable to sharp adjustment in asset prices. 4. In the past publicly owned banks were not chartered as shareholding companies and were thus not subject to ordinary company law. They often had special tailormade charters defining status, field of activity, and controls on an ad hoc basis. They had special obligations to finance public entities and programs at preferential conditions, while at the same time enjoying privileged market position in the form of exclusive right to operate in certain geographical or business areas, or in the form of government guarantees for their liabilities. In recent years this special status has been gradually reduced under the influence of both a change in national policies and the pressure of the EU to apply uniform competition to the banking sector. 5. In the American free banking era (1837–1863) entry into the banking industry was unrestricted. Banks issued their own notes and had to satisfy collateral requirements, which differed across states. They were not subject to extensive supervision, although some public controls (e.g., limits to the aggregate amounts of notes) were enforced at state level to prevent unsound issues. Accordingly the system did not include any access to public lending of last resort facilities in times of stress. Failures and losses on notes differed significantly by state, but have been generally interpreted as being excessive. 6. The continental European hands-on approach tends to allow banks to undertake a certain business only after explicit permission and under strict surveillance from the public authorities, contrary to the hands-off attitude valued by the US tradition. It is precisely noninterference policy that can be inferred from the words of no less influential a person than Alan Greenspan. In his words, “government action can retard progress but almost certainly cannot ensure it” and “our regulatory roles are being driven increasingly toward reliance on self-regulation similar to what emerged in more primitive forms in the 1850s in the United States” (Greenspan 1997, pp. 48–49).

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7. See Padoa-Schioppa (1999). True to style, an EU directive was passed in 2000 specifying that the issuance of electronic money should be subject to bank-like licensing and prudential controls, with all new tools for delivering de facto banking services included in the realm of supervised business. In the United States, in contrast, e-money is still viewed as falling outside the area that requires a banking licence. 8. See, for instance, Danthine, Giavazzi, von Thadden and Vives (1999). 9. The removal of barriers to interstate banking in 1991 with the Federal Deposit Insurance Reform Act occurred at about the same time as the creation of the single market in the European Union. 10. Arbitrage is a trading activity aimed at profiting from differences in prices as the same security, currency, or commodity is traded in two or more markets. 11. Mergers and acquisitions services are the services investment banks provide to corporations engaged in taking over another corporation or in merging into a single entity. Included among such services are search of a counterparty, advice on the required financial package, valuation, and placing new equities on the market. 12. In the market for unsecured deposits, credit institutions exchange liquidity without the guarantee of collateral. The largest part of the turnover in this market is represented by very short-term transactions. 13. In particular, repo transactions were conducted on the basis of various local master agreements, and only recently a European standard has been developed. Moreover a Directive had to be issued in June 2002 and is presently being implemented at the national level, in order to ensure the legal reliability of collateralization techniques and practices, including the validity and effectiveness of the transfer of title arrangements, especially in cases of insolvency. 14. Federal Reserve Board (1998). 15. The expression “unwarranted strategic objective” is used here to shorten what would otherwise be a lengthy treatment of a complex issue that goes beyond the scope of this book. In brief, it can be said that the EU economic constitution, analyzed in chapter 3, sets common objectives that are incompatible with the pursuit of economic self-sufficiency as an admissible strategic goal for a member country. 16. The long controversy over state aid to the German Landesbanken epitomizes the complexity of competitive game in the European Union. A Landesbank is an institution under public law, often established by a special law of the German Bundesland or the region concerned. Shareholders are, as a rule, the Bundesland and regional savings banks. A Landesbank acts as a central institution for the local savings banks in matters such as liquidity management and the clearing of payment transactions, and supplements the banking services of the savings banks. It further acts as a public sector bank. With a market share of more than a third,

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the savings banks and Landesbanken represent a very significant proportion of the German banking market. This strong market position is to a large extent the result of public support through public guarantee mechanisms, allowing the Landesbanken to fund themselves cheaply on the market. The large German commercial banks, such as Deutsche Bank, Commerzbank, Dresdner Bank, and Hypovereinsbank, had complained for years to both national and European authorities that they were being victimized by unfair competition. Any swift resolution of the problem was hampered, inter alia, by the strong political ties of the Landesbanken. In late 1999, the European Banking Federation lodged a complaint with the European Commission about the unfair state aid. The European Commission confirmed that the system of public guarantees did not comply with EU competition law. In July 2001, the Commission reached an agreement with the German government on the gradual phasing out of the public support system. It is expected that this will have a major structural impact on the German banking sector. 17. The legislative procedure required to adopt or amend a EU directive takes three to four years. Member states have traditionally preferred to inscribe European rules in directives rather than in secondary legislation, which is more flexible, in order to keep closer control over the process. 18. The so-called Committee of Wise Men, chaired by Alexandre Lamfalussy, was created in July 2000. Its tasks were to assess the conditions for implementation of EU securities regulation, study how the mechanisms for regulating securities markets in the EU can best respond to market developments, propose scenarios to adapt current practices in order to ensure greater convergence and cooperation in day to day implementation. The Committee’s report, known as the Lamfalussy Report, was submitted to the Ecofin Council in February 2001. Alexandre Lamfalussy (1929–), professor emeritus at the University of Louvain-la-Neuve, has been general manager of the Bank of International Settlements in Basel (1985–1993) and president of the European Monetary Institute from 1994 until 1997. 19. Before the UK reform, the single-agency approach had been adopted by Norway (1986), Canada (1987), Denmark (1988), and Sweden (1991). After 1997 Japan and Korea followed suit. In the United Kingdom, the competencies of eight preexisting regulatory and supervisory bodies (including the Bank of England) were concentrated. 20. Full disclosure to the market of information on a bank’s condition was not traditionally part of the tool kit of a banking supervisor. This potential conflict is not eliminated by the single-agency approach. To deal with it, certain countries, for example, Italy and the Netherlands, have preferred the solution of specializing supervisory agencies by objective: one agency is entrusted with the goal of stability for both banks and securities firms, while another is assigned transparency and investor protection. This solution, sometimes referred to as the “twin peaks” approach, may prove to be effective, as it allows maintaining prudential supervision

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close to the monitoring of systemic risk and to other functions related to financial stability. 21. In general, moral hazard is defined as a situation in which an economic agent misleads or tricks a counterparty in order to pursue his or her own personal interest. For instance, in insurance contracts the concept is used to capture the tendency of people with insurance coverage to change their behavior in a way that leads to larger claims against the insurance companies. 22. On the pros and cons of attributing supervisory responsibilities to the central banks, see Goodhart and Schoenmaker (1995), Ferguson (2000), Briault (1999), Padoa-Schioppa (2003a), and Goodhart (2002). 23. The word “almost” is used here because there are indeed a few exceptions. One of them is supervision and regulation of the insurance industry in the US, which is still a state competence. Another example has been banking supervision in Germany, which for a short period in the 1950s was a competence of the regions. It is symptomatic, however, that the latter system was abandoned after few years. 24. Article 105.5 of the Treaty. 25. The Treaty also gives the Eurosystem a twofold (consultative and advisory) role in the rule-making process. The ECB must be consulted on any draft legislation (both Community and national) in the fields of banking supervision and financial stability. Moreover it can provide, on its own initiative, advice on the scope and implementation of Community legislation in these same fields. 26. According to Article 105.6 of the Treaty, the Council may, acting unanimously on a proposal from the Commission and after consulting the ECB and the European Parliament, confer upon the ECB specific tasks concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings. 27. The main forum to coordinate the central banking function with the supervisory one is the Banking Supervision Committee. Created in 1989 by the then central bank governors of the EU and re-established by the ECB Council, the Committee is composed of high-level representatives of banking supervisory authorities and central banks of the EU countries. It has the task of addressing all the financial stability issues raised by the introduction of the euro. It so fulfills the twin functions of bridging the central banking and supervisory tracks to banking and financial stability in euroland and of working as a forum for cooperation among banking supervisors. Most of the recommendations issued by the Brouwer report and the demands for enhanced cooperation raised by the Eurosystem are being addressed within this committee. 28. See, for instance, Begg et al. (1998), Prati and Schinasi (2000), and Vives (2001).

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29. As Charles Goodhart and Dirk Schoenmaker (1993) have shown, in most banking crises central banks have been actively involved. 30. Lending of last resort is generally defined as the central bank facility providing short-term loans to illiquid but solvent banks hit by a liquidity shock. The term is often used extensively to include any form of central bank support to ailing banks. 31. The classic theory of the lender-of-last-resort function of the central bank in the nineteenth century was formulated by the British economist and constitutionalist Walter Bagehot (1826–1877). According to this theory, the central bank should publicly announce its readiness to provide freely liquidity support in times of need, but only to solvent institutions, at a penalty rate and assisted by good quality collateral valued at pre-crisis prices. See Bagehot (1873). 32. A less unlikely event is a rapid withdrawal of deposits and other funds by uninsured wholesale creditors, in particular, in the interbank market. However, since interbank counterparties are much better informed than depositors, this event could not occur without raising in the market a strong suspicion that the bank is actually insolvent. If such a suspicion were to be unfounded and not generalized, the breadth and depth of today’s interbank market is such that other institutions would probably replace (possibly with the encouragement of public authorities) those that withdrew their funds. In this regard the emergence of the areawide money market lowers banks’ liquidity risks because the number of possible sources of funds has become considerably larger than in the past. Chapter 6 1. The first monetary use of gold has been traced back to the reign of Pharaoh Menes in Egypt (2850 BC) by the discovery of small gold bars stamped with the name of the pharaoh that circulated as money. The first circulation of gold coins is believed to date from around 635 BC, and was first used in Lydia (Bernstein 2001). 2. This model was not always welcomed as it was viewed as opening a road to monopoly, and some countries (the United States, in particular) challenged the model for many years. Over time, however, central banks spring up everywhere. 3. In a multilateral netting system, commitments to transfer funds accumulate during the day, and each participant transfers only its multilateral position vis-à-vis all the other participants at the end of the day, settling in central bank money. This implies that in the course of the day each participating bank extends credit to the other participants, thus running both credit and liquidity risk vis-à-vis its counterparties. Credit risk or exposure is the risk that a counterparty will not settle an obligation in full, either when due or any time after. In exchange-for-value systems, the credit risk is generally defined to include replacement cost risk and principal risk.

