From Institutional Investor‘s new “From the Archive” section, we are proud to offer you a glimpse into the past. Below is a story about the problems that faced the European Central Bank, originally published in September 2001 by now-International Editor Tom Buerkle. It is preceded by a short introduction:
The European Central Bank is facing the greatest challenge of its history. In recent months, the central bank has been the only institution with the capability of stopping the rout in European bond markets from breaking up the euro. The bank’s government bond purchases have been very controversial, though, prompting two senior bankers to quit the ECB and arousing political opposition in Germany. It’s no exaggeration to say that the fate of the euro depends on the ability of the ECB and its new president, Mario Draghi, to steer a path through the debt crisis.
A decade ago, the ECB faced a similar, if less daunting, challenge. The euro had fallen sharply since its launch and many economists and politicians were questioning the abilty of the central bank and its first president, Wim Duisenberg,to manage the currency and the euro area economy. In “Making Sense of the ECB,” our September 2001 cover story, II went deep inside the Frankfurt-based institution to examine the shortcomings of the central bank’s framework and expose the gap between the bank’s top executives and Europe’s political leaders. The issue may have changed, but many of the tensions at the bank remain the same today.
-Tom Buerkle, International Editor
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Fashioning a one-size-fits-all monetary policy for 12 countries was never going to be easy. But the European Central Bank’s repeated blunders raise doubts about its mandate, structure and leadership.
By Tom Buerkle
September 2001
Institutional Investor Magazine
During years of wrangling over the creation of the European Central Bank, the big worry among policymakers was whether the institution could be insulated from politics. So it’s no small irony that after three years of operation, it’s not the ECB’s independence but its competence that is the critical issue.
The European economy’s sudden stall this spring presented the bank with its first serious test. It emerged with less-than-flying colors. While the Federal Reserve Board was slashing U.S. interest rates aggressively, the ECB held steady, despite intense market and political pressure for a reduction. It insisted that growth was on track and that restraining inflation remained its chief priority. ECB president Wim Duisenberg, in a notorious remark that stretched the line between dogged determination and arrogant obstinacy, dismissed criticism of the bank’s refusal to cut rates by declaring, “You might say I hear, but I do not listen.” Then, just when the bank had begun to bring the critics around to its line of reasoning, it made a U-turn, cutting rates in May even as inflation was rising.
That reduction, from 4.75 percent to 4.5 percent, did little for growth or confidence, which have continued to plummet across Euroland, but it did deal a blow to the bank’s credibility. The ECB was upbraided by both the OECD and the International Monetary Fund for not communicating its policies effectively. The European Parliament voted overwhelmingly to recommend that the ECB overhaul its decision-making procedures. The harshest critic of all, the foreign exchange market, drove the euro back down to near the low reached in September 2000. To cap it all off, European Union governments began maneuvering over a successor to Duisenberg, putting pressure on the ECB chief to step down early next year.
Of course, life was bound to be difficult for the ECB in its early years. As the world’s only central bank managing a currency shared by 12 countries, it was without precedent and had few traditions to draw on. Moreover, the ECB serves as a convenient punching bag for those frustrated by the shortcomings of the euro-zone economy and the single currency. And the recent, rapid shifts in the global economy would challenge any central bank - just ask Alan Greenspan.
But even acknowledging these caveats, recent months have exposed fundamental flaws in the bank’s structure, strategy and leadership. Its cumbersome 18-member governing council, its consensus decision making and its fortnightly meetings all appear to induce caution that can delay urgently needed action. The bank’s two-pillar strategy, which seemingly accords as much weight to money-supply figures as to output, inflation and other indicators of real economic activity, has lost credibility with academics and market analysts alike. The bank has struggled just to measure its key aggregate: M3. And crucially, the bank’s central target of keeping inflation between 0 and 2 percent is at once too imprecise and too strict, running the risk of tipping parts of Euroland into deflation.
Making matters worse, the ECB’s attempts to explain its strategy have at times descended into farce. Contradictory comments by members of the bank’s governing council left market watchers baffled about the prospects for rate cuts this spring. Duisenberg himself has twice triggered declines in the euro in recent months with comments that appeared to indicate a lack of concern over the currency’s exchange rate. Many ECB watchers question whether he is up to the job. “I don’t think he understands a lot about economics and financial markets,” says Daniel Gros, director of the Centre for European Policy Studies in Brussels.
The criticisms haven’t gone unnoticed at the Eurotower, the 36-story Frankfurt skyscraper that houses the central bank. Several members of the ECB’s governing council who spoke with Institutional Investor were defensive and even combative as they discussed the bank. But all concede that the ECB’s efforts to explain its policies have been fraught with trouble.
