November 15, 1990 eCONOMIC COMMeNTORY Federal Reserve Bank of Cleveland

A European System of Central Banks: Observations from Abroad by W. Lee Hoskins

Xhe European Economic Community, movement of goods, services, labor, and capital. The gains from trade, as re- hoping to strengthen the economic bene- In an effort to enhance the economic sources seek their most efficient use, fits of the single-market initiative, seems advantages of a single market, the will occur with or without the establish- headed toward monetary union as out- European Economic Community is 1 ment of a common monetary policy or lined in the Delors Commission's report. considering monetary union. A the existence of a single currency. In the That route would eventually establish a European System of Central Banks last century, the various German states European System of Central Banks would be structured after the Ger- achieved substantial economic gains (ESCB) with powers to conduct a com- man Bundesbank model and vested from the Zollverein (customs union) mon monetary policy and, presumably, with the power to conduct a single before they achieved political and mone- to issue a single European currency. monetary policy and perhaps issue a tary union. Nevertheless, with appro- common currency. In a recent speech priate safeguards, a monetary union can Throughout history, nations have devised to a group of German bankers and augment the benefits of a single market. many institutions to carry out these same business representatives, Cleveland tasks, often relying primarily on the pri- Federal Reserve Bank President W. vate sector and market discipline, and giv- Discussions of monetary union often Lee Hoskins argued that price sta- ing governments a minimal role. Today, emphasize the gains that could result bility must be the sole objective of a central banks, functioning as extensions from eliminating the exchange risks and central bank, and pointed out some of governments and issuing fiat curren- currency-conversion costs associated pitfalls that the Community must cies, attempt to ensure monetary stability. with intra-European trade. In reality, avoid if monetary union is to be However, we have come to call upon cen- however, these costs are relatively small successful. tral banks to perform many operations and unimportant. Any benefits from Eur- that extend well beyond this traditional opean monetary union will result most role. The poor record of central banks directly from the ability to strengthen with respect to price stability reflects this money as a medium of exchange, as a who hold that money or who denomi- diffusion of purpose. temporary store of value, and as a unit nate their wealth in it. When that trust is of account. Acting in these capacities, eroded, individuals and businesses In the context of comments on the money reduces the information and devise elaborate and expensive schemes Delors report, I will describe those transaction costs associated with com- to minimize their cash holdings and to institutional attributes that allow central merce, thereby allowing for better deci- protect their wealth. Such unproductive banks to focus solely on their primary sions, longer-term contracts, and im- uses of resources necessarily lessen the objective: price stability. proved productivity. economic benefits afforded from the use of money. Should the trust between • Economic Benefits of a As the German people know so well, issuers and holders of money collapse Monetary Union the economic efficiencies of money completely, so too will the functions of Benefits of the economic unification of depend first and foremost on the stabil- money, and trade will revert to barter. Europe will accrue primarily from the ity of its purchasing power. Issuers of removal of artificial restraints on the money must forge a trust with those

ISSN 0428-1276 • The Primary Objective of a usage, for example, price stability has Community to adopt a similar price- Central Bank: Price Stability at least three interpretations. To some, stability directive. The primary role of a central bank is to it implies that prices can rise, but not to provide an immutable guarantee of the such an extent that inflation affects pri- I have suggested that the Federal long-term stability of the purchasing vate decisions. Others interpret price Reserve System adopt a stable price power of money. In this way, a central stability as an expected zero-inflation level as the sole target for monetary pol- bank maximizes the efficiencies that rate, but see no need to offset actual icy. When prices deviate from the base- money affords and creates an environ- jumps in the price index. Accordingly, line level, the System must act to bring ment conducive to sustained growth in the price index can drift up or down. prices back in line.5 I also support Con- a nation's standard of living. Countries A third interpretation of price stability gressional legislation to underscore the with relatively low, stable rates of infla- requires the central bank to offset any importance of price-level targeting. Such tion seem to experience relatively deviations in the price level from its a system would be simple to monitor, faster rates of real economic growth. baseline value. and the legislature could easily hold the Price stability not only eliminates the central bank accountable for attaining need to hedge against inflation, but it The Bundesbank views its principal the goals of the directive. removes an important source of uncer- directive, "safeguarding the currency," tainty