The European Central Bank

By Michael Heine and Hansjörg Herr

The European Central Bank administers monetary policy for the eurozone and is tasked with maintaining price stability by keeping inflation below 2 per cent. This brief mandate belies the complexity of managing the monetary policy for the 19 member states of the euro, not to mention the political implications thereof.

This book sets out the history, development and day-to-day workings of this key institutional pillar of the European Union. It assesses its work, independence, the policies and instruments at its disposal and the evolution of its role during, and after, the eurozone crisis of 2010. Incomplete monetary union, Germany's hegemonic ambitions and different economic policies from individual member countries are shown to pose formidable challenges to the ECB's macroeconomic management.

• Language: English
• Publisher: Agenda Publishing
• Release date: Nov 19, 2020
• ISBN: 9781788212977

Michael Heine

Michael Heine is Professor at Hochschule für Technik und Wirtschaft Berlin at the University of Applied Sciences, Berlin.

Book preview

THE EUROPEAN CENTRAL BANK

Finance Matters

Series Editors: Kathryn Lavelle, Case Western Reserve University, Cleveland, Ohio and Timothy J. Sinclair, University of Warwick

This series of books provides advanced introductions to the processes, relationships and institutions that make up the global financial system. Suitable for upper-level undergraduate and taught graduate courses in financial economics and the political economy of finance and banking, the series explores all aspects of the workings of the financial markets within the context of the broader global economy.

Published

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Michael Heine and Hansjörg Herr

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Jonathan Ashworth

THE EUROPEAN CENTRAL BANK

MICHAEL HEINE AND HANSJÖRG HERR

© Michael Heine and Hansjörg Herr 2021

This book is copyright under the Berne Convention.

No reproduction without permission.

All rights reserved.

First published in 2021 by Agenda Publishing

Agenda Publishing Limited

The Core

Bath Lane

Newcastle Helix

Newcastle upon Tyne

NE4 5TF

www.agendapub.com

ISBN 978-1-78821-294-6 (hardcover)

ISBN 978-1-78821-295-3 (paperback)

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Typeset by Newgen Publishing UK

Printed and bound in the UK by CPI Group (UK) Ltd, Croydon, CR0 4YY

CONTENTS

Tables and figures

Preface

1.Introduction: European integration

2.From the Bretton Woods system to European Monetary Union

3.The Maastricht Treaty and the Stability and Growth Pact

4.Structure, political and legal framework of the European Central Bank

5.Preconditions for a stable monetary union

6.The failure of the two-pillar strategy of the ECB and the revival of Wicksell

7.Increasing economic fragility in the EMU before the financial crisis

8.Monetary policy during the Great Recession

9.Monetary policy and the escalation of the euro crisis until 2012

10.The ECB holds the euro together

11.The fiscal policy framework in the EMU: no partner for the ECB

12.Financial market supervision, banking union and financial market regulation

13.The Covid-19 crisis and its effects on the EMU

14.Prospects for European monetary policy and EMU

Notes

Bibliography

Index

TABLES AND FIGURES

TABLES

  7.1Net financial assets by sector in selected EMU countries (% of national GDP), 2001 and 2009

10.1The asset purchase programme of the ECB, monthly net purchases

10.2The asset purchase programme stocks, October 2019 (in € million)

12.1Capital requirements for banks in the EU (% of risk-weighted assets)

13.1Levels of fiscal impulse and deferrals/liquidity guarantees adopted in response to the Covid-19 crisis by 15 June 2020 (% of 2019 GDP)

13.2Private debt in selected EMU countries (% of GDP)

FIGURES

  1.1Governance structure of EU and EMU

  2.1Bilateral exchange rates against the US dollar for selected EU countries, 1970–2000

  4.1The organizational structure of the European System of Central Banks

  6.1Annual growth rates of M3, consumer price index and real GDP in the EMU, 1999–2019

  6.2Refinancing rates of the ECB and money market interest rate, 1999–2019

  6.3The euro–US dollar exchange rate, 1999–2020

  7.1Real GDP in selected EMU countries, 1998–2018

  7.2Long-term interest rates in selected EMU countries, 1989–2019

  7.3House prices in selected EMU countries, 1998–2018

  7.4Share prices in selected EMU countries, 1999–2019

  7.5Nominal labour compensation per hour worked in selected EMU countries, 1996–2018