“We undoubtedly have difficulty to communicate,” acknowledges Jean-Claude Trichet, governor of the Bank of France and putative successor to Duisenberg. But Trichet and other council members attribute much of the problem to having to communicate with electorates in 12 countries in nine languages rather than to a series of faux pas. Says Guy Quaden, governor of the National Bank of Belgium: “I don’t think we have made an important mistake since the beginning of monetary union. But the problem is probably one of communication.”
More surprisingly, members of the governing council also allow that the bank was slow to recognize how quickly global markets could transmit economic weakness from the U.S. to Europe. “Perhaps we underestimated the financial links between the U.S. and Europe, and especially Germany,” admits Ernst Welteke, the president of the German Bundesbank.
ECB members appear to be preoccupied with establishing the authority of their young institution, a predilection that may incline them toward a harder policy line. Take the bank’s vaunted independence. At Germany’s insistence, Europe’s leaders gave the ECB the thickest fire wall against political interference of any central bank. Its independence is written into the Maastricht Treaty, and the governing council sets its own inflation target rather than shooting at one set by politicians. Yet the bank, surprisingly, seems to lack confidence in its freedom. Several members of the council acknowledge that a significant factor in deciding not to cut rates in April - when everyone in the markets was expecting the bank to ease - was a desire to assert the ECB’s independence at a time when certain finance ministers, most notably Belgium’s Didier Reynders (Institutional Investor, July 2001), were clamoring for a reduction.
Yves Mersch, governor of the Central Bank of Luxembourg, says the April decision hinged on standing up to political interference: “As a young institution, you might have to react slightly differently than if you have a track record with a higher amount of predictability. Standing firm must not become obstinacy, and obstinacy in my opinion is silly. But standing firm is different. That contributes to your credibility as an independent institution.” Christian Noyer, the ECB’s vice president and a council member, concurs. “Certainly, we had to resist pressures,” he says. “The pressures were based on an assessment of growth per se, which is not in our strategy. We would only respond to signs of an easing in risks to price stability.” If the bank was perceived to be bowing to pressure, he adds, that would be “a big danger to credibility and, therefore, to our success in the medium term.”
Mea culpas aside, ECB council members stoutly defend Duisenberg and insist that they’ve got monetary policy just about right according to the bank’s strict anti-inflation mandate. They express frustration at the markets’ almost mystical faith in the Greenspan Fed and corresponding lack of trust in the ECB. But as Europeans they have their own bible - namely, the Maastricht Treaty - and they don’t question its strictures. “We are in a totally different universe because we have this commitment to deliver very low inflation,” says Trichet, adding that “less than 2 percent is much more demanding than implicitly less than 3.5 or something like that” - contrasting the ECB’s explicit inflation target with the Fed’s assumed but unspecified one.
Lucas Papademos, the Bank of Greece governor and newest member of the ECB governing council, may be best placed to compare the European bank and the Federal Reserve, having worked as a senior economist at the Boston Fed in the 1980s. He says the European bank’s relative caution on rates is easily explained. “The fundamental reasons are the specific inflation objective, which is important for a new central bank to attain in a very difficult environment, and various features of the euro-area economy. Although there is restructuring, we have not yet experienced increases in productivity and in the functioning of the economy that can help us achieve at the same time a high rate of growth and low inflation.”
The markets may have rewarded the Fed for its pro-growth bias, but council members believe that the best thing they can do for growth is to keep prices stable, allowing consumers and businesses alike to plan and to feel confident. They believe that the ECB’s more rigorous stance will be proved correct over time. Indeed, long-term interest rates remain slightly lower in Europe than in the U.S. despite the stark difference in the two central banks’ policies toward short-term rates. The ECB’s chief economist, Otmar Issing, widely regarded as the intellectual heavyweight on the governing council, said in May that the central bank’s practice of setting monetary policy only for the medium term “doesn’t allow for managing demand and smoothing the business cycle. The ECB has neither the intent nor the ability to do so.” As Duisenberg never tires of saying at his monthly press conferences, “Maintaining a favorable perspective for price stability is the best contribution monetary policy can make to fostering economic growth over the long run.”
ECB members can dish out criticism of their own - usually at the 12 governments sharing the euro. Duisenberg justified keeping rates on hold in April by saying that it was up to the 12 to foster growth by relaxing labor laws and encouraging investment through privatization and tax reform. “Monetary policy cannot lift the euro area’s production potential, which is largely determined by structural factors,” he contended. (Duisenberg declined to be interviewed for this article.)