associated with making long- as a mandate for price stability in the • An Institutional Structure to term contracts and committing to long- sense of not allowing inflation to affect Achieve the Price-Stability Objective term investments. Price stability also private decisionmaking. More impor- To secure a goal of price stability for cements the social contract whereby tant, the Bundesbank interprets this the ESCB, the European Community governments do not impose taxes on directive very narrowly in its operations, must craft an institutional structure wealth without the consent of their exhibiting a general distaste for inflation capable of carrying out that task. The citizens." The uncertainty and hidden exceeding 2 or 2.5 percent per year. Con- structure must offer no leeway for polit- taxes that inflation generates reduce sistent with its legal mandate, the ical maneuvering, which ultimately long-term investments, which have Bundesbank does at times pursue other would undermine the central bank's proven vital to technological advances policy objectives, notably, exchange-rate pledge to maintain price stability. and sustained real economic growth. stabilization. Yet, it has maintained its credibility in pursuing price stability. A perennial issue in the debates about Credibility is important because it The prominence given to price stability central banking — one that is espe- reduces the real economic costs of main- in nearly all proposals for a European cially germane to the establishment of taining price stability in the face of ran- central bank is heartening. The Delors the ESCB — is how to balance central dom economic shocks or policy errors report recommends that price stability bank independence from political pres- that periodically buffet price indexes. be the primary objective of the ESCB sures with central bank accountability and encourages the central bank to sup- to the public. The Delors Commission, port other Community economic poli- As the Delors Commission undoubt- wisely choosing the Bundesbank as a cies and exchange-rate stabilization edly realizes, the Deutsche Bundes- model, recommended that the ESCB be only when price stability is not com- bank Act provides the German central independent of European fiscal author- promised. bank with a foundation for its credibil- ities, but nevertheless noted the need to ity. But more important, through years make the central bank accountable to In recommending this approach, the of steadfastly interpreting its primary the "democratic process." Delors Commission is following the directive narrowly, the Bundesbank has German example of central banking. built a strong reputation for consis- Independence: Countries that afford The Deutsche Bundesbank Act speci- tently pursuing low inflation. This their central banks a high degree of inde- fies that the primary function of the reputation has strengthened a rather pendence typically have experienced Bundesbank is to "safeguard the cur- vaguely stated official objective. No lower rates of inflation.6 The basic rency." The Act also requires the other central bank enjoys a similar requirements to ensure central bank inde- Bundesbank to support the economic level of credibility for price stability. pendence are that the central bank have policies of the federal government, but no obligation to purchase the debt of any only "without prejudicing" its primary The ESCB, initially, will lack such a fiscal authority, and that the respective function. Nevertheless, I am concerned reputation. Because good reputations are finance ministers be excluded from vot- that in some subtle — yet important — slow to build and quick to vanish, many ing on monetary policy. Nevertheless, respects, the Bundesbank model is not economists recommend that central concern remains because most European strictly appropriate for the ESCB. banks adopt rules for price stability that central banks presently assist in financ- are verifiable, unambiguous, and ing their governments' fiscal budgets. Terms such as "safeguarding the cur- enforceable. I have long advocated such Many, for example, prefinance their rency," "monetary stability," or "price a rule for the Federal Reserve System, governments' budgets by buying and stability" are ambiguous. In common and I would encourage the European reselling the debt. Even the Bundesbank can grant temporary short-term credit to nors highlights the importance of a ability — is ambiguous and subject to the government. The ESCB must remain decentralized structure for a central change. Priorities will shift as political free of all hints of fiscal assistance if it bank. Over the past 25 years, as the and economic circumstances alter the hopes to establish credibility for price U.S. price index rose nearly fourfold, implicit weights that elected officials stability. presidents were twice as likely as gover- assign to specific objectives. Being ulti- nors to dissent from the FOMC's mately responsible to Congress, the Fed- Although buying government debt is majority in favor of a tighter monetary eral Reserve System has an incentive to the most direct and obvious linkage policy, while governors were five times alter the weights that it gives to various between central banks and fiscal author- as likely as presidents to dissent from goals. This provides monetary policy ities, indirect channels of influence also the majority in favor of an easier decisions with a myopic focus. Fash- exist. The structure of the Federal monetary policy. ioned in this manner, accountability Reserve System