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4. Systemic risk is the risk that failure of one participant in a transfer system, or in financial markets generally, to meet its required obligations will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a transfer system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets. 5. Recommendation to this end were made in the 1990 “Report of the Committee on Interbank Netting Schemes” (so-called Lamfalussy Report). In 2001, the G10 governors endorsed a report on “Core Principles for Systemically Important Payment Systems,” which complements the 1990 standards and extends their applicability globally (CPSS 2001a). 6. Fedwire is the Federal Reserve funds transfer system. Fedwire is used for transferring reserve account balances of depository institutions and government securities. Fedwire is also used for the settlement of other clearing systems, such as CHIPS. 7. Folkerts-Landau, Garber, and Schoenmaker (1996). 8. Safety is, in the perception of the general public, the foremost attribute of central bank money. For a regime of paper currency, central bank money is what gold used to be for a commodity currency regime. People’s confidence in the central bank as issuer of the currency derives in part from legal tender status, in part from the way it is managed by the central bank. Availability means that since it “owns the printing press,” the central bank can produce money in unlimited amounts. It should not be forgotten that for a long time deflation rather than inflation was the major threat to monetary stability and therefore availability in potentially unlimited amounts was a key antidote to financial crises. As ultimate provider of liquidity, the central bank is indeed able to address unexpected liquidity shocks or coordination failures in the interbank market. Efficiency comes from the fact that instead of establishing a transactional relationship with every other bank, each bank can hold its reserves in one place, the central bank, where its debit items are cleared against its credit items. This is what made central bank money an essential cog of the monetary mechanism. Neutrality consists in the fact that the central bank remains external to banking system, does not compete with it, and does not operate directly with the public. Finality, an economic manifestation of the legal tender status, means that the discharging of a pecuniary obligation has been completed at the moment of settlement in central bank money. Since, in a world of fiduciary currency, money is always a promise rather than a good, the dividing line between money and credit is both essential and hard to draw. It is the “outside” position in the monetary system that makes central bank money the final means of settlement. 9. In the past central banks were operationally involved in the field of securities settlement systems only for the management of government debt. However, as the trend is for debt and equities to be settled under the same “roof,” securities

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settlement systems have progressively moved to private hands and tend to be userowned or owned by an exchange. Exchange-for-value settlement system is a system that involves the exchange of assets, such as money, foreign exchange, securities, or other financial instruments, in order to discharge settlement obligations. These systems may use one or more funds transfer systems in order to satisfy the payments obligations that are generated. The links between the exchange of assets and the payments system(s) may be manual or electronic. 10. As indicated in chapter 2, the Treaty of Maastricht explicitly assigns to the Eurosystem the task of promoting the smooth operation of payment systems by means of providing facilities and issuing regulations. As the Treaty makes no distinction between retail and large-value payments, the Eurosystem closely follows both, as well as securities settlement systems. Overall, the Treaty is as good a basis for effective action as that provided to other monetary jurisdictions by the charter of their central banks. 11. The United States and euroland give similar interpretations to the role of the central bank in retail payments. In the United States a key provision of the 1913 Federal Reserve Act imposes that all checks should be cleared nationwide under the same conditions. More recently, in 1998, a committee headed by the then vice chair of the Board of Governors of the Fed, Alice Rivlin, revisited the role of the Fed in retail payments and confirmed its operational involvement in the field. It strongly recommended that the Fed should play a leading role toward enhancing the efficiency, effectiveness, and convenience of retail payments in cooperation with market participants (Rivlin 1998) 12. One of the attractiveness of the name “euro” was that it had the same spelling in all languages of the European Union (apart from the Greek alphabet). 13. While the fees charged to customers for domestic credit transfers rarely exceed between euro 0.10 and euro 0.20, a survey conducted by the European Commission in 2001 showed that the average fee for cross-border transfers is euro 24, with peaks exceeding euro 60 in some countries. As to the speed of execution, while for domestic transfers it is sometimes less than a day, cross-border transfers take several days, occasionally even more than a week. 14. This approach is not shared by all central banks worldwide. In the United States, the Fed is inclined to allow e-money to be issued by nonbank entities and to refrain, for the time being, from setting strict requirements of redeemability. This difference in approach reflects the more general difference in policy attitudes toward financial innovation highlighted in chapter 5. Compared to others, the European approach is liberal in allowing licensed banks to conduct a wide range of activities, but strict in requiring a license to enter the banking business. As a result reserving the right to issue e-money to credit institutions is equivalent to inviting its issuers to adopt a specific legal structure, not a way of creating a privilege for a particular group of institutions.

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15. One reason for the decision was that TARGET was developed well before the start of EMU, with the participation of all EU central banks and before knowing which member states would be in it. Therefore it would not have been fair to exclude the central banks of Denmark, Sweden, and the United Kingdom from participation in its operations. The arrangement was made subject to special conditions that prevent the intra-day liquidity in euro to banks outside the euro area from spilling over into overnight credit. 16. While the fees for cross-border TARGET transactions are harmonized, domestic TARGET payments are priced on the basis of national decisions and differ considerably in terms of both fee structure and fee level. Domestic prices per payment can be lower than euro 0.20 in some countries and higher than euro 2 in others. The problem of cost recovery for many RTGS systems in TARGET is illustrated by the fact that seven out of sixteen TARGET components process each less than 1 percent of the overall number of TARGET payments. Full-fledged competition between national RTGS systems would imply that every commercial bank is free to choose through which national system to enter TARGET. This would in turn imply that national central banks no longer retain an exclusive business relationship with the banks of their national jurisdiction, but rather compete to attract any euro area commercial bank. The need to plan for the second generation of TARGET is also based on the experience of both the United States and the pre-euro German system. In these two systems, which started with composite systems similar to TARGET, the various components have converged, over time, toward a single infrastructure. 17. The initiative was taken by the Basel-based Committee on Payment and Settlement Systems (CPSS). 18. This is called “payment-versus-payment,” meaning that settlement in one currency occurs if, and only if, the other currency also settles. 19. Of course, the emergence of a euro area infrastructure would not conflict with the development of “international” or “global” infrastructures in the field of securities settlement, analogous to the Continuous Linked Settlement Bank in the field of payment systems. 20. CPSS (2001b). 21. Recently some authors (notably King 1999; Friedman 1999; Bengtsson 1999a, b) have suggested that the further development of e-commerce and associated computerization will attenuate, or even remove altogether, the demand for central bank money, notably for currency, and that such vanishing demand for monetary base will in turn limit, or even prevent, the central bank from setting nominal interest rates in such a system. Others (notably Goodhart 2000; Woodford 2000b; Freedman 2000) suggest that the IT revolution is not going to remove the demand for currency, and even if it did so (as a theoretical matter), the central bank would still be able to set the country’s nominal interest rate. They argue that the ability of the

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central bank ultimately depends on the fact that it is the government’s bank, and thus has the power to intervene in financial markets without concern for profitability. It can buy or sell the relevant assets in any amount needed to obtain the desired interest rate—even at a loss—thereby forcing its profit-seeking commercial confreres, in the last resort, always to dance to its tune yet in a market-friendly way. Chapter 7 1. The average share of the euro in the international money market issues by nonresidents of the euro area rose from 8 percent for legacy currencies in the period 1994 to 1998 to 21 percent in the period 1999 to 2002. 2. Figures in this paragraph, as well as in the previous ones, are drawn from ECB (2003). 3. This assessment can be found, inter alia, in Bergsten (1997), although the author clearly emphasized the uncertainties regarding the precise timing and size of the projected appreciation of the euro. 4. In 1999 to 2000, GDP growth was 4.0 percent per year on average in the United States against 3.0 percent in the euro area, and growth forecasts were consistently more favorable for the United States. This was partly due to the favorable productivity developments in the United States and the perceived superiority of the country in terms of labor, product, and financial markets. 5. For the “invisible currency” argument it is hard to find any supporting or contrary evidence, and there is no academic analysis of it. The “banknote conversion” argument appears unconvincing when one looks at the figures. Estimates of the total stock of illegally held banknotes, and of banknotes circulating outside euroland, suggest that this stock was too small to influence the exchange rate. Indeed, the order of magnitude of the estimated total—less than euro 40 bn at the time of the cash changeover (Padoa-Schioppa 2003b)—corresponds to a small fraction of the volume transacted in the foreign exchange market of the euro in just one working day—USD 352 bn on average per day in April 2001 (BIS 2002). 6. Comparisons with pre-January 1999 are made by calculating the value of the euro in term of the pre-euro currencies, the so-called synthetic euro. True, the exchange of the euro in January 1999 was below the average level of the synthetic euro over 1994 to 1996. It has to be considered, however, that this was a period of exceptional weakness of the US dollar. If one looks further back, a period in which the synthetic euro was significantly lower that the minimum reached in October 2000 is the 1984 to 1985 period. In terms of US dollar, the 0.83 minimum level of October 2000 compares with a minimum of 0.68 in February 1985. 7. The statement was issued at a moment when the euro quoted around 0.95 against the US dollar and the effective nominal exchange rate was 17 percent below the

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January 1999 level. The concept of “overshooting” was developed by Dornbusch (1976). In short, there is overshooting if the short-run change (i.e., depreciation or appreciation) in the exchange rate of a given currency is larger than its change in the longer run. 8. Between 1999 and 2001, consumer prices increased on average by 2.0 percent per year in the euro area against 2.8 percent in the United States. 9. For an overview of models of the real exchange rate based on fundamentals, see Koen et al. (2001), Maeso-Fernandez, Osbat, and Schnatz (2001), and Meredith (2001). 10. The “target zone” proposal goes back to 1983, when it was formulated by Bergsten and Williamson (1983). It has been periodically discussed in policy circles, but no agreement for implementing it has ever been reached. For an account of the discussions on Oscar Lafontaine’s proposal, see The Economist (1998). 11. See Williamson (1994) for a collection of essays on the determination of the equilibrium exchange rate and Alberola et al. (1999) for a review of theoretical and empirical work on equilibrium exchange rates. 12. The high degree of exchange rate variability in the past twenty-five years is apparent in the movement of the real effective exchange rates of the major currencies. The real effective exchange rate of the US dollar (1990 = 100) fell from 143.2 in May 1970 to 95.7 in October 1978, peaked at 146.1 in March 1985, and subsequently fell back to 91.9 in May 1995. The real effective exchange rate of the Japanese yen (1990 = 100) soared from 57.0 in August 1970 to 110.6 in October 1978, dropped to 74.5 in October 1982 before rebounding to 154.4 in April 1995. 13. Such change in the European attitude is led by the strong and unsurprising correlation between a country’s openness and its willingness to let exchange rate considerations influence its policy-making. The more a country is open to international trade, the more a depreciation of its exchange rate is likely to import inflation over the medium term without any significant improvement in its competitive position. As shown in Mussa et al. (2000), individual countries of euroland were very open to international trade prior to EMU. The degree of openness, as measured by the average of exports and imports of goods and services as a percentage of GDP, was around 35 percent on average and exceeded 60 percent in small countries like Belgium and Ireland. This is one reason why the case for exchange rate stability was strengthened and, in the end, monetary union was adopted within euroland. Conversely, economic relations among members of euroland have now become domestic in nature. As a result euroland is much less vulnerable to external shocks and influences than its constituent countries prior to the establishment of the EMU. 14. As developed in De Grauwe (1988) and Edison and Melvin (1990), two basic views have been expounded in the economic debate on the effects of exchange rate fluctuations. The first one, which can be called a “fundamentalist view,” assumes

