Mr. Issing comments on the problem of credibility of the European Central
Contribution of Prof. Otmar Issing, a member of the Directorate of the Deutsche
Bank
Bundesbank, at the Annual Meeting of the American Economic Association, held in Chicago on
4/1/98.
On January 1, 1999 the curtain will rise on a worldwide première. It will be the
first time ever in history that sovereign states have abandoned their own currencies in favour of a
common currency and transferred their monetary policy sovereignty to a newly created
supranational institution. What makes this process all the more unusual from an historical
perspective is that the national currencies involved are not being abolished because of their
weakness; on the contrary, proof of a large measure of monetary stability is demanded as a
precondition for what is essentially a political project.
The euro will likewise have to demonstrate a large measure of stability if it is to
contribute successfully towards integrating Europe and not towards dividing it. Various
individuals have vowed emphatically in the past that this will indeed be the case. However,
public statements in favour of a stable euro hardly constitute a copper-bottomed guarantee on
their own.
Why should rational citizens be expected to believe these promises? It is a
question of the credibility of announcements and of economic institutions. The catchword
"credibility" points to a mountain of publications which, following the pioneering work of
Kydland and Prescott (1977) and of Barro and Gordon (1983), have appeared since then.
The European Central Bank (ECB) will represent the birth of a completely new
institution. The euro will replace national currencies which - like the D-Mark - can look back on
a successful past history. On the other hand, the potential participating countries are insisting on
retaining their political sovereignty. For the foreseeable future, therefore, monetary union will
lack the reinforcement of a political union.
Understandably, this state of affairs has fired the imagination of economists. The
publications on this subject now fill whole libraries. Even if, ultimately, the complex
phenomenon of European monetary union (EMU) cannot be clinically dissected, I would like to
emphasise one point: the credibility of the ECB.
In the Maastricht Treaty the signatory states opted for a very specific central bank
constitution. Does their choice stand up to the critical assessment of professional economists?
What criteria for the establishment of a central bank can be derived from theory and empirics? Is
there a normative theory of central bank constitutions at all? First of all, however, we should
consider why credibility is important and how it can be established.
I The problem of credibility
As a general principle, credibility facilitates interpersonal relationships.
Credibility is capable of substantially reducing transaction burdens. In terms of monetary policy,
this always boils down in the end to the promise of stable money. At first sight, therefore, the
problem appears to be reduced to the call for absolute stability in the value of money.
Hence, in the sense of a constant unit of account, Irving Fisher's index currency
would be the appropriate answer. But this view did not prevail among the theoreticians. Back in
1935 Hayek already pointed to the conflicts between price level stabilisation and shifts in relative
prices.
Price level stabilisation is generally no longer prescribed as an objective today.
Even in the discussion on zero inflation there is no demand to reverse an increase in prices
caused, say, by terms-of-trade effects. Moreover, problems of inflation measurement are
currently featuring strongly again.
This gives rise to two tasks in tackling the problem of credibility in monetary
policy practice. Firstly, monetary policy makers must define the (positive) rate of inflation which
they target over the medium term, which the general public has to expect and by which they can
judge the central bank's performance. Secondly, the central bank has the task of explaining any
deviations from this rate to the general public and to make it clear how and within what
timeframe it intends to bring inflation back on to the target path. Quite clearly, these factors are
especially important above all in the context of inflation targeting (M. King, 1997).
In monetary policy practice and theory alike this problem is closely linked to the
question of the relevant aims of central bank policy.
For the sake of brevity, let me postulate the following three principles as the
quintessential findings of a multitude of publications:
-There is no long-term trade-off between inflation and unemployment or
growth.
-The transient costs of macroeconomic stabilisation policy depend not only on
the central bank's credibility but also - and above all - on the degree of
microeconomic flexibility.
-Central bank independence significantly enhances the probability of monetary
stability. It entails no output losses.
II Building up credibility
Experience shows that those central banks which have a successful record of
stability behind them are most likely to enjoy credibility. Very broadly, such a successful track
record is characterised over the long term by a low level of, and a small variation in, the inflation
rate.
When prices rise, the crucial factor is the underlying cause. A fundamental
consideration in building up and defending an anti-inflationary track record is that the central
bank should never resort to the instrument of unanticipated inflation. If the public feels duped by
the central bank, that central bank forfeits it credibility for many years to come.