Echoing Duisenberg’s point is Welteke, who has maintained a Bundesbank tradition of attacking his government over the slow pace of German economic and financial reforms. “As the economy cannot be adjusted by exchange rate fluctuations,” Welteke says, “other political instruments must be used to adjust developments within the monetary union. There’s fiscal policy, social policy including labor markets, wage developments or labor mobility like in the U.S. Or transfer systems like in Germany. But these factors - labor mobility and transfer mechanisms - will never be the case in the European monetary union. And therefore we need more flexibility in other political sectors.”
It’s certainly true that governments, and not the central bank, are primarily responsible for boosting Europe’s growth rate. EU leaders acknowledged as much at their Lisbon summit in June 2000 when they agreed on a ten-year program of structural reforms designed to boost growth and employment. They simply haven’t delivered on those reforms yet.
It’s also true that although politicians and industrialists would always welcome lower rates, most would argue that the ECB has made no serious policy errors. It showed decisiveness in December 1998 when, one month before the introduction of the euro, it coordinated an interest rate reduction among the original 11 countries participating in monetary union. Four months later the bank made a more aggressive half-point cut to insure that the emerging-markets crisis wouldn’t derail the euro-zone economy. “The ECB has shown that it was not obsessed by the inflation risk,” says Vincent Koen, a senior OECD economist. Between November 1999 and October 2000, the ECB raised rates seven times, a total of 225 basis points, in what central bank governors contend was early, decisive action to nip inflation in the bud. Duisenberg and his colleagues have “done a very good job” of conducting monetary policy, concludes Klaus Friedrich, chief economist at Dresdner Bank. “We have a good record on price stability. That’s all I want from a central banker.”
The ECB’s problems do carry a cost, though. Uncertainty about the bank’s strategy and statements can hamper the ability of financial markets to transmit monetary policy decisions to the economy efficiently, while the bank itself appears to have difficulty reaching timely decisions when economic conditions are changing rapidly. In retrospect, the bank’s half-point rate cut in 1999 came when the economy was already in a strong upswing, and its quarter-point increase in October 2000 hit an economy that was already slowing sharply. Similarly, the bank decided not to cut rates in April, when it might have given a boost to confidence, then cut in May when the downturn was in full swing. “They missed an opportunity,” rues one senior EU official.
The costs of miscues may be limited so far, but they are likely to grow unless the central bank corrects its chief defects: poor communications, a complex and questionable strategy, an unwieldy structure and shaky leadership.
Poor communications
The ECB’s most glaring weakness is simply explaining its policies. It’s not for want of trying. Duisenberg holds a press conference immediately after the first council meeting of every month and appears before the European Parliament several times a year. Other council members also appear before national parliaments and make frequent speeches aimed at explaining the bank and its policies. But the net result is often Babel, which may not be surprising given the bank’s multiplicity of tongues. Gros of the Centre for European Policy Studies rated six major central banks on 15 standards of transparency and placed the ECB a close second behind the Bank of England and well ahead of the Federal Reserve, which ranked fourth. Nevertheless, when Gros polled more than 100 analysts and investors, he found that they regarded the Fed as having by far the most intelligible monetary policy, giving it a rating of 4.3 on a scale of 1 to 5, compared with a lowly 2.2 for the ECB. “The ratings do indicate that there is a communication problem and that the ECB decisions seem less clearly understood than those of the other central banks,” Gros stated in a report prepared for the European Parliament’s economic and monetary affairs committee in May.
A recent OECD report on the euro-area economy asserted that the ECB suffered from a “communication gap” and suggested that the bank imitate the Fed by relying more on “carefully scripted written statements” and less on monthly press conferences and interviews. Conveying the nuances of a central bank’s policy stance isn’t easy in any forum, as Greenspan can testify. But Duisenberg’s practice of going to the press immediately after the council’s first meeting each month is “a recipe for gaffing,” says Koen, the OECD economist who co-authored the report.
This view receives support from Hans Tietmeyer, the former Bundesbank president who could sway the markets with a single comment. “Transparency does not mean presenting many speeches or giving many interviews,” he says. “Sometimes less can be more. Look, Alan Greenspan is not doing many interviews. He is doing his statements; he is doing his hearings. You can say that is boring, but that is what I call verbal discipline.”
Asked about the OECD report at his July press conference, Duisenberg expressed determination to carry on as usual. “We are faced with the dilemma of, on the one hand, being as open and transparent as possible, and on the other hand, with what we would see were we to have fewer press conferences. I doubt whether we would also see less speculation and guesswork in [press] circles.”
Other council participants contend that press conferences enforce discipline on members, who need to explain ECB policies in their own language to their own citizens. The council devotes a significant part of its first meeting each month to deciding on the terms of reference for comments about policy. “Wim is totally assured that this consensus is backed by the governing council,” explains Trichet. “Then he responds to questions. What he says considerably helps all governors of national central banks, because it’s a written way of having the terms of reference and avoiding talking at cross-purposes.”