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that fluctuations are, at all times, the outcome of disturbances in the economic fundamentals. This implies that fluctuations are not economic “costs” but the proper corrections that grant stability to other economic variables. As a result any attempt to stabilize exchange rates will eventually lead to greater fluctuations in other key variables such as domestic production. The second view is that fluctuations may turn into “misalignments” owing to factors such as irrationality, “bubbles,” and extrapolative rules in the determination of exchange rates. In this case economic agents are not necessarily able to assess correctly how fundamentals affect the exchange rate, unless the latter diverges “too much” from its equilibrium value. In view of the author, at least some of the large exchange rate movements for both advanced countries and emerging markets do not plausibly reflect economic fundamentals. This means that the implications of exchange rate fluctuations are not always a “fair price” to be paid in order to gain greater stability in some key variables but become a cost for the international community. 15. Even in limiting the observation to the last two decades, we can see that a number of episodes confirm the close relationship between wide exchange rate swings and disturbances in the world’s economy. For instance, movements in the US dollar–Japanese yen rate—which exhibited high variability along a rising trend from 250 Japanese yen per US dollar in mid-1985 to 85 in mid-1995—triggered recurrent trade frictions. They are among the contributing factors of the rise and subsequent bursting of the Japanese asset price bubble in the late 1980s. The appreciation of the yen is also one of the factors behind the protracted loosening of monetary policy in Japan in the second half of the eighties, which in turn contributed to the Japanese asset bubble. 16. “Peg” is the Bretton Woods jargon, which indicates the linkage of all currencies to the dollar. It indicates an exchange rate regime in which the monetary authority of a country announces an official par value, or “parity,” of its currency vis-à-vis another currency or basket of currencies and then seeks to maintain the actual market exchange rate within a band above and below that value. According to IMF (2001), three types of pegs are consistent with this definition. First, in “currency board arrangements” (e.g., Bulgaria) the exchange rate is fixed without any possibility to fluctuate within a band around the parity (the width of the band is therefore set to zero). This “hard peg” form implies an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the monetary authority to ensure the fulfillment of its legal obligations. Second, in the “conventional fixed peg arrangement” (e.g., China) the country pegs its currency at a fixed rate to a major currency or basket of currencies, where the exchange rate fluctuates within a narrow margin of at most ±1 percent around the parity. Third, in the case of “pegged exchange rates within horizontal bands” (e.g., Denmark) the band is wider than ±1 percent. The latter was the case of the multilateral exchange rate mechanism (ERM) of the European Monetary System (EMS), replaced with ERM II on January 1, 1999. See IMF (2001).

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17. To be effective, a pegging policy requires a blend of consistent policies, sheer strength, gaming skill, and persuasion. Economic policies need to be consistent with the chosen parity, but since full consistency does not exist on earth and markets are capricious anyway, the policy maker is from time to time confronted with market sentiments and pressures at odds with the chosen exchange rate. Here is where “sheer strength” must be available and credible, that is, where the traditional instruments of the Bretton Woods days are called to work. 18. According to IMF (2001), in the “crawling peg” regimes (e.g., Bolivia) the exchange rate of the currency is adjusted periodically in small amounts at a fixed, pre-announced rate or in response to changes in selective quantitative indicators. In the “crawling band” regimes (e.g., Israel) the currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically according to criteria similar to those used for crawling pegs. Finally, in the “managed floating” regime (e.g., Czech Republic) the monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange rate market without specifying, or pre-committing to, a pre-announced path for the exchange rate. 19. Most currency boards in the world are linked either to the euro or to the US dollar. The euro-based currency boards are in Bosnia and Herzegovina, Bulgaria, Estonia, and Lithuania, while the currency boards of the East Caribbean Currency Union, Hong Kong, and Djibouti are based on the US dollar. The Brunei dollar pegs to the Singapore dollar also under a currency board arrangement. The countries and other territorial communities that have “euroized”, meaning they have unilaterally adopted the euro as their currency, are the European micro-states (e.g., Vatican City), the French territorial communities (e.g., Mayotte), and, in the Balkans, Kosovo, and Montenegro. Finally, dollarization has taken place in Ecuador, Panama, Puerto Rico, San Salvador, and a number of micro-states or territorial communities (e.g., American Samoa). A discussion of the arguments on the corner solution theory is provided by Fischer (2001). The concept of corner solution is found, for the first time, in Eichengreen (1994), who observed that the middle ground of exchange rate regimes located between free floating and the full surrendering of monetary control at country level (e.g., monetary unions, dollarization, and euroization) is being “hollowed out.” This does not mean, however, that Eichengreen is an advocate of the corner solution view. 20. In the discussion about the prescription of the corner solution theory, the Eurosystem has taken the view that intermediate regimes, including pegs and managed floating, may be appropriate, and therefore should remain an option for a number of countries. 21. The phases of such cycles can be described as follows: sound policies and favorable production conditions (e.g., a high saving rate and low wages for skilled labor) are rewarded by large inflows of capital, which facilitate further investment;

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however, it can also cause overinvestment and waste as well as strong appreciation of the currency. The ensuing loss of competitiveness and exports deteriorates the overall performance, which causes a loss of confidence by markets, hence capital outflows, depreciation of the exchange rate, and a rise in inflation. After a crisis the cycle often starts up again. Throughout a cycle those foreign lenders who are quick enough to pull out their money in time preserve the benefits of high returns enjoyed during prosperity. Perhaps more numerous, however, are those lenders whose money is consumed during the crisis. 22. Calvo and Reinhart (2002) developed the idea that many emerging market economies do not pursue a fully flexible exchange rate regime for fear of the float, especially when there are currency mismatches in the external financial position of a country. In such circumstances such countries remain exposed to financial crises triggered by an excessive depreciation of the exchange rate. Despite a number of benefits, currency board arrangements (CBAs) leave economies very exposed to external shocks, and it is not easy to discontinue them once this becomes evident. In particular, the experience with CBAs shows that the degree of fiscal discipline and domestic flexibility that a country can afford in a given point in time may be insufficient to withstand major external shocks. As the Argentine experience illustrates, this can lead to a substantial overvaluation of the real exchange rate of the domestic currency, namely the exchange rate adjusted in order to take inflation into account. This leads to declining growth and difficulty to service the country’s debt (so-called currency–growth–debt trap). However, when drawing lessons from this experience for countries currently adopting CBAs, one should pay attention to some major differences from Argentina. It is a country different from countries such as Bulgaria, Estonia, and Lithuania, as it is not a small open economy. It has a substantial share of its foreign trade with countries whose currencies fluctuate vis-à-vis the US dollar. Also Argentine currency was not being anchored in the relation to a broader process of regional integration. These structural differences help show both why the CBA experience failed in Argentina and why it has not in the mentioned countries. 23. Poirson (2001), for instance, examines the exchange rates of ninety-three countries over the period 1990 to 1998, and finds that significant discrepancies exist between de jure regimes (especially free floats) and de facto ones. 24. A prominent example of recent progress in regional integration in Asia is the so-called Chiang Mai initiative (March 2000), which foresees a network of bilateral swap arrangements among member countries of ASEAN, China, Japan, and Korea. The swap arrangements are to supplement existing international financing facilities. 25. The distinction between “market-led” and “government-led” international monetary system was first made in Padoa-Schioppa and Saccomanni (1994). 26. A list of the main recent episodes of financial instability includes, for industrial countries, the stock market crash in the United States (1987), the banking crises in

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a number of Scandinavian countries (Norway in 1990–91, Finland and Sweden in 1991–92), the difficulties in the Japanese financial sector throughout a large part of the 1990s, and the LTCM crisis in the United States (1998). For the Scandinavian countries and Japan, unlike the United States, the crisis also entailed a considerable and prolonged slowdown in economic activity. In emerging market economies, severe financial crises hit Mexico (1994–95), several Asian economies (1997–98), Russia (1998), Brazil (1999), Argentina (2001–02), and Turkey (2001). Each of these episodes has its own story. Common to all, however, is the phenomenal development of the financial sector over the last twenty-five years. 27. In countries with deficient supervisory institutions or practices, there is a greater risk that sudden reversals of capital flows will upset the exchange rate, macroeconomic equilibrium, and the ability of local debtors to honor their obligations. As to contagion, the international transmission of instability may be facilitated by a lack of transparency as well as by the unprecedented size of capital flows. So-called herd mentality—namely the propensity of individual market participants to behave like all others, regardless of whether the others’ assessment of the situation is correct— tends to exacerbate this risk. This is particularly the case when the amount of public information available for distinguishing between good and bad borrowers is scarce. 28. The BIS commenced its activities in Basel, Switzerland, on May 17, 1930 and is thus the world’s oldest international financial organization. It fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability. The BIS functions as a forum for international monetary and financial cooperation, as a bank for central banks, providing a broad range of financial services and as a center for monetary and economic research. 29. Cooperation in banking supervision started with the establishment of the Basel Committee on Banking Supervision in 1974, in the aftermath of the collapse of the Bankhaus Herstatt in Germany and Franklin National in the United States. The result was the Basel concordat, whereby the responsibilities for supervising foreign branches were clearly defined in order to avoid any escaped supervision of an international bank. In 1983, following the crisis of the Italian group Banco Ambrosiano, the principle of international consolidated supervision was adopted, extending the agreement of the 1975 concordat to foreign subsidiaries of banks. The first crisis of the Latin American debt in the 1980s was an incentive to the adoption of internationally agreed capital requirements, with the Basel Capital Accord of 1988. Similarly, in the payment system field, the concerns raised by the operational difficulties experienced by the Bank of New York contributed to the launch of the work on minimum standards for netting systems described in chapter 6. The G7 and the IMF became actively involved in regulatory and supervisory issues after the 1994 Mexican crisis. The Financial Stability Forum (FSF) was created in 1999 in response to the 1997–98 Asian crisis. 30. In one important way the present configuration is incomplete. It lacks a statutory authority for the liberalization of capital movements. The World Trade