If, on the other hand, prices rise for exogenous reasons, the subsequent
disinflationary policy course can actually enhance the central bank's reputation. The phase
following German reunification is a case in point. In the context of the reunification boom and a
sharp increase in unit labour costs, the annual rate of price increases in the years 1991/92 came
dangerously close to 5% (in western Germany). Once the general public was convinced that the
Bundesbank would not tolerate any acceleration in the rate of inflation, long-term interest rates
responded positively even before the inflation rate declined.
Considered from this aspect, the whole discussion about rules versus discretion
revolves around the problem of how far monetary policy makers need to be bound to a formal
ex ante
rule in order to convince the public of the central bank's unwavering commitment to its
set task. For monetarists the answer is clear. In addition, a strict monetary rule also protects the
central bank against political pressure. But such a rule also prevents the central bank from
making mistakes which inevitably result from the attempt to seek constantly to examine all
available information for its relevance and to make it usable for discretionary decisions.
Other approaches to overcoming the problem of dynamic inconsistency or
insufficient credibility are targeted at the policy makers themselves. According to Rogoff (1985),
for example, monetary policy should be entrusted to conservative central bankers. Contractual
solutions à la Walsh (1995), with a clear-cut target and strict penalties in the event of its
nonachievement, likewise belong in this category.
Hardly anyone would deny that credibility is extremely important. Any monetary
policy that lacks credibility must be paid for with higher real interest rates. The expectations of a
well-informed and fundamentally critical general public must not be disappointed. Central banks
have to take this into account in pursuing their policy; above all, they should take care not to
exacerbate any prevailing uncertainty through their own policy. There is little to suggest that the
necessary policy-based stabilisation of expectations can be achieved by means of a purely
discretionary approach.
III The European Central Bank
Obviously, the new ECB will have no established track record to inspire
confidence. To what extent the accumulated credibility of national central banks which will form
part of the European System of Central Banks from the beginning of stage 3 can be transferred to
the new institution is an open question. One must therefore resort to theoretical insights and
empirical lessons in seeking to predict the level of credibility that will be enjoyed by the ECB.
The main criteria for making this prediction are the ECB's Statute, strategy and leading
personalities.
The Statute
The Maastricht Treaty gives the European System of Central Banks (ESCB) a
clear mandate in Article 105: "The primary objective of the ESCB shall be to maintain price
stability." Its support for the general economic policies in the Community must be without
prejudice to the objective of price stability. Article 107 guarantees the decision-making bodies
independence in making their decisions. The members of the Executive Board are to be
appointed for eight years, and that term of office shall not be renewable (Article 109a). By
contrast, the Governors of the national central banks, who are to be appointed for at least
five years, may be reappointed (Article 14, Protocol on the Statute of the ESCB and the ECB).
The EMI has already proposed that longer terms of office should be chosen.
I think it goes without saying that an independent central bank cannot freely
choose its own objectives. But the mandate of price stability has to be defined more precisely; an
initial consensus has already been achieved. "While theory does not provide a precise definition
of price stability and while measurement problems exist, there has been a broad consensus
among central banks for several years that a range of 0%-2% inflation per annum would be
appropriate" (EMI).
To this extent, therefore, the theoretical insights and empirical lessons are
adequately reflected in the Statute. Does that mean that the credibility problem has automatically
been solved? Many politicians - but also quite a few economists - think so. In Germany, for
instance, commentators incessantly point out that the ECB Statute, especially as regards its
constitutional status, is even more rigorous than the Bundesbank Act. They conclude that the
euro will be as stable - a frequently heard formulation is "at least as stable" - as the Deutsche
Mark.
Nevertheless, hardly anyone will expect that the ECB will want or be able to keep
the inflation rate below 2% perpetually and under all circumstances. Additional efforts will
therefore be needed to establish credibility convincingly from the outset. This is all the more
necessary as, given the high unemployment in most European countries, pressure will be exerted
on the ECB right from the start to tone down the priority of price stability in favour of boosting
employment. That is the tenor of demands now being made to amend the Statute accordingly.
