By comparing the Federal Reserve’s response to the crisis with the European Central Bank, Tim Decker suggests a new perspective for a faster way out of the crisis, which is based on the empowerment of the policy mandate and institutional governance structures of the central banks. It requires as usual though, the equivalent political will.
The Euro Crisis Drags On – the US Continues to Slowly Recover
The most recent European Commission summit on the 22nd of May left little in terms of actual solutions to the crisis that continues to hamstring the euro zone. The most relevant topics on the agenda were the moves toward tax evasion and tax fraud. While certainly an issue, there must be more significant matters of interest to Europe’s leaders than this as it endures its “sixth successive quarter of shrinking GDP”. Even once strong ‘core’ countries like Finland and the Netherlands are succumbing.
What is more worrying is that the EU’s largest trading partner, the US (where the financial crisis that sparked the euro zone crisis, no less) has outperformed it economically. Even with American unemployment numbers rising slightly recently, the nation’s GDP advanced around 2.5% between January and March 2013 according to the US Commerce Department. While these numbers are unlikely to produce mass euphoria, the US economy has grown for 15 consecutive quarters compared to six quarters of recession across the Atlantic.
The most recent report from the US Federal Reserve’s Federal Open Market Committee (FOMC), released 1 May, 2013, indicates that the Fed, in accordance with its dual mandate, has decided to “continue purchasing additional securities” and to “keep the target range for the federal funds rate at 0 to 0.25%” as long as unemployment remains above “6.5%, [and inflation] to be no more than 0.5% above the Committee’s 2% longer-run goal”. Why has the US been able to recover better than the euro zone? Why has the Federal Reserve’s response to the crisis been more dynamic than the European Central Bank (ECB)?
This article will examine an often undiscussed aspect of the euro zone crisis – that of the actual policy mandates and institutional governance structures of the central banks at the heart of the solution. A close examination between the two shows clear areas of improvement for the ECB. These improvements require political action. European leaders need to act decisively and not be held hostage by a small minority of member states. This most recent EC summit demonstrates the lack of imagination and willingness to act. With German elections scheduled for September, action is unlikely to happen. But can Europe afford to wait another three months after all it has endured so far?
Independence and Precise Targets – Not Always A Good Thing
The ECB was established in 1998 by the Treaty on European Union (TEU), also known as the Maastricht Treaty. Like most central banks, the ECB was the latest incarnation of various attempts at economic and monetary union. After earlier protracted struggles for economic and monetary unions, politicians were quite happy to enact anything; believing that achieving any substantial progress was better than nothing. While no single currency was ever designated as the anchor for a common currency, because of its relative strength and policies of the national central bank, the Deutsch Mark and the Bundesbank emerged as the de facto leaders. In addition to following a Germanic model, key committees charged with providing recommendations for what Europe’s monetary union would look like were composed of the governors of the central banks of the member states. These bankers conveniently decided to not implement any kind of political oversight on the new ECB. “[The Delors] Committee members strongly felt that they were not in the position to make any suggestions regarding the political arrangements, which they considered to be the responsibility of elected politicians”. This initial reluctance by political officials to involve themselves in the finer details of economic policy continues today and, arguably, the largest obstacle to a viable solution.
Further codifying this independence from political oversight, Article 107 of the Maastricht Treaty states that “the ECB, nor a national central bank, nor any member of their decision making bodies shall seek to take instruction from Community institutions or bodies, from any government of a Member State or any other body”. Defenders of the ECB will argue that the central bank does report to the Community at large, and that groups like the Economic Financial Affairs Council (ECOFIN) and Eurogroup serve as political counterweights to the ECB. However, none of these groups possess formal instruments or powers to bring the ECB to full account for its actions, or influence its decisions. This isolation and immunity from political influence, when combined with an equally strict policy mandate, creates the perfect storm of inaction which the euro zone members are stuck with today.
Article 105 of the Maastricht Treaty identifies another inheritance of the German model of central banking. Unlike its American counterpart, the ECB pursues a primary policy objective of ensuring price stability. While the Treaty recognizes the need for the ECB to pursue other objectives, as defined by Article 2 of the Treaty, these objectives come secondary and are prohibited from interfering or circumventing the primary objective. Making matters worse, the ECB Governing Council specifically quantified its definition of price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. In laymen’s terms, it aims to keep inflation below, or close to, 2% “over the medium term”.
