THE EURO AND

ITS CENTRAL BANK

GETTING UNITED AFTER THE UNION

TOMMASO PADOA-SCHIOPPA
The Euro and Its Central Bank
The Euro and Its Central Bank

Getting United after the Union

Tommaso Padoa-Schioppa

The MIT Press

Cambridge, Massachusetts
London, England
© 2004 Massachusetts Institute of Technology

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Library of Congress Cataloging-in-Publication Data

Padoa-Schioppa, Tommaso.
The euro and its central bank : getting united after the union /
Tommaso Padoa-Schioppa.
p. cm.
Includes bibliographical references and index.
ISBN 0-262-16222-9 (alk. paper)
1. Euro. 2. European Central Bank. 3. Monetary policy—European Union
countries. I. Title.

HG925.P33 2004
332.4¢94—dc22 2003070615

10 9 8 7 6 5 4 3 2 1
To Paolo Baffi and Franco Modigliani
Contents

Preface ix
Acknowledgments xix

1 The Roads to the Euro: A Historical Overview 1

1.1 Politics: From War to Sweet Commerce 1
1.2 Fall of the Berlin Wall and Rise of the Euro 6
1.3 The United Kingdom, European Union, and the Euro 9
1.4 Economy: Resolving an Inconsistent Quartet 11
1.5 Central Banking: From Old to New Anchors 15

2 A Profile of the Eurosystem: The Newest Central Bank 21

2.1 The Eurosystem 21
2.2 Center and Periphery 23
2.3 Decision-Making in the Eurosystem 27
2.4 Independence and Accountability 32
2.5 A Polity in the Making 35
2.6 Appendix: Institutions of the European Union 36

3 Economic Policies: A Special Economic Constitution 41

3.1 Policy Assignment 42
3.2 Interplay 45
3.3 Coordination 47
3.4 Market Policy 51
3.5 Money and Exchange Rate 52
3.6 Fiscal 53
3.7 Employment 59
3.8 While the Jury Is Out 61
3.9 Appendix: Euroland’s Economic Structure and Challenges 63

4 Monetary Policy: As Strong as the Deutsche Mark 67

4.1 Mandate, Strategy 68
4.2 Debates on the ECB Strategy 72
viii Contents

4.3 Practice and Evaluation of the Strategy 78

4.4 Operations 83
4.5 Transmission 86
4.6 Transparency, Communication 91

5 Financial System: The Euro as Unifier 97

5.1 Single Market and Currency Segmentation 97
5.2 The Continental European Model 99
5.3 The Shock of the Euro 102
5.4 Regulation and Supervision 107
5.5 The Institutions of Supervision 111
5.6 The Eurosystem and Financial Stability 115

6 The Payment System: The Plumbing of Euroland 119

6.1 Historical Background 119
6.2 New Risks, New Technologies 122
6.3 One Currency, One System 124
6.4 Banknotes and Other Retail Payments 127
6.5 Large-Value Payments 130
6.6 Securities Settlement Systems 133
6.7 Main Challenges 135

7 The Eurosystem in the Global Arena: A New Actor in a New Play 139
7.1 The Euro outside Euroland 139
7.2 Fall and Rise of the Euro 143
7.3 Three Floating Currencies 147
7.4 Pegs and Corners 151
7.5 The Euro as an Anchor 154
7.6 Cooperation for Financial Stability 157

8 The Trials Ahead: From Infancy to Maturity 165

8.1 Price Stability and Growth 165
8.2 A Perfect Central Bank 168
8.3 Incoming Countries 173
8.4 A Reluctant Global Actor 176
8.5 Policy, Politics, Polity 179

Abbreviations 183
Notes 185
Bibliography 231
Index 243
Preface

This book goes to the press thirty-five years after I entered the profession
of central banking, which I have practiced almost without interruption. I
was hired by the Bank of Italy in 1968, and in the 1980s and 1990s my
work involved active participation in the making of the European mone-
tary union. In 1998 I joined the European Central Bank to serve a yet to
come currency and an institution that almost no one expected to see
evolve from the rarefied empyrean of utopian projects to the bumpy
ground of factual reality.
The main purpose of this book is to offer a guided tour of the euro and
its central bank (the Eurosystem) to readers who, due to the novelty of the
enterprise, are unfamiliar with it. It is to be expected that people’s infor-
mation about institutions adjusts slowly, and that any profound change
takes time to become common knowledge. My purpose is to explain in
simple terms the euro, the structure and activities of its central bank, its
economy, the financial system to which it refers, its monetary policy, the
way its monetary policy interacts with the overall process of economic
policy, and its international dimension. The historical process that led to
the adoption of a single currency is reviewed in the first chapter. The main
challenges facing this young institution, today and for the years to come,
are identified throughout the course of the book and specifically addressed
in the final chapter.

Although the guided tour is limited to the territory of Europe, the road
map used is a general paradigm of what I believe central banking involves.
I gradually developed this, not quite standard, belief over the course of my
banking career, when searching for a single and consistent conceptual
order in which all the activities of a central bank would have their place.
To each of these multiple activities—from monetary analysis and policy,
to banknote printing and handling, to market operations, banking super-
x Preface

vision, payment systems, relations with other policies and other public
institutions, and international cooperation—I had been assigned at differ-
ent stages of my professional life. And for some of these functions I had
discovered that I lacked the powerful support of a university background
I had for monetary policy, because these activities were scarcely treated
both by the literature and by ordinary textbooks on money and banking.
Indeed, what I had not realized as a young economist and only came to
understand through practice is how much central banking is about issues
other than monetary policy.
As I explain in chapter 2, the paradigm proposed is drawn from the three-
stage evolution of modern central banks over the last two hundred years.
This evolution began with the invention of a new medium of exchange—
paper currency replacing, but backed by, gold. It continued with the devel-
opment of commercial bank money (deposits replacing, but backed by,
banknotes) and culminated when the currency severed all links with a
precious metal to back its value.
The monetary system emerging from this evolution is one in which the
currency has no other value than its purchasing power, which is in turn
exclusively based on trust, whence the expression fiduciary money. The
stock of money is composed by liabilities of both the central bank and
commercial banks, and its total is determined by the response of a profit-
driven market to the policy-driven action of the central bank.
Modern central banks are the institutions in charge of the public
interests associated with the currency in a regime of fiduciary money.
Central banking thus consists of a range of highly interdependent activi-
ties, whereby the public interest involved in currency-related matters is
pursued. Such activities have technical and policy aspects and are strongly
influenced by institutions. No doubt, they involve economic analysis in
the first place, but cannot be fully understood if their legal, technological,
organizational, and political dimensions are not considered.
The three historical stages have generated and shaped the triadic
configuration whereby any central bank operates for the functioning of
payment circuits, the stability of the banking system, and the conduct of
monetary policy. And it is worth noting that the three activities are respec-
tively related to the three well-known functions of money as medium of
exchange (an efficient payment system), store of value (the safety of bank
deposits), and unit of account (the stability of prices).
There are reasons why the European experience provides a very conve-
nient case for expounding the central bank paradigm I’ve outlined above.
Indeed, in the move from the old ground of the nation-state to the still
Preface xi

largely incomplete ground of a new European polity, central banking and

currency matters had to be thought out anew. Without a clear paradigm
it would have been impossible to design a new central bank and to build
it on solid foundations, while still acknowledging the very diverse tradi-
tions, monetary structures, and institutions encompassed in the new
design. For a newly created monetary jurisdiction—the land of the euro,
or euroland—it was necessary to write a new central bank charter, to con-
struct a new infrastructure, to adopt and communicate a new policy frame-
work. This endeavour required a model and called to service legal expertise,
market practice, experience in organization, and information technology,
as well as economic analysis.

