Introduction to Management and Organisational Behaviour

1
Chapter 7The EMU, the ECB and monetary policy
in Euroland
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The Long Road to Maastricht and to the Euro
3
The Maastricht Treaty

• A firm commitment to launch the single currency
  by January 1999 at the latest.
• A list of five criteria for admission to the
  monetary union.
• A precise specification of central banking
  institutions.
• Additional conditions mentioned (e.g. the
  excessive deficit procedure).

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The Maastricht Convergence Criteria

• Inflation
• not to exceed by more than 1.5 per cent the
  average of the three lowest rates among EU
  countries.
• Long-term interest rate
• not to exceed by more than 2 per cent the average
  interest rate in the three lowest inflation
  countries.
• ERM membership
• at least two years in ERM without being forced to
  devalue.

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The Maastricht Convergence Criteria

• 4. Budget deficit
• deficit less than 3 per cent of GDP.
• 5. Public debt
• debt less than 60 per cent of GDP
• Note Observed on 1997 performancefor decision
  in 1998.

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Interpretation of the Convergence Criteria
Inflation
Straightforward fear of allowing in unrepentant
inflation-prone countries.
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Interpretation of the Convergence Criteria
Long-Term Interest Rate

• A little bit too easy to bring inflation down in
  1997 artificially or not and then let go
  again.
• Long interest rates incorporate bond markets
  expectations of long term inflation.
• So criterion requires convincing markets.
• Problem self-fulfilling prophecy
• if markets believe admission to euro area, they
  expect low inflation and long-term interest rate
  is low, which fulfils the admission criterion
• conversely, if they dont, all is lost

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Interpretation of the Convergence Criteria ERM
Membership

• Same logic as the long-term interest rate need
  to convince the exchange markets.
• Same aspect of self-fulfilling prophecy.

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Interpretation of the Convergence Criteria
Budget Deficit and Debt (1)

• Historically, all big inflation episodes born out
  of runaway public deficits and debts.
• Hence requirement that house is put in order
  before admission.
• How are the ceilings chosen?
• deficit the German golden rule
• debt the 1991 EU average compatible with
  deficit rule

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Interpretation of the Convergence Criteria
Budget Deficit and Debt

• Problem No. 1
• a few years of budgetary discipline do not
  guarantee long-term discipline
• the excessive deficit procedure will look to that
  once in euro area, more later.
• Problem No. 2 artificial ceilings. Hence some
  flexibility (look at the tendency)

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The Debt and Deficit Criteria in 1997
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The next wave of candidatesQuite different
development levels (GDP per capita as of EU)
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The next wave of candidatesThe inflation
criterion
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The next wave of candidatesThe budget and debt
criteria
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The next wave of candidatesA door half-open
fears in the Old Europe

• Cheap labour force

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The next wave of candidatesA door half-open
fears in the Old Europe

• But low labour productivity

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The next wave of candidatesA door half-open
fears in the Old Europe

• Cheap, but all that cheap

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Architecture of the monetary union
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A Tour of the Acronyms

• N countries with N National Central Banks (NCBs)
  that continue operating but with no monetary
  policy function.
• A new central bank at the centre the European
  Central Bank (ECB).
• The European System of Central Banks (ESCB) the
  ECB and all EU NCBs (N15).
• The Eurosystem the ECB and the NCBs of euro area
  member countries (N12).

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The System
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How Does the Eurosystem Operate?

• Objectives
• what is it trying to achieve?
• Instruments
• what are the means available?
• Strategy
• how is the system formulating its actions?

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Objectives (1)

• The Maastricht Treatys Art. 105.1
• The primary objective of the ESCB shall be to
  maintain price stability. 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.
• Article 2. The objectives of European Union are a
  high level of employment and sustainable and
  non-inflationary growth.
• In clear
• fighting inflation is the absolute priority
• supporting growth and employment comes next.

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Two central bank models

• Objectives
• Anglo-French model several goals, with no
  priority on inflation.
• German model price stability is considered the
  primary objective.
• Institutional Design
• Anglo-French model political dependence ensures
  that Minister of Finance decides.
• German model political independence severely
  guarded.