The French central bank chief calls the press conference “the least-bad solution” to trying to get the bank’s multinational, multilingual council to sing in harmony. One ECB member concedes privately, however, that the bank would do better to rely on formal statements rather than let Duisenberg “go immediately to the lions” after the meeting. But he says any change would draw a barrage of criticism that the bank was changing tack and being less open.
Some ECB members attribute the communications problem to cultural and political differences between continental Europe and the Anglo-American world of financial markets and express hope that the gap would be bridged by the U.K.'s entry to the euro zone. Trichet recalls the euro-skepticism he encountered when he spoke to a financial audience in New York a year before the launch of the single currency: “I was very surprised, because I was telling them, ‘But we will make it. There is no doubt that we will make it. You have to look and trust the messages that are coming from continental Europe. If you don’t prepare for that, you are making a mistake, obviously.’ So I’m not surprised that we still have a lot of difficulty. First of all, those who were saying and telling their masters, telling their stockholders, telling their CEOs, ‘No, no, the euro will not make it,’ I think it might be very difficult to change totally their position. So they probably are saying, ‘Well, they were stupid enough to set up the euro, but now I can tell you it won’t work.’”
Trichet confides that he has an “intimate conviction” that Britain will join the single currency eventually, a feeling reinforced by the failure of the Conservative Party’s anti-euro campaign in the recent U.K. general election. “When the U.K. joins,” he says, “the vision of the U.S. will be totally changed, because through English-language analysis they will have a much more empathetic view of what’s going on in Europe.”
Luxembourg’s Mersch cites a disconnect between the long-term process of European integration, which he says is progressing faster in many ways than the unification of the American states in the 18th and 19th centuries, and the very short-term focus of financial markets. “That’s why the euro, in the news, goes down more often than it goes up, even if it stays at the same level,” he says. “If you are outside a very complex process, you have the reflex of measuring this process according to what is familiar to you and to be slightly doubtful about what is different from your familiar environment.”
But attempts to blame markets for failing to understand the bank are fundamentally misguided and reflect a lack of savvy at the ECB, says an official at one national central bank. “Most of the people in the central bank are not used to talking to financial markets, because they come from countries with repressed markets,” this official says. “You need people with a market culture. The Americans and the British are more used to that.” To that extent, the ECB would benefit greatly from British participation in the euro, the official adds.
Questionable strategy
The bank also faces growing criticism over its monetary policy, an issue that is intimately related to its communications problems. Alone among major central banks, the ECB has elaborated a two-pillar strategy for containing inflation: targeting growth of the money supply, M3, and monitoring economic activity including inflation, output and other indicators. Most central banks have long since abandoned rigid money-supply targeting, believing that there is no clear short-term link between the growth of money and inflation. In theory, the ECB places even more emphasis on money-supply growth than the Bundesbank, which monitors German M3 closely but has never identified it as a separate pillar of its monetary strategy. The ECB’s rationale is that its M3 data is reliable, while indicators of economic activity in the euro zone are still in their infancy and tricky to assess. In practice, the ECB’s devotion to money-supply targeting appears less absolute. Unfortunately, the complicated strategy makes it difficult to predict the central bank’s actions, as the surprise rate cut in May illustrated.
The ECB’s inflation target is as questionable as its strategy. Some critics, like Lars Svensson, a monetary expert at Stockholm University, fault the 0-to-2 percent range for being imprecise and therefore fostering uncertainty about ECB policy. Others regard the goal as simply too tight. Hans-Werner Sinn and Michael Reutter of Munich’s Ifo Institute for Economic Research calculate that the euro area’s overall inflation rate would ordinarily tend to be nearly 1 percentage point higher than that of Germany, because of the propensity of fast-growing economies, such as Spain’s and Ireland’s, to have higher inflation rates. If that is true, and if, as many economists believe, the ECB is really targeting a euro-zone inflation rate of 1.5 percent, then the one-size-fits-all monetary policy runs the risk of pushing Germany into deflation - no idle risk, as anyone at the Bank of Japan can attest.
Considering that Germany had an average inflation rate of 2.5 percent from 1985 to 1998, the ECB’s target implies a tighter monetary policy for the country than the Bundesbank’s, say Finn and Reutter. That analysis is vigorously contested by Bundesbank economists, whose models predict that 2 percent inflation in the euro zone implies 1.7 percent inflation in Germany. Nevertheless, the head of the Bundesbank regional office in Berlin and Brandenbury, Klaus-Dieter KÙhbacher, said in May that the ECB should rethink its inflation target.
