Central banking in a monetary union: reflections on the proposed statute of the European Central Bank

Carnegie-Rochester North-Holland

Conference Series on Public Policy 38 (1993) 231-238

Central banking in a monetary union: reflections on the proposed statute of the European Central Bank A comment Marvin

Goodfriend*

Reserve Bank of Richmond,

Federal

Richmond,

VA, 23261,

USA

Institutional structure is of little interest to economists trained to identify a firm with a production function, or a government with a social-welfare function. From the perspective of traditional economics, it is hard to see why businessmen and bureaucrats care so much about structure. Modern agency and contract theory, however, tells us that structure influences the incentives of individuals in an organization and therefore the behavior of the organization itself. Since this is no less true in the public than the private sector, one suspects that the legal structure of the European Central Bank might matter a great deal. I begin the body of my comments below with a very brief summary of the proposed

structure

of the European

Central

Bank.

Next, I discuss some

pitfalls of excessive decentralization. After that, I comment on problems that the European Central Bank might experience, given its statutory structure, in delivering price stability. Finally, I address issues in banking policy. Statutory

structure

in brief

The European monetary union is to be a federal one, known as the European System of Central Banks. Policy is to be formulated by a Governing Council composed of a six-member Executive Board and a Governor from each of the *Senior author’s Federal

Vice President

and Director

alone and not necessarily Reserve

of Research.

those of the Federal

The

views expressed

Reserve

here are the

Bank of Richmond

or the

System.

0167-2231/93/$06.00

0 1993 - Elsevier Science Publishers B.V.

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(currently twelve) national central banks whose country is in the European Economic Community (EEC). The Governing Council will meet regularly at a facility to be known as the European Central Bank, and the Executive Board will have its offices there.

The Governors,

however, will work mainly

at their own national banks, visiting the European Central Bank for regular Governing Council meetings. Policy decisions will require a simple majority vote, and policies formulated by the national

banks.

The problem

of excessive

by the Governing

council will be implemented

decentralization

As currently structured, policymaking power in the European Central Bank The twelve national central bank Governors will be highly decentralized. could easily outvote the six Executive Board Members on the Governing Council. Moreover, at least for a while, the EEC will continue to have a weak central government, so there will be little political force, outside the European Central Bank, making the Governing Council care about EEC conditions

as a whole.

The extreme regional decentralization of the Governing Council is reminiscent of the early Open Market Committee of the Federal Reserve. Established informally in 1922 with five of the twelve Research Banks, its membership was broadened to include all twelve banks in 1930 before it took its modern form, in the Banking Act of 1935, led by a Chairman with six other members of a Board of Governors and five of the twelve Reserve Bank Presidents. As is well-known decentralized

from Friedman

structure

and Schwartz

(1963,

of the Open Market Committee

pp. 407-419),

the

in the 1920s depended

for its stability on the leadership of Benjamin Strong, Governor of the Federal Reserve Bank of New York. Strong was a preeminent personality who had the confidence of financial leaders inside and outside the Federal Reserve. While he lived, his powers of persuasion, personal courage, and good judgment gave coherence and purpose to Federal Reserve policy. [See Chandler (1958).] After Strong died in October 1928, however, the Open Market Committee became unworkable. As Friedman and Schwartz (p. 416) put it, a committee “consisting of independent persons from widely separated cities, who share none of that common outlook on detailed problems or responsibilities which evolves in the course of long-time collaboration . . . is likely to be able to take decisive action only if it happens to include a man who is deferred to by all the rest and is accustomed to dominate.” The Federal Reserve lacked such a man in the absence of Governor Strong. Without such personal leadership, the highly decentralized structure of power within the Federal Reserve made for drift and indecision. 232

The 1935 centralization

of Open Market Committee

power in the Board of

Governors, appointed by the President of the United States, solved the problem of excessive decentralization. Recently, there has been serious discussion of removing Reserve Bank Presidents from the Open Market Committee enhowever, is tirely. [See Wessel and Wartzman (1992).] F ur th er centralization, not needed to eliminate

drift and indecision.