Over the last thirty years I have seen central banking change profoundly
everywhere in the world. The profession I joined in 1968 was one where
currencies were anchored to gold and the issuing institutions strictly
obeyed, in most countries, the nation’s executive power. With few excep-
tions, the Treasury thus was de facto the real maker of monetary policy.
Insofar as the link to gold left some scope for a discretionary monetary
policy, this was often committed to pursue full employment together with,
and sometimes even more than, price stability. Indeed, back then many
central bankers and a large part of the academic profession were convinced
that monetary policy could durably elevate the growth rate of the economy
by appropriately balancing low inflation and high employment, and pos-
sibly by partially sacrificing the former to have more of the latter.
Most central banks were in charge of bank supervision. While no sig-
nificant banking crisis had occurred since the 1930s, supporting an ailing
bank—not only with liquidity but also with capital—was seen as a hall-
mark of the good central banker. Deposit insurance was an American spe-
ciality, and the notion of moral hazard was confined to the jargon of
private insurers.
Payment practices were based on the hand-to-hand transmission of cash
and on orders to transfer deposits imparted to banks through checks or
giros. The technology used—paper, hand-written signatures, and the postal
service—had settled decades earlier and was widely accepted as a stable, if
not immutable, component of the monetary system. Banks’ chief execu-
tives and top central bank officials had since long stopped devoting much
attention to payment system matters.
In that not too distant era, monetary policy, financial stability, and
banking supervision formed a single composite whose parts were difficult
to disentangle. It was the national currency itself, with its multiple func-
xii Preface

tions, that unified the constituent parts. Central banks were seen by
the public, and were in fact, the creators and the overall custodians of the
currency. Seemingly generic expressions like “to secure the currency” could
be read in the charter of many central banks.
In many respects, and notably from an institutional point of view, that
world of thirty years ago was closer to what central banking had been 100
or 150 years earlier than to what it is today.
Today currencies are no longer anchored to gold. Central banks are
granted independence, albeit in various degrees in different places. They
have been assigned the mission of preserving price stability. Economic
theory has firmly re-established the long-term neutrality of money. Mean-
while a new combination of information and communication technolo-
gies, coupled with the explosion of financial transactions in both volume
and value, has brought payment system issues back to the highest con-
sideration for both commercial and central bankers. Finally, the financial
industry has been transformed by the powerful waves of innovation, dereg-
ulation and globalization, and instability has come back. Recently the task
of supervising banks has been taken away from the central bank in a
number of countries. Some wonder if financial stability—a “land in
between” monetary policy and prudential supervision—still ranks among
the tasks of a contemporary central bank. All these changes were accom-
panied, and to a certain extent fostered, by the emergence of ideas and
policy attitudes strongly oriented to reduce the role of government rela-
tive to markets. After moving for many decades toward expanding inter-
vention of public powers in economic activity, the pendulum reversed its
direction in the late 1970s. The emancipation of central banks from the
tutelage of the political power, the narrowing and focusing of their
mandate, and, in many countries, the assignment of banking supervision
to a separate agency were part of this evolution.
These developments seem to have altered the old composite to the
point that one may question whether the old triadic configuration is still
a valid description of central banking. I think it is. The triadic framework
is derived from the inner structure of monetary and banking systems,
which recent changes have not wiped out. Central banks are most pro-
minently involved in monetary policy and payment system issues. As to
financial stability, despite the recent creation of separate supervisory
agencies, no central bank in the world regards it as lying outside its sphere
of interest. Commercial banks are critically close to central banks as
primary creators of money, providers of payment services, managers of the
stock of savings, and counterparties of monetary policy operations. In
point of fact, no central bank stays out of the management of a financial
Preface xiii

crisis when one occurs. The triadic paradigm is indeed a leitmotiv of the
book and is used to organize its structure. A consequence of this choice is
that compared to other books on central banking, this one devotes a
relatively small proportion to monetary policy (chapter 4) and larger
proportions to the financial system and the payment system (chapters 5
and 6 respectively).

Turning from central banking to Europe, the relationships among

European states have immensely changed over the same third of a
century in which I served as central banker, following a path that at a
point intersected the evolutionary path of central banking.
As I am a central banker by profession, so I am an advocate of a united
Europe by political conviction. Actually I embraced the political convic-
tion before embracing the profession, the citizen making his choice before
the worker. As a child, I had seen the bombing of bridges and cities, wit-
nessed the passing of German and then American troops through the street
outside the house, and sensed the anguish and insecurity pervading the
atmosphere around. As a teenager, I listened to my history teacher explain-
ing to the whole school that the day before (March 25, 1957), an impor-
tant Treaty had been signed in Rome. Six European countries had just
committed themselves to creating a common market where goods, ser-
vices, capital, and persons could circulate freely. To achieve such goal, and
as a step toward a politically united Europe, in which solid peace would
be established after centuries of bloody warfare, they were to renounce part
of their sovereignty. That a united Europe was a worthwhile objective
became the strongest of my political convictions.
The process of European integration (of which the Treaty of Rome is the
foremost foundation) gradually transformed the nature of the relationships
between European states. A new and unprecedented institutional construct
was gradually created, something in between an international organization
and a federation of states, more than the former and less than the latter.
The construct was primarily economic in content but eminently political
in nature, because its very essence—indeed the objective that aroused
simultaneously positive support and fierce opposition—consisted in reor-
ganizing the structure of power. Agitating an ugly image to help their fight,
opponents claimed that the project pursued the replacement of nation-
states with a new European super-state. In reality, it pursued the distribu-
tion of government through several layers (of which the European Union
was to be just one), in order to have a minimum and efficient overall power
structure. What was to be superseded was not the power of the nation-state
but its unbounded character.
xiv Preface

The evolutionary path of intra-European relationships can be visualized

as the gradual move of the European Union from the international to the
domestic model of economic order. The move went from the dismantling
of tariffs and quotas, to the creation of a customs union, to the removal of
nontariff barriers through the adoption of a pervasive common economic
legislation, to the creation of a central authority to enforce common com-
petition rules. To appreciate the relevance of such move, suffice it to note
that, in the late 1950s, the free circulation of goods, services, capital, and
persons was not yet fully in place within the states signing the Treaty of Rome.
The evolutionary path of European integration and that of central
banking crossed in the late 1980s. In the economic field, the completion
of the single market was well underway. In the monetary field, it seemed
that the time had come to grant central banks full independence and a
narrowly defined mandate. In the political field, there was the strong will
to make a big new step toward a united Europe. The creation of a single
European monetary policy lies at the crossroad of these three paths.
Thus in Europe the transformation of central banking has led not only
to reforming the functions and the charter of the institution described
above but also to detaching both the currency and the central bank from
the center of political power. Recalling Alexander the Great’s effigy on
ancient coins, one should realize how big a break with history has
occurred. The full implications of this detachment are still unfolding, and
it is impossible to predict today where they will lead economic, monetary,
and political reality.
Both paths have amply occupied my life because, for a curious accident,
money became the leading project for further European integration just at
the time when I was in the maturity of my professional life. My profession
and my European conviction thus became a single activity. I served at the
EU Commission in 1979 to 1983, the early years of the European Mone-
tary System. I was directly involved in the preparation of the blueprint for
a single currency in 1987–89, in the 1989–91 negotiation leading to the
Maastricht Treaty, and in the 1993–97 preparatory work for the launch
of the euro. Because the euro and the Eurosystem are at the crossroads
of the two paths, this book is about both central banking and European
integration.