attempts to minimize becomes the antithesis of independence. these indirect connections between the Although Germany has a central bank power to create money and the ability to with a similar decentralized structure, When, instead, legislatures measure ac- spend public funds. For example, the nearly all other European nations seem countability in terms of an operationally System is self-financing: It generates its to favor a more centralized arrangement. unambiguous and technically achievable own revenues, pays its own bills, and As the European Community considers goal, accountability effectively comple- remits its profits to the U.S. Treasury. the governance structure of the ESCB, ments central bank independence by The Federal Reserve is not subject to it should be careful not to adopt a struc- giving the central bank a single long- the appropriations process of the U.S. ture that could compromise the price- term focus. Self-imposed monetary Congress, since this could prove to be stability objective. rules can lack force and credibility with a conduit for political pressures. the public because a believable enforce- Accountability: While supporting the ment mechanism does not exist. Has a The governance structure of a central independence of the ESCB, the Delors central bank policy committee ever dis- bank can also affect its susceptibility to report stresses a need to make the cen- missed itself for generating inflation, or political influence. Within the Federal tral bank accountable to the "democratic for consistently missing a monetary tar- Reserve System, the Federal Open process." Central banks are products of get? When a superior legislative body Market Committee (FOMC) decides governments and as such are naturally that is responsive to the public imposes monetary policy by a majority vote of accountable to the governmental enti- the rules on a central bank, those rules the seven governors and the five voting ties that create them. This accountabil- are more likely to be enforced and are District Bank presidents. The Presi- ity can provide a useful support for cen- more credible. For this reason, I, along dent of the United States appoints the tral banks, or it can become a serious with a number of other Federal Reserve seven governors of the Federal Reserve impediment to their proper functioning. officials, have supported Congressional Board, subject to Senate confirmation. The outcome depends on how a nation legislation that would mandate price To minimize the potential for political or a group of nations frames central stability as the Federal Reserve's influence, the Federal Reserve Act bank accountability. primary goal. stipulates that governors serve a single 14-year term. Each District Bank's When a nation does not assess central • Pitfalls to Avoid board of directors, with the approval of bank performance in terms of an unam- Although most legislatures acknow- the Board of Governors, appoints a biguous, verifiable goal, such as price ledge the importance of preventing president of that regional Reserve Bank. stability, accountability is a detriment to inflation, none specify price stability as The District Bank directors represent the bank's smooth functioning and the sole business of central banks, and banking and other public interests in becomes an avenue for political influ- few even accord it top priority. The each district. Commercial banks elect ence. The Federal Reserve System offers Delors report envisions the ESCB most of the directors, and the Board of an example. The U.S. Congress created undertaking other economic functions, Governors chooses the remainder. the System and retains the power to alter notably, exchange-rate stability. I This dispersion of power among dif- its form and function. Congress requires object to such contingency plans on ferent individuals who have come to the Federal Reserve "...to promote effec- two counts: First, they create doubts the central bank through different tively the goals of maximum employ- about a central bank's willingness and paths, and with different allegiances, ment, price stability, and moderate ability to pursue its primary objective. helps to reduce the concentration of long-term interest rates." However, Con- Second, these contingencies are often political interests and to lessen the gress allows the System discretion in technically infeasible and of dubious impact of external political influences how best to pursue these goals. economic merit. on the central bank.

With multiple goals and no overall rank- Foreign-Exchange Intervention: The An analysis of the voting record of Fed- ing of System objectives, the criterion Delors report, for example, would eral Reserve Bank presidents and gover- for success — the measure of account- instruct the ESCB to smooth European Currency Unit exchange-rate move- on the central bank to avoid high on the supervision and regulation of the ments. Research indicates that central interest rates could result in the ESCB financial community. banks cannot conduct intervention inadvertently financing borrowing by separate from monetary policy. Focus- individual member countries. Some Implicit in a macroeconomic approach ing monetary policy on an exchange European countries have fiscal policies to financial crisis is a willingness to rate is, at times, consistent with price that seem unsustainable. Others sup- allow individual institutions, even large stability, such as when a central bank port various inefficient industries. With ones, to fail. Discount-window lending, acts to