  7.6Nominal unit labour costs in selected EMU countries, 1996–2018

  7.7Consumer price index in selected EMU countries, 1998–2020

  7.8Current account balances in selected EMU countries (% of GDP), 1998–2018

  7.9Budget deficit in selected EMU countries (% of GDP), 1998–2018

7.10Government debt in selected EMU countries (% of GDP), 1998–2018

7.11Main refinancing rate of the ECB and the federal funds rate of the Fed, 1999–2019

  8.1Total hours worked in selected EMU countries and the US, 1998–2018

  8.2Unemployment rates in selected EMU countries, 1999–2019

  8.3Balance sheets of ECB and Fed (% of domestic nominal GDP), 2003–19

  8.4General government structural budget balances (% of potential GDP) in selected EMU countries and the US, 1999–2019

  8.5Public investment (% of total gross capital formation) in the EMU, US and Germany, 1999–2019

  9.1Target2-balances of selected EMU countries, 2008–19

10.1Credit to the private sector in the EMU (€ billion) and the US ($ billion), 1996–2019

12.1European system of financial supervision

PREFACE

With the creation of the European Monetary Union (EMU) in 1999, the participating member states took a bold step towards further economic and political integration. The development followed the logic of European integration since the Second World War – start with economic integration and political integration will follow. However, the creation of a monetary union implies that member states are giving up national sovereignty and establishing supranational institutions. At the very least a supranational central bank is needed to manage the EMU’s monetary policy.

The preparation for the implementation of monetary union was far from complete. The European Central Bank (ECB) was created but other powerful supranational institutions in the EMU were missing. A vacuum developed with insufficient institutions in the EMU to manage its macroeconomic development while reducing room for manoeuvre for macroeconomic policy at the national level. The history of EMU is a history of the ECB struggling with the incompleteness of the monetary union. Cooperation among states could have reduced the lack of institutions in the EMU. However, cooperation was insufficient and became interwoven with the struggle of different member countries to increase or defend their influence and enforce their own economic policy strategy. Germany as the biggest country in the EMU followed hegemonic ambitions. However, its power and willingness to stabilize the whole monetary union was incomplete.

With this in mind, we analyse the history of the EMU and especially the policy and role of the ECB in the framework of macroeconomic management. The first draft of the book was finished in early 2020, just as the Covid-19 crisis hit Europe. We then added Chapter 13 to provide some analysis of the early response to the crisis – as far as this is possible in June 2020.

We would like to thank Alison Howson for support and debates and for her encouragement to write this book. We also thank an anonymous reviewer for helpful comments. Last but not least, we thank Lukas Handley for his technical support.

Michael Heine

Hansjörg Herr

1

INTRODUCTION: EUROPEAN INTEGRATION

The idea of creating a borderless Europe, while preserving the cultural independence of the individual countries or regions, is centuries old. In recent history, the first moves towards political European integration date back to the early twentieth century, but the First World War put paid to any ideas of integration and left Europe divided. It was not until after the Second World War that the first serious attempt at European integration took place. The United States, in particular, strongly encouraged and supported economic and political integration in Europe, as a strong Europe provided a buffer to Soviet ambitions during the Cold War. The American European Recovery Program, also known as the Marshall Plan, made a considerable financial and political contribution to integration in the western part of Europe and included cooperation between the formerly hostile countries.

A formal alliance between the main continental European countries became concrete in 1951 (in force 1952) with the foundation of the European Coal and Steel Community, signatories to which were Belgium, the Federal Republic of Germany, France, Italy, Luxembourg and the Netherlands. These six countries also founded the European Atomic Energy Community, including Euratom, as a joint international organization in 1957 (in force since 1958).