The low inflation target may explain some of the euro’s weakness. Avinash Persaud, head of global research at State Street Bank, points out that the ECB and its stern anti-inflation mandate were designed for a world driven by bond market flows, in which inflation truly is enemy No. 1. But equities drive today’s markets, and for stock investors, growth has become king. According to State Street’s data, unhedged cross-border capital flows in equities amounted to some 170 percent of bond market flows last year, compared with just 39 percent in 1995. As Persaud puts it: “The equity investor looks at Europe and says, ‘The ECB is part of the problem. It is not shooting for growth. The inflation target is asymmetrical, it is skewed to the downside.’”
Despite the criticism, Europe’s commitment to very low inflation remains an orthodox theology that few officials are willing to question. The EU commissioner for economic and monetary affairs, Pedro Solbes, says that suggestions that the ECB isn’t doing enough to sustain growth are “unfair.” The bank’s inflation target, he insists, “is not the wrong strategy.”
At the core of the strategy problem lies the ECB’s inherent dilemma: managing a single currency with a single monetary policy for a dozen different countries whose growth and inflation rates have been diverging since the launch of the euro in 1999. This has always been the biggest challenge of monetary union, and the events of the past two years have done little to ease the skeptics’ doubts. Although the overall EU-12 inflation rate stood at 2.8 percent in July, national rates varied from a high of 5.2 percent in the Netherlands to a low of 2.2 percent in France. Calculations by Paul De Grauwe, an economist at the Catholic University of Leuven in Belgium, show that while the ECB was raising its key short-term interest rate by 100 basis points between May 2000 and May 2001, the effective real interest rate increased by 300 basis points in Ireland, where inflation had fallen; rose by 50 to 100 basis points in Italy and France; was unchanged in Germany; and fell by 200 basis points in the Netherlands, thanks to a surge in inflation there. Given such sharp discrepancies, “the ECB will always find it difficult to move,” De Grauwe says. “It will be a paralyzed institution. We are much less likely to have forceful decisions like the Federal Reserve’s. As long as these differences are there, we will perceive the ECB as not being up to the job.”
ECB officials insist that divergences were to be expected and have not prevented the governing council from setting monetary policy from a euro area rather than a national perspective. Euro-zone countries narrowed their inflation and interest rate differentials dramatically in the late 1990s as part of the “forced march” to qualify for the single currency, and today they are low by Europe’s historical standards. As Luxembourg’s Mersch puts it, “Between Sicily and Milan, the divergence in growth has been much, much larger, and inflation, too, and it was never ever questioned that they should not have the same monetary standard.”
Even so, the euro area has developed patterns that weren’t anticipated, especially the contrasting economic performances of Germany and France. Many French politicians feared that European monetary union would tie their economy to a monetary system modeled on the Bundesbank’s and suited to German needs. Today economists worry that, if anything, Germany has locked itself into the single currency at an uncompetitively high exchange rate, while France is benefiting from nearly 20 years of its “franc fort” policy. Trichet, who has been a vigorous champion of the strong franc, says it has permitted France to “improve its situation from a cost-competitive standpoint in a way that has been really striking.” From 1997 through 2000 France’s cumulative growth has exceeded Germany’s by 3.5 percentage points and Italy’s by 4.5 points, and the country has enjoyed one of the world’s largest current-account surpluses. That performance, and the franc fort policy, are a source of “great rejoicing” to Trichet.
Welteke, by contrast, is irritated by the prevailing pessimism about Germany. He dismisses talk of a return to stagflation, although the DIW institute, one of the government’s official economic forecasters, has predicted that German growth would slow to just 1 percent this year. Germany is simply suffering from a prolonged shakeout in its construction industry following the unification boom, Welteke says. Moreover, higher consumer prices and energy charges absorbed much of the tax cut that Germans received in the first half of 2001. But the Bundesbank president insists that the economy will recover in the second half. “When the growth of 2001 will be close to the average of the ‘90s, this is not a reason to be depressed,” Welteke says.
What about the constraints that EMU imposes on Germany? Here Welteke first notes that Germany wasn’t the driving force behind monetary union, having wanted to construct a European political union beforehand. “But that is history,” he says. “While the one-size-fits-all monetary policy does present certain problems for Germany - more so than for other countries - we are not hankering to return to a national monetary policy. The reason behind European monetary union was to overcome nationalistic monetary policy. Therefore, I cannot deal with such arguments, such fears.” So how should Germany respond to its current economic difficulties if not with lower interest rates, such as the massive, 200-basis-point reduction recommended by the DIW institute? “Speed up the structural reforms,” says Welteke. “Improve our education and university system.”