E pluribus unum is the title I first proposed for the book. The publisher
objected that such a title would mislead a computer, or even a person in
a bookstore, making them believe that the book is about the United States,
whose seal carries this motto. I reluctantly surrendered to the needs of com-
Preface xv

merce, but I recall this little episode to highlight a leitmotiv of the whole
book. This leitmotiv is the process of effectively making the Eurosystem—
composed as it is by the European Central Bank and the national central
banks of the countries that have adopted the euro—the single, strong, effec-
tive, publicly recognized central bank of the euro. Through its chapters the
book shows that, five years after the birth of the euro, this process is still
at an early stage and proves dauntingly arduous.
As the Eurosystem is for the euro what the Federal Reserve System is for
the dollar, common sense suggests that it should rapidly and forcefully
organize itself as a system across the full range of the multiple central bank
activities reviewed above. Indeed, I extensively explain how inextricably
linked such activities are in practice. However, I also show how distant
the Eurosystem still is from achieving a full and balanced blend of these
activities into a single central bank.
Anyone who compares the central bank of the euro with a traditional
central bank is struck by the fact that while for monetary policy this con-
dition has been reached, for most other activities the single, excellent
(effective and efficient) central bank of the euro is still in the making. Each
of its national components maintains the full infrastructure of a stand-
alone central bank and endeavours to keep it active. Each has its own bank-
note printing process, a proprietary system for transferring central bank
money, a dealing room, and a foreign exchange reserve management
capacity. Each defines its own position and speaks its view in most inter-
national forums, offers (or can offer) to other central banks around the
world to manage their reserves in euro, and entertains (or can entertain)
its own representative offices abroad. These various activities are hardly
harmonized, shared, or pooled.
Reflection can mitigate the surprise caused by this state of affairs. The
fact is that for a very long time each national central bank had separately
performed the full range of central bank activities reviewed in this book.
Each bank has joined the Eurosystem with the full-fledged—and often
quite overstaffed—structure it needed to operate as a stand-alone central
bank.
After the euro, this organization entails heavy economic costs, difficult
problems of internal coordination, creeping competition between national
central banks, and the risk of giving contradictory signals to the outside
world. It also entails that the Eurosystem as a whole lacks the control or
the information a central bank normally has over its area of jurisdiction.
For example, it lacks a comprehensive and integrated picture of the main
financial institutions operating in the euro area.
xvi Preface

The central bank running the euro is thus, for the moment, a very special
one. A normal central bank perform in an integrated way the three central
banking functions, involving monetary policy, payment systems, and
banking supervision. It exerts operational and regulatory powers, interacts
with other public authorities, practices a special magistery over the finan-
cial community, intervenes in crises, works with other central banks, and
takes clear-cut positions on international monetary and financial matters.
It does all that in one way, with one style, under a single command, not
in a variety of ways across its organization. From the point of view of the
perceptions of people and markets, all such activities refer to one and the
same public good, confidence in the currency. And we know that in a
modern market economy, confidence—rather than intrinsic value—is the
foundation of the value of money. A normal central bank is a monopolist.
Today’s Eurosystem is, instead, an archipelago of monopolists.
Could e pluribus unum then be taken as the guiding motto for the
evolution the Eurosystem has just started and is bound to pursue in the
coming years? Philologists say that the right interpretation of the motto
on the seal of the United States should not be derived from classical Latin,
where it means “one among many,” but rather from a later tradition where
it means making “a union out of many.” The book indeed argues that the
“unum” should be the Eurosystem, not the European Central Bank.
The Eurosystem should evolve from the present archipelago to a single
central bank, but it should not do so by transferring all activities from the
national central banks to the European Central Bank. It should do so by
organizing, rationalizing, consolidating, and controlling activities from the
center, while letting the conduct of activities be performed by national
central banks or groups thereof. The various chapters of the book explain
how this could gradually happen. In sum, the American version of the
motto, rather than the classical Latin one, should be adopted for the
Eurosystem.
A paradigm of central banking, not the Treaty, should be the road map
to perfection. It would indeed be an illusion to expect, or pretend, to obtain
a full and satisfactory answer solely from legal interpretations. And while
the Treaty provides useful guidance, those who carry the responsibility to
manage the euro and are accountable for that responsibility have known
for years what a central bank is and how vague the wordings of central
bank statutes have historically been.

The book aspires to be instructive for students, interesting for scholars,

and accessible to the general public. In a certain respect it is an interdis-
Preface xvii

ciplinary work because, in addition to economic concepts and proposi-

tions, it frequently uses categories and conceptual instruments from the
historical, political, and legal literature.
I am not part of the academic profession and in two respects this is not
an academic book. First, it does not use the formal tools of the academic
literature. Second, it does not incorporate in the text a systematic review
of the literature on the various subjects it touches upon. Yet the book aims
at being based on rigorous analysis and aligned to recent strands of eco-
nomic research. To keep the text short and readable, extensive references
to the literature, to the academic debate, as well as a host of historical ref-
erences, conceptual clarifications, and institutional commentaries are
provided in the endnotes as background and extensions of the main text.
The apparatus of endnotes almost makes up—with the main text—a
second and extended book.
The reader should also be warned that I am not a remote observer of the
subject I treat. I am an ECB-actor, not an ECB-watcher. No author is ever
objective, but every author must strive to be intellectually independent
and honest. Although I consider this book to be consistent with the fun-
damental orientation of the European Central Bank and its charter, I am
sure that any of my colleagues in the Council of the Bank would have
written a different, and perhaps quite different, book on the same subject.
Each would have probably made a different selection of topics, and chosen
a different structure. Some colleagues will certainly disagree, and even
strongly disagree, with some ideas, passages, or statements. The book
expounds my own views and opinions; in no way can it be interpreted as
the official view of the European Central Bank.
A degree of subjectivity is simply part of the pluralism that characterizes
and enriches an institution governed by two collegial bodies, composed of
individuals with diverse experiences, views and backgrounds, appointed by
governments rather than by co-optation.

As far as I am concerned, this is also the legacy I owe to my two eminent

masters in central banking, to whom the book is dedicated, Franco
Modigliani and Paolo Baffi. As teacher at MIT, Franco had given me the
foundations of monetary and central banking, or—I would say—the robust
and flexible footwear, with which I have walked for the rest of my life,
perhaps not always going to places he liked. Thereafter, and until today,
he has been an incessant interlocutor, a generous co-author, a wise friend,
and an admirable example of how to combine rigor and common sense,
passion and objectivity, simplicity and analytical thoroughness, pedantry
xviii Preface

and imagination*. Paolo Baffi was the governor for whom I closely worked
in 1975 to 1979, and he ranks among the distinguished and internation-
ally respected monetary economists of his generation. For the Bank of Italy,
where he served for more than fifty years, Paolo Baffi has been above all
the founder and the inflexible applicant of principles, which are essential
preconditions for the integrity and effectiveness of any institution. To
innumerable officials, including me, he taught that decisions require
rigorous analysis though the product is mechanical, that analysis
and internal debate must be completely free, and that the hierarchy of
the grades must never eclipse the quality of the arguments.