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Organization, as the institution presiding over the liberalization of cross-border economic trade, has limited competence in the field of financial services but none in the field of financial account transactions. As to the IMF’s Articles of Agreement, they relate to current transactions but not to the financial account. This gap implies that unlike in the EU, international regulation and liberalization are not part of a single process. 31. To overcome the former limit, the Financial Stability Forum (FSF) was created, as a body comprising, for the G7 countries, representatives of Treasuries, central banks, financial supervisors, and chairs of the main international institutions and regulatory bodies. To overcome the second limit, a wider forum (called G20) was created in 1999, which includes a number of major transition and emerging economies. Although both the FSF and the G20 are in the process of assessing their role, the structure of the system of international cooperation described in the text has not fundamentally changed. 32. A significant example is participation in the meetings of G7 finance ministers and central bank governors. Up to the launch of stage three of the EMU in 1999, participation in these meetings was restricted to the respective national authorities of the G7 countries. With the transfer of the core competencies related to monetary and exchange rate policies from the national to the Community level, adequate arrangements needed to be made to take into account this new allocation of competencies in euroland. As part of this adaptation of existing practices, it was agreed that both the ECB president and the Eurogroup presidency are to join in the part of the meetings that deal with macroeconomic surveillance and exchange rate issues. While the three central bank governors of the euro area G7 countries (France, Germany, and Italy) do not participate in this part of the meetings, they take part when the G7 deals with other issues, for instance, international financial architecture and debt initiative in favor of highly indebted poor countries. As far as monetary policy in the euro area is concerned, the ECB president presents the views of the Eurosystem. Conversely, the Eurogroup presidency contributes to the discussion on other economic developments and policies in euroland. Given the shared responsibility of the ECB and the Eurogroup for exchange rate matters, the views presented at G7 meetings reflect the outcome of prior consultations within the euro area. G7 consultations on exchange rate matters may also lead to foreign exchange market operations and communication with markets, as exemplified by the concerted intervention in support of the euro carried out on September 22, 2000, and the G7 statement published on the day after the meeting of G7 ministers and governors in Prague. 33. A telling episode was the discussion among Ministers of Finance and governors held in spring 2002 about the EU definition of a common European position on IMF issues. Three possible models were considered: (1) an informal coordination model whereby EU countries seek to coordinate their positions in the IMF Board through “common understandings,” (2) a structured coordination model, estab-

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lishing ex ante both the issues on which common views are requested and the mechanism to represent such views at the IMF Board, and (3) the single-chair model, meaning a single EU or euroland constituency at the IMF. The chosen formula eventually was the second one, which is the structured coordination model. It should be noted that the voting powers of euroland’s countries in the IMF add up to 22.6 percent of the quotas, against 17.2 percent of the United States. It should further be noted that only three of the twelve countries of euroland are members of the G7 and that these three members are not mandated to speak on behalf of euroland. Chapter 8 1. In 1994 to 2000, the United States had a growth rate of about 4 percent on average per year, with GDP growth rate above potential in six out of seven years. 2. As was argued in chapter 2, operating and supervising the payment system refers to money as a means of payment; ensuring price stability refers to money as a unit of account and a store of value; pursuing the stability of banks refers to money as a means of payment and a store of value. 3. Every country and central bank has joined the euro and the Eurosystem with the full-fledged central banking infrastructure that characterizes the pre-euro situation. Luxembourg has even gone as far as to newly set up its own full-fledged central bank (which it did not have on the eve of the euro), as this was a precondition to be a full member of EMU. National central banks are generally still equipped to perform all central banking functions as stand-alone institutions (in such fields as payment services and banknote printing). 4. Article 98 of the Treaty of Paris of 1951 that established the European Coal and Steel Community (ECSC). A similar accession entitlement is contained in the Treaty on European Union. Article 49 of the Treaty states that “Any European State which respects the principles set out in Article 6(1) may apply to become a member of the Union.” The principles set out in Article 6(1) are liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law. 5. The four enlargements took place in 1973 (Denmark, Ireland, and the United Kingdom), 1981 (Greece), 1986 (Spain and Portugal), and 1995 (Austria, Finland, and Sweden). 6. The Copenhagen European Council also acknowledged in June 1993 the EU’s capacity to absorb new members with a view to the future accession of central and eastern European countries. In a protocol attached to the Amsterdam Treaty of 1997, it was agreed that at least one year before membership of the EU would exceed twenty, an Intergovernmental Conference should be convened in order to undertake a comprehensive review of the composition and functioning of the EU institutions. The Luxembourg European Council in December 1997 emphasized that the operation of the EU institutions must be strengthened as a prerequisite for

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enlargement. The Treaty of Nice, signed on February 26, 2001, mainly aims at adapting the way in which the European institutions operate in order to make it possible for the European Union to take in new member states. Under the Nice Treaty, the present configuration of the European Commission (consisting of one or two commissioners per member state) will be maintained until the European Union has 27 member states. At that point, the Council will have to decide on the number of commissioners, as well as on a rotation system. Moreover from January 1, 2005, new provisions will apply with regard to qualified majority decision-making within the Council. The votes of each member state will be re-weighted and a new threshold for an act to be adopted will be applied. Additional requirements for an act to be adopted will also have to be met regarding the number of member states voting in favor, and the percentage of the population of the EU represented by those member states. Finally, after the European elections in June 2004, the number of representatives elected to the European Parliament from each member state was adjusted. Respecting the relative shares of parliamentarians from each member state, the total number of members of the European Parliament was maintained as close as possible to 732. After emerging from the acrimonious and protracted power wrangling that led to the complex compromise formulas contained in the Nice Treaty, the heads of state and government declared the European Union ready for enlargement. At the same time, however, they called for a deeper and wider debate about the future of the European Union. To this end, at the Laeken European Council in December 2001, the heads of state and government decided to set up a convention with the task of elaborating further institutional reform. The convention drew up a draft Constitution in the form of a Treaty, which was discussed in an Intergovernmental Conference opened in Rome in October 2003. 7. The last criterion requires the candidate countries not only to translate into national legislation the substantive body of EU rules and regulations—what in EU jargon is dubbed acquis communautaire—but also to ensure their effective implementation and application. 8. Article 124 of the Treaty. 9. ERM II (the successor of the exchange rate mechanism of the European Monetary System that operated between 1979 and 1998, referred to in chapter 1) prescribes currencies to be kept within a fluctuation band of plus and minus 15 percent around fixed, central rates. Exchange rate strategies, such as free floats (currently the policy of Poland) and pegs against anchors other than the euro (e.g., Latvia’s peg to the SDR) are to be changed before a country can join ERM II and eventually the euro. 10. Under the rotation system approved by EU leaders (and yet-to-be ratified by national parliaments), the members of the Board would retain permanent voting rights, while governors would exercise their voting rights on a rotating basis. Since the group of governors exercising the voting right should be reasonably represen-

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tative of the euro area economy as a whole, governors would hold the voting right with different voting frequencies, with governors from large countries voting more frequently than those from medium-sized and small countries. Governors would be placed into three groups, in relation to a country ranking based on the economic and financial weight of their home countries. In any case the differentiation among governors on the basis of home countries has only one, purely auxiliary, purpose: to determine who votes when. For all decisions in the Council, such as on interest rates, the “one member, one vote” principle would continue to apply to those exercising their voting right. This means that the force of argument will still count in the deliberations and not a governor’s home country, or whether that country is large or small. 11. For a full discussion of these three elements, see Padoa-Schioppa (2000b). 12. True, no Group of Three has come into being as yet, nor are there signs that such a group will emerge in the near future. However, in G7 the deliberations on macroeconomic policies have already evolved from a round table of many countries to a focused discussion on the three major economies, their situations, how they interact, and the implications worldwide. 13. This is shown by the unification of the European trade policy or the increasing independence of central banks from their Treasuries. 14. The central provisions for the external representation of the Economic and Monetary Union are laid down in Article 111(4) of the Treaty and Article 6 of the Statute of the ECB. Building on these provisions, the European Council decided in 1997 and 1998 that two bodies would represent euroland externally, the Eurogroup and the ECB. On behalf of the former the EU presidency (i.e., one of the twelve finance ministers of euroland) would speak on a semiannual rotation scheme. On behalf of the latter the ECB president or his/her nominee would speak, as stated by the ECB Statute itself (Article 13.2). 15. This explains why both the Eurogroup and the ECB have a somewhat special position. In the IMF, for example, the ECB was given observer status, to reconcile the fact that only quota-holders can be members of the IMF Board with the need to have one of the key policy makers (the central bank of the second largest currency of the world) at the table. In OECD meetings, the ECB representative is part of the European Community delegation. At the Bank for International Settlements (BIS), the ECB is a shareholder and a regular participant in all G10 activities. In the G7 the president of the ECB attends (like the president of the Eurogroup) the parts of the meetings that deal with macroeconomic surveillance and exchange rate issues and speaks on behalf of an area of twelve countries, including nine that are not members of the G7 itself. In their attempt to reflect the Treasury–central bank scheme that characterizes all delegations in macroeconomic cooperation, a difficulty arose in identifying “Who is the Treasury” with the European Union. The difficulty derives from the multilayered policy structure discussed in chapter 3, but the fierce

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attempts to keep the Commission out of the action also reflect the persistent jealousy of member states for the role of Brussels. For a discussion on the adaptation of international organizations after EMU, see Henning and Padoan (2000). 16. NAFTA and MERCOSUR in the Western Hemisphere and ASEAN + 3 in Asia are noteworthy experiences. However, with the establishment of the single market and of the single currency, Europe has gone much beyond any other regional arrangement. The relevant economic literature has mainly focused on trade and monetary aspects of regional integration. See, for instance, Frankel and Wei (1993), Bayoumi and Eichengreen (1993), Frankel and Rose (1998), Eichengreen (1998), Alesina and Barro (2002), and Wyplosz (2001). 17. The 1998 edition of the New Oxford Dictionary defines policy as “a course or principle of action adopted or proposed by a government, party, business, or individual”; politics as “the activities associated with the governance of a country or area, especially the debate or conflict between individuals or parties having or hoping to achieve power”; and polity as “a form or process of civil government or constitution, an organized society, a state as a political entity.” 18. As Goethe puts it: “A master shows his powers in limitation, and freedom follows only law’s direction.” 19. As the case of Switzerland and the Swiss franc shows, a strong polity is not necessarily the same thing as a strong world power. A stable and well-established political system, long-lasting independence, and reliable institutions may well be sufficient to produce a strong polity.

