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Criticising the European Central Bank
From: Cambridge University Press
| By:
Otmar IssingVitor GasparIgnazio AngeloniOreste Tristani |
EDITOR'S INTRODUCTION |
 With the launch of the euro as the currency of 12 European countries on January 1, 2002, the role of the European Central Bank (ECB) has become much more significant than it has ever previously been. How the ECB will work, and for whose benefit, are among the most important issues now facing Europe. In this extract from their acclaimed book Monetary Policy in the Euro Area, a team from the ECB led by ECB Chief Economist Otmar Issing looks at some of the criticisms levied at their institution in the run-up to the launch of the single currency, and attempt to give some answers. |
 hile the debate concerning the ECB strategy is still active, and it is certainly too early to provide a balanced account of it, it may be useful to briefly mention some of the main critical views that have been raised so far. We will focus on four of the most vocal criticisms that characterised the debate during 1999-2000, the first year of 'Stage Three' of Economic and Monetary Union (EMU). |
According to the Centre for Economic Policy Research (see, e.g., Begg et al., Monitoring the European Central Bank. Update: May 1999), the ECB strategy is unclear because of the existence of two pillars. While there are important links between money growth and inflation in the medium and long run, in practice financial innovation makes these links unpredictable in the short run. Therefore, it is claimed, the ECB will have to frequently ignore the signals coming from the first pillar, just like the Bundesbank has done in the past. It would be advisable, it is concluded, to simply disregard the first pillar and concentrate on the information from the second. |
This criticism contains a grain of truth: financial innovation has, indeed, often destabilised money demand relationships in recent decades and any mechanistic reaction to deviations of money growth from the reference value would be unwarranted. However, this line of criticism does not lead, in our opinion, to the conclusion that money should be altogether dismissed from a strategy. It would have been too hasty for a new central bank, mandated to preserve price stability in the euro area, to ignore the special role that money has played in the history of inflation, in Europe and in the world. However, monetary aggregates are not, cannot be, the only elements of the decision making process: deviations from the 'reference value' are interpreted as an indication, important but not conclusive, of potential inflationary or deflationary risks. Developments in the broad aggregate known as M3, which possesses particularly desirable long-run stability properties, will never be interpreted rigidly, nor will changes in monetary growth automatically trigger corrections in monetary policy. In addition, money also serves as a useful signal of continuity with those central banks (including, but not only, the Bundesbank) which have, in the past, successfully used monetary aggregates as part of their strategies. |
Additional criticisms
A second line of argument criticises the ECB for excessive flexibility in interpreting monetary aggregates and pleads for a traditional monetary targeting strategy (see M.J.M. Neumann, 'On the Choice of a Strategy for the European Central Bank's Monetary Policy', 1998, www.zei.de). Reports prepared by the 'EMU Monitor' group organised by the Zentrum für Europdische Integrazionsforschung of the University of Bonn, argue that the reference value for money 'should be taken more seriously' as a guide for monetary policy decisions (e.g., EMU Monitor, Press Statement No. 4, 24 November 1999). Specifically, the ECB should spend more time explaining why there have been deviations of the rate of growth of money from the reference value whenever such deviations occur. From this viewpoint, the broadly based assessment is seen as a step towards a practice of 'looking at everything', which would allegedly pave the way towards a fully discretionary and short run oriented monetary policy. This view, opposite to the one previously discussed, is subject to the same counter-argument. The stability of money demand cannot be trusted completely: hence the reference value for money must be considered neither as a completely irrelevant policy indicator (the CEPR view), nor as a sufficient one (the EMU Monitor view). It is precisely for this reason that the ECB has decided to attribute to money a prominent role, but to avoid announcing a target value for the rate of growth of a particular aggregate. |