* Franco passed away in September 2003, a few days before receiving the manu-
script of this book and reading this dedication.
Acknowledgments

In the two years in which work on this book almost exhausted my free
time, I have received precious help and support by many persons, to whom
I want to express my warm gratitude here. Two stand on the top of the
list. The first is Pierre Petit, my counsellor at the ECB, who assisted me
indefatigably from the elaboration of the first outline to the final comple-
tion of the manuscript. Pierre has been an independent and congenial
daily interlocutor, providing enormous background work, comments,
suggestions, checks and critical remarks, that were rigorous, penetrating,
careful, and precise. The second is Elizabeth Murry, economics editor at
The MIT Press, who decisively contributed to this book becoming what it
is. She guided me in identifying the appropriate structure and language of
the book and in getting me to come close to the best I could do. The great
deal I have learned from her about writing will remain with me beyond
this book. C. Randall Henning, Charles Wyplosz, and several anonymous
reviewers have thoroughly and carefully read the manuscript, providing
a host of precious comments and suggestions. A number of colleagues in
the Bank have assisted me in putting together materials for the book and
contributed to checking the facts and the literature. I am particularly grate-
ful to Ignazio Angeloni, Thierry Bracke, Ettore Dorrucci, Andrea Enria,
Koenraad de Geest, Gabriel Glöckler, Peter Hördhal, Arnaud Marès, Ignacio
Terol, and Christian Thimann. Els Ysewyn has patiently and carefully
assured the handling of the manuscript and the thorough check of bi-
bliographical references. Early and decisive encouragement to undertake
the project came from Rudi Dornbusch and Olivier Blanchard. Alan Blinder
gave me precious advice at a critical juncture. By reading the manuscript,
Franco Continolo, Wim Duisenberg, and Barbara Spinelli have comforted
me that I was not sinking in the muddy waters of abstruseness, platitudes,
or personal hobbyhorses, while providing me with precious comments.
Needless to say, neither these persons nor the European Central Bank bear
any responsibility for the content of the book.
The Euro and Its Central Bank
1 The Roads to the Euro: A Historical Overview

Maastricht is the small town of the Netherlands where, in 1992, the

member states of the European Union (EU) signed the Treaty that created
the euro and its central bank. Rather than a sudden decision, the euro was
the result of a long-term development that started in the aftermath of
World War II.
After experiencing political oppression and war in the first half of
the twentieth century, Europe undertook to build a new order for peace,
freedom, and prosperity. Despite its predominantly economic content,
the European Union is an eminently political construct. Even readers pri-
marily interested in economics would hardly understand the euro if
they ignored its political dimension.
In reality, the Treaty of Maastricht and its implementation in the 1990s
represent the meeting point of three, not just one, different roads, going
through political, economic, and central banking fields. Although they
have influenced each other significantly, movement along each road was,
to a great extent, driven by an inner logic specific to each field. The overall
development was thus the outcome of a complex interaction.
To highlight this complex evolution it is necessary to follow each road
separately, while explaining the key interactions. Sections 1.1 to 1.3 are
devoted to political developments, section 1.4 to the economic ones, section
1.5 to central banking. Table 1.1 is a recapitulation of the overall process.

1.1 Politics: From War to Sweet Commerce

The intellectual seeds of a politically united Europe were laid down by

enlightened figures of the early 1940s, when mutual hatred seemed the
only bond between the European peoples. Persons like Jean Monnet,
Altiero Spinelli, Jacques Maritain, Luigi Einaudi, and Helmut von Moltke
(to quote just some names) searched what kind of arrangements could put
2 Chapter 1

Table 1.1
General chronology

1948, May Congress of The Hague

1951, April Treaty of Paris signed, establishing the European Coal and Steel
Community
1952, April Treaty signed, establishing the European Defence Community
1954, August French National Assembly fails to ratify the European Defence
Community Treaty
1957, March Treaty of Rome signed, establishing the European Economic
Community (EEC)
1958, January Start of the EEC
1968, July Customs union completed
1971, August End of the Bretton Woods system with declaration of the
inconvertibility of the US dollar into gold
1972, March Introduction of the “snake,” an exchange rate agreement
between five European countries (Belgium, France, Germany,
Italy, the Netherlands)
1973, January The United Kingdom, Denmark, and Ireland become members
of the European Communities
1979, March Start of the European Monetary System (EMS)
1979, June First elections for the European Parliament by direct universal
suffrage
1981, January Greece becomes a member of the European Communities
1986, January Portugal and Spain become members of the European
Communities
1986, February Single European Act signed, which provides for the completion
of the internal market by 1992
1988, June European Council in Hannover, where a Committee, chaired by
Jacques Delors, is charged with the task of studying and
proposing stages leading toward an economic and monetary
union
1989, April Delors Report presented, which gives a blueprint for Economic
and Monetary Union
1990, October Reunification of Germany
1992, February Maastricht Treaty signed, establishing the European Union
1993, January Single European Market inaugurated
1994, January European Monetary Institute (EMI) established
1995, January Austria, Finland, and Sweden join the European Union
1997, October Treaty of Amsterdam signed
1998, June Establishment of the European Central Bank
1999, January On January 1, the euro introduced as the official currency in
eleven member states (Belgium, Germany, Spain, France,
Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal,
and Finland)
2001, January Adoption of the euro by Greece
The Roads to the Euro: A Historical Overview 3

2001, February Treaty of Nice signed, amending the Treaty on European Union
and the Treaties establishing the European Communities
2002, January Introduction of the euro bank notes and coins
2002, February Convention on the Future of Europe opens in Brussels
2003, April Accession Treaty signed by the existing fifteen member states
and the ten acceding countries (the Czech Republic, Estonia,
Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia,
and Slovakia)
2003, October Intergovernmental Conference (IGC) convened to discuss and
agree on a new treaty for a Constitution for Europe
2004, May The Czech Republic, Estonia, Cyprus, Latvia, Lithuania,
Hungary, Malta, Poland, Slovenia, and Slovakia become
members of the European Union

an end to centuries of wars, interrupted only by precarious truces based on

a balance of power.1 Those precursors of history concluded that a lasting
peace could only be established by creating a political order superior to
the, as yet unbounded, power of nation-states.
“Never again a war among us” was the motto of Robert Schuman, Konrad
Adenauer, and Alcide De Gasperi, the three political leaders of France,
Germany, and Italy who, in the late 1940s and early 1950s, undertook to
unite Europe.2 The first step, proposed by the Frenchman Jean Monnet,
was to pool and jointly manage coal and steel, the two strategically crucial
resources for the control of which three wars had been fought between
1870 and 1945. In 1951 six countries (France, Germany, Italy, Belgium, the
Netherlands, and Luxembourg) implemented Monnet’s idea by entrusting
a common institution—the European Coal and Steel Community (ECSC)
—with the governance of coal and steel production. For the first time
European countries voluntarily agreed to forgo their sovereignty in a
strategically important, albeit limited, field. The model for further projects
had been set.
The next attempt, directly addressing the heart of state sovereignty, was
in the field of defense. In 1952 the six ECSC countries stipulated a treaty
to create a European Defence Community (EDC), with a single European
army under a unified military and political command. In France, however,
one of the signatory countries, nationalist sentiments were still strong in
the political establishment and in a segment of the public opinion. Even-
tually the French Parliament denied ratification and the EDC Treaty never
came into force.
Having failed on defense, attempts at molding a politically united
Europe reverted to the economic field. In 1957 a third treaty was signed
4 Chapter 1

in Rome and founded a European Economic Community (EEC). The chief

objective was to create a common market where goods, services, capital,
and persons could freely circulate under common rules and institutions.3
Peace, the idea behind the Coal and Steel Community, was further
pursued through tighter economic interdependence. Sweet commerce
would replace barbarian bellicosity. As the French political philosopher
Charles de Montesquieu had put it in the mid seventeenth century, “com-
merce cures destructive prejudices. . . . It polishes and softens barbarous
mores. The natural effect of commerce is to lead to peace.”4 The founders
indeed premised the new Treaty on building powerful common interests
among European people with political union as the eventual result.5
The Treaty of Rome became the basis of the integration process in the
four decades that followed its coming into force, and it still represents the
most important founding act of a united Europe, almost the equivalent of
a constitutional charter. Based on it are the state-like institutions that today
rule the European Union, mainly from Brussels.6 The creation of a unified
market was basically an implementation of the provisions of the Treaty by
these institutions.
I should note again that, although the integration process cornered pri-
marily the economic field, its motivation and guidance were genuinely
political.7
Over the years the advances, pauses, and temporary retreats in the imple-
mentation of the Treaty of Rome were chiefly determined by political
factors. Between 1958 and 1965 the momentum remained very strong,
despite political change in France, where in 1958 the weak and politically
unstable IV Republic gave way to the more robust and nationalistic pres-
idential system of the V Republic, led by Charles de Gaulle.8 This was
due to the impulse coming from the recent adoption of the Treaty and
from very pro-European government leaders in Germany, Italy, and the
Benelux.
Rapid progress was accomplished. The institutions of the EEC—the
Commission, the Council of Ministers, the Parliament, and the Court of
Justice—were set up. The method for implementing the common market
was established. This consisted in adopting, economic sector by sector,
legally binding European legislation, whose force was superior to national
legislation, just as US federal law prevails over state law. Thus obstacles to
the freedom of trade were removed and key national economic norms
harmonized, mainly for manufactured goods. The customs union, the first
step toward the creation of a common market for goods, was completed
by July 1968, eighteen months ahead of schedule.9 For agricultural prod-
The Roads to the Euro: A Historical Overview 5