Bibliography

Further Readings This section provides a short selection of references that is intended to serve as a suggestion for further reading on topics covered in this book. These references are mainly of a general character, in order to be useful also for nonspecialized readers. More specialized references, such as research articles published in academic journals, are referred to in the text and included in the main part of the Bibliography. A number of books have been published on the process of European integration leading up to the Maastricht Treaty. Dyson and Featherstone (1999) provide the most comprehensive effort to analyze the process toward EMU, with particular focus on the political aspects of the Maastricht treaty negotiations. An earlier reference, PadoaSchioppa (1987), contains a report on the economic system of the EEC that was requested by the Commission of the European Communities, and that was prepared by a group of distinguished economists and political scientists. The report focuses on the economic consequences of a number of political decisions taken by the EEC in 1985, including the decisions to create a market without internal barriers. There are a number of good references on the economic policies of the European Union. One example is the report “One Market, One Money,” by Emerson et al. (1992), which provides an early, but thorough, economic appraisal of the costs and benefits of a European monetary union, prepared by the Commission’s staff. A more academic treatment of the subject is provided by De Grauwe (2003), who examines the costs and benefits of monetary unions in general, and also focuses on the specific case of EMU and its economic policies. Another source of information on European economic policies is given by Pelkmans (2001), who focuses on economic integration in Europe and how to design regulatory and policy frameworks to promote integration. On the subject of monetary policy, Walsh (2003) provides an excellent overview of recent theoretical and policy-related developments in monetary economics and monetary policy. The book presents and discusses not only theoretical economic models but also quantitative evaluations of these models and recent empirical evidence. Issing et al. (2001) discuss monetary policy in the euro area from the view-

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point of the ECB. They provide a comprehensive treatment of the monetary policy strategy of the ECB, and also describe the operational procedures and institutional features of the Eurosystem. Useful reading on the financial system in the euro area includes Goodhart et al. (1998), who focus on different aspects of financial regulation, including the needs for regulation, various forms and incentive structures for financial regulation, and prospects for financial regulation in the future. A recent conference volume edited by Gaspar et al. (2003) includes a number of papers that investigate the ongoing transformation of the European financial system. On the topic of the euro area payment system, ECB (2001) provides an overview (alongside detailed information on national payment systems). The more specific description of TARGET, the new European payment system that was designed in preparation for the introduction of the euro in 1999 is given in ECB (1999). On the international environment and exchange rate relationships, Corden (2002) presents a systematic overview of different exchange rate regimes, and how the regime choice is related to economic policies in general. Corden presents both theoretical arguments and actual experiences from different countries when discussing various types of exchange rate regimes. Related to this issue is the topic of financial crises. Eichengreen (2002) looks at the international financial architecture and explains what underlying factors may have been behind recent crises in financial markets. Moreover he goes on to propose various policies aimed at avoiding the dangers of crises, and to discuss how to manage them better in case they do occur. In addition to the references mentioned above, a vast amount of useful information can be found on official Web sites. For example, the ECB site (www.ecb.int) contains official publications relating to monetary policy, payment systems, financial stability, and other issues of relevance for the ECB. It also contains links to working papers and occasional papers, as well as speeches, press releases, legal documents, and euro area statistical data series. Publications related to the general area of payment systems are also available on the Web site of the Bank for International Settlements (www.bis.org). More general information on the European Union and its institutions can be found by accessing the Europa Web site (europa.eu.int). This site provides coverage of EU affairs, European integration, as well as legislation currently in force or under discussion. It also provides links to the Web sites of each of the EU institutions, where more information is available about the policies administered by the European Union.

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Index

Abbreviations, list of, 183–84 Accession Treaty, 3 Accountability, 32, 33–34 and communication, 95 vs. transparency, 96 Action Committee for the United States of Europe, 185n.1 Adenauer, Konrad, 3, 6, 186n.2, 187n.7 Allocation fiscal policy for, 11 as national function, 57, 58 Amendments to EU treaties, 5, 196n.28 Amsterdam Treaty (1997), 2, 9, 36, 227n.6 Anchor of currency, 151, 152, 153 dollar as, 12, 190n.27 (see also Bretton Woods system) euro as, 12, 154–57 and exchange-rate agreement, 148 gold as, viii, ix, 15–16, 17, 19, 180, 190n.27 state (political power) as, 15, 16, 180 Andreotti, Giulio, 6, 189n.18 Argentina, 152, 153, 224n.22, 225n.26 ASEAN group, 198n.7 ASEAN + 3 group, 230n.16 Asset management, market integration in, 105 Austria euro introduced for, 2 and European Union, 2, 227n.5

institution of supervision in, 112 Automatic stabilizers, 55, 201n.27 Baffi, Paolo, xv–xvi Bagehot, Walter, 216n.31 Banca d’Italia, 17, 85, 87. See also Italy independence of, 32, 94 Banco Ambrosiano, 225n.29 Bank-assurance, 99, 101 Bank of England. See also United Kingdom euro market activities of, 105 independence granted to, 32 and inflation forecast, 93 new responsibilities of, 206n.8 and “one voice versus many voices” issue, 94 operating procedures of, 86 Banking Supervision Committee, 215n.27 Bank for International Settlements (BIS), 158, 225n.28, 229n.15 Bank of Japan, independence granted to, 32 “Banknote conversion” argument for weakening of euro, 146, 220n.5 Banknotes, 22, 120, 123 and central bank, 22 and commercial bank money, viii for euro, 127–30 and gold, 15, 16

244

Bank reserves, 84, 208n.26 Banks. See also Financial system publicly owned, 99, 101, 212n.4 range of functions of, 100 Banque de France, 17 dependence of, 94 and overnight interest rate, 209n.31 Basel Capital accord (1988), 225n.29 Basel Committee on Banking Supervision (BCBS), 160–61, 225n.29 Basel concordat, 225n.29 Belgium. See also Benelux countries and bank-assurance links, 101 euro introduced for, 2 in European Coal and Steel Community, 3 institution of supervision in, 112 policy transmission in, 87 and “snake” agreement, 2 Benelux countries, and Treaty of Rome implementation, 4 Berlin wall, fall of, 7 BIS (Bank for International Settlements) 158, 225n.28, 229n.15 Brazil, financial crisis in, 152, 154, 225n.26 Bretton Woods system, 11, 12, 150, 190n.27 collapse of, 2, 17, 71, 150, 157, 176, 190n.29 and exchange rates, 145, 148 and pegging, 152 policy conflicts undermining, 14–15 vs. present global system, 157, 158 Britain. See United Kingdom Broad Economic Policy Guidelines, 202n.31 Brouwer I report, 109 Brussels, 4, 186–87n.6 Budgetary policy, 54, 200n.21 Bulgaria, 173, 222n.16, 223n.19, 224n.22 Bundesbank. See Deutsche Bundesbank

Index

Bundesbank Act (1957), and Maastricht Treaty, 21 Canada, division of economic responsibilities in, 56 CAP (Common Agricultural Policy), 5, 11, 39 Capital market activity, market integration in, 104–105 Capital mobility, 12, 13, 14, 15, 148, 191n.32. See also Four freedoms Cash changeover, 127–29 Central arbiter, 107 Central bank money, 121–23, 126, 129–30, 137, 209n.32, 210n.36 Anglo-American tradition, 136 availability of, 123, 217n.8 solution to crisis, 117–18 Central banks and banking, viii, x, xiii–xiv. See also European Central Bank; Eurosystem as archipelago of monopolists, 170–71 and banking supervision, 116 centralized vs. federal structure of, 23–24 changes in, ix, x and changes in monetary systems, 22 credibility of, 89, 210n.38 as crisis defense, x, 115 and European integration, xii and exchange rate, 52 history of, 15–19 independence in, 28 as paradigm for Europe, xiv and payment-system problems, 122 perfection of, 168 policy profile of, 81 and political power, ix, x, xii three activities of, viii, x, 22–23, 168–69 three-stage evolution of, viii

Index

Central bank track to financial stability, 115–16 China, 142, 151, 222n.16 Coal and Steel Community, European, 2, 3, 4 Cohesion Fund, 11, 58, 190n.28 Cohesiveness and euroland economy, 90 and transmission of monetary policy, 86–87 Commercial bank money, viii, 22, 121, 123, 129, 130 Committee on Payment and Settlement Systems (CPSS), 135, 160–61 “Committee of Wise Men,” 110, 214n.18 Common Agricultural Policy (CAP), 5, 11, 39 Common market, 187n.9 implementation of, 4–5 as “single market,” 8 (see also Single market) Common regional development fund, 5 Common rule mode of policy coordination, 48 Communication, of monetary policy, 92–96, 211n.41 Competition, among NCBs, 171. See also Policy competition Competitive mode of price-setting decisions, 88, 90 Complementarity, in payment system, 123–24 Condition of indifference, 125–26, 127, 129 Confidence, and money, 22, 169 Congress of The Hague, 2 Consolidation, and payment system, 136 Constitutional structures of member states, 197–98n.4

245

Constitution for Europe, Intergovernmental Conference for, 3, 36, 196n.33, 228n.6 Consultative forum, 47, 48, 56, 62 Continental European model, 99–102, 137, 212n.6 Continuous linked settlement (CLS) system, 133, 219n.19 Convention on the Future of Europe, 3, 9, 39, 190n.24 Coordination of policies. See Policy coordination Copenhagen European Council, 173, 227n.6 Corner solution theory, 15, 152, 191–92n.34, 223nn.19, 20. See also Two-corner solution theory Corporatism, 59, 202–203n.34 Corrigan, Gerald, 119 Council of Ministers, 35, 38, 199n.1. See also ECOFIN and draft constitution, 39 and establishment of monetary policy, 67 Court of auditors, 188n.12 CPSS (Committee on Payment and Settlement Systems), 135, 160–61 Credibility, of central bank, 89, 210n.38 Credit rationing, 87 Crises in banking and finance, 97 central banks as defense in, x, 115–16 and cooperative effort, 158, 159, 225n.29 and Eurosystem, 116, 118 and exchange rate agreement, 150 and exchange rate strategy, 154 of 1930s, 212n.3 solutions to, 116–18 Cross-border mergers, 102–103 Cross-border payment services, 129, 218n.13

246

Currency, 6. See also Money; Single currency and central banking, ix–x commodity vs. paper, 22 and confidence, 22, 169 and economic/political/social strength, 36 international use of, 139–40 paper, viii, 16, 22, 120 (see also Banknotes) social factors in soundness of, 181 Currency board arrangements (CBAs), 224n.22 Currency segmentation, 98, 105 euro as end of, 102 Customs union, 4, 187n.9 Cyprus, accession of, 3, 173 Czech Republic accession of, 3, 173 and “managed floating” regime, 223n.18 Decentralization, 24–25, 26, 31 of mechanics, 85 of policy execution, 85 Decision(s), 25, 26 interest-based vs. wisdom-based, 29–30 and strategy, 77 Decision-making, 27–31 by majority vote, 5, 28–29, 36, 195n.20, 196n.20 (see also Majority voting) and noncompetitive mode of pricesetting, 88–89, 90, 91 unanimity requirement in, 5, 29, 45, 188n.10, 195n.20, 196n.32 Defense policy, 45 Deficit reduction, 61 Deficit spending, 17, 200n.21 three percent limit on, 54 Deflation, 80, 167. See also Stability, price

Index

De Gasperi, Alcide, 3, 6, 186n.2 de Gaulle, Charles, 4, 5, 187n.8 Delors, Jacques, 2, 6, 188n.15 Delors Committee and Report, 2, 7, 179, 188–89n.15 and Treaty of Maastricht, 7 Denmark EEC joined by, 2, 5, 227n.5 and European System of Central Banks, 21 “opt-out” clause for, 174, 189n.20, 194n.1 and pegging of currency, 222n.16 and Single European Act conference, 9 TARGET used in, 131, 219n.15 and Treaty of Maastricht, 7 Deposit insurance, ix Deutsche Bundesbank, 67, 72 decentralization of policy execution in, 85 and ECB, 81 and EMI, 196n.23 and euro as anchor, 156 Eurosystem compared to, 21 independence of, 94 and interbank interest rates, 87 and liquidity transfer, 131 Deutsche mark, 36 as European standard of value, 145 and exchange rate yardstick, 147 international role of, 142–43 outside Germany, 128 and reunification of Germany, 14 as standard for euro, 67, 143 Deutsche mark (DM) regime, 13 Discount rate, 209n.32 Dollarization, 152, 153, 156, 223n.19. See also US dollar Duisenberg, Willem, 78, 146 East Asia, 152, 153 East Caribbean Currency Union, 223n.19