The balance

between

Regional

and Board representation struck in 1935 has worked well in the Open Market Committee, and absolute centralization would jeopardize the independence of the Federal Reserve by potentially President of the United States.

bringing

it under the control

of the

As it is currently structured, the extremely decentralized Governing Council of the European Central Bank, the counterpart of the Federal Reserve’s Open Market Committee, is susceptible to the same indecisiveness as was the early Open Market committee. In the absence of a statutory Chairman who can dominate the Council with the help of the Executive Board, the Council’s power to deliver coherent and decisive policy will likely need a single individual with the skill, force of personality, and stature of a Governor Strong. Too many able men of equal ability might lead to conflict and paralysis; none, to indecisiveness. Restructuring the Governing Council, along the lines of the modern Open Market Committee, would avoid such problems.

Maintaining

price

stability

Article 105 of the proposed statute for the European Central Bank says that its primary objective is to maintain price stability, and that it shall support policies of the European Community aimed at achieving other objectives such as economic growth and high employment, but without prejudice to its price stability objective. Such explicit statutory language seems remarkable from the U.S. point of view, where only recently congress rejected a resolution proposed by Stephen Neal to give the Federal Reserve a mandate for price stability.

[See Black (1990).] Th e mandate for price stability given to the European Central Bank will no doubt help to fight inflation. But how will the highly decentralized structure of the Governing Council affect the European Central Bank’s ability to actually deliver stable prices?

One view is that decentralization insulates a central tionary pressures emanating from the central government.

bank from inflaIn the U.S., for

example, having Reserve Bank Presidents on the Open Market Committee probably cushions the Federal Reserve somewhat from administration pressure for faster money growth. [See Gildea (1990).] This view makes sense for the U.S. because there is a strong federal government with a strong executive. Moreover, Federal Reserve districts each contain many states and even cut across state lines; and the selection 233

process for Reserve

Bank

presidents

is essentially

independent

of state politics.

The EEC, however, has a relatively weak central government, and the regional representatives on the Governing Council are Governors of national central

banks.

My concern

is that with such a structure,

national

political

pressures might easily produce a majority on the governing Council favoring inflationary monetary policy because of its perceived pro-growth effects or its potential

seigniorage.

To avoid this problem,

proposed a scheme for regional representation deliberately scrambles national interests.

(1990)

has actually

on the Governing

Graboyes

Council that

Under the European Monetary System currently in place, the Bundesbank is the leader and effectively determines, through the fixed exchangerate mechanism, monetary policy for the EEC as a whole. [See Giavazzi and Giovannini (1989).] It is not at all clear, however, that Germany will be able to exert monetary discipline in a Governing Council where decisions are taken by majority vote. The proposed statute for the European Central Bank is apparently silent on the disposition of seigniorage. The way this issue is settled, however, could affect the incentive of members on the Governing Council to vote for inflationary policy. For example, returning annual earnings of the European Central Bank to national governments on some basis, perhaps prorated by relative size of GDPs, would give countries an incentive to pressure the European Central Bank, through their representatives on the Council, to inflate. On the other hand, national central bank Governors, who are in the majority on the Governing Council, might be less interested in inflation if the proposed statute allowed European Central Bank earnings to be spent by the Of course, this latter disposition of seigniorage might central government. lose its price-stabilizing incentive effects if the structure of the Governing Council were changed to give the Executive Board a majority, or if the central EEC administration arranged to share these revenues with the national governments. In any case, the incentive

to pursue inflationary

policy would be mini-

mized by reducing seigniorage. One way of doing so would be to pay interest on required reserves. Better still, since reserve requirements are not necessary to implement monetary policy, they could be eliminated entirely. [See Goodfriend and Hargraves (1983).] F ree - market interest rates on bank liabilities and full-service checkable deposit services would also reduce seigniorage by reducing the demand for currency. In addition to obtaining the revenue from seigniorage, narrowly defined, member countries would have an incentive to inflate to reduce the real value of any nominal debt they might have outstanding; and inflation would raise still more revenue if taxes were not fully indexed. Strictly enforced statutory debt ceilings and full indexation of taxes would be useful to remove these 234

additional

incentives

Banking

policy

to inflate.