The global economy has also posed unexpected challenges for the ECB in its formative years. Throughout the spring Duisenberg and his colleagues maintained that the euro area would be relatively unscathed by the U.S. slowdown and would post healthy growth in 2001. But now some ECB members acknowledge that, having relied too much on trade-based forecasting models, they failed to realize how the surge of European investment in the U.S., coupled with global equity market linkages, could spread economic contagion.
“We did not appreciate, for example, that DaimlerChrysler’s negative earnings result of $4 billion in the U.S. from Chrysler would have such a major impact on Daimler’s investment decisions in Germany,” Welteke says.
Belgium’s Quaden cites Bank for International Settlements figures that show that European companies now derive five times as much in sales from their U.S. subsidiaries as they do from exports to the U.S. Equity markets also appear to transmit economic trends across the Atlantic more quickly. “At the opening of Wall Street every afternoon in Europe, there is a clear influence of Wall Street on the European financial markets,” Quaden notes. All of this suggests that Europe’s business cycle may be tied much more closely to that of the U.S. today, in contrast to the early 1990s or late 1970s, when European growth offset American weakness. As ECB vice president Noyer sums it up, “The economy is more internationalized, that’s natural, but nobody had realized it to the full extent before.”
All these factors - poor communications, questionable strategy and a rapid change in the global climate - were on full display in April and May when the ECB wrongfooted markets, an experience that council members still struggle to explain.
The possibility that the economic slowdown would be sharper than expected was beginning to pervade market thinking when, in late March, Trichet and ECB chief economist Issing were quoted as saying inflation risks had eased. Both later insisted that their remarks had been taken out of context. Virtually all ECB watchers were predicting a quarter-point cut at the bank’s April 11 meeting. But after Belgium’s Reynders said on the eve of the meeting that the ECB should “assume its responsibilities” for growth - pretty blatant pressure for a rate cut - the bank surprised the markets and didn’t budge on rates. Many believe the governing council was sharply divided, with central bankers from Spain, the Netherlands and Ireland vehemently against rate cuts because of their high growth and high inflation rates back home. Council members refuse to talk about factions.
As EU inflation rose from 2.6 percent in March to a peak of 3.4 percent in May - well above the bank’s target - the markets’ expectation of rate cuts evaporated. But on May 10 the governing council unleashed a quarter-point cut, to 4.5 percent. The rationale? Fresh data suggested that the euro zone’s key M3 money supply figure had been distorted by nonresidents’ money market holdings. Removing the distortions brought M3 growth back within the ECB’s 4.5 percent reference rate.
Market analysts were stunned. After all, nothing much had changed with M3: The central bank had merely managed to quantify the euro holdings of investors outside the euro zone. Stockholm University’s Svensson dismissed the official explanation as “one of the weakest I’ve heard. Everyone knew that some of the euro-zone money supply was held by foreigners. That is not a reason for changing interest rates.” The ECB’s Noyer counters that a “cumulation” of data, including indications of slower growth and an absence of upward pressure on wages, persuaded the council that the inflation outlook had eased in the weeks just before the decision. Issing defended the rate cut by saying that the bank had all along promised to adjust M3 for nonresident holdings. “We have delivered what we had to deliver,” he said at a June conference.
But few ECB watchers found such arguments persuasive. The net effect of the April and May meetings “hurt their credibility because they did cut in the end, but they cut at the worst point. They cut when inflation was at its peak,” says the OECD’s Koen. Norbert Walter, chief economist of Deutsche Bank, calls the ECB’s April and May decisions “a typical result of two groups of categorically different views agreeing on a compromise.”
Council members deny any split, and Duisenberg went out of his way in July to affirm the bank’s policy stance, saying that its 4.5 percent benchmark rate would be appropriate “for some time.” The move suggested that the bank retains a preference for gradualism and caution, even if the markets don’t. Indeed, Luxembourg’s Mersch said Duisenberg’s comment was intended to quell speculation about further rate cuts. “People were expecting a reversal of the policy stance,” he says. “From that point of view, there was never a question of having a divergence of opinion” on the council.
Unwieldy structure
Perhaps most troubling for the ECB, the events of the spring exposed weaknesses in the bank’s structure and leadership, and prompted increasing calls for a revamp of the institution. Many believe the bank could improve its decision making and help markets better understand its policies by abandoning current practice, which is to decide po icy by consensus, and instead letting members actually vote at meetings and publish the minutes of policy debates at those meetings. The European Parliament overwhelmingly endorsed that view in June. “We want the ECB to have credibility and confidence,” says Christa Randzio-Plath, the chairwoman of the Parliament’s economic and monetary affairs committee who drew up the recommendations. Willem Buiter, the chief economist of the European Bank for Reconstruction and Development and a former member of the Bank of England’s monetary policy committee, contends that the British model of taking formal votes on policy and airing central bank debates through published minutes is better than the ECB practice of striving for transparency through press conferences. “Central bankers should shut up and set rates and let their record of actions speak for itself,” he says. Most ECB members, however, instinctively reject the idea of publishing minutes, even if their names were withheld, as this could subject them to intense political pressure at home. Welteke objects to a possible “renationalization of monetary policy” and adds that “as long as possible, we should avoid formal voting.”
