Does a less active Central Bank lead to greater economic stability? Evidence from the European Monetary Union.

• Author: Mafi-Kreft, Elham

On January 1, 1999, 11 European countries gave up the independence of their monetary policy by joining the European Monetary Union (EMU). Since that time, these countries have shared a common currency, the euro, and, more important, are all now under the direction of a common European Central Bank (ECB) that controls monetary policy for the entire euro area. In accordance with Article 105(1) of the Maastricht Treaty, the primary objective of the ECB is to maintain price stability. The institutional designs of the ECB as well as their stated primary objective lead most economists to believe that the new ECB is a relatively inactive central bank in the pursuit of short-run macroeconomic stabilization. Thus most, if not all, of the countries in the EMU are now under a central bank that is much less active than was their previous national central bank. In this article, we examine whether this shift in the activism of the monetary regime has resulted in more or less macroeconomic stability for these countries.

Even before the official starting date for the EMU, a substantial academic literature speculated on how the move toward a common central bank would affect the macroeconomic stability of these countries. This literature has generally concluded that the movement toward a common central bank would make these economies more unstable because of the inability of a common central bank to tailor monetary policy to the needs of each country. As each country experiences country-specific shocks, the ECB will not be able to counter these shocks as well as a system of autonomous central banks. Thus, this previous academic literature has concluded on theoretical grounds that the EMU-member countries will suffer wider swings in real economic activity after the move to a common central bank. (1)

A monetarist critique of this position, however, has yet to appear in the literature. The monetarists have long argued that monetary policy is the main source of economic instability, even when the policy is well-intentioned. Brunner (1985:12) states the monetarist position concisely: "Discretionary management ultimately fails to deliver, even with the best intentions, on its promise." The monetarists believe that problems with lags and proper timing result in policy errors that induce less, rather than more, economic stability. If this position is correct, it suggests that having a common central bank that is unable to "optimally" respond to individual country-specific shocks could actually result in greater economic stability in the EMU member countries, not less. In other words, a common policy that is less responsive to country-specific shocks will result in greater stability because there will be fewer macroeconomic swings induced by monetary policy errors. However, for some countries that used to have a very inactive national central bank (such as Germany's Bundesbank), the new ECB might actually be more active than the old national central bank. In this case, the monetarist position would argue that these economies would become more unstable after moving under a more active ECB.

Three decades ago, a substantial academic debate raged about the relative effectiveness of fiscal and monetary policy at providing economic stabilization. Now, a consensus appears to have emerged that fiscal policy is generally less effective than monetary policy to promote short-run economic stability. (2) In this modern view, fiscal policy should primarily be concerned with promoting long-run economic growth through maintaining reasonably low marginal tax rates, constraining deficit finance, and removing regulations and taxes that interfere with domestic or international economic transactions. Monetary policy, on the other hand, is now accepted as the primary method with which countries can conduct economic stabilization. The main debate that remains is whether well-intentioned monetary activism is actually effective at promoting stability, a debate that is more important today than ever before with fiscal policy no longer being considered an effective stabilization tool.

The formation of the EMU provides a unique opportunity to see how a change in the activism of monetary policy affects the economic stability of a country. The evidence from this European monetary transformation will clearly help to resolve the substantial disagreement among economists on the issue of whether monetary activism provides more or less macroeconomic stability. If well-intentioned activist monetary policy cannot promote economic stability, it would suggest that the main focus of central banks should be on long-run price stability, rather than on short-run macroeconomic stabilization.

This article proceeds by first reviewing some of the previous literature on the EMU and presenting a monetarist critique of this literature. We then proceed to measure how active each country's national central bank was before the formation of the EMU and compare this with how active the new ECB has been since it was created. Finally, we examine which countries have seen the greatest increases (or decreases) in economic stability since joining the EMU, and attempt to find a correlation between the change in the activism of monetary policy and the change in economic stability.

The EMU: Origins and Previous Literature

The Maastricht Treaty signed on February 7, 1992, by the 15 members of the European Union called for the creation of a new ECB by January 1, 1999. The ECB would be assigned the task of conducting the single monetary policy for the 11 EMU members. (3) The statute of the ECB (Protocol, Article 2) states that the primary and overriding goal of the European monetary authority is to "maintain price stability." (4) Following almost perfectly the monetarist view, constant growth rate rules for the money supply have a prominent role in the statute of the ECB (the euro area M3 money supply has a 4.5 percent growth rate reference value, for example). Undeniably, the ECB is based on a more monetarist framework similar to that of the old German Bundesbank, where the weight that monetary policy puts on long-run price stability significantly exceeds the weight put on maintaining short-run economic stability.

In his address to the Federal Reserve Bank of Kansas City in 1999, the president of the ECB, Wire Duisenberg, reemphasized the commitment to price stability of the ECB. Duisenberg (1999) stated that monetary policy should never be reoriented away from its primary objective of maintaining price stability. He continued by emphasizing that low and predictable inflation is necessary for maintaining sustainable output growth and high levels of employment. Duisenberg made it clear that the ECB believes that even moderately high rates of inflation are harmful to economic growth. (5) Furthermore, the fact that the ECB is following this more nonactivist framework can be found by looking at its actions in 2001 when the global risk of a recession was apparent. That year, while the U.S. Fed cut interest rates 11 times and the Bank of England cut interest rates 7 times, the ECB cut interest rates only 4 times despite worldwide pressures to do more.

Even before the ECB formally came into existence in 1999, an academic literature began to emerge speculating on how the move toward a common central bank would affect the economic stability of the European member countries. The consensus that emerged from this literature contained little hope that there would be an increase in economic stability. Eichengreen (1992), Bayoumi and Eichengreen (1993, 1997), for example, pointed out that the members were not forming an optimum currency area as was defined by Mundell (1961). An optimum currency area consists of a group of countries that share similar economic shocks and between which labor and capital can flow freely. Because of the dissimilarity of the shocks historically experienced by the EMU member nations, there are likely to be situations in the future where the optimal monetary policy will differ across these countries. A common central bank, however, will be unable to tailor monetary policy to suit the needs of each nation simultaneously. Because the new ECB will be unable to optimally respond to these asymmetric (country-specific) shocks, the economies of these nations will become less stable as a result.

Similarly, De Grauwe (2000) shows that for asymmetric shocks the ECB would stabilize too little from the point of view of what would be optimal for the individual member states because it will be reacting to an average across all countries. Stevens (1999) claims that the inability of the ECB to respond to individual country needs could eventually lead to members withdrawing from the EMU. Likewise, Salvatore (2002) claims that when a country is hit by an asymmetric shock, the country will ultimately have to wait for the economy to self-correct. Salvatore believes that the self-correcting process may be lengthy, and no government could politically afford to tolerate such a drawn-out process. Salvatore provides evidence that Italy and Spain are the EMU members that will most often face asymmetric shocks, and, therefore, will face the highest cost of the shared monetary policy.

A Monetarist Critique of the Previous Literature

The previous literature on the likely effects of moving toward a common ECB is rooted in a fundamentally activist theoretical framework. However, substantial disagreement exists among macroeconomists about the validity of this position. In particular, monetarists believe that there are problems in monetary policy implementation that may significantly reduce the potential for active monetary policy to stabilize an economy, even if the policy is well-intentioned.

The monetarist view can be summarized by a belief that lags in the implementation of monetary policy create a situation in which it is generally impossible to properly time monetary stimulus and contraction. Thus...