At the time of its launch, European economies were in the doldrums at the time and vast amounts of capital were pouring out, approximately one hundred fifty billion dollars last year. Yet, even if that flow reverses, the system will still have a major flaw: Unlike the U.S. Federal Reserve System, the ECB is trying to operate a uniform monetary policy in an area that isn’t united politically and lacks a common fiscal policy. That means there are no automatic adjustment mechanisms, such as budgetary transfers or easy migration, to salve economic hardship or defuse political problems in any hard-hit region.
The ECB is hardly to blame for a system set up by its political masters. But the way the bank works compounds the problem. The ECB gives the impression of weak leadership under its president, Wim Duisenberg, thanks to his consensual management style. The bank’s other five full-time executive committee members often disagree in public. And the 11 heads of member countries’ national central banks, which with the committee make up the bank’s 17-member rate-setting governing council, sometimes behave as if they still ran an independent monetary policy.
Now, the bank needs to win the respect of the markets. It won’t be easy, because the bank has saddled itself with two measures to decide what key interest rates should be. The so-called twin-pillar approach mandates the bank to consider both money-supply growth and a broad-based analysis of inflationary risks when setting rates. That’s asking for trouble because the two measures could easily send contradictory signals. Indeed they do. Since the euro’s launch, broad money-supply growth has been consistently above the bank’s 4.5% target — indicating that higher rates are needed. But, until very recently, inflation has been well under the 2% upper limit that the ECB set for Europe — suggesting that steady or lower rates were required, especially against a background of anemic growth and high unemployment.
Despite its travails, though, the ECB has scored some notable successes. The euro zone’s 11 national money markets have been stitched together into a seamless whole. The ECB’s Europewide payments system works without a hitch. And the euro is a clear No. 2 behind the dollar and ahead of the yen as a reserve currency. International companies issued more bonds denominated in euros than in dollars last year. All the same, growing concern in financial markets about the ECB’s performance is eroding its credibility. The euro’s big swings are sapping public confidence and deterring investors. Instead of controlling the markets, the ECB sometimes seems to be controlled by them. Some analysts, for instance, figure the ECB was railroaded into jacking up its rates on Feb. 3 to 3.25% from 3% by the euro’s chronic weakness.
The final objective of the ECB’s policy will be price stability. In the pursuit of this objective, the ECB will need to develop an appropriate monetary policy strategy. In its Report, the EMI confines the list of possible strategies to just two, namely monetary targeting and direct inflation targeting. The final decision on which – or which combination of – the two strategies will be used will be taken by the ECB in 1998.
Monetary targeting is based on the assumption that, in the long run, inflation is a monetary phenomenon. If a stable relationship exists between money supply and inflation, price stability can be achieved/maintained indirectly by controlling the supply of money. The crucial feature of this strategy is the existence of a broadly stable relationship between money supply and prices. Although preliminary evidence is encouraging, uncertainty remains as to whether structural adjustments linked to the introduction of the single currency might undermine the money supply/price relationship and so reduce the effectiveness of monetary targeting as a means to control inflation.
With respect to inflation targeting, the focus of monetary policy is on the future expected inflation rate. A wide range of indicators is used to predict the outlook for inflation in a future period (say, 1 or 2 years ahead), and monetary policy is adjusted accordingly. The crucial feature of this strategy is a stable relationship between aggregate demand in the economy and prices i.e. whether, on the basis of the available information on economic performance, the ECB will be able to make an accurate assessment of future inflation. Once again, the structural adjustments implied by the introduction of the single currency may undermine the stability of such relationships making the use of direct inflation targeting less effective as a monetary policy framework.
The differences between these two strategies are smaller than they may appear. Within a framework of monetary targeting, the overriding policy objective remains price stability; thus, if for some exceptional reason (e.g. a major structural change) money demand is seen to increase without implying inflationary pressures, the money supply will be allowed to breach the target range. Similarly, within a framework of direct inflation targeting, money supply will certainly be among the more important indicators used to measure potential inflationary pressures. Hence, whichever strategy the ECB will choose, the implementation of monetary policy by the ECB is likely to be rather similar.
At the world level, the euro will eventually bring great benefits. US companies rarely have to bear an exchange-rate risk. Whether their customers or suppliers are situated in Russia, Argentina or China, their invoicing is almost always in dollars. European firms will in future benefit from the same type of advantages with the euro. They will be able to invoice in the currency in which their costs are expressed. They will thus be better placed to face world competition. Their efforts to boost productivity will no longer run the risk of being nullified by a currency shock.
Furthermore, the euro’s arrival will constitute a major change in the international monetary system. That system is currently dominated by the dollar. By the end of 1995, about 50% of world exports were invoiced in dollars, whereas the United States accounts for only 19.6% of world trade (20.9% for Europe). From 1999 the euro will give Europe a monetary importance consistent with its economic and commercial role.
The euro will also enable firms to make direct savings in terms of foreign exchange conversion and hedging costs; the gain is estimated at ECU 30 billion a year. This will be supplemented by a considerable simplification of cash management and in particular, although this benefit is not quantifiable, by a higher confidence in investment decisions. These benefits will be connected with firms’ European activities but they will also reinforce their competitive position in the world export market.
The European Union has made a giant leap with the adoption of the euro. It has experienced some turbulence, but with sound policies and a willingness to work through any future problems, EU can ultimately prosper. The euro has caused a new financial optimism in Europe and around the world. If the EU can integrate its member nations’ financial policies, the euro will be second only to the dollar. Time, ultimately, will show the outcome of all the work put into ensuring the continued health of the euro and the EU member nations.