Index

ECB. See European Central Bank ECB Board, 26, 27–28 and establishment of monetary policy, 67 and implementation of policy, 25, 26 and new members, 228–29n.10 ECB Council, 25–26, 27, 27–31 and bank crisis, 118 and change in strategy, 80, 82 decision-making under enlargement of, 175–76 deliberation style of, 77 growth and employment neglected by, 53 as melting pot, 172 and TARGET, 133 weighted voting in, 195n.21 ECB two-pillar strategy, 68, 69, 80, 82, 205n.2 ECOFIN Council, 56, 198–99n.11 Economic constitution, EU, 42, 44, 45, 61, 213n.15 and market policy, 52 and policy coordination, 46 Economic and Financial Committee, 56, 198–99n.11 Economic and Monetary Union (EMU), 6, 60, 111, 130, 139, 176, 178, 179, 202n.32 Economic performance, 41 and economic policy, 61 improvement possible in, 166 and interplay of decisions, 45–46 in United States, 204n.45 Economic policy(ies), 41 assessment of, 61–62 assignment of, 42–45 coordination of, 11, 46–51, 56, 177 employment policy, 42, 43, 59–61, 203n.38 exchange rate policy, 42, 43, 52–53 fiscal policy, 11, 42, 43, 44, 45, 53–59 goals of, 11, 43–44

247

interplay of, 45–47 market policy, 42–43, 43, 48, 51–52 monetary policy, 52, 67, 68–92 (see also Monetary policy) and Treaty of Rome, 11 Economic and Social Committee, EU, 59, 203n.35 EDC (European Defence Community), 2, 3 EEC. See European Economic Community Efficiency, 44, 53, 123, 217n.8 EIB (European Investment Bank), 11, 190n.28 Einaudi, Luigi, 1, 185n.1, 211n.41 EMI (European Monetary Institute), 2, 8, 195–96n.23 e-money, 130, 136, 213n.7, 218n.14 Employment policy, 42, 43, 59–61, 203n.38 “Empty chair crisis,” 188n.11 EMS. See European Monetary System EMU (Economic and Monetary Union), 6, 60, 111, 130, 139, 176, 178, 179, 202n.32 “E pluribus unum,” xii, xiv Equity and euro area responsibilities, 44, 53 as national or regional concern, 57–58 and Treaty of Rome, 11 Erhard, Ludwig, 187n.7 ERM (exchange rate mechanism), 188n.13, 222n.16 ERM II, 228n.9 ESCB (European System of Central Banks), 21 Estonia accession of, 3, 173 and currency board arrangements, 224n.22 euro-based currency board in, 223n.19

248

EU. See European Union EU Council of Ministers. See Council of Ministers Euro. See also Single currency and business outside euro area, 98 chronology of development of, 2–3 creation of, 1 as “currency without a state,” 35 Deutsche mark as standard for, 67, 143 economic road in development of, 11–15 and financial system, 102–107, 111 (see also Financial system) first day of, 119 and history of central banks, 18–19 as international currency, 139–47 (see also International role of euro) name decided on, 8, 127 notes and coins for introduced, 3, 8 political determination of, 180 political road in development of, 1, 3–11 synthetic, 220n.6 Euro, future of. See Future of euro and Eurosystem “Euro area,” 197n.1 Euro-dollar market, 98 Eurogroup, 52, 198n.11, 229n.15 Euroization, 152, 153, 223n.19 Euroland, ix, 197n.1 as fragmented area, 85 in key triad, 154, 177 European Central Bank (ECB). See also Central banks and banking; ECB Board; ECB Council; Eurosystem and central bank paradigm, viii–ix communication practices of, 92–93, 96 and cross-border payment services, 129 and e-money, 130, 213n.7 (see also e-money)

Index

establishment of, 2 and European Monetary Institute, 8 and European Parliament, 37 and Eurosystem, xiv exchange rate intervention by, 146 and exchange rate policy, 53 as head of system, 24 and inflation rate, 79 as lacking track record, 81 minutes of meetings of, 196n.25 and monetary policy, 71–72, 72–74, 78 (see also Monetary policy) NCBs’ future relationship to, 171–72 and new countries, 175 and participation in international organizations, 229n.15 and September 11 aftermath, 118 European Central Bank, future of. See Future of euro and Eurosystem European Coal and Steel Community, 2, 3, 4 European Commission, 35, 37 Community regulatory framework proposed by, 130 and competition, 171 and cross-border payments, 129 downgrading of role of, 177 and draft constitution, 39 and economic policy, 56 and market integration, 107 and new members, 228n.6 and state aid in banking crisis, 117 European Community, and redistribution, 11 European Convention (June 2003), 36 European Council, 2, 5, 38 and ECOFIN, 199n.11 and “euro” as name, 127 and exchange rate, 53 and labor force participation rate, 61 European Court of Justice, 35, 38 European Defence Community (EDC), 2, 3

Index

European Economic Community (EEC), 2, 3–5 revenue sources for, 5, 188n.12 and United Kingdom, 9 European fixed exchange rate system, 7 European integration, xi–xii, 58 and central banking, xii European Investment Bank (EIB), 11, 190n.28 European Monetary Institute (EMI), 2, 8, 195–96n.23 European Monetary System (EMS) and anchor role, 148 beginning of, 2, 5 and DM regime, 13 in exchange rate crisis (1992–93), 7 and exchange rate mechanism, 188n.13, 222n.16 and fixed exchange rates, 145 and inconsistent quartet, 14 and monetary policy, 70 paths leading to, xii and United Kingdom, 9 European Parliament, 5, 35, 37–38 and draft constitution, 39 ECB president appears before, 93 Eurosystem accountable to, 34 first elections for, 2 members’ representation in, 228n.6 and mix of monetary and fiscal policies, 56 perception of, 95 seat of in Strasbourg, 186n.6 European public opinion, slow emergence of, 95 European Regional Development Fund, 190n.28 European Social Fund, 190n.28 European System of Central Banks (ESCB), 21 European Union (EU), 1, 35–36 accession of new countries into, 173–76, 227nn.4, 5, 227–28n.6

249

adoption of name, 8 decision-making of, 195n.20, 196n.32 (see also Decision-making) evolution of, xi–xii finances of, 39 and fiscal policy, 53 incompleteness of, 35–36, 50, 106, 179, 180 institutional architecture of, 179–80 institutions of, 36–39 (see also specific institutions) and international organization vs. federal state, 45 legislation of, 197n.2 Maastricht Treaty creates, 1, 2 and market policy, 51, 52 and monetary power, 19 and policy coordination, 50 preconditions for membership in, 173 and responsibility for main public goods, 44–45 three pillars of, 8–9 and Treaty of Nice, 3 Euro-scepticism, 7, 10 Eurosystem, xii–xiii, 21–23. See also European Central Bank and accession of new countries, 173–76 as archipelago of monopolists, xiii–xiv as catalyst, 163 center and periphery in, 23–27, 31, 176 decision-making in, 27–31, 195n.20 (see also Decision-making) and “e pluribus unum,” xiv and European Union, 35–36 and execution of policy, 25–26 and financial stability, 115–18, 163 (see also Stability, financial) fiscal and political counterpart in, 57 independence and accountability in, 32–34

250

Eurosystem (cont.) international role of, 139 (see also International role of euro) and national bank systems, xiii, 163, 170 (see also National central banks) and national price setters, 90 as perfect central bank, xiv, 168–72 as unified “system,” 98–99 Eurosystem, future of. See Future of euro and Eurosystem Eurosystem Statute, reform of, 176 Excessive Deficit Procedure, 202n.31. See also Stability and Growth Pact Exchange rate(s), 12–13 and corner solutions, 15 and ECB, 53 and economic constitution, 53 and European Monetary System, 5 factors in strategy for, 154 floating of, 147–51 fundamentalist view on, 221–22n.14 and incoming members, 174 and international role of euro, 143–47 key variables for, 167 “misalignments” view on, 222n.14 as monetary-policy variable, 69–70 and 1992–93 EMS crisis, 7 and pegging, 151–54, 222n.16, 223n.17 and single currency, 145, 147, 203n.36 and Treaty of Rome, 11, 13 Exchange rate mechanism (ERM), 188n.13, 222n.16. See also ERM II Exchange rate policies, 42, 43, 52–53 Exchange rate regimes with euro link, 154–56 fully flexible, 224n.22 Exchange rate targeting, as monetary policy, 69–70 Externalities, 178 External sector, 64

Index

Faust (Goethe), and paper notes, 16, 192n.36 Federal Reserve Act (1913), and Maastricht Treaty, 21 Federal Reserve System, US. See US Federal Reserve Fiduciary money (currency), viii, 19 and Germany, 67 Finality, 123, 217n.8 Financial Holding Companies Act (1999), 100 Financial intermediation, 99 Financial sector, 64 Financial Services Authority, 111 Financial Stability Forum (FSF), 226n.31 Financial system, 97. See also Banks Continental European model of, 99–102, 212n.6 and euro, 102–107, 111 and financial stability, 115–18 (see also Stability, financial) regulation and supervision of, 107–16 restructuring of, 98 and single currency, 99 under single market, 98 wholesale activity, market integration in, 103–104 Finland banking crisis in, 225n.26 euro introduced for, 2 and European Union, 2, 227n.5 institution of supervision in, 112 and interest rates, 87 Finnish central bank, 85 Fiscal policy(ies), 43, 53–59 assignment of, 42, 45 in interaction with monetary policy, 56–57 three goals of, 11, 43, 44 Flexibility fiscal, 55 in labor market, 60

Index

Forecasts, economic by Bank of England, 93 publication of, 95–96 Foreign exchange transactions, settlement of, 133 Foreign and security policy, 45 Four freedoms, 179, 186n.3, 189n.17 hindrances to, 48 laws passed to implement, 6 and single currency, 15 support for (1980s), 14 and theory of optimum currency areas, 12 France and bank-assurance links, 101 central bank independence in, 32 in European Coal and Steel Community, 3 deficit limit exceeded by, 54–55 de Gaulle as leader in, 4, 5, 187n.8 economic output from, 64 euro introduced for, 2 and European Defence Community, 3 franc supported, 7 inflation in, 67 institution of supervision in, 112 and interest rate structure, 87 and monetary policy rates, 88 and “snake” agreement, 2 Friedman, Milton, 18, 193n.40 Fungibility, preservation of, 129–30 Future of euro and Eurosystem, 165 and global cooperation, 176–79 and incoming countries, 173–76 and lack of political union, 179–81 and perfect central bank, 168–69 and price stability with growth, 165–68 Galí, Jordi, 74 Game theory paradigm, 89–90 General equilibrium paradigm, 89, 210n.39