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Why has a German model prevailed?

• Political independence of ECB is even greater
  than Bubas statutes harder to change.
• Monetarist revolution was important on this
  (Barro-gordon is a good synthesis)
• Empirical evidence supportive of the better
  performance of economies with independent central
  banks.

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Inflation and credibility of the central bank
(Barro and Gordon)

• Only unanticipated inflation can reduce
  employment

• Workers are interested in real wage level, but
  can only affect nominal wage, and anticipate
  inflation.
• A surprise monetary expansion augments activity
  and reduces unemployment to the left of UN at
  the price of a higher inflation (short-run
  Phillips curve).
• Workers then revise expectations and Phillips
  curve shifts upwards. In the long run, we get
  back to UN with higher inflation.

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Inflation and credibility of the central bank
(Barro and Gordon)

• Rational expectations

• Government tries to minimize loss function

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Inflation and credibility of the central bank
(Barro and Gordon)

• Nash equilibrium no actor can unilaterally
  improve its situation.

• A is not, since B is reachable by monetary
  policy
• B is not since revision of expectations brings
  new short-run curve and new choice C.
• E is Nash, since expectations are rational, and
  best point chosen by gvt

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Inflation and credibility of the central bank
(Barro and Gordon)

• Nash equilibrium is not Pareto-optimal at all. A
  would be much better than E, but not credible
  equilibrium because of discretion of monetary
  policy time inconsistency.
• Very similar to collusion problem.
• Repetition of game could secure reputations for
  not deviating (no surprise inflation).
• But the condition  patience  (trading long
  run gains against short-run losses)
• Systematic inflation bias in  weak states 
  (short time horizon) / strong preference for low
  unemployment / high UN

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Barro and Gordon in open economies

• Different countries will have different
  equilibrium inflation rates. Suppose Italian
  inflation is much larger than the German one.
• In an open economy, there are consequences for
  the XR. Suppose PPP is verified ITL should
  continuously depreciate to compensate. Can Italy
  fix parity to  import  low inflation from
  Germany? No

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Barro and Gordon in open economies

• However, adopting the DM is credible.
• Italy gets low inflation in F / Germany has no
  loss from this, since the unemployment /
  inflation are unchanged.
• It works the same for the monetary unification,
  with some caveats
• EMU has to be total to be credible.
• If the new common central bank has  average
  preferences  of the two former central banks,
  less gain in Italy, and some loss in Germany.
• It is therefore optimal to designate a very
  conservative central banker in order to maximise
  the gains.
• In fact, Rogoff even showed that the central
  banker should be more conservative than any
  member before the Union.

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The  Rogoff banker 

• Each central bank has an optimal stabilization
  path depending on its underlying preferences.
• The member countries gain an average long-run
  lower inflation rate by designating an ECB with a
  flatter slope of optimal stabilization path.
• However in a recession, the ECB will be less
  accomodating than what citizens in any country
  would like THIS IS THE PRICE OF CREDIBILITY
• But it creates conflicts with elected officials
  independence / accountability issue.

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The  Svensson banker 

• The problem comes from a difference in
  preferences between the individuals and the ECB
  in terms of the trade-off between inflation and
  unemployment the slope.
• It can be solved, by giving the ECB a different
  (lower) inflation target, rather than a different
  weighting scheme.

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Objectives (2)

• Making the inflation objective operational does
  the Eurosystem have a target?
• It has a definition of price stability
• The ECB has defined price stability as a
  year-on-year increase in the Harmonised Index of
  Consumer Prices (HICP) for the euro area of below
  2.
• And it has an aim
• In the pursuit of price stability, the ECB aims
  at maintaining inflation rates below, but close
  to, 2 over the medium term.

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Objectives (2)

• Leaves room for interpretation
• where below 2 per cent?
• what is the medium term?
• There are remaining issues with this setting
• Impossible to stabilize pure asymmetric shocks
• Asymmetric responses to symmetric shocks are
  tricky

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Asymmetric shocks

• In a pure asymmetric shock, euroland output and
  prices remain unchanged no stabilization
  possible. Appears super-conservative

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Asymmetric reponses

• ECB stabilizes in E, but results in unemployment
  F and R

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Does One Size Fit All?