In 1957 (in force 1958) the Treaty of Rome, the treaty establishing the European Economic Community (EEC) was agreed. The main focus of this agreement was on the stepwise reduction of customs duties between the member states and the common organization of agriculture. The customs union decided in the Treaty of Rome came into force in 1968. A further step towards integration took place in 1967 when the three previous agreements were merged to form the European Community (EC). These integration steps were accompanied by the expansion of the Community with the accession of new member states.¹

At the monetary level, in the 1950s and 1960s, European integration took place under the umbrella of the Bretton Woods system signed in 1944 and established in 1946. The system implemented fixed exchange rates, which could only be changed by agreement of the member states. The US dollar became the world’s reserve currency. The International Monetary Fund (IMF) and the World Bank were founded as the Bretton Woods’ institutions. The system guaranteed stable exchange rates and a stable international monetary system until the end of the 1960s. The system collapsed in the early 1970s pushing the EC-countries into a period of monetary instability. As a response the European Monetary System (EMS) was founded in 1979, which formed the monetary framework for the integration of the EC until the European Monetary Union (EMU) of 1999. In the EMS, Germany’s Deutschmark dominated the system and the Deutsche Bundesbank more or less dictated monetary policy for all EMS-member countries (see Chapter 2).

After the Treaty of Rome, with the exception of the EMS, there were no further attempts to deepen integration for a long time. The EC was completely preoccupied with the enlargement process and there was no political mobilization for further integration. This changed in the mid-1980s. In 1986 (in force 1987) the European Single Act was passed. The aim of which was to create a common internal market by the end of 1992. Until then, the customs union formed the core of European integration, which excluded many sectors including the insurance and banking industry and transport to public tenders. The four (indivisible) freedoms to be implemented in the European Single Act were:

1. Free movement of persons (e.g. abolition of border controls, freedom of establishment of firms and employment);

2. Free movement of all services (e.g. liberalization of financial services and transport and communications sectors);

3. Free movement of all goods (e.g. elimination of customs duties and non-tariff restrictions);

4. Free movement of capital (e.g. liberalization of financial markets, elimination of existing capital controls).

By the end of 1992, all of the goals set out in the Act had been achieved.

Jacques Delors, president of the European Commission from 1985 to 1995, was the main driving force behind monetary integration. In 1988, the heads of governments of the member states of the EC instructed Delors to chair a committee to draw up proposals for monetary integration.² In April 1989, the committee presented the Report on Economic and Monetary Union in the European Community, known as the Delors Report. This provided a plan for a monetary union for the countries of the EC, which was to be established gradually. At the summit of EC heads of government in June 1989, however, the report was controversially received. According to Niels Thygesen (1989), one of the independent expert contributors to the Delors Report, the divisions were over its political and economic implications: Behind the apparent defeatism of many British comments on the feasibility of economic and monetary union lies another, deeper concern … [would] government not feel unacceptably constrained by adherence to an economic and monetary union in implementing its policies? (Thygesen 1989: 650f.).

Britain was not prepared to give up the freedom to follow its own economic policy. For Germany which dominated the EMS the present EMS is in some respects so attractive from a German viewpoint that it may be difficult to persuade Germany to reform the system (Thygesen 1989: 647). The establishment of an independent central bank, the clear objective of price stability in a monetary union and the proposal in the Delors Report for budgetary rules made the project more appealing for the Germans. France actively supported the plan for a monetary union in the Delors Report. It was obviously convinced that it would be able to compete successfully with Germany in a monetary union, having already lost much of its monetary policy autonomy to Germany in the EMS anyway. Italy and smaller EMS countries followed the French line.

The plan to establish a monetary union followed the so-called locomotive theory. The locomotive theory, which most European politicians followed when deciding on monetary union, states that a common currency would create realities that would push for further integration and advance the formation of a European state. This followed the logic of European integration after the Second World War, which was always driven by economic integration steps. However, the locomotive theory is yet to be confirmed in the case of EMU – the resistance of member states to take further steps towards state formation, in addition to the ECB, has been too great. Some important integration steps took place, but so far the expectations of the locomotive theory have not come to pass. Criticizing the locomotive theory, the Deutsche Bundesbank has always favoured the coronation theory, in which a common currency should only be introduced after unification of economic and financial policy in the EU and after substantial political integration (Deutsche Bundesbank 2016: para 10). However, this has to be taken in the context of a Bundesbank that was not in favour of the quick realization of monetary union.