251

Geographical mobility of workers, 12, 60 German Bundesbank, 17, 18 Germany in European Coal and Steel Community, 3 communication style in, 94 deficit limit exceeded by, 54–55 division of economic responsibilities in, 56 economic output from, 64 and EMS policy conflict, 15 euro introduced for, 2 hyperinflation in (1923), 16, 18 inflation rate in (1949–1998), 67 institution of supervision in, 112 Länderfinanzausgleich (Regional Financial Compensation) in, 59, 202n.33 Landesbanken in, 213–14n.16 and monetary policy, 70 reunification of, 2, 7, 14, 174–75 and “snake” agreement, 2, 13, 145, 192n.35 and Treaty of Rome implementation, 4 Global financial system, 162 Globalization, as payment-system challenge, 136 Goals of economic policy, 11, 43, 44 Goethe, Johann Wolfgang von, 192n.36 and paper notes, 16, 192n.36 quoted, 230n.18 Gold, first monetary use of, 216n.1 Gold anchor, viii, ix, 15–16, 17, 19, 180, 190n.27 Gonzalez Marquez, Felipe, 6, 189n.18 Government sector, 64, 204n.42 Great Britain. See United Kingdom Great Depression, 168, 212n.3 Great Inflation of the 1970s, 75, 76

252

Greece euro adopted by, 3 and European Communities, 2, 227n.5 relative poverty of, 174, 204n.43 and Single European Act conference, 9 Greenspan, Alan, 211n.42, 212n.6 Growth, as future challenge, 165–68 G7 (Group of Seven), 150, 184, 204n.44 in cooperative framework, 158 and decision-making, 163 and euroland, 226n.33 foreign-exchange intervention by, 146, 147 as loose-coordination example, 49 meetings of restricted to national authorities, 226n.32 shortcomings of, 151, 159, 162 three major economies as focus of, 229n.12 G20 forum, 184, 226n.31 Hands-on approach to regulation and supervision, 99, 102 Harmonized Index of Consumer Prices (HICP), 68, 79, 80 Herd mentality, 225n.27 Herstatt risk, 133, 225n.29 Hicks, John, 17, 206n.16 HICP (Harmonized Index of Consumer Prices), 68, 79, 80 Hume, David, 69 Hungary, accession of, 3, 173 IAIS (International Association of Insurance Supervisors), 160–61 IASB (International Accounting Standards Board), 160–61 IMF. See International Monetary Fund “Inconsistent quartet,” 12–13, 14, 148, 191n.32 and corner solution theory, 152

Index

Independence, 32–33, 34 India, and number of key currencies, 151 Indifference condition, 125–26, 127, 129 Inflation, 67, 78. See also Stability, price distribution of rates of, 81–82 and future support for Eurosystem, 168 German hyperinflation, 16, 18 and government’s overcreation of money, 16 Great Inflation of the 1970s, 18, 75, 76 growth of, 79 key variables for, 167 long-term expectations for, 81 and monetary-policy re-evaluation, 79–80 and money, 193n.41 and 1970s United States, 207n.18 and “real money gap,” 207n.20 reduction of, 61 rules for, 75, 207n.19 and separation of supervision, 111–13 and unemployment (Phillips curve), 17, 18, 193n.39, 207nn.16, 17 Inflation bias problem, 210n.38 Inflation forecasts, by Bank of England, 93 Inflation targeting, in monetary policy, 69–70, 71, 73 Information and communication technology (ICT), for payment system, 122 Instability, financial, 224–25n.26 Instruments of monetary policy, 84 Interest rate, 208nn.28, 29 and bank reserves, 208n.26 and central bank rates, 87 changes in, 78 natural equilibrium of, 75, 76

Index

Intergovernmental Conference (IGC), 3, 36, 196n.33, 228n.6 International Accounting Standards Board (IASB), 160–61 International Association of Insurance Supervisors (IAIS), 160–61 International Monetary Fund (IMF), 30, 198n.7 Articles of Agreement of, 49, 226n.30 and Bretton Woods conference, 190n.27 common European position on, 226–27n.33 and cooperation for financial stability, 159, 163 and ECB, 229n.15 euroland weight in, 227n.33 exchange-rate regime of, 190n.29 and exchange rate rules, 150 exclusion of, 151 inflation targeting recommended by, 71 voting power on, 195n.22 International Organization of Securities Commissions (IOSCO), 135, 160–61 International role of euro, 139–43 and cooperation for financial stability, 157–63 and euro as anchor, 154–57 and exchange rate, 143–47 and floating of dollar/yen/euro, 147–51 in future, 176–79 and pegging of currencies, 151–54, 222n.16, 223n.17 “Invisible currency” argument for weakening of euro, 145–46, 220n.5 Ireland EEC joined by, 2, 5, 227n.5 euro introduced for, 2 income of, 204n.43 institution of supervision in, 112 and Schengen agreement, 189n.17

253

IS-LM model, 191n.32, 192n.37, 206n.16 IS-LM-plus-Phillips curve model, 74–75, 206–207n.16 Italy Banca d’Italia, 17, 85, 87 central bank independence in, 32, 94 in European Coal and Steel Community, 3 and economic differences vs. political divisions, 30–31 economic output from, 64 euro introduced for, 2 institution of supervision in, 112 and interest rate structure, 87 policy transmission in, 87 and “snake” agreement, 2 and Treaty of Rome implementation, 4 Japan bank functions in, 100–101 banking crisis in, 225n.26 central bank role in, 53 and equity holdings, 141 in key triad, 154, 177 liquidity trap of, 79 as model, 166 Japanese yen proposed fixing of exchange rates for, 147–48 as reference currency, 156 and US dollar, 222n.15 Keynes, John Maynard, 17 Keynesian IS-LM model, 192n.37, 206n.16 Keynesian IS-LM-plus-Phillips curve model, 74–75, 206–207n.16 Kohl, Helmut, 6, 7, 188n.14, 189n.19 Laeken European Council, 228n.6 Lafontaine, Oscar, 147

254

Lamfalussy, Alexandre, 214n.18 Lamfalussy report, 110, 214n.18 “Last resort clause,” 116 Latvia accession of, 3, 173 currency peg of, 228n.9 Law of one price, 103 Lending-of-last-resort solution to crisis, 116–17, 216nn.30, 31 Lithuania accession of, 3, 173 and currency board arrangements, 224n.22 euro-based currency board in, 223n.19 Lucas, Robert E., 18, 69, 193n.40 Luxembourg. See also Benelux countries in European Coal and Steel Community, 3 economic output from, 64 euro introduced for, 2 income of, 204n.43 institution of supervision in, 112 Luxembourg compromise, 188n.10 Luxembourg European Council, 227n.6 Luxembourg process, 203n.38 Maastricht criteria, 7, 8 Maastricht Treaty, 1, 2, 7, 19 budget rule from, 54 on central-bank independence, 32 from central banking point of view, 23 collegial decision making of, 77 and decision-making principle, 29 ECB Council and Board derived from, 27 and economic policy, 48 and EU economic constitution, 61 “European Union” term adopted through, 8 foundations of single European currency from, 19 and history of central banking, 15

Index

and monetary policy, 68 and payment systems, 218n.10 on policy-making steps, 25–26 and political union, 36 ratification of, 7, 189n.23 and supervisory institutions, 111–14 and Treaty of Rome, 9, 15 Majority voting, 36, 196n.32 and de Gaulle veto, 5 in ECB Council, 28, 29 qualified majority, 5, 188n.10, 195n.20 and Single European Act, 6 Malta, 3, 173 “Managed floating” regime, 152, 223n.18 Maritain, Jacques, 1, 185n.1 Mark, German. See Deutsche mark Market integration, 103–106 impediments to, 106–107 Market policy(ies), 42–43, 43, 48, 51–52 Market system, 178–79 Mechanics of policy implementation and execution, 83, 84–85 MERCOSUR, 198n.7, 230n.16 Mergers, cross-border, 102–103 Mergers and acquisitions (M&A) services, 103, 213n.11 Messina conference (1955), 10 Mexico, financial crisis in, 152, 225n.26 Mitterrand, François, 6, 188n.14 Mobility of capital, 12, 13, 14, 15, 148, 191n.32. See also Four freedoms Mobility of workers, geographical, 12, 60 Modigliani, Franco, xv, 17, 192n.37 Moltke, Helmuth James Graf von, 1 Monetary policy. See also European Monetary System assignment of, 42, 43 and central bank development, 22

Index

and central-bank perfection, 169 and creation of money, 17 de-politicization of, 18–19 Deutsche mark as standard in, 67 as European-level responsibility, 52, 53 and Eurosystem, 23 and exchange rate policy, 53 in interaction with fiscal policy, 56 mandate for, 68 and natural rate of unemployment, 18 and neutrality of money, 18, 193n.41 operations in, 83–86 and other central banking functions, 91 and payment system, 119 price stability as priority for, 53 in recent past, ix–x and separation of supervision, 111–13 single policy adopted, 8 strategy for, 68–72 strategy debates in, 72–78 strategy practice and evaluation in, 78–83 transmission of, 86–92, 92, 157, 205n.3 transparency and communication of, 92–96 two pillars of, 68, 69, 80, 82, 205n.2 Monetary system, viii, 121. See also European Monetary System Money, 120. See also Currency creation of by state, 16–17 e-money, 130, 136, 213n.7, 218n.14 fiduciary, viii, 19 functions of, viii and inflation, 193n.41 and monetary-policy re-evaluation, 79, 80 neutrality or nonneutrality of, 17, 18, 68, 192n.38 and prices, 69 silence of, 211n.41 and social contract, 180

255

Money stock, viii as monetary-policy variable, 69–70 Money targeting, as monetary policy, 69–70, 71 Monnet, Jean, 1, 3, 185n.1 Montesquieu, Baron de (Charles de Secondat), 4, 186n.4 Moral hazard, ix, 111, 215n.21 M3, 69, 78–79, 83, 205nn.4, 5 Multi-currency system, management of, 151 Multilateral netting system, 121, 216n.3 Mundell, Robert, 12 Mundell-Fleming analyses or model, 13, 191n.32 Musgrave, Richard, 11 Mutual recognition of national regulations, 51, 199n.14 NAFTA, 198n.7, 230n.16 National Bank of Belgium, 17 National central banks (NCBs), xiii, 24, 25, 26, 194n.7 and central bank operations, 83, 84, 85 competition among, 171 and national constituency vs. Eurosystem, 163 as national entities, 172 stand-alone features of, 169–70 National price setters, and Eurosystem, 90 National public budgets, 200n.21 NCBs. See National central banks Netherlands. See also Benelux countries and bank-assurance links, 101 in European Coal and Steel Community, 3 euro introduced for, 2 institution of supervision in, 112 and “snake” agreement, 2