ucts a Common Agricultural Policy (CAP) was created, based on a common

administratively set price at which producers were entitled to sell their
products on the market or, if market demand proved insufficient, to the
EEC itself.
This phase of rapid progress ended in 1965–66, when a major crisis
occurred that virtually blocked the project of a clear, albeit gradual and
limited, pooling of sovereignty to a supranational institution. The crisis
came when, according to the timetable set by the Treaty of Rome, una-
nimity was to be widely replaced by qualified majority voting in the
decision-making. It was caused by the French President Charles de Gaulle,
who blocked the transition to the majority rule by imposing the practice
that countries should have the right to veto any decision contravening
what, in their exclusive judgment, they deemed to be a national “vital
interest.” While the notion of vital interest suggested that veto would be
used only in exceptional circumstances, in practice, unanimity became the
conditions for taking decisions.10
As a consequence of the 1965–66 crisis, the creation of a common
European market slowed down considerably and even rolled back.11 The
stalling became particularly pronounced in the 1970s, a decade of economic
stagnation, high inflation rates, and exchange rate instability. Nevertheless,
even during this long stalemate, some progress was made in European
unification, mainly through successive amendments of the Treaty.
In 1970, the Community was endowed with its own sources of revenue.12
In 1972, the field of Community action was extended to environmental,
social, industrial, and energy policies. In 1973, the United Kingdom,
Denmark, and Ireland became new members. In 1974, periodic gatherings
of the (by then) nine heads of state or government were formalized into a
European Council, meeting at least three times a year. In 1975, a regional
policy and a common regional development fund were created, aimed at
helping the economically backward regions. In 1979, the European
Parliament, previously a body of selected national parliamentarians, started
to be elected directly by the people. Despite the limited powers of the Euro-
pean Parliament, this mobilized political parties and voters on European
issues and began “democratizing” the otherwise elite- and executive-driven
EU system. Finally, in 1979, the European Monetary System (EMS) was
created, as a fixed, but adjustable, exchange rate system.13
While, these steps notwithstanding, the 1970s had been a decade of
general stall, in the 1980s a decisive acceleration was imparted to the
European process. This was partly due to the positive economic environ-
ment created by an expansion that started in 1982 and lasted for the whole
6 Chapter 1

decade. Not less, it was due to the prolonged political stability that pre-
vailed in most countries and to the strongly pro-European Union leader-
ship of Helmut Kohl, François Mitterrand, and other national figures in
various countries.14 As president of the European Commission, Jacques
Delors played a decisive role.15 Under these favorable circumstances, new
impetus was given to old projects and new ones were launched.
In 1986, a treaty (the Single European Act) amended the Treaty of
Rome.16 To finally achieve a single market without internal frontiers (end
1992 was set as deadline), it introduced extensive recourse to majority
voting for the adoption of the necessary legislation. The long standstill
came to an end and in about five years hundreds of new EU laws were
passed that implemented freedom of circulation not only for goods but
also for capital, services and persons.17 The single market started on January
1, 1993.

1.2 Fall of the Berlin Wall and Rise of the Euro

The renewed dynamism of the 1980s reached a new milestone in 1988,

when the single currency was set on the European agenda and a committee
chaired by Jacques Delors was asked by the European Council to draw a
blueprint for Economic and Monetary Union (EMU).
The decision to replace national currencies with a single European one
was perhaps the most advanced step in the long history of European inte-
gration. Together with an army, the currency is the foremost expression of
national sovereignty. It is not by accident that names like Louis, real or
sovereign, have been chosen in the past by the French, the Spanish, and
the English to designate currencies. Although strong economic and tech-
nical arguments pleaded for a single currency, as explained later in this
chapter, they would have been insufficient to determine the move to the
euro had fundamental political decisions not driven the process.
Like Adenauer, De Gasperi, and Schuman in the 1950s, Kohl, Mitterrand,
Andreotti, and Gonzalez in the 1980s knew little about the economic and
technical arguments for or against monetary union.18 In line with the
original motivations of the 1950s, they saw the single currency mainly as
a further step—and as a prerequisite for yet other steps—in the political
unification of Europe. In the 1970s they had directly experienced how
urgent the need for a tighter union was for their own countries and for
Europe as a whole to play a role in the international world. To move
forward decisively, they chose the monetary goal, sometimes against their
own experts.19
The Roads to the Euro: A Historical Overview 7

Besides the vision of political leaders, unusual historical contingencies

played a role. During the crucial phase in which the blueprint prepared
by the Delors Committee was at the junction of either being shelved or
becoming a concrete political commitment, the Berlin wall fell (Novem-
ber 1989) and the course of post–World War II European history suddenly
changed. The reunification of Germany became possible. Both the hope of
closing the last wound of World War II and the fear of a resurrection of
German hegemony revived at once. From this situation came a decisive
impulse to the implementation of the single currency. By supporting the
single currency, the German government gave the clear sign that reunifi-
cation of the nation and further European integration were two insepara-
ble aspects of one and the same policy.
The Treaty of Maastricht was negotiated in 1991 on the basis of the
Delors Report and was signed in February 1992. With the exception of the
United Kingdom and Denmark, which obtained a special “opt out” clause,
the signatories committed themselves to start the single currency at an
imperatively fixed final date (January 1, 1999).20 The date was not contin-
gent on any further decision, nor on a minimum number of participants,
but only on compliance with macroeconomic requirements.21 The require-
ments, the so-called Maastricht criteria, included convergence toward price
stability, sound public finances, exchange rate stability, and low long-term
interest rates.
In the aftermath of the signing of the Treaty and concurrent with the
process of ratification, the European fixed exchange rate system underwent
a serious crisis. Severe tensions in foreign exchange markets led to the exit
of the Italian lira and the British pound from the EMS in September 1992,
to repeated devaluation of the Spanish peseta and the Portuguese escudo,
and to extraordinary measures to support the French franc.22 The EMS was
saved by the decision (August 1993) to widen its margins of fluctuation
from 2.25 to 15 percent, but lost much of its disciplinary function.
When the Maastricht Treaty was ratified and entered into force on
November 1, 1993, the climate in Europe had departed from the euro-
euphoria of Maastricht and a somewhat paradoxical situation had arisen.23
Because of the gravity of the 1992–93 EMS crisis, the goal of a single cur-
rency seemed to have drifted apart and so-called euro-scepticism had
gained ground in official and political circles as well as in the public
opinion. Indeed, toward 1994 few were convinced that EMU would
actually start at the set date. Only some top political leaders, and
most notably the German chancellor Helmut Kohl, did not abandon the
project.
8 Chapter 1