A third line of criticism is presented by, for example, Lars Svensson who, in a recent and widely quoted paper dealing with monetary policy issues for the Eurosystem, argued against the ECB's choice to as-sign 'a prominent role to an essentially irrelevant money-growth indicator in analysis and communication' ('Monetary Policy Issues for the Eurosystem', Carnegie-Rochester Conference Series on Public Policy 51, pp. 79-136, 1999). Svensson's criticism seems to deny that money can, in plausible circumstances, play any role in policy. To illustrate his point, Svensson specifies a simple theoretical model in which money has no role in the monetary policy process, either as a link in the transmission of monetary policy or as an information variable. The irrelevance of money in the model ultimately rests on the hypothesis that the 'true' model of the monetary policy transmission mechanism mainly operates through an aggregate demand relationship. Accordingly, changes in the monetary policy instrument affect long term nominal interest rates and, with sticky inflation and sticky inflationary expectations, long term real rates, which matter for consumption and investment decisions. The addition of a money demand equation to this scheme does not change the substance of the transmission process. Hence the alleged irrelevance of money as an indicator. |
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| The symbol of the euro, Europe's new currency. | |
While not denying that coherent models of the monetary policy transmission mechanism can be written in which money is not a useful variable for monetary policy, it remains unclear, in our view, whether these models represent a reasonable approximation of the actual functioning of monetary economies. Many alternatives exist, among the range of plausible models, in which money plays a relevant role. First, as amply demonstrated by the literature of the 1970s, money does not need to be an active link in the transmission chain to provide useful policy guidance. In particular, in the presence of informational and transmission lags and given that there are substantial uncertainties on the statistical quality of many key indicators, premium should be placed on variables, such as money, that are observed timely and accurately. Second, modern theories of the transmission mechanism based on the credit supply suggest that bank balance sheets size and composition may play a key role in the propagation of shocks, whether originating from monetary policy or from other sources. |
Hence, the conclusion that money is an irrelevant indicator is not robust. The ECB strategy simply reflects this result and, in addition, it adopts the view that the theoretical and empirical long run relationship between money growth and inflation, on the one hand, and the uncertainties surrounding the short run functioning of the transmission mechanism, on the other hand, place the burden of proof on those who deny a useful role for money, not on those who advocate it. As also emphasised by Baltensperger ('La Banque centrale européenne et sa politique monétaire', Swiss National Bank Quarterly Bulletin 1, pp. 48-73, 2000), showing that money plays no role within a model in which it is excluded a priori can hardly be seen as a convincing proof. |
Finally, the ECB monitoring group organised by the Centre for European Policy Studies has taken a milder critical position. On the central issue of money, it has claimed that money should indeed play an important role in the ECB strategy, but mainly in view of the apparent link between asset price inflation and excess supply of liquidity (see www.ceps.be). While noting that asset price bubbles can develop and burst without effects on consumer price inflation (as in the Japanese experience), Gros et al. (Quo Vadis Euro?, 2000) express the view that it is useful to monitor money growth carefully when it deviates persistently and over extended periods of time from the reference value. This position is not inconsistent with our own. The logical relationship between money and prices is complex and, at least in some circumstances, it could indeed unfold through asset price dynamics that anticipate future developments of aggregate demand incompatible with the maintenance of price stability. Asset price movements could, in other words, represent one of the channels through which the link between monetary developments and future threats to price stability manifests itself. |
Conclusion
To summarise, the lack of consensus amongst different observers of the ECB often strikes as more profound than the disagreement of each critic with the ECB itself. Within diametrically opposite views, the position of the ECB emerges as a reasonable midpoint, which reflects recent advances in economic research without jumping on the train of the currently most fashionable theory and without forgetting long-established results. |
Nevertheless, the ECB continuously makes an effort to be involved in the debate with its critics, through an intense economic seminars programme and through active participation in academic conferences, most notably the ECB Watchers Conferences in Frankfurt. This reflects the view that 'never has the situation been more urgent to exploit the potential gains [from trade in ideas between central bankers and academics] than in the current context as we embark on the hazardous process of monetary union in Europe' (Issing, 'The ECB and its Watchers', speech delivered at the ECB Watchers Conference, June 1999). |
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