Giovannini has pointed out the lack of attention to banking policy in the statute as currently written. In this final section I would like to suggest two aspects of banking policy that might beneficially be considered in a revision. For the most part, chartering, branching, supervision, and regulation continue to be the domain of national governments. EEC countries moving rapidly to deregulate and unify their banking and financial markets, however, should be mindful of the problems with deposit insurance that plagued the U.S. in the 1980s. For the most part, European deposit-insurance systems have been supported by relatively relaxed rules for supervision and regulation. Such rules worked reasonably well as long as international banking was restricted and banking was heavily concentrated and even cartelized within individual national markets. But free, continent-wide banking will bring an end to such protected markets, requiring more formal regulation and supervision to protect government deposit insurance against abuse by bank The statute for the European Central Bank would seem to be a managers. natural place to formalize an EEC-wide set of rules for regulation and supervision. These could, at least in part, be managed by the Governing Council or its Executive Board and administered by the national central banks. Apparently, not much if anything was said in the proposed statute about another important instrument of banking policy ~ central bank discountwindow lending. Will each national central bank have the right to decide for itself whether to make loans to banks in its own country? Will the discount rate be set by the Executive Board or the Governing Council? Having it set by the Executive Board would correspond more closely to Federal Reserve practice. But having it set by the entire Governing Council would allow for better coordination of discount and monetary policy. These and other questions

ought to be addressed

in the statute.

[See Goodfriend

(1993).]

For discount-window policy to be run efficiently, a central bank should monitor potential borrowers on an ongoing basis in order to lend only to illiquid and not to insolvent banks. Thus, the European Central Bank should supervise and regulate borrowers eligible to use its discount window, though it could conceivably judge the appropriateness of discount-window credit on the basis of supervisory information collected elsewhere and made available to it on a timely basis. Discount-window lending could be inappropriate even if the European Central Bank required good collateral to back discount-window loans. Requiring good collateral protects the central bank from loss in the event of a default. Discount window lending, however, often serves to pay off unin235

sured depositors, who run a bank at the first sign of trouble. Such lending has the effect of stripping assets from the institution, potentially raising the cost to the government of covering insured deposits if the bank turns out to be insolvent. In the presence of deposit insurance, the government agency responsible for cIosing banks should safeguard public funds by closing insolvent banks promptly. resolution Central with the Bank is terms of

To prevent of insolvent

an open-discount institutions,

window from delaying

discount-window

the timely

officers of the European

Bank should cooperate closely with government agencies charged responsibility for resolving bank failures. If the European Central to operate a discount window, it would be useful to spell out the such cooperation in the proposed statute.

236

References

Black, R.P., (1990). Richmond,

Economic

In Support of Price Stability, Review, (January/February),

Chandler, L., (1958). B en j amin Strong, The Brookings Institution. Friedman, M. and Schwartz, A., (1963). States, 1867-1960. Princeton: Princeton

Federal Reserve Bank of 3-6.

Central Banker.

Washington,

D.C.:

A Monetary History of the United University Press.

Gildea, J., (1990). E x pl aining FOMC Members’ Votes, Thomas Mayer, (ed.), The Political Economy of American Monetary Policy. New York: Cambridge University

Press.

The New Palgrave Dictionary Goodfriend, M., (1993). D iscount Windowjn of Money and Finance, Newman, Peter, Murray Milgato, and John Eatwell, teds.). Goodfriend, M. and Hargraves, M., (1983). An Historical Assessment of the Rationales and Functions of Reserve Requirements, Federal Reserve Bank of Richmond, Economic Review, (March/April), 3-21. Graboyes,

R.F., (1990).

Street Journal/Europe,

A Yankee Recipe for a EuroFed Omelet.

The Wall

August 1.

Giavazzi, F. and Giovannini, A., (1989). Limiting Exchange Rate Flexibility: The European Monetary System, Cambridge, Mass.: MIT Press. Wessel, D. and Wartzman, R., (1992). Brady Backs Review of Plans to Alter Fed, The Wall Street Journal, August 5.

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