Meanwhile, however, and to some extent independently, the macroeco-

nomic requirements set for joining the single currency acquired a life of
their own. They were adopted by markets and observers as benchmark of
good economic policy behavior, to the point that complying with them
became a central issue and an influential argument in the domestic eco-
nomic policy debate of each country. As to the furthering of European uni-
fication, it was clear that failing to implement the single currency would
have dealt a major blow to the decade-long design to build a united Europe.
These circumstances largely explain why, in the 1994–97 period, signifi-
cant progress was made toward meeting the Maastricht criteria.
After the coming into force of the Treaty, technical preparation began
for the move to the single currency. The European Monetary Institute
(EMI), forerunner of the European Central Bank (ECB), was set up in
Frankfurt in 1994. In 1995 the name of the new currency—the euro—was
chosen. The definition of the monetary framework of the future ECB was
initiated at the EMI. The design and features of the new notes and coins
was approved. It was also decided that while the single currency would be
introduced on January 1, 1999, with the disappearance of intra European
exchange rates and the adoption of the single monetary policy, the
national banknotes would be replaced by euro notes and coins only at
the beginning of 2002.
Toward the end of the 1990s, the overall economic and political climate
became again propitious to the single currency. In May 1998 the heads of
state and government of the European Union took the three final decisions
needed to start the single currency. First, eleven countries were selected as
eligible for joining the euro; second, the conversion rates between their
currencies were set; and, third, the president and the other members of the
executive board of the ECB were appointed. On January 1, 1999, the euro
became the single currency.
The Single European Act and the Maastricht Treaty brought some
changes to the European vocabulary. With the former, what the Treaty of
Rome called the “common market” came to be called the “single market,”
to mark a fresh start. With the latter, the term European Union (EU) was
adopted to designate the so-called three-pillar construct comprising the
European Communities (the economic and monetary field), a common
foreign and security policy, and cooperation in fields of justice and home
affairs. While all the provisions, tasks, and procedures pertaining to the
first pillar foresee a strong role for supranational institutions, the latter two
pillars are up to now governed essentially by intergovernmental coopera-
tion, involving the unanimity rule. In the rest of the book we will often
The Roads to the Euro: A Historical Overview 9

use the term “the Treaty” for the integrated European charter formed by
the Single European Act, the Treaty of Maastricht, and the Treaty of Rome.
After Maastricht, the political process of advancing the union by way of
Treaty changes continued. In Amsterdam (1997) and in Nice (2000) two
new treaties were stipulated, mainly focused on political and institutional
aspects of the European Union. Attempts were made to strengthen the
second and third pillars set up in Maastricht as well as to prepare the EU
institutions for future enlargements to up to twelve new members. The
results were modest. In particular, the Treaty of Nice produced rather com-
plicated, and possibly unworkable, compromise formulas. Thus, while the
member states declared the European Union ready for enlargement
anyway, they also implicitly recognized the need to strengthen the Union
and decided to launch, by 2004, yet another round of constitutional
reform. In February 2002 a Convention on the Future of Europe, made up
of government representatives and parliamentarians, comparable, in a
sense, to the Philadelphia Convention back in 1787, was put in charge of
preparing a new treaty reform.24

1.3 The United Kingdom, European Union, and the Euro

Throughout the process leading to the euro, a special element, one that
has often been in the limelight, is the position of the United Kingdom.
Those who focus exclusively on the economic and monetary significance
of the euro may fail to see that behind the nonparticipation of the pound
sterling in the euro there are strong political motivations, before the eco-
nomic and monetary ones.
Indeed, the reluctance to a single currency, and the final request to be
exempted from a firm commitment, were just another instance of the cau-
tious attitude toward European integration the United Kingdom has main-
tained over half a century. This attitude consisted in resisting and even
opposing any transfer of national powers to a jointly governed suprana-
tional institution. At the same time, however, and in line with traditional
British pragmatism, this attitude comprised a disposition to join EU
arrangements and institutions, once implemented and proved successful.
Some prominent examples illustrate the point. The United Kingdom tried
to stop (in 1956–57) the stipulation of the Treaty of Rome, but asked to
join the EEC three years after the start. With Greece and Denmark in 1984
it opposed calling the conference that negotiated the Single European Act,
but adhered to it in the end. It stayed out of the EMS in 1979, but joined
it eleven years later. It opposed the Social Charter in 1989, but signed it in
10 Chapter 1

1997. It still rejects the 1985 Schengen agreement, whereby most EU

member states have abolished all controls at their common borders.
It is fair to say that scepticism and pragmatism (or perhaps empiricism)
have permeated British attitudes for fifty years. Scepticism, because most
Britons simply disbelieve that continental Europeans really want a United
Europe and generally assume Europeans will never do what they say they
will. Not by accident, euro-scepticism is an expression coined by the British
press, although the sentiment it depicts is present also in the European
continent. The sentence spelled out by the British delegate when he left
the Messina conference in 1955 (which drew the first plan of what became
the Treaty of Rome) still stands out as a monument of euro-scepticism. “I
leave Messina happy, because even if you continue meeting, you will not
agree; even if you agree, nothing will result; and even if something results,
it will be a disaster.”
Many continental Europeans would like the unification process to
benefit in full from the high tradition of political freedom and art of gov-
ernment the United Kingdom has built up over the centuries. They are
frustrated by the reserved attitude of many British politicians, journalists,
publishers and the general public.
A reserved attitude, however, can be well understood when set against
the background of history. For centuries the British Isles have been con-
fronted with efforts by one or the other of European continental powers
to unify the continent under a single rule through military, diplomatic, or
dynastic initiatives. As an insular power, Britain was naturally protected
from invasion and had its main interests on the sea. However, it felt threat-
ened by the rise of a dominating power on the continent. When Philip II
of Spain in the sixteenth century, Louis XIV in the seventeenth century,
Napoleon in the nineteenth century, or Hitler in the twentieth century
engaged themselves in such attempts, Britain acted to rally coalitions that
restored the balance of power and impeded domination by one state. In
playing this role, Britain protected the weak and built its own strength.
In the five decades since the end of World War II, when the continent
sought peace and security, no longer via the establishment of a precarious
balance of power but by peacefully and gradually uniting, the deep-seated
political instincts of Great Britain emerged again. The unification of the
continent was seen as a threat rather than the foundation of peace and
order. Hence there was a great reluctance to accept any transfer of sover-
eignty to common institutions.
The debate about joining the euro is still very open in the United
Kingdom. Some economic and monetary arguments echo those used when
The Roads to the Euro: A Historical Overview 11

the Treaty of Maastricht was prepared; others are more specific to the con-
tingent or structural situation of the UK economy. Important as they are,
however, economic arguments are perhaps not the crux of the matter.
Eventually, and rightly so, the British élite and the voters will decide on
the basis of the deeper, albeit less precisely formulated, political and his-
torical considerations that are governing the relationship between the
United Kingdom and the European continent.