The governing council’s consensus approach is also complicated by its size. The 18 members consist of Duisenberg, his five colleagues on the ECB’s executive board and the governors of the 12 central banks in the euro zone. The council is comparable to the Federal Reserve’s Federal Open Market Committee, which has 19 members. But at the FOMC only 12 members cast votes on policy. That setup strengthens the hand of Greenspan and his six colleagues on the Fed’s board of governors at the expense of the 12 regional presidents, only five of whom actually vote. At the ECB, by contrast, all 12 central bank governors as well as the executive board have a say. The number of council members and the executive board’s lack of dominance “make it more difficult for the ECB to reach decisions,” contends Thomas Mayer, senior economist at Goldman Sachs International. “Hence they tend to lag developments rather than being ahead of the curve.”
The problem will only get worse if countries in Eastern and Southern Europe that are bidding to join the European Union gain entr?e and push for quick admission to the euro zone. The Centre for Economic Policy Research has estimated that the council could gain several new members by 2006 and grow to as many as 30 by the end of the decade. That makes reform of the council an urgent matter. “It’s not an issue for the next generation,” says Francesco Giavazzi, an economics professor at Bocconi University who has studied the topic.
Any attempt to limit voting power could expose divisions between the executive board, whose role would almost certainly be enhanced, and the central bank governors, who would be the most likely ones to lose votes, and power. That may explain why few council members are eager to take up the issue. The ECB’s Noyer estimates that it would take ten to 15 years for EU enlargement to turn the council’s size into a problem. “We have started to reflect on it, but we don’t regard it as an urgent issue,” he says. Welteke believes that any attempt to streamline the council could lead to a renationalization of monetary policy as certain countries - and it’s hard not to see Germany and France being among them - retain voting rights while others lose theirs. “As a young institution, when you start a game, you should not change the rules too quickly,” he says.
Shaky leadership
A more fundamental problem at the ECB may be council members’ lack of expertise. Economists point out that several of the central banks among the 12 represented gained independence only in the 1990s and even then shadowed the Bundesbank, pegging their exchange rate to that of the deutsche mark. Asked if this was a fair criticism, Luxembourg’s Mersch replies: “Yes, this idea is fair, and you do not overstate it enough. In all other countries except Germany, we had an external monetary policy objective, an exchange rate objective.” But Mersch contends that lack of experience is not a problem for ECB policymakers so much as it is for ordinary citizens, who don’t appreciate that prices can be stable within the euro area while the euro exchange rate fluctuates so much outside it. “Why are our newspapers full of the exchange rate of the euro against the dollar?” he asks. “Before, no one asked what is the exchange of the Belgian franc against the dollar. No one was interested.”
Questions of competence inevitably lead to Duisenberg. In the 1960s and early 1970s, he worked as an economist in academia and on the staff of the IMF. As a young minister of finance in the Netherlands, he engaged in a burst of Keynesian deficit spending in the 1970s, then became one of the first to call for fiscal austerity and structural reform to cure the “Dutch disease” of high debt and low growth. In 15 years as president of the Dutch central bank, he presided over Europe’s second-hardest currency, the guilder. Trichet extols his “unique and profound experience. He was chairman of the BIS. He was participating in all the G-10 meetings of governors. He enjoys the full support of all of us.” Yet many ECB watchers regard Duisenberg as strictly a compromise candidate, chosen because he was neither German nor French. “Duisenberg for 15 years played golf and went to meetings where he didn’t do anything because the Nederlandsche Bank was just shadowing the Bundesbank,” says the OECD’s Koen. “He’s just stubborn, and bad with the media.”
Duisenberg has hurt himself - and the ECB - time and again with his comments on the euro. Last October, shortly after the bank participated in the only coordinated intervention in support of the currency, he responded to a journalist by saying the ECB wouldn’t necessarily intervene again if turmoil in the Middle East sparked a slide in the euro. The euro promptly tumbled against the dollar, effectively undoing much of the work of the intervention. In May the markets interpreted an offhand remark by Duisenberg as indicating a lack of concern about the exchange rate, and the euro sank again.