The revolution in the German Democratic Republic, the fall of the Berlin Wall in November 1989 and East Germany’s accession to the Federal Republic of Germany in 1990 burst in on this debate over monetary union. German unification undoubtedly accelerated the realization of the EMU. Until then, political decision-makers had been extremely cautious. Karl Otto Pöhl (Voxeurop 2010: para 7), then president of the Deutsche Bundesbank, said of the currency reform: I was convinced that wouldn’t come for another hundred years. France’s president at that time, François Mitterrand, stated: Germany can only hope for reunification, if it stands in a strong Community (Voxeurop 2010: para 9). In contrast to the United States, other countries, such as the UK and Italy, were sceptical about German reunification. Without a doubt, the EMU would not have been realized so quickly, nor existed in this form, without the developments in Germany. In effect, Germany accepted French demands for monetary union in exchange for unification (Black et al. 2018: 28 ff.; van Middelaar 2019). In February 1992 (in force since 1993) the Maastricht Treaty was signed, and the creation of a monetary union was decided. It was then established at the beginning of 1999 (see Chapter 2). In 1992, the EC was renamed the European Union (EU).

From a narrow economic perspective, nation states are defined by their own currencies. If they do not have a national currency, they are a region in a currency area. By implication, the decision to create the EMU was a major step towards deeper integration and not comparable with the previous gradual evolutionary integration process in Europe. The importance of this fact cannot be underestimated, and it will be dealt with intensively in the following chapters.

In addition to monetary union, the Maastricht Treaty established two further pillars of integration: the Common Foreign and Security Policy and cooperation in Justice and Home Affairs. There was little further development of either pillar, which reflects the philosophy of the Maastricht Treaty not including a vision of a European state. EU enlargement also continued.³ In early 2020, 19 member states had adopted the euro.

The creation of a monetary union like the EMU implies a radical reduction of national sovereignty. Different dimensions play a role here (Cohen 1998). First, a national currency is a national symbol and part of national identity. Hans Tietmeyer, president of the Deutsche Bundesbank from 1993 until 1999, expressed this for the Germans: The German people have a broken – interrupted – relationship with their own history. They can’t parade like others. They can’t salute their flag with the same enthusiasm as others. Their only safe symbol is the Mark (quoted in Cohen 1998: 37). Second, to give up the national central bank means losing possibilities of seigniorage: the government no longer benefits from the profits made by the central bank. For currencies with an international role, seigniorage creates substantial benefits for governments. Third, national governments lose a lender of last resort for public households. In times of great need, they cannot rely on a central bank to provide financial means in crises situations. In several chapters that follow we show that this point has played an important role in the short history of the EMU. Finally, a national currency increases the freedom of national macroeconomic policy. It allows depreciations or a nationally oriented interest-rate policy. Of course, the room for manoeuvre for national macroeconomic policy depends on the openness of a country and especially the openness of the capital account and the international role of the currency. Even with high capital mobility, in developed countries with their own currencies, for example Sweden, the UK or Canada, some room for monetary policy exists, which nations in a currency union do not have.

A number of treaties followed, with the Lisbon Treaty of 2007 (in force 2009) being the most important.⁴ The Treaty transferred limited rights to the EU level. Among other things, the application of qualified majority voting (QMV) for certain decisions was introduced. The rights of the European Parliament were also strengthened.

Despite these integration steps, the EU continues to operate more as a confederation of states than as a federal one. In a confederation of states, the sovereignty of the member states is preserved. Although they can transfer rights to a central level, they can also withdraw them and even withdraw from the confederation entirely, for example, as the UK has done. In the case of federal states such as the United States, individual states join together to form a sovereign federation, whereby the relations between the federal state and the member states are legally regulated. In this case, the central state assumes certain overarching competencies such as defence, internal security, diplomatic representation and international trade agreements. It regulates the tax system and collects its own federal-level tax revenues. Central government institutions also determine monetary and fiscal policy. There is no such central state in the EU, and there are no strong independent institutions at a central level – except for the European Central Bank (ECB).