1.4 Economy: Resolving an Inconsistent Quartet

What we have followed so far is the political road to the euro. We take
now the economic road.
Although its principal objective was to establish freedom of circulation
of goods, services, capital and persons, the Treaty of Rome was more than
that. Referring to the classic taxonomy proposed by Richard Musgrave
(1958) for fiscal policy—allocation (aimed at efficiency), stabilization
(aimed at stability), redistribution of resources (aimed at equity)—we can
say that the full spectrum of economic policies was indeed covered by the
Treaty.
As for allocation, not only the market mechanism was contemplated but
also other more command-directed methods. First and foremost these were
in the field of agriculture through the CAP.
As for stabilization, member countries committed themselves to “treat
[their] exchange rate policy as a matter of common interest”25 and to
“regard their economic policies as a matter of common concern and . . .
co-ordinate them.”26 In the mid-1950s these loose prescriptions were
deemed sufficient because other powerful arrangements were in place. In
the monetary field, the key stabilizer was the dollar-based fixed exchange
rate system founded at Bretton Woods.27 In the budgetary field, public
sector budgets were broadly in equilibrium and did not threaten overall
economic stability as large deficits were to do in the 1970s and afterward.
As for redistribution, the task of helping less developed members and
regions to catch up was entrusted to the European Community from the
outset and extended considerably afterward. The instruments for this have
been the so-called structural funds, the borrowing and lending activity of
the European Investment Bank (EIB), and, more recently, the Cohesion
Fund.28
Although the Treaty of Rome hardly mentioned money, it would be an
error to think that its authors forgot to consider what monetary order was
required by a single market. Rather, they knew that the yet to be created
12 Chapter 1

single market had from the outset an exogenous monetary order and even
an implicit single currency, which was the US dollar. The regime of Bretton
Woods forbade countries to act unilaterally to gain competitive advantages
through a devaluation. And in the mid-1950s, with Europe just emerging
from the war and the United States dominating the world economy, that
regime was seen as an everlasting one.
The dollar-based fixed exchange rate regime was not everlasting, and it
is noteworthy that as soon as it began to falter in the late 1960s, a debate
started about how to replace it with a European arrangement.29 The eco-
nomic road from Rome 1957 to Maastricht 1992 is the road from a dollar
anchor to a “proprietary” anchor called euro.
Two economic paradigms have led Europe along this road. The first is
the theory of optimum currency areas and the second, the proposition of
the “inconsistent quartet.”
Robert Mundell’s path-breaking theory of optimum currency areas
(OCA), by questioning the one-to-one correspondence between monies
and states, made a monetary union spanning over several countries an
institutional arrangement conceivable to economists. The theory identi-
fied several properties, namely the conditions under which an area would
gain from adopting a single currency, regardless of the political borders. In
the formulation developed in the 1960s by Mundell (1961), McKinnon
(1963), and Kenen (1969), those conditions included, among others, the
mobility of factors of production (notably labor and capital), price and
wage flexibility, economic openness, and the diversification in production
and consumption. Such conditions happened to largely coincide with the
economic project underlying the Treaty of Rome and with the effective
implementation of the four freedoms. After the 1960s the OCA theory
further evolved through an academic debate that is still underway and has
accompanied the main steps that led to the adoption of the euro. On the
one hand, no conclusive case could easily be made ex ante to establish
whether OCA properties were sufficiently present to warrant the adoption
of a single currency, namely the euro.30 On the other hand, it has been
increasingly recognized that the very adoption of a single currency can
significantly contribute to fulfilling the optimality conditions on an ex
post basis (the so-called endogeneity of OCA) by removing barriers and
catalyzing the implementation of the Single Market Program and its four
freedoms.31
The second paradigm is embodied in the proposition that free trade,
mobility of capital, fixed exchange rates, and independence of national
monetary policies are mutually incompatible. This proposition was put
The Roads to the Euro: A Historical Overview 13

forward by Padoa-Schioppa (1982) to explain the difficulty the EC had

encountered over a quarter of a century in implementing the free mobil-
ity of capital in a regime of fixed exchange rates, while leaving monetary
policy to national authorities. The proposition was an application of the
Mundell-Fleming analyses of the macroeconomics of open economies with
capital mobility.32 It was further referred to by Krugman (1987), to argue
that—with the establishment of the single market and fixed exchange
rates—independent national monetary policies were no longer possible.33
More recently, the proposition has been the basis of the “two-corner solu-
tion theory” discussed in chapter 7.34
In Europe the paradigm of the inconsistent quartet pointed to the neces-
sity of a single currency, while the OCA theory only referred to the single
currency merely as a possibility. This explains perhaps why it acted power-
fully in pushing toward the adoption of the euro and ceased to be debated
after the launching of it.
A careful reading of the Treaty of Rome suggests that its authors did not
ignore the inconsistency, but dealt with it without tackling the heart of
the problem, namely in radical institutional terms. For one thing, they
foresaw the commitment to regard exchange rate policies as a matter of
common interest and to coordinate economic policies. In addition they
advocated gradualism in removing capital controls, hence softening one
of the key prescriptions of the Treaty. Finally they allowed the temporary
reintroduction of capital controls in the event of serious tensions. In
practice, this approach proved ineffective. The prescribed coordination of
national economic policies never took root, and the task to resolve the
inconsistency thus fell on capital movement restrictions. The Treaty of
Rome perceived the inconsistency, but it failed to resolve it and it took
thirty-three years before this fundamental flaw was rectified.
Between the dollar standard and the establishment of the euro, the
anchor role was played, for about twenty-five years, by the strongest
European currency, the Deutsche mark (DM). The DM regime began in 1972
with an arrangement called the “snake.”35 In 1979, the snake was replaced
by the EMS, which included two “large” currencies (the French franc and
the Italian lira) in addition to the small ones already pegged to the DM.
Although all participants officially had the same status, the Deutsche
mark, being the strongest and most stable currency, was the anchor and
the monetary policy of the Deutsche Bundesbank, firmly oriented toward
price stability, became the monetary policy of the whole area. This strongly
contributed both to the fight against inflation and to the preservation of
orderly trade relations within the European Union. And as convergence of
14 Chapter 1

individual macroeconomic performances was gradually restored, full

implementation of the four freedoms, which in the early 1980s was still
largely unfulfilled, gained new support.
In the 1980s the contradiction between the four elements of the quartet,
instead of producing a rolling back of European integration as it did in the
1970s, caused a movement forward. Seen in the light of the inconsistent
quartet, the road toward the single currency looks like a chain reaction in
which each step resolved a preexisting contradiction and generated a new
one that in turn required a further step forward. The steps were the start
of the EMS (1979), the re-launching of the single market (1985), the deci-
sion to accelerate the liberalization of capital movements (1986), the
launching of the project of monetary union (1988), the agreement of
Maastricht (1992), and the final adoption of the euro (1998).
The difficulties inherent in the inconsistent quartet were aggravated by
the fact that, in the course of the 1980s, the EMS became both increas-
ingly rigid and increasingly exposed to tensions. On the one hand, coun-
tries that had succeeded in abating inflation to “German” levels (like
France), or that still struggled to dis-inflate (like Italy), became less and less
inclined to devalue. On the other hand, capital mobility had become so
high that markets could mount huge pressure against a currency, even
when costs and prices were relatively convergent.
Finally the EMS was further strained and eventually blown up by a policy
dilemma arisen from German reunification, which boosted growth in
Germany while the rest of Europe was stagnant. Monetary policy was
confronted with conflicting needs and the tightening decided by the
Bundesbank on the basis of domestic considerations precipitated the crisis
of 1992–93. The timing was such that the crisis did not interfere with the
Treaty negotiation and only influenced the process of ratification. The
whole episode was a striking confirmation of the paradigm of the incon-
sistent quartet. What determined the crisis was indeed the existence of a
conflict about the course of monetary policy, against the background of a
combination of fixed exchange rates with full capital mobility.
The paradigm of the inconsistent quartet explains the crises of the
Bretton Woods and the EMS regimes. Common to both is the emergence
of a conflict between national and international interests after a prolonged
period in which they had coincided. In both the domestic inflationary
shock of a major political event (the Vietnam war for the US dollar, the
reunification of Germany for the Deutsche mark) marked the passage from
harmony to conflict. In both cases capital movements, albeit of a differ-
ent size and speed, exacerbated the conflict.
The Roads to the Euro: A Historical Overview 15

There were, however, also significant differences. The policy conflict

that undermined the Bretton Woods system arose from an accommodative
policy of the anchor country (the United States), which ran counter to the
anti-inflationary preferences of other important players, such as Germany.
In the EMS the policy of the anchor country—Germany—was too restric-
tive for its partners. More important, the exits were opposite. The inter-
national monetary system went to a floating exchange rate system, and
Europe to the single currency. In terms of the recently expounded propo-
sition that in an environment of capital mobility only so-called corner
solutions work for exchange rates, one can say that the world and Europe
moved to opposite corners.
In conclusion, the economic road to the single currency has been one
in which the gradual pursuit of the initial objective of the four freedoms
was tenaciously pursued over the long run, despite pauses and temporary
fallbacks. Along the road, one of its conditions, namely consistency
between the economic and the monetary order, was initially fulfilled, then
violated, then partially surrogated, and finally embodied in the single
currency. The fact that the Treaty of Maastricht takes the form of an
amendment of the Treaty of Rome is not a simple formality. It reflects the
substance of the matter, in that it removes a fundamental flaw in the
original Rome Treaty.