prevent an inflation-induced the power to create money no longer particularly at or below market rates, can depreciation of its currency. Just as easi- vested at the national level, some easily become a subsidy to firms that do ly, however, intervention can be incon- nations could experience difficulties in not meet the market test. If the Euro- sistent with price stability, such as when placing debt. This further highlights pean Economic Community is unable to real economic factors alter exchange the need for a price-level target. allow certain firms to fail, it should rates. Then, intervention raises doubts remove the bailout function from the about the central bank's commitment to Financial Panic: Questions also arise central bank and vest that responsibility pursue a stable price level. If traders concerning the role of the ESCB in an independent agency that is directly expect policy to switch between price should a government or a state-run responsible to the European Council and exchange-rate objectives, they will enterprise default on its obligations. and European Parliament. The Euro- continue to hedge against inflation and Major defaults, stock market crashes, pean Parliament should fund the bailouts exchange risk, creating uncertainty and and other shocks occasionally buffet through specific budgetary appropria- costs. Intervention then reduces the the economy, producing financial tions. Such an arrangement would efficiency of money. panics.' A financial panic can slow ensure direct political accountability for money growth dramatically and place the bailouts while preserving the mone- Inflation-Unemployment Trade-off: strong downward pressure on prices. In tary integrity of the central bank. Similarly, many legislators on both such cases, an increase in the monetary base is consistent with an objective of sides of the Atlantic believe that central • Conclusion: Monopoly or price stability. banks should attempt to exploit possible Competition? short-term trade-offs between inflation The Delors Commission seeks to grant and unemployment in an effort to stabi- Financial panics are especially precar- the ESCB a European monopoly for lize the business cycle. I disagree. ious because, in confronting them, a the issuance of fiat money. I have sug- Besides jeopardizing credibility, such central bank must stabilize the price gested four general criteria to ensure attempts are not systematically feasible. level without providing bailouts to that this institution produces an effi- Money-stock changes can temporarily specific institutions or groups of insti- cient product: First, unambiguously alter employment and output only if tutions. Should it fail, the public will establish price stability as the sole these changes cause confusion about come to view the central bank as a objective of the central bank; second, the nature of price movements or if mar- political institution and will question make any government-sponsored cen- ket frictions prevent individuals from its commitment to price stability. tral bank completely independent from adjusting prices quickly. In either case, fiscal authorities; third, hold the central there is no stable trade-off between real To avoid the perception of political bank accountable to a legislative body economic activity and inflation. As mar- expedience, the central bank must (the European Parliament) solely for kets anticipate the resulting inflation, approach the task in a manner that attainment of a stable-price rule; and more and more inflation is built into the emphasizes its macroeconomic aspects, fourth, address any financial crisis that economy, quite independent of the phase rather than its lender-of-last-resort char- threatens price stability only through of the business cycle. U.S. inflation acter. The general objective is to pro- open-market operations. immediately after the last recession was vide a temporary injection of liquidity roughly as high as it was at the business- without attempting to prop up insolvent The Delors report, using the Deutsche cycle peak in the late 1960s. firms or even giving such a perception. Bundesbank as a model, endorses most Supplying liquidity exclusively through of these recommendations. However, Financing Debt: The ESCB could face open-market operations not only avoids beyond Germany, few European nations a unique challenge to price stability loans to specific institutions, but is also appreciate the dangers of mingling the because of the ability of national gov- more efficient. Offering loans to indivi- power to spend with the power to issue ernments in the European Community dual banks, especially institutions that fiat currency. I find it difficult to accept to issue debt. Because the borrowings are approaching insolvency, creates a the argument that governments, which of many European nations are large moral hazard problem that, in the long individually resort to the inflation tax, relative to credit markets, monetary run, can increase the frequency of finan- will collectively choose to avoid that union could allow the debt of some cial crises. Lending, and the associated revenue source, particularly in an individual nations to raise interest rates moral hazard problems, requires the cen- arrangement that lessens the dominance throughout the Community. Pressures tral bank to spend substantial resources of the Bundesbank. Today, Germany's low-inflation monetary policy provides • Footnotes a price anchor to countries participat- 1. The European drive toward economic ing in the European exchange-rate