The power centre of the EU is the European Council (see Figure 1.1). The European Council website states: The European Council defines the EU’s overall political direction and priorities (European Council 2019). Only the heads of government of the EU member states vote in the European Council. Since 2009 the European Council selects a president for a two-and-a-half-year term. For specific areas there are the European Councils of Ministers, for example, the important Economic and Financial Affairs Council (ECOFIN) with the finance and economics ministers of the EU countries, the European Forestry and Environmental Skills Council, etc. Votes in the Councils are in many cases majority decisions, whereby 65 per cent of the EU population and 55 per cent of the EU member states are needed to achieve a majority. Decisions in the so-called sensitive areas must be made unanimously, for example on common foreign and security policy, EU finances or harmonization in the area of tax law or social security. It goes without saying, therefore, that there is no common army or police force in the EU. The member states are also responsible for their own social security. For example, there is neither a European pension system nor a European unemployment insurance scheme.

Figure 1.1 Governance structure of EU and EMU

Although the European Parliament is directly elected by the EU population, it has no exclusive legislative competence as normal national parliaments do. Laws, called directives, can only be passed jointly with the European Council. If there is no agreement, the draft laws are not implemented. However, the European Parliament has the right to be consulted on a number of issues.

The members of the European Commission (ECo) are proposed to Parliament by the European Council. Parliament can only reject the ECo proposed by the Council as a whole – and not individual commissioners. The ECo has mainly administrative tasks such as monitoring directives. It can also introduce its own legislative initiatives. Finally, the European Court of Justice monitors and interprets European laws.

The ECo manages the EU budget, but neither it nor the European Parliament can issue taxes. This means that the EU central level cannot issue government securities or otherwise borrow to finance budget deficits. An anti-cyclical fiscal policy at the central level is thus ruled out. EU financing is essentially based on transfers from member states.⁵ The EU central budget stagnated at an average value between 2014 and 2020 of around 1 per cent of the EU’s gross domestic product (GDP), with a downward trend – during the 1990s the value was around 1.25 per cent. The EU central budget must be adopted unanimously by the member states after obtaining the consent of the European Parliament. In terms of 2014–20 expenditure, the agricultural sector accounted for 39 per cent, followed by the cohesion fund (34 per cent) and expenditure to increase competitiveness (13 per cent) (EU 2018). By comparison, the central budget in the US accounts for over 20 per cent of GDP (US Government Publishing Office 2019).

With some exceptions, the EMU’s governance structure is integrated into the EU governance. The big exception is the central bank of the euro area. The ECB is an extremely powerful institution at the central level of the EMU and as such can make its own decisions. But because in the EU there is no fiscal power in the EMU, it has no separate central budget. In this regard, EMU-countries are normal members of the EU. The EMU is therefore in a unique historical position: in the field of monetary policy it has the character of a nation state, but in almost all other areas it does not.

With the establishment of the EMU, the Eurogroup was created. It consists of the finance or economics ministers of the countries belonging to the EMU. Since 2005, the Eurogroup has elected a president for a two-and-a-half-year term. The Eurogroup has no formal powers and cannot enforce decisions. However, the informal power of the Eurogroup is significant as it dominates the European Council. For example, it monitors the budgetary policies of the EMU countries and important economic policies concerning the EMU are discussed there.

The ECB is the most powerful supranational institution in the EMU. In the Governing Council of the ECB, each governor of the national central banks has a seat. The European Council appoints a president, a vice-president and four directors of the ECB’s Executive Board. All members of the Executive Board belong to the Governing Council of the ECB (for details see Chapter 4).

The EMU has not led to the formation of a European state. Political power lies with the European Council and, respectively, the Eurogroup. The EU/EMU structure is flanked by an immense number of intergovernmental agreements designed to compensate for the lack of a genuine supranational authority. The governance system of the EU and the EMU is between an intergovernmental and a supranational governance system, as the European Council and the Eurogroup are the power centres of the system. For the EMU this kind of middle system has been strengthened by specific EMU institutions which were created after the 2007/08 financial crisis to handle its consequences (Polster 2019). The analysis in the following chapters of the ECB, its monetary policy and the EMU will show that the lack of a supranational governance system poses a fundamental problem for the ECB and the stability of the EMU as a whole.

Following this brief overview of European integration, we will examine the ECB, its policies and their interactions with other macroeconomic policies in the eurozone in more detail. We start with the turbulence in foreign