The new European Central Bank faces daunting challenges in its first months of operation. A new CEPR report asks whether the design of the ECB is robust enough to withstand global financial turmoil.

German engineering is deservedly the envy of the world. Rare design flaws have therefore received undue attention. Conspicuous examples include Ralph Nader’s charge that the original VW Beetle was ‘unsafe at any speed’ and, more recently, the Mercedes A-Class rollover during a test drive. Neither problem was insuperable, but both were public relations disasters and took a great deal of time and money to put right.

Since the design strategy for the European Central Bank (ECB) has emphasized its similarities to the Bundesbank, the latest CEPR report asks whether the euro is safe with German monetary engineering. According to the Report, the first in a major new series intended to inform public debate on Europe’s monetary policy, the ECB may not be fully prepared to meet the early challenges it may face.

The Report argues that the remarkable exchange rate stability within Euroland in the face of global financial turmoil may have led European policy-makers to underestimate the risks ahead.

• First, the design of the ECB raises serious concerns. These will emerge sooner or later but are likely to be dramatically exposed if large shocks, such as the global financial crisis, hit Euroland.
• Second, just a few weeks before the euro’s launch, important decisions about the operational procedures of the ECB remain to be taken.
• Third, even under normal economic conditions, the ECB will face problems arising from Europe’s rigid labour markets and the existence of 11 independent fiscal authorities.

The authors argue that the ECB’s design does not put sufficient decision-making power at the centre of the system. According to the Report, the governors of Euroland’s national central banks retain too much power relative to the executive board in Frankfurt. This is likely to inhibit the development of a truly European perspective and weaken the centre when quick decisions have to be made. This is evident in two areas:

First, the national governors, who will make up a large majority on the ECB Council, are likely to be driven by national perspectives and will find it difficult to come to coherent decisions when economic conditions diverge within Euroland.

Second, the lack of centralized banking supervision, together with the absence of clear responsibilities in crisis management, will make Euroland’s financial system fragile. No secure mechanism exists for creating liquidity in a crisis, and there are problems for dealing with insolvency during a large banking collapse.

To tackle these issues, the Report contends, more power and responsibilities should be shifted to the ECB. For example, the ECB’s research and other support services should be beefed up. Supervision should also be centralized, and responsibilities for managing the system in crisis situations should be clearly spelled out.

The ECB’s mandate is to pursue price stability but even at this late stage, the procedures it will use to achieve this objective are unclear. What is more, there is considerable latitude in how the mandate can be interpreted: the ECB must achieve a target range for inflation, but has discretion over how quickly to offset any deviations from the target range. At a time when global deflation has become a serious potential threat, it is important that the ECB pays as much attention to avoiding undershoots of its target inflation range as it does to avoiding overshoots, according to the authors.

The ECB should also clarify its other responsibilities. Central banks with good reputations pay attention not only to price stability but also to output fluctuations and financial stability. The Report advises the ECB to be transparent about those other responsibilities, which in no way conflict with its mandate to pursue price stability.

Transparency implies that the ECB should preannounce its monetary policy rule and discuss the circumstances in which it will exercise its discretion to depart from normal behaviour. Each meeting of the ECB Council should be seized as a chance for communication. The Council can either publish its minutes or announce not merely its expectations for Euro-11 inflation and output, but the range for current interest rates implied by its rule and the reasons for any discretionary departures from the rule.

Even if the global financial crisis recedes, the ECB is likely, for some time, to face two problems not encountered by the US Federal Reserve Board, a comparable institution. The first is that labour markets are more rigid in Europe, potentially giving rise to more persistent recessions. The ECB should therefore strive to avoid hard landings, which can quickly translate into permanent unemployment.

The second problem is that fiscal policy is in the hands of 11 uncoordinated authorities, which may give rise to free-riding, as individual fiscal authorities hope that European restraint is achieved by other members’ actions. The ECB cannot succeed if any monetary tightening becomes the excuse for fiscal expansion by individual members of Euroland.

Paradoxically, the first problem may hold a solution to the second, the Report concludes: since finance ministers care even more about recession than the ECB, labour market sluggishness increases the ECB’s power to create recessions if fiscal discipline breaks down. It may therefore prove possible to sustain some cooperation between fiscal and monetary authorities within the Euro-11. The Euro-11 committee would then play a key role in coordinating fiscal policies across Euroland.