256

Netting system, 121, 122, 131, 216n.3 Neutrality of central bank, 123, 217n.8 Neutrality of money (question of), 17, 18, 68, 192n.38 New Zealand, 71, 206n.13 Nice, Treaty of, 3, 9, 36, 39, 227–28n.6 “No-bail-out-clause,” 54 Noncompetitive mode of price-setting decisions, 88–89, 90, 91 Nondisclosure method, for monetary policy, 72 Nonmonetary actors, 91 Nonmonetary policy matters, 31 Norway, 225n.26 OCA (optimum currency areas), theory of, 12, 13, 190–91nn.30, 31 OECD (Organization for Economic Cooperation and Development), 30, 229n.15 One Market, One Money report, 191n.31 One-to-one correspondence model, 170–71 One price, law of, 103 Open market operations, 84 Operational target, 83, 84 Optimum currency areas (OCA), theory of, 12, 13, 190–91nn.30, 31 “Opt-out” clauses, 7, 174, 189n.20, 194n.1 Organization for Economic Cooperation and Development (OECD), 30, 229n.15 Overnight rate, 84 “Overshooting,” 146, 221n.7 Paris, Treaty of (1951), 2, 173, 227n.4 Patinkin, Don, 193n.40 Payment system, x, 119, 122–24 challenges to, 130, 135–37 cross-border transfers, 129, 218n.13 currency specificity of, 121 historical background of, 119–22

Index

innovations in, 22 large-value payments in, 124, 130–33 in recent past, ix retail payments in, 124, 127–30 securities settlements in, 124, 133–35, 217–18n.9 and single currency, 124–27, 129 Pegging of national currencies, 151–54, 222n.16, 223n.17 Pension systems, 92, 100, 211n.1 Phillips, Alban W. H., 193n.39 Phillips curve, 17, 18, 193n.39, 207nn.16, 17 Poland, 3, 156, 173, 228n.9 Policy, economic. See Economic policy(ies) Policy competition, 47, 48, 49–50 vs. protectionism, 107 and supervision, 114 Policy coordination, 46–51, 56–57 and introduction of euro, 177 under Treaty of Rome, 11 Policy-making, 76 and monetary policy, 76–77 Political union, lack of, 36, 44, 50, 179–81 Portugal deficit limit exceeded by, 54 devaluation of escudo, 7 economic output from, 64 euro introduced for, 2 and European Communities, 2, 227n.5 institution of supervision in, 112 monetary policy instruments of, 209n.31 Price setters, national, and Eurosystem, 90 Price stability. See Stability, price Price stabilization, primacy of, 33 Private money solution to crisis, 117 Privatization, and payment system, 135–36

Index

Protectionism, 106–107 Prudential controls, 108 Public goods, 44–45, 57, 58 international, 178 Public interest interpretation of, 28 as national interests, 172 Public opinion in Europe, slow emergence of, 95 Public ownership of banks, 99, 101, 212n.4 Purchasing power parities (PPP), 204n.40 Qualified majority, 5, 188n.10, 195n.20 Rational expectations school, 18, 193n.42 Real-time gross-settlement (RTGS) systems, 123, 130–31, 134, 172, 219n.16. See also TARGET Redistribution on Europe-wide basis, 11, 58, 190n.28 as national function, 57–58 Redundancy, 170 Regional development, aid for, 5, 39 Regionalism, 179 Regulation, 108 of financial system, 108–10 Reputation, of central bank, 210n.38 Reserve requirement, 84 Retail activity, market integration in, 105–106 Risk, systemic, 122, 217n.4 Rivlin, Alice, 218n.11 Romania, 173 Rome, Treaty of. See Treaty of Rome RTGS (real-time gross-settlement) systems, 123, 130–31, 134, 172, 219n.16. See also TARGET Rueff, Jacques, 211n.41

257

Russia financial crisis in, 15, 225n.26 and number of key currencies, 151 Safety, 123, 217n.8 Schengen agreement, 10, 189n.17 Schuman, Robert, 3, 6, 185–86n.2, 186n.5 Schuman declaration, 186n.5 Securities markets, 100 Securities settlement systems, 124, 133–35, 217–18n.9 Security as EU objective, 45 EU’s failure to provide, 35, 180 Shocks, price, 79, 208n.24 Single-agency approach, 111, 214nn.19, 20 Single currency, 6–8. See also Euro challenge in adoption of, 90–91 and exchange rate, 145, 147, 203n.36 as matching American dollars, 142 and OCA theory, 12, 13, 191n.31 and payments system, 124–27, 129 political determination of, 180 road toward, 14, 15 and single market, 48, 97–98, 199n.12 substitutability of, 123 and system of banking and finance, 99 with unachieved polity, 181 Single European Act, 2, 6, 8–9, 189n.16 and United Kingdom, 9 Single institution mode of policy coordination, 46, 47–48 Single market, 2, 98 beginning of, 6, 8 and public ownership of banks, 101 regulatory/supervisory framework for, 109 and single currency, 48, 97–98. 199n.12 Single Market Program, 12, 52

258

Slovakia, accession of, 3, 173 Slovenia, accession of, 3, 173 Smithsonian Agreement, 190n.29 “Snake” exchange rate agreement, 2, 13, 145, 192n.35 Social Charter, and United Kingdom, 9–10 “Sound money-sound finances” principle, 55 Spain central bank independence in, 32 devaluation of peseta, 7 economic output from, 64 euro introduced for, 2 and European Communities, 2, 227n.5 institution of supervision in, 112 Spinelli, Altiero, 1, 185n.1 Stability, financial, 108, 115–18 and central banks, x international cooperation for, 157–63 and payment systems oversight, 123 Stability, macroeconomic, 44, 53, 61 Stability, price. See also Inflation as central bank mission, x through cooperation between central bank and price setters, 90 and euro as anchor, 156 exchange rate contrasted with, 148 as future challenge, 165–68 and HICP, 80 and M3 growth, 69 and new members, 175 as priority, 19, 53, 68, 167 quantitative definition of, 68, 73, 79 and supply shock, 79 Stability and Growth Pact (SGP), 48, 55, 200n.20, 201–202n.28 budget rule from, 54, 200n.23 fiscal rule in, 58 and national governments, 91 Stability programs, 200n.23

Index

Stabilization fiscal policy for, 11 as national function, 57 shift from monetary to fiscal, 55 Stabilizers, automatic, 55, 201n.27 Standing facilities, 84 Structural funds, 11, 58, 190n.28 Structured coordination model, for IMF representation, 226–27n.33 Subsidiarity, 24, 25, 45, 57, 115, 194n.9 Substitutability, in payment system, 123 Supervision of banks, 22, 23, 108 of financial system, 108–16 Supranationalism, 178 Svensson, Lars, 73, 74 Sweden banking crisis in, 225n.26 and European System of Central Banks, 21 and European Union, 2, 227n.5 TARGET used in, 131, 219n.15 Switzerland, 230n.19 Synthetic euro, 220n.6 Systemic risk, 122, 217n.4 TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) system, 125–26, 131–33, 172, 219nn.15, 16 Target zones, 53, 147–148, 199n.17 Taxation, 201n.25 Taxpayers’ money solution to crisis, 117 Taylor rule, 207n.19 Tietmeyer, Hans, 30, 196n.24 Transparency, 32 vs. accountability, 95–96 and communication, 95 of monetary policy, 92 “Treaty, the” 8–9 Treaty of Amsterdam (1997), 2, 9, 36, 227n.6

Index

Treaty on European Union accession entitlement in, 227n.4 and Treaty of Nice, 3 Treaty of Maastricht. See Maastricht Treaty Treaty of Nice, 3, 9, 36, 39, 227–28n.6 Treaty of Paris (1951), 2, 173, 227n.4 Treaty of Rome, xi, xiv, 2, 3–4, 19 and economic policies, 11–13, 48 and EU economic constitution, 61 and Maastricht Treaty, 9, 15 and Single European Act, 6 and United Kingdom, 9 Turkey, financial crisis in, 152, 225n.26 Two-corner solution theory, 13. See also Corner solution theory Two-pillar strategy, 68, 69, 80, 82, 205n.2 Unanimity requirement in decision making, 5, 29, 45, 188n.10, 195n.20, 196n.32 Unemployment, 167 challenge of, 41 factors in reduction of, 62 and future support for Eurosystem, 168 and inflation (Phillips curve), 17, 18, 193n.39, 207nn.16, 17 and wage bargaining for single wage rate, 60 Unemployment policy, 59–61 Unit of account, and euro, 128, 141 United Kingdom, 9–11. See also Bank of England division of economic responsibilities in, 56 EEC joined by, 2, 5, 227n.5 and European System of Central Banks, 21 European Union joined by, 227n.5 inflation in, 67 market-based finance in, 100

259

monetary policy in, 18, 70, 206n.8 “opt-out” clause for, 174, 189n.20, 194n.1 and pound sterling, 7, 140, 142 and Schengen agreement, 189n.17 TARGET used in, 131, 219n.15 Thatcher revolution in, 18, 193n.44 and Treaty of Maastricht, 7 United Nations, 198n.7 United States. See also at US bank activities in, 100 banking supervision in, 113–14 central bank role in, 53 cross-borders mergers in, 103 division of economic responsibilities in, 56 in economic comparison with Euroland, 62–65, 204n.45 and equity holdings, 141 and exchange rates, 145 financial system as single entity in, 99 government sector in, 64, 204n.42 growth rate of, 227n.1 “hands-off” approach in, 102, 212n.5 inflation in, 67 in key triad, 154, 177 market-based finance in, 100 as model, 166 monetary policy in, 18 and response to Great Depression, 212n.3 and retail payments, 218n.11 value of transactions in, 132 Universal banking, 99, 100–101 US Constitution, interstate commerce clause of, 62 US Constitutional Convention Convention on Future of Europe compared to, 9 as single founding act, 42 US dollar as anchor, 12, 190n.27 (see also Bretton Woods system)

260

US dollar (cont.) and euro, 145 other currencies pegged to, 151 power of, 141–42, 142 proposed fixing of exchange rates for, 147–48 and regional clustering, 156 and Vietnam War, 14 US Federal Reserve, 17 and e-money, 218n.14 Eurosystem compared with, xiii, 21 federal structure of, 26–27 and Fedwire, 123, 131, 132, 217n.6 and financial structure, 86, 210n.36 and independence, 34 inflation tamed by, 18 and liquidity transfer, 131 and monetary policy, 70, 71 and 1987 stock market crash, 118 and “one voice versus many voices” issue, 94 operating procedures of, 86 and publication of forecasts, 93 rediscount operations of, 209n.32 and September 11 aftermath, 118 and target-interest-rate announcement, 92 track record of, 81 VAT, minimum standard rate for, 201n.25 “Vital interest,” veto based on, 5 Volcker, Paul, 18, 193n.43 Voting. See Decision-making; Majority voting Wage equalization, 60 Wage setting, 89 Walras, Léon, 89 World Bank, 159, 190n.27, 198n.7 World Trade Organization, 198n.7

Index