union consists of two parts. The single- W. Lee Hoskins is president of the Federal Reserve Bank of Cleveland. The material in mechanism. An ESCB structure that market initiative refers to the goal of eliminating all artificial barriers restricting this Economic Commentary is based on a dilutes Germany's influence without movements of economic resources in the speech presented to a group of German establishing a clear, mandatory price- European Economic Community by 1992. bankers and business representatives in level target will almost certainly make Monetary union refers to the goal of even- Munich on September 4, 1990. Germany worse off. tually establishing a single monetary policy throughout the Community. The Delors Com- If the European Economic Community mission was charged with preparing an initial cannot adopt a legal commitment to recommendation for monetary union. price stability along the lines that I have 2. For a discussion and references to evi- suggested here, Germany might not dence, see William T. Gavin, "In Defense of wish to grant the Community a mono- Zero Inflation," Working Paper 9005, Fed- eral Reserve Bank of Cleveland, June 1990. poly in this area. Instead, your country might foster a monetary-policy compe- 3. See David Altig and Charles T. Carlstrom, "Inflation and the Personal Tax Code: Assess- tition by strengthening sanctions ing Indexation," Working Paper 9006 , Fed- against countries that attempt to reim- eral Reserve Bank of Cleveland, July 1990. pose barriers to the free movement of 4. This English translation of the Deutsche capital and real resources. Bundesbank Act is found in The Deutsche Bundesbank, Its Monetary Policy Instru- The resource movements associated ments and Functions, Deutsche Bundesbank with the single-market initiative will Special Series No. 7, October 1982. confer great benefits on the European 5. A 2 percent band around the target level Economic Community. They will cre- would be acceptable provided that the target ate natural competition for sound is an unchanging price level. government policies, and the move- 6. For a discussion and references to evi- ments of resources across borders will dence, see "Central Bank Independence," effectively register votes on policy. Federal Reserve Bank of Cleveland's 1989 Governments that institute excessive Annual Report. rates of taxation, through inflation or 7. All 12 District Bank presidents attend the more explicit means, will see their tax FOMC meetings and participate in delibera- bases shrink. This competition will tions, but only five vote at any particular time. foster—indeed encourage—coordina- 8. Some appointments, however, fill vacan- tion of monetary and fiscal policies cies left in existing terms. even without the establishment of a 9. See "Central Bank Independence," single European central bank. This Federal Reserve Bank of Cleveland's 1989 competition either will produce an Annual Report, footnote 3, p. 18. evolutionary convergence of inflation- 10. A price-level target could eliminate a his- ary preferences among the European toric source of such shocks: abrupt shifts in monetary policy. states, thereby completing the ground- work for monetary union, or it will graphically illustrate the impossibility of forcing monetary union on countries that have different inflation preferences. Economic Commentary is a semimonthly periodical published by the Federal Reserve Bank of Cleveland. Copies of the titles listed below are available through the Public Affairs and Bank Relations Department, 216/579-2157.

Does the Fed Cause Christmas? A Monetary Policy for the 1990s Inflation and Growth: Working Charles T. Carlstrom and W. Lee Hoskins More vs. Working Better Edward N. Gamber May 1, 1990 Michael F. Bryan January 1, 1990 August 15, 1990 A Critique of Monetary Can R&D Be the Rx for the Midwest? Protectionism Underlying Causes of Commercial Julia Melkers and Randall Eberts W. Lee Hoskins and Bank Failures in the 1980s January 15, 1990 Owen F. Humpage Lynn D. Seballos and May 15, 1990 Is Current Fiscal Policy an Obstacle James B. Thomson to Sound Monetary Policy? Making Sense of the Moynihan September 1, 1990 W. Lee Hoskins Gambit: A Perspective on the Social Can State Employment Declines February 1, 1990 Security Debate Foretell National Business Cycles? David Altig Randall W. Eberts How Are Wages Determined? June 1, 1990 Erica L. Groshen September 15, 1990 February 15, 1990 Current Outlook: Sustained Growth, Sustained Inflation Don't Worry, We'll Grow Out The Economic Outlook: Growth John J. Erceg and Paul J. Nickels of It: An Analysis of Demographics, Weakens, Inflation Unchanged June 15, 1990 Consumer Spending, and John J. Erceg and Paul J. Nickels Foreign Debt March 1, 1990 Minority-Owned Banks: History Michael F. Bryan and and Trends Susan M. Byrne The Case for Price Stability Douglas A. Price W. Lee Hoskins October 1, 1990 July 1, 1990 March 15, 1990 The Outlook After the Oil Shock: State and Local Red Ink: Crisis The High-Yield Debt Market: Between Iraq and a Soft Place or Opportunity? 1980-1990 John J. Erceg and Richard H. Jefferis, Jr. Brian A. Cromwell and Lydia K. Leovic April 1, 1990 Irene A. Wirkus October 15, 1990 July 15, 1990 Standardizing World Securities Oil, the Economy, and Monetary Clearance Systems Payment System Risk and Financial Policy Ramon P. DeGennaro and Reform Gerald H. Anderson, Christopher J. Pike W. Lee Hoskins Michael F. Bryan, and August 1, 1990 April 15, 1990 Christopher J. Pike November 1,1990

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