The ECB defends this apparent explicit target as a measureable yardstick by which to hold it accountable. However, this price stability definition was not defined in the Maastricht Treaty. Essentially, the ECB has filled a void to further limit its accountability. The reluctance of politicians to involve themselves in complex and technical economic governance allowed the ECB to “fill out for itself the fine print of the contract it has with the politicians”. Central banks should have a greater responsibility than just maintaining prices. A complex society should have a central bank that is equally equipped to handle dynamic issues. Luckily for reluctant European leaders, a template for a more efficient and effective central bank is not far away.
Checks, Balances, and Ambiguity – A Better Choice
The euro zone is experiencing what the US tried desperately to avoid when it created its central bank in 1913. The inherent distrust in centralized authority and a particular sensitivity to the power of banks prevented a central bank developing prior to the 20th century. It took the American Civil War and the need to move money across the country, and a series of financial panics to spark Congress into establishing a National Monetary Commission which culminated in the Federal Reserve Act of 1913.
Originating from an act of Congress, but infused with a large degree of semi-autonomy, created frequent power struggles between regional Federal Reserve Banks and the Board of the Federal Reserve in Washington D.C. This dispute was settled by the Banking Act of 1935, where the central Board (which Congress has lots of influence over via Senate approval requirements stipulated in Section 10 of the Federal Reserve Act) was given ultimate authority in any dispute with the Banks. The Fed is not just a central bank, nor just a regulatory agency. Its diffuse power structure reflects its unique status even among American political institutions. While I am not arguing that the ECB needs to exactly model the Fed, the point remains of a need for political oversight. Members of the system are subject to repeated confirmation by elected representatives, and Congressional committees can challenge the Fed and hold it directly accountable at any time. Congress retains the ultimate trump card should the Fed get out of control or perform in a manner deemed unacceptable. This constant implicit threat, combined with a well designed self-reinforcing system based on checks and balances, ensures the Fed is powerful enough to act when it needs to and has the autonomy to make its own decisions.
The Federal Reserve certainly makes full use of the power and autonomy invested in it by Congress; often frustratingly so. Particularly during the days of Chairman Greenspan, the Federal Reserve is notorious for being vague and ambiguous. This characteristic is by design. To guarantee its relevance in the future, its founders followed a typical American institutional design by charging it with ambiguous targets. Unlike the ECB, the Fed pursues multiple policy objectives of equal importance. Section 2A of the Federal Reserve Act states that the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Put simply, the Fed pursues two primary goals that do not compete with, or override, each other – price stability and maximum employment.
This ambiguity surrounding its policy objectives actually gives the Fed more power to act than the ECB. The difference in the frequency of use between the Fed and the ECB of the short-term interest rate is significant. Starting at the end of 2000 the Fed reacted very aggressively by cutting the interest rate from 6.5% to around 2% by the end of 2001. Beginning in 2004 it raised the rate, tightening its monetary policy, to 5% until the beginning of the financial crisis in August 2007 where it again dropped the rate to an unprecedented level of practically 0%. In contrast, the ECB during the same time period acted less aggressively in combating the economic slowdown in the early 2000s, and raised the rate less during the boom period of the mid-2000s. Similarly, the reaction to the financial crisis in 2007 was slower and less aggressive than its American counterpart.
Leadership Through Action
The ECB’s struggles can be pinpointed to previous European leaders’ reluctance to immerse themselves in the technical and complicated world of economic governance. Politics and economics are intrinsically linked. Ignoring one will lead to the devolution of the other. Europe is learning this lesson the hard way. Time has come for euro zone leaders to motivate themselves and take some action. There is no magic bullet to solve the crisis, but remaining inactive is worse than making the wrong decision. “One of the most important phrases [Chairman of the Board Ben] Bernanke used in his speech is a reference to banks playing a ‘supporting role': central banks can create a positive environment, but they cannot single-handedly create growth and prosperity”.
The euro zone has the power and the institutions already in place to help itself. The answer is not another EU President for the Economy, but rather empowering the ECB to do its job and redesign its mandate to work for the people and not the banks.
Tim Decker is a recent Master’s graduate from the London School of Economics where he studied “Politics and Government in the European Union”. His dissertation, “Europe’s Incomplete Monetary Union – Solving the Democratic Deficit, the European Central Bank and the US Federal Reserve Compared” examined the institutional governance structure of the ECB and the Federal Reserve in terms of its democratic legitimacy. An American raised in Germany and the United Kingdom, his interests include American foreign policy, European Affairs, and international relations.