• With one monetary policy, particular national
  conditions cannot be attended to.
• This is another version of the asymmetric shock
  concern of the OCA theory the cost must be
  borne.
• Monetary policy may also affect differently
  different countries.

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Instruments (1)

• Remember the channels of monetary policy
• longer run interest rates
• credit
• asset prices
• exchange rate.
• These are all beyond central bank control.
• Instead it can control the very short-term
  interest rate European Over Night Index Average
  (EONIA).
• EONIA affects the channels through market
  expectations.

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Instruments (2)

• The Eurosystem controls EONIA by establishing a
  ceiling, a floor and steering the market
  in-between.
• The floor the rate at which the Eurosystem
  accepts deposits (the deposit facility).
• The ceiling the rate at which the Eurosystem
  stands ready to lend to banks (the marginal
  lending facility).
• In-between weekly auctions (main refinancing
  facility).

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EONIA Co.
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The Two-Pillar Strategy

• The monthly Eurosystems interest rate decisions
  (every month) rests on two pillars.
• Monetary analysis
• evolution of monetary aggregates (M3 should grow
  by 4.5 a year if income and prices grow at 2
  and velocity -0.5)
• Economic analysis
• broad review of economic conditions
• growth, employment, exchange rates, abroad.

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Issues with ECBs strategy

• Is the inflation ceiling of 2 too low?
• Conventional inflation measures badly measure
  technical progress and substitution.
• Some inflation is good for flexibility in real
  wage (money illusion).
• Dangerously close to liquidity trap at least
  for some members.
• Is the band too narrow? Target rate instead of
  ceiling might be preferable?
• Relying too much on money stock?
• The strong relationship between money and
  inflation is not that strong for low inflation
  countries M3 is a noisy signal of inflation in
  eurozone.
• Direct inflation targetting asset prices
  monitoring?

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Comparison With Other Strategies

• The US Fed
• legally required to achieve both price stability
  and a high level of employment
• does not articulate an explicit strategy.
• Inflation-targeting central banks (Czech
  Republic, Poland, Sweden, UK, etc.)
• announce a target (e.g. 2.5 per cent in the UK),
  a margin (e.g. 1) and a horizon (23 years)
• compare inflation forecast and target, and act
  accordingly.

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Taylor Rule Interpretation

• Taylor rule
• i i a(? - ?) b (y - y)
• Take ? 2
• i 4 (2 real, 2 target inflation).
• Choose a and b
• a 2.0, b 0.8.
• Compare with actual EONIA.

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A Taylor Rule Example
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Independence and Accountability

• Current conventional wisdom is that central banks
  ought to be independent
• governments tend not to resist to the printing
  press temptation
• the Bundesbank has set an example.
• But misbehaving governments are eventually
  punished by voters.
• What about central banks? Independence removes
  them from such pressure.
• The ECB is the most independent of all but is
  there a democratic deficit?

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Redressing the Democratic Deficit

• In return for their independence, central banks
  must be held accountable
• to the public
• to elected representatives.
• Examples
• the Bank of England is given an inflation target
  by the Chancellor. It is free to decide how to
  meet the target (instrument independence), but
  must explain its failures (the letter)
• the US Fed must explain its policy to the
  Congress, which can vote to reduce the Feds
  independence.

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The Eurosystem Weak Accountability

• The Eurosystem must report to the EU Parliament.
• The Eurosystems President must appear before the
  EU Parliament when requested, and does so every
  quarter.
• But the EU Parliament cannot change the
  Eurosystems independence and has limited public
  visibility.
• Because the initial contract is not clear
  enough, the ECB has had the tendency to fill the
  gaps itself, mainly focusing on price stability,
  with no role for the other objectives.

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The Record So Far

• A difficult period
• an oil shock in 2000
• a worldwide slowdown
• September 11
• the stock market crash in 2002
• Afghanistan, Iraq
• The weak dollar

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Inflation Missing the Objective, a Little
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The Euro Too Weak First, Then Too Strong?
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The Euro Longer perspective
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But No Seriously Asymmetric Shocks
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Although inflation has not fully converged