Incidentally, the provision according the powers to make exchange rate
arrangements is likewise a potential source of vulnerability. Pursuant to Article 109, the EC
Council may, subject to certain preconditions, conclude formal agreements on an exchange rate
system in relation to non-Community currencies. Subject to similar conditions, the Council may
formulate general orientations for exchange rate policy in relation to non-Community currencies.
Strategy
In respect of monetary policy instruments, the Treaty contains only general
guidelines and otherwise gives the ECB complete freedom in implementing its policy. For the
ECB, as a new institution, it is imperative that it undertakes a precommitment in relation to the
general public to which its policy is bound and which makes it accountable. The preparatory
work undertaken by the EMI has reduced the possible alternatives to just two strategies, that is
monetary targeting and inflation targeting.
A monetary target emphasises the central bank's responsibility for monetary
conditions and demarcates its responsibility vis-à-vis other policy areas and exogenous shocks.
Monetary targeting informs the public about the central bank's fundamental orientation and can
thus help to stabilise inflation expectations. In adopting such a precommitment, the ECB would
subject itself to a sharp discipline; it will have to justify any deviations from the target path to the
public.
The empirical studies undertaken so far indicate that the money demand in the
euro area should be sufficiently stable for a strategy of monetary targeting (and more stable than
in the individual countries). There is thus a good chance that, from a "technical point of view",
monetary targeting will fulfil the prerequisites.
On the other hand, we should remember that the initial phase of monetary union,
in particular, will be burdened by a number of imponderables. Clearly, these could have an
impact on the growth of the money stock. It is thus advisable to supplement the strategy of
monetary targeting pragmatically (but not arbitrarily) by including some elements of direct
inflation targeting. The multitude of additional information could be compressed in this sense
into a formal inflation forecast.
Personalities
The ECB Statute does not seek to establish a currency standard excluding all and
any room for discretionary manoeuvre. Consequently, a role will be played by the personalities
responsible for formulating and implementing monetary policy. That applies especially to an
institution which is completely new.
Public controversies about the filling of top posts damage credibility. Monetary
union will not be additionally bolstered by a political union. The leading personalities will
therefore be associated almost inevitably with their respective national states, yet in the end they
are to execute a common policy, namely a single European monetary policy, and to withstand
political pressure. The same applies, by the way, to the Governors of the national central banks.
Misgivings are therefore called for if, for example, there are intentions to introduce
accountability towards the national parliament.
IV Conclusion
The Maastricht Treaty has largely laid the foundations for a stability-oriented
monetary policy as far as the institutional arrangements are concerned. Those foundations need
to be complemented by an appropriate strategy and a convincing decision regarding the choice of
the leading personalities.
The launching of a new central bank and a new currency is accompanied by
uncertainty. The associated risk premium in the interest rate can be kept down by choosing an
appropriate strategy and suitable top executives. The financial markets will keep a critical eye on
the ECB right from the start. The initial monetary policy course thus takes on crucial importance.
Some people are therefore already advising the ECB to pursue a particularly restrictive course
right from the outset so as to nip any mistrust in the bud, as it were.
Such an uncompromising approach would inevitably give rise to tensions within
the Council. It is also hard to imagine that the ECB would meet with general approval for such a
course among the people of Europe, given the high level of unemployment. At the moment we
do not even know whether there is a stable European consensus on the acceptable or optimal rate
of inflation. The trend towards the convergence of inflation rates at a low level is a good omen.
In a monetary union without a flanking political union, we shall simply have to wait and see
whether this convergence of preferences will prove to be a lasting phenomenon.
The consensus regarding the preference for stable money - the common "stability
culture" - is all the more important as monetary union will have to survive for the foreseeable
future without the additional support of a political union. For this reason, the right choice of
participants based on the convergence criteria takes on supreme importance. The public finance
position plays a particular role in this assessment. The fiscal criteria have to be met on a
sustainable basis, in other words not just at the beginning of stage 3. Finally, the member states
must implement the crucially necessary reform of their labour markets and in general
significantly cut back the dense jungle of overregulation. Without a far greater degree of
flexibility at the microeconomic level it will neither be possible for monetary union to yield the
desired benefits nor for the ECB to find broad and ongoing acceptance for a monetary policy
geared to ensuring price stability in accordance with the Maastricht Treaty.