The Eastern enlargement of the currency union: Challenges for the ECB's monetary policy

TABLE OF CONTENTS

TABLE OF FIGURES

LIST OF TABLES

Introduction

The Monetary Policy Strategy of the European Central Bank

Challenges in the Decision-Making Process
The Governing Council of the ECB as the main Decision-Making Body
The Three-Group Rotation System
Evaluation of the Rotation System

The Challenge of Heterogenous Membership
Inflation differentials
Asymmetric Shocks
Different Business Cycles
Balassa-Samuelson-Effect
Policy challenge in completing transition

Conclusion and Points of Criticism

Bibliography

TABLE OF FIGURES

Figure 1: Overview of the monetary strategy of the Eurosystem

Figure 2: The three-group rotation system for the ECB Governing Council (scenario for a euro area of 27 Member States)

LIST OF TABLES

Table 1: Mismatch between the political and economic weighting in the ECB Governing Council11

Table 2: Inflation rates in % measured by HICPs (12 Month average rates, Nov 05- Nov 06)..1

Table 3: Business cycle correlation (with EU-12) for the period 1990- 2001

Introduction

The eurozone member countries have agreed to permanently abandon economic policy instruments such as monetary and exchange rate policies and to accept the European Central Bank (ECB) as the decision making body to determine the common monetary policy, notably the interest rates and the money supply. It goes without saying that such an institution is not able to fine-tune its decisions in order to meet particular economic challenges in certain member countries. In this respect, the eastward enlargement of the European Monetary Union (EMU) will bring major challenges to the ECB, as varying inflation rates in different member countries and the determination of a single interest rate may have disruptive consequences.

From the viewpoint of the eastward enlargement of the eurozone the paper illustrates the various challenges the ECB inevitably has to face. Further, it describes the reform of the ECB Governing Council. An important question concerning the ECB is the following: Is there a danger for the single European monetary policy from letting Central and Eastern European Countries (CEEC) join the eurozone or from letting them join the eurozone too early? The seminar paper is organised in three separate, although related parts. The first section briefly discusses the monetary policy strategy of the ECB. Next, the institutional challenges in the decision-making process are explained. Section 3 provides an analysis of the challenges due to the heterogeneity of the member countries. Finally, the last part draws some overall conclusions and refers to points of criticism.

The Monetary Policy Strategy of the European Central Bank

Since 1st January 1999 the ECB has the task of formulating and implementing the monetary policy for the eurozone. In article 105(1) of the Maastricht Treaty the primary objective of the European System of Central Banks (ESCB) is defined as maintaining price stability (ECB 2004, p.41): “without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2”. In this respect, Article 2 of the Treaty mentions as objectives of the Community “a high level of employment[..], substantial and non-inflationary growth, a high degree of competitiveness and convergence of economic performance” (Treaty of Maastricht 1992). Following the definition, price stability would mean an inflation of zero. The Maastricht Treaty, however, does not identify which price index is the important one for monetary policy. According to Favero (2004, p.21) the ECB policy strategy consists of the following three main components:

(1) The operational definition of price stability is inflation of the Harmonised Index of Consumer Prices (HICP) between 0% and 2% per year, in the medium term.
(2) The first pillar of the ECB monetary policy strategy is money: a quantitive reference for the growth rate of M3 has been set at 4.5% and kept more or less at that value.
(3) The second pillar of the monetary policy strategy would be the extensive assessment of the outlook for future price developments and the risks to price stability in the euro area which play a significant role. Then, the target is precisely specified and the strategy is tightly defined. In order to assess the risks to price stability in the best possible way, the ECB decided to divide the analysis of the prospects for inflation into the above mentioned two categories which are shown in Figure 1 (“two pillar strategy”).

Figure 1: Overview of the monetary strategy of the Eurosystem

illustration not visible in this excerpt

Sources: ECB 2004, p.66, Klöckers 2002, p.121

The purpose of the first pillar is to show how prominent the role of money is (though this has changed in the meantime). The “monetary analysis” focuses on a longer-term horizon, considering the long-run link between money and prices. This analysis mainly serves as a means of cross-checking from a medium to long-term perspective, the short to medium indications for monetary policy are coming from the economic analysis. The ECB Governing Council has set a reference value for monetary growth which relates to the broad aggregate M3 and is derived as a medium-term concept. The second pillar which the ECB refers to as the “economic analysis” takes into account that short to medium-term determinants of price developments will be influenced to a large extent by economic developments, unemployment and wage developments, as well as by the exchange rate, raw material prices and the global economic situation. Furthermore, financial market and other asset prices are also considered. (Klöckers 2002, p.120ff., ECB 2004, p.55).

Challenges in the Decision-Making Process

The Governing Council of the ECB as the main Decision-Making Body

The ECB´s Governing Council is in particular responsible for formulating the monetary policy of the euro, i.e. to take decisions on the level of key ECB interest rates (ECB 2004, p.44). It is therefore the main decision-making body of the ECB (ECB 2006, p.52) and comprises the members of the Executive Board of the ECB and the governors of the national central banks (NCB) of the euro area countries. The Governing Council faces the challenge to influence conditions in the money market and thereby the level of short-term interest rates to ensure that price stability is maintained over the medium term (ECB 2004, p.49). In order to take this challenge, the ECB is always confronted with a high level of uncertainty in terms of the nature of the economic shocks hitting the economy and the existence and strength of the relationships that link macroeconomic variables. The Governing Council acts after the principle “one member, one vote” which means that votes are not weighted. Therefore, the vote of the governor of the NCB of the biggest euro area country counts as much as that of the NCB governor of the smallest country, with each member having in principle one vote. Consequently, the governors should act in the interest of the euro area as a whole (ECB 2006, p.53f.). However, this is to be doubted with regard to the different member countries´ requirements due to their heterogeneity.

The Three-Group Rotation System

Against the background of the enlarged eurozone there were doubts that monetary policy decisions could not be taken timely and efficient anymore, since the Governing Council would become too large and hardly capable of acting. The implementation of a rotation system, which is a reform proposal of the ECB, is aimed at maintaining the functioning of the monetary policy after the enlargement and, thus, preserve the confidence of everyone in the monetary policy and the currency.

With the enlargement of the euro area the number of NCB governors holding a voting right will be restricted to 15 (“cap”) (ECB 2006, p.54f.). As soon as the number of EMU member countries exceeds 15, the rotation system begins. The voting rights modalities were adjusted by 1st May 2004 in order to maintain the Governing Council´s capacity for efficient and timely decision-making with only the 6 members of the Executive Board maintaining permanent voting rights. The NCB governors, in contrast, will vote on the basis of the pre-established rotation system which is shown in figure 2 for 27 member states. They vote with different frequencies pre-established according to objective criteria in order to ensure that governors with voting rights are from countries which, taken together, always represent the euro area economy as a whole (“Minimum representation”). The NCB governors are divided in three different groups corresponding to a ranking of the size of their countries´ economies. The basis of this ranking is an indicator consisting of the share of the country in the aggregate gross domestic product (GDP) at market prices (5/6) and the share of the country in the total assets of the aggregated balance sheet of the monetary financial institutions (1/6) (ECB 2006, p.54ff, Belke 2003, S.16ff.).

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