In July Eddie George, governor of the Bank of England, said after a G-10 meeting that he was worried about the “perverse” effect of the strong dollar in boosting European inflation while depressing growth in the U.S. The comments sparked a brief euro rally by suggesting widespread official concern about the dollar’s strength, but Duisenberg cut it short the next day when, questioned by reporters, he challenged George’s analysis and insisted that the weak euro wasn’t adding to European inflation. Ironically, several ECB members acknowledged that the governing council had rehearsed a clear line on exchange rates, and Duisenberg himself had reiterated that line at his press conference a few days earlier when he said the euro had significant potential for appreciation. To comment on George’s remarks was a “gaffe after a long series of gaffes,” says Eric Chaney, an economist at Morgan Stanley in London. “You can’t trust the ECB by listening to the messages of its leaders.”
Privately, some council members concede the damage. “Clearly he shouldn’t have said that,” one member says of Duisenberg’s May remarks. Trichet cites the success of Robert Rubin, the former U.S. Treasury secretary, in sticking with the mantra that a strong dollar is in the interest of the U.S. “Mr. Rubin was extraordinary in coining the appropriate one-sentence single response to any question,” Trichet says. Asked if that was the best policy to follow, he replies, “Sure.”
Council members nevertheless rally around Duisenberg. “I have no reason to criticize him,” Welteke says. “My feeling is there would be no one better than him. And he has the support of all members of the ECB council.”
Pressure on Duisenberg looks set to intensify, however, as political jockeying has broken out over his successor. Back in 1998, in a move aimed at persuading France to drop its campaign to win the top ECB job for Trichet, Duisenberg announced that he would stay at his post at least through the introduction of euro notes and coins in January and February 2002 but that he intended to resign before his eight-year term concluded in 2006. French President Jacques Chirac won an informal understanding from EU leaders that Trichet would succeed Duisenberg. The deal was never spelled out, however, and Trichet’s succession hopes have been cast into doubt by French magistrates’ investigation into whether he was guilty of wrongdoing as French Treasury director in the early 1990s, when he helped oversee the bailout and restructuring of Cr?dit Lyonnais.
Duisenberg has refused to discuss his departure publicly, but tensions over the timing have been rising. Reynders, the Belgian who presides over the informal body of finance ministers from the 12 euro countries, revived the issue in April by calling for Duisenberg to say when he intends to resign. Jean Lemierre, the French president of the EBRD, appeared to put himself in the running by discussing the ECB presidency with journalists. And in June, Jean-Claude Juncker, the prime minister and finance minister of Luxembourg, said he had been approached informally about the ECB presidency. Many EU officials think that Reynders had sounded him out before a finance ministers’ meeting.
A spokesman for Chirac says that France continues to support Trichet as the next ECB president, fully expects him to get the job and won’t discuss the possibility of other candidates. But officials at the ECB headquarters believe that the recent speculation all leads back to Paris and to French efforts to scout out alternative successors. “I don’t understand why the French are pressing ahead,” one ECB council member says. “Trichet is the only good candidate they have and is one of the only persons recognized as having the skills and the experience that is needed.” Rather than raising the succession issue now, this official argues, “they should ask Duisenberg, ‘Could you stay on for one or two years?’” In other words, until Trichet is cleared. Welteke expresses exasperation with the succession talk: “These rumors and these discussions do not help the euro, they do not help the ECB, and they do not help Wim Duisenberg in his very difficult job.”
As if the ECB didn’t have enough of a challenge on its hands, in coming months the bank must organize what economist Issing calls the biggest logistical exercise ever in peacetime: the introduction of euro notes and coins. The bank went into high gear in August, unveiling previously undisclosed security features of the currency, launching an E80 million ($73 million) advertising campaign and admonishing citizens to beware of attempts by retailers to disguise price hikes when converting prices into euros. Despite some criticism from the European Parliament over the ECB’s refusal to provide euro currency to the public before January 1, the central bank is confident that the changeover will proceed smoothly and provide a fresh boost to the European economy. Common euro prices from Helsinki to Lisbon should spur competition and reduce inflation, while the transformation of the euro from a notional currency to tangible notes and coins should remove lingering doubts about its value. “It should enhance confidence in the euro on the part of citizens, and that should be the case worldwide,” says the ECB’s Noyer.
It has been a daunting three years for the European Central Bank, and its biggest tasks lie ahead. Officials caution against making any hasty judgments about the bank. It has achieved a good record of price stability, Welteke contends. “And perhaps we should look back six years ago - to recall what the arguments against the euro and the European monetary union were,” he says. Just imagine the turmoil Europe might have experienced if it had had to go through the emerging-markets crisis, or the Kosovo war, without the protective blanket of monetary union. “We were very successful in convincing people that the euro could be a success - I say could be a success. Let’s make an assessment in ten years’ time.”
Unfortunately, Europe’s sputtering economy can’t wait that long.
