European Economic Perspectives 25

Words and Deeds

Europe’s single currency has entered its second year. CEPR’s latest Monitoring the European Central Bank Report assesses the ECB’s performance, focusing in particular on the issues of transparency and financial supervision.

Just as the European Central Bank (ECB) has quickly and fully established its authority in monetary policy-making, so CEPR’s Monitoring the European Central Bank team has established its leadership among ‘ECB-watchers’. This year’s Report, the second in the series, focuses on two key issues: transparency and accountability; and the supervision of financial institutions. The Report argues that:

• Despite its efforts, the ECB is not fully transparent – its true objectives remain unclear and its deeds do not always match its words.

• The absence of a centralized supervisory institution means that the ECB may not have the information that it would need in the event of a systemic crisis.

Both these shortcomings are intimately related and reflect Europe’s ambivalence towards its own integration process, the Report argues. Reviewing the ECB’s first year of operations, the Report suggests that:

• In a relatively calm environment, the ECB had a successful first year and displayed more flexibility than expected regarding asymmetries within the euro-zone.

• Tender auctions through which the ECB provides banks with liquidity have remained heavily oversubscribed throughout the year. This leads to inefficiencies in the allocation of liquidity. Moving from fixed rates with rationing to flexible, market-clearing rates would solve the difficulty without reducing ECB control.

• TARGET, the wholesale payment system set up by the ECB, has delivered on its promises and has successfully established links with other pan-European wholesale systems. Retail payments, however, remain far too costly due to antiquated and anti-competitive practices.

• The ECB’s policy strategy remains difficult to interpret. The monetary policy framework, with its emphasis on ‘two pillars’ – targets for both monetary growth and inflation – seems better designed to conceal strategy than to help the public understand it. Not only do the words fail to reveal the ECB’s reasoning, but they do not always match its deeds.

• European long-term interest rates continue to be heavily influenced by conditions in the United States. This and the behaviour of the euro against the dollar suggest that market participants are not yet fully convinced that the ECB will treat the exchange rate with benign neglect.

The Report notes that the ECB has been accused of lacking transparency and accountability, especially when compared to the Bank of England. But there is a key difference between the two institutions: the ECB is goal-independent – it decides what price stability means in practice without any political counterweight – whereas the Bank of England is goal-dependent – the Chancellor of the Exchequer sets its inflation target. This difference shows up in various institutional and operational features:

• Political responsibility: the ECB Governing Council arbitrates among conflicting short-term interests, and its composition reflects a balance of different interests. In contrast, the Bank of England’s Monetary Policy Committee (MPC) fulfils a technical task and is composed of specialists

• Transparency about policy: the ECB is ex post transparent, to be judged on whether it has achieved its stated goals, whereas the Bank of England is ex ante transparent – it explains how it intends to meet its assigned goals.

• Accountability for decisions: the ECB Council makes decisions on the basis of collective accountability, whereas MPC members are individually accountable.

• Appointments: members of the ECB’s Executive Board are appointed for eight-year single terms, whereas MPC members are appointed for three-year renewable terms.

• Reputations: the ECB aims at gradually achieving a collective reputation as a goal-setting institution, whereas MPC members build individual reputations by achieving goals set elsewhere.

The ECB’s ultimate challenge is to gain political legitimacy. Here it suffers from two handicaps: first, as a goal-setting institution, its actions are open to political debate; and second, the chains of delegation and control from Europe’s citizens to the ECB’s Governing Council are long and complex. Moreover, the ECB’s design reflects national as well as European interests, a characteristic it shares with other EU institutions like the Commission. National conflicts are probably not the most relevant ones in the short-term design of European monetary policy. Other competing coalitions of interests, such as creditors versus debtors and insiders versus outsiders in the labour market, which cut across national borders, find no representation.

The current Inter-Governmental Conference has the explicit task of preparing the EU for enlargement and this has clear implications for the ECB itself. The Report offers these proposals:

• Reducing national influence in the ECB’s Governing Council by giving more power to the Executive Board. This could be achieved by introducing revolving terms for ECB governors according to a pre-set schedule. The size of the Council should stay fixed as new countries join the euro-zone.

• Giving the European Parliament a greater role in the appointment of the Executive Board. Simultaneous reform of the election rules for the Parliament should foster cross-border coalitions and true European parties.

• Removing the ECB’s goal-independence and making its mission the specific technical task of implementing a well-specified goal – in the form of an inflation target – set by the Parliament (after appropriate electoral reform).

In the short term, there are some measures that the ECB itself can take without Treaty amendments. The Report does not support proposals to publish individual voting records and minutes focusing on individual differences (until institutional reforms have made the ECB goal-dependent). Instead, it argues that the Governing Council can build a collective reputation. And the ECB can shift to ex ante transparency about policy by publishing its internal forecasts and presenting policy plans for various contingencies.

With regard to financial supervision, the Report notes that at present it is not clear whether systemic risk in banking and financial markets will increase or decline with the advent of the euro – there are forces operating in both directions. But without appropriate supervision, regulation and institution-building, it seems likely that the factors that increase risk will prevail. Growing interbank transactions, for example, create a web of exposures with the potential to transmit financial failures across Europe in a domino-like fashion.

Current arrangements make national taxpayers bear the costs of bank bailouts, which provides appropriate incentives for regulation and supervision remaining at the national level. But two difficulties are likely to emerge, according to the Report:

• Emergency interventions involve not only the supply of liquidity, which the ECB is well equipped to provide, but they also require real-time coordination of targeted private lending to keep troubled institutions operating. This could become a problem given the dispersion of decision-making authority and information.

• The creation of transnational financial institutions raises new questions about who bears the costs of emergency support.

The ECB’s ability to cope with systemic crises is untested so far. Three possible solutions can be envisaged:

• Status quo: the ECB develops procedures to deal swiftly with possibly contagious bank failures.

• Centralized: an independent European regulatory body is set up as a counterpart to the ECB to take over functions currently exercised at the national level.

• Decentralized: markets are allowed to perform more monitoring and evaluating functions, based on Europe-wide disclosure principles, supplemented with incentives designed to enhance financial soundness and mechanisms for prompt corrective action and orderly closure of failing financial institutions. The ECB can use its constitutional rights to issue or initiate legislation to get this process going.

The status quo is risky, the Report concludes. A centralized solution is not politically feasible in the near future because it requires relinquishing national control and a Treaty revision, even if it is the correct long-term solution. Hence, decentralization becomes the relevant interim solution, with the ECB ensuring that systemic crises are not triggered by illiquidity, and national Treasuries ensuring that they are not triggered by the failure of large institutions.

This article summarizes One Money, Many Countries: Monitoring the European Central Bank 2 by Carlo Favero, Xavier Freixas, Torsten Persson and Charles Wyplosz.

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