Apel, Emmanuel (2003), Central Banking Systems Compared – The ECB, the pre-euro Bundesbank, and the Federal Reserve System, London and New York: Routledge.
De Grauwe, Paul (2009), The European Central Bank, Economics of Monetary Union – 8th Edition, Oxford: Oxford University Press
The Economist, http://www.economist.com/news/leaders/21578386-euro-zone-desperately-need-boost-no-news-bad-news-sleepwalkers – Accessed 27 May, 2013.
The EC Commission, An Action Plan to strengthen the fight against tax fraud and tax evasion, http://ec.europa.eu/taxation_customs/resources/documents/taxation/tax_fraud_evasion/com_2012_722_en.pdf – Accessed 27 May, 2013
European Central Bank (1999). Monthly Report, Monthly Bulletin, Frankfurt, January 1999.
Federal Reserve Bulletin (1937), XXIII November, 1937, 1062 – p.333.
The US Federal Reserve Press Release, 2013 Monetary Policy Releases: Release Date 1 May, 2013, http://www.federalreserve.gov/newsevents/press/monetary/20130501a.htm – Accessed 30 May, 2013
Maastricht Treaty (Treaty on European Union) (1992), CONF-UP-UEM 2002/92, Brussels, 28 May, 2013.
US Department of Commerce – Bureau of Economic Analysis, http://www.bea.gov/newsreleases/national/gdp/2013/gdp1q13_adv.htm – Accessed 30 May, 2013
Van Overtveldt, Johan (2010), Bernanke’s Test – Ben Bernanke, Alan Greenspan, and the Drama of the Central Banker, B2 Books, USA: Agate Publishing.
Verdun, Amy (1999), The Institutional Design of the European Monetary Union: A Democratic Deficit, Journal of Public Policy, 18:2. 107-132.
Zhang, Moran – US Q1 GDP Rises 2.5%, Misses Forecast As Economic Growth Momentum Slows, International Business Times, http://www.ibtimes.com/economy-us-q1-gdp-rises-25-percent-misses-forecast-economic-growth-momentum-slows-1219583 – Accessed 30 May, 2013
 The EC Commission, An Action Plan to strengthen the fight against tax fraud and tax evasion, http://ec.europa.eu/taxation_customs/resources/documents/taxation/tax_fraud_evasion/com_2012_722_en.pdf – Accessed 27 May, 2013
 The Economist, http://www.economist.com/news/leaders/21578386-euro-zone-desperately-need-boost-no-news-bad-news-sleepwalkers – Accessed 27 May, 2013.
 US Department of Commerce – Bureau of Economic Analysis, http://www.bea.gov/newsreleases/national/gdp/2013/gdp1q13_adv.htm – Accessed 30 May, 2013
 Zhang, Moran – US Q1 GDP Rises 2.5%, Misses Forecast As Economic Growth Momentum Slows, International Business Times, http://www.ibtimes.com/economy-us-q1-gdp-rises-25-percent-misses-forecast-economic-growth-momentum-slows-1219583 – Accessed 30 May, 2013
 The US Federal Reserve Press Release, 2013 Monetary Policy Releases: Release Date 1 May, 2013, http://www.federalreserve.gov/newsevents/press/monetary/20130501a.htm – Accessed 30 May, 2013
 Verdun, Amy (1999), The Institutional Design of the European Monetary Union: A Democratic Deficit, Journal of Public Policy, 18:2. 107-132.
 Maastricht Treaty (Treaty on European Union) (1992), CONF-UP-UEM 2002/92, Brussels, 28 May, 2013.
 European Central Bank (1999). Monthly Report, Monthly Bulletin, Frankfurt, January 1999.
 De Grauwe, Paul (2009), The European Central Bank, Economics of Monetary Union – 8th Edition, Oxford: Oxford University Press
 Apel, Emmanuel (2003), Central Banking Systems Compared – The ECB, the pre-euro Bundesbank, and the Federal Reserve System, London and New York: Routledge.
 Federal Reserve Bulletin (1937), XXIII November, 1937, 1062 – p.333.
 De Grauwe, Paul (2009), The European Central Bank, Economics of Monetary Union – 8th Edition, Oxford: Oxford University Press
 Van Overtveldt, J (2010), Bernanke’s Test – Ben Bernanke, Alan Greenspan, and the Drama of the Central Banker, B2 Books, USA: Agate Publishing.