Seminar 9: The Brave New World of European Central Banking


The central institution of the EMU is the European Central Bank (ECB).

In this seminar, we will discuss the nature of that institution: Why it was constructed and it’s design flaws.

The ECB was born out of the Maastricht Treaty. The negotiations leading up to this were intense. Policy and academic debates focused on the design of central banking. Two different models competed for attention:

  1. The Anglo-French model (AFM)
  2. The German model (GM)

These central banking models differ in their objectives and institutional design.

The design

The AFM model operates from the assumption that the objective of central banking is more than price stability. It includes financial and banking stability, maintaining high employment and stabilisation of the business cycle.

In the GM model, the primary objective of central banking is price stability.

In terms of design, the AFM model operates from the assumption that central banks are relatively dependent upon government decisions.

The GM model operates from the assumption that political independence from government (not financial markets) is what matters.

The GM model was enshrined in the Maastricht treaty, particularly Article 105 and 107.

Both of these articles stipulate that the ECB must be completely independent from political interferences, and that it’s only responsibility is price stability.

Although, it does not rule out that this should be complemented with a concern for the wider objectives of the EU community as laid out in Article 2.

No lender of last resort

Printing money or ‘overdraft credit’ facilities are strictly prohibited in the Treaties. This is an interpretation that led to an intervention by the German Constitutional Court in the aftermath of the euro crisis.

The policy of outright monetary transactions (OMT), aimed at resolving the sovereign debt crisis was interpreted in Germany, as ‘printing money’. It was considered ‘fiscal’ policy.

The language of the Treaties make the ECB tougher on inflation and more independent than the Bundesbank, and any central bank in the world.

For example, a government majority in the German parliament can change Bundesbank statues. This is not the case with the ECB, where any change requires treaty changes, and unanimity among all 28 EU member states.

In 2008/2009, the implication of not having a lender of last resort is meant that countries faced with a financial crisis were effectively issue debt in a foreign currency.

Why did the German model prevail?

It is worth asking why member-states accepted the German model (transferring unprecedented economic sovereignty to an international technocratic institution)?

There are many explanations for this. But scholars tend to prioritise two factors: the dominance of the monetarist idea and the strategic position of Germany in the negotiations.

The monetarist revolution stipulated that central banks and government cannot lower unemployment without creating a systematic inflation bias. The only way to lower unemployment is through supply-side reform.

Three policy areas became central to the underlying economic philosophy and ideational framework of European central banking:

  1. Monetary = interest rates targeted at output gaps
  2. Fiscal = balanced stable budgets
  3. Financial stability = banking union
  4. Structural reform = flexible labour market and lower labour taxes

It was only after the crisis that banking stabilisation and financial market regulation emerged as a core policy concern. Before that, they were barely considered.

The case for independence 

The empirical evidence in favour of political independence is quite strong.

Most studies suggest there is a tradeoff between political independence and inflation (as we discussed two weeks ago).

But this is not a free-lunch, as monetarist theory assumes: It depends on the level, type and extent of incomes policies, and coordinated wage setting, and credit regulation (whereas monetarism assumes it depends on labour-price flexibility).

Economic ideas matter!

European conservatism 

The Federal Reserve, particularly during a crisis, has always taken a pragmatic turn toward Keynesian macroeconomics, in order to maintain growth and employment.

Despite the Eurozone experiencing the worst ever unemployment crisis on record, the ECB struggles to take responsibility for stabilising output and employment fluctuations.


This is considered the responsibility of national governments, who are mandated to technically design ‘structural’ reform policies: product and labour market liberalisation.

See the Macroeconomic Imbalance Scorecard and new EU economic governance reforms.

However, is this really true? Is it really the case that the ECB has not influenced the political and policy response to the crisis in member-states?

Independence and accountability

One way to empirically observe the difference between the ECB and the FED is to compare their policy actions since 1999. See Figure 8.2 in De Grauwe (p156).

The data suggests that the ECB is much more cautious in changing it’s policy rate and much less active in targeting the output gap. It is, by most empirical measures, more conservative.

This raises some political economic problems of accountability. The ECB effectively sets its own objectives. It considers employment (structural reform) and fiscal policy (budget rules) the responsibility of national politicians.

But if politicians make bad decisions, they remain accountable to the electorate. They can be voted out of office. This is not the case with technocrats in the ECB.

Technocratic decisions from a political economy perspective are always political, because there are always distributional implications.

Whilst the ECB is the most independent central bank in the world, it is also the most unaccountable central bank in the world.

But is there a necessary tradeoff between accountability and independence?

Macroeconomic stability

The accountability of the ECB is weak for two reasons.

  1. First, the Euro area lacks strong political institutions capable of exerting control over its performance
  2. Second, it has interpreted the Treaties to mean that it’s only objective is price stability and anti-inflation.

Financial and “macroeconomic stability is on the shoulder of politicians“. This is a quote from Jean Claude Trichet.

The Germans tends to agree, as outlined in this speech of the President of the Bundesbank, Jens Weidman.

But if the ECB, and central banking more generally, is not responsible for macroeconomic stability (economic and employment performance) in the Euro area, then who is?

If it is national governments, then politicians have a policymaking problem: member-states don’t have any macroeconomic tools to promote policies such as real exchange rate convergence, other than promoting supply side ‘structural reforms’.

These reforms might promote a business friendly growth strategy that is useful in the long-long term, but electorates may not be willing to wait that long.

In recognition of this lack of accountability at the ECB, there has been an attempt to increase accountability indirectly such as issuing regular press reports, hosting media meetings and releasing monthly bulletins.


Remember, the Euro system decision making process = the executive board of the ECB (president, vice-president and four directors) + the governing council (governors of the 18 national central banks).

It is assumed that national central bank governors act in the Euro-wide system interest. But do they? Does the Dutch Central Bank think in terms of what’s in the interest of the euro area, or what’s in the interest of the Netherlands?

Perhaps the most peculiar feature of the Euro system is that the responsibility for banking regulation and supervision was kept firmly in the hands of nation-states.

The broad principle of banking regulation and supervision was set out in an EC Directive (the second banking directive, 1989) prior to the signing of Maastricht.

It sets out two clear principles:

  1. Hone country control – the responsibility for supervising Deutsche Bank rests with Germany regardless of where it’s activities take place
  2. Home country responsibility – each country is responsible for regulating its own financial market

This lack of effective European wide supervision allowed private banks to expand their balance sheets and take on excessive risk from 2001 onwards, risks that ultimately ended up on the public sector balance sheets of governments, and then the ECB.



Asset price bubbles

From 2001 onwards, the balance sheet of the major Eurozone banks exploded.

The ratio of total assets in German banks was 4 times their deposit ratio. This means they were borrowing massively on the inter-bank money market. They were borrowing short and lending long.

From 1999-2008 the problem in the Euro area was not inflation but the emergence of asset-price bubbles, which could be observed in the growth of the money supply (M3).

This was a clear signal to the ECB that future financial crises were on the horizon.

An excessive focus on inflation prevented the ECB from taking action in these asset markets. This is unsurprising. The problem of exploding bank-credit is not a problem, by definition, in most monetarist macroeconomic theories!


Since 2011, the Euro system has instituted the ‘European Systemic Risk Board’, which is a step toward more centralized financial and banking authority.

Most control remains at the national level.

But overall, the brave new world of European central banking is not really that brave, with the exception of OMT, and the expanded asset purchasing programs.

Most of those policy choices with political salience (fiscal and income) remain in the hands of national governments.

What is brave is the extent to which the ECB has intervened in national policymaking, and the extent to which it is not accountable for its decisions.

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