1.5 Central Banking: From Old to New Anchors

The third road to the euro concerns the history of central banks and mon-
etary policy. Indeed, it just happened that the forty-year period between
1958 and 1998 was a key period in that history too, not only in the process
of European integration. It was a coincidence, but a strategically impor-
tant one. This section explains how this period in the history of central
banking helped the move toward the euro and how its outcome was
embodied in the Maastricht Treaty.
Until about the last third of the twentieth century central banks were
tied to two, not always mutually consistent, anchors. The first was the
state, and the second was gold. As the holder of political power had always
considered the striking of coins as its own prerogative, the right to print
notes (what the jargon calls the “printing press”) was granted to central
banks by the sovereign government itself. As to the gold anchor, since
central banks were expected to stand ready to convert banknotes into gold
on request, the amount of money they could create was, or should have
been, dependent on the amount of gold in their vaults.
16 Chapter 1

One anchor—gold—was not always tight, as it was technically possible

to activate the printing press independently of the amount of gold on
reserve. The other anchor—the government of the state—was not always
wise, as its own vested interest (fighting wars, gaining popular support by
increasing public expenditures, etc.) at times led to overcreation of money.
Indeed, with the advent of banknotes, the main risk associated with the
creation of money was no longer the scarcity of gold and hence deflation,
for the growth in economic activity could be matched with enough means
of payments. The main risk became, instead, an excessive use of the print-
ing press and hence inflation.
That the printing press embodied a dangerous temptation was clearly
seen by the German poet and scholar Goethe in the early era of paper cur-
rency. In his most famous drama, Faust, it is Mephistopheles, the devil,
who advises the emperor to solve his financial problems by simply issuing
paper notes, supposedly backed up by the gold that is as yet unearthed in
the soil.36 And, ironically, it was Germany that experienced, over a century
after Goethe, the worst abuse of the printing press. In November 1923 a
liter of milk cost 360,000,000 German Reichsmarks, one US dollar was
worth 40,000,000,000, and the overall sum of cash in circulation reached
the astronomical figure of 3,877,000,000,000,000, (or 3,877 trillion)
Reichsmarks. In part, this explains the fierce concern with price stability
of both the Bundesbank and the German people.
The history of modern central banking can be looked at as a search
for the optimal framework—institutional, intellectual, or operational—in
which to set the newly discovered power to create value out of printed
paper. This search explains a great deal of the successive migrations of
the printing press from the sovereign government to a private institution,
then back to the public sphere, and finally to an independent agency. The
public policy need was to shelter the creation of money from the influ-
ence of whoever may have an interest in using it for self-financing at no
cost. The temptation was to make money creation subservient to any
interest other than the peoples’ interest to have a “sound currency.” The
modern notion of an independent central bank corresponds to the prin-
ciple that the central bank needs institutional protection from that
temptation.
As long as the principle held firm that public budgets should be balanced
(or could only be violated in exceptional circumstances, as in wartime), a
publicly controlled central bank was better sheltered than a private one.
Pressure for excessive money creation was more likely to come from the
private than from the public sector. For most of the twentieth century the
The Roads to the Euro: A Historical Overview 17

prevailing institutional model was increasingly one in which the central

bank depended on the Treasury. Accordingly, those central banks that—
unlike the Banque de France founded by Napoleon in 1800—were not state
institutions from the start were nationalized in the course of the century.
Others retained the form of a limited company (Banca d’Italia, National
Bank of Belgium) but depended on the government for their policy deci-
sions. With two notable exceptions—US Fed, and German Bundesbank,
shaped on the US model—central banks were subordinated to the govern-
ment for most of the second half of the twentieth century. When the Treaty
of Rome was stipulated, this was not a real threat to monetary stability
because fiscal discipline was prevailing in most countries and because cur-
rencies were still anchored to gold, via their link to the dollar and the
latter’s link to gold.
The three decades of the 1960s, 1970s, and 1980s witnessed the disrup-
tion of this consolidated setting. Driven by political and social change,
the role of the state in the economy grew and the size of public budgets
swelled. The welfare state enlarged through publicly funded pension
systems, national health care, and expanded unemployment subsidies.
Meanwhile the idea of deficit spending became widely accepted, intellec-
tually and politically. Treasury-dependent central banks became increas-
ingly exposed to political pressures to finance public deficits through
monetary creation. With the advent of deficit spending in the 1970s the
public sphere became an unsafe haven for central banks. Meanwhile, and
partly under the pressure of the same forces, the Bretton Woods system
collapsed and the last remaining link between money and gold was
severed. A new framework for managing the currency had to be built. New
anchors were needed.
The break from gold permitted, and demanded, money to be managed
entirely on the basis of human will rather than on Nature, that is to say,
on policy decisions rather than the extraction of gold from mines. A new
intellectual paradigm for the conduct of monetary policy became ever
more necessary.
The intellectual paradigm prevailing at the time, built on the founda-
tions laid by Keynes, Hicks, and Modigliani,37 was that in an imperfect
world with rigid wages, monetary policy could permanently affect real
economic activity.38 Money was not neutral. There was a trade-off between
inflation and unemployment, described by a curve (the Phillips curve, from
the name of its inventor) where lower unemployment levels are associated
with higher inflation rates.39 This allowed governments to achieve lower
rates of unemployment by accepting a higher rate of inflation.
18 Chapter 1

The nonneutrality of money was, however, challenged by Patinkin,

Friedman, and Lucas.40 In the 1970s the proposition that there was a
natural rate of unemployment, from which monetary policy could not
depart in the long-run, was supported by empirical evidence. In many
industrial countries, the Phillips curve had shifted over time toward com-
binations of both higher inflation and higher unemployment.
Today there exists a broad consensus about long-run neutrality of
money, but views on the short-term effects remain divided.41 The rational
expectations school takes a radical position and asserts that the public
expects policy to respond systematically to economic developments so that
only random and unexpected actions would have an effect in the end.42
At an empirical level, the evidence is mixed. It suggests that also system-
atic and expected changes in monetary policy may have short-term
impacts on the real economy due to various frictions, adjustment costs,
and information imperfections.
Recognition of the long-run neutrality of money widened acceptance of
a hierarchy of goals for monetary policy. A consensus developed that there
is no significant policy alternative for central banks to focus primarily on
the attainment of price stability, while leaving other policies (labor market
policies, supply side policies, fiscal policies) to aim at full employment.
In parallel with the evolution of ideas, the policy of central banks also
evolved from an overly ambitious to a more sober view of what could actu-
ally be achieved through the conduct of monetary policy. In the United
States, for example, monetary policy in the late 1960s and in the 1970s
aimed at fostering high employment and often disregarded its conse-
quences on prices until inflation had become high and publicly blamed.
In those same years the United Kingdom and several continental European
countries went through a similar experience. Only toward the end of the
1970s did attitudes change. In the early 1980s, under Paul Volcker, the
Federal Reserve tamed rampant inflation by severely restricting monetary
creation and changing market expectations.43 In the same period the Bank
of England under the Thatcher government did the same.44
Germany was the notable exception to the inflationary experience of
most industrial countries in the second half of the twentieth century, prob-
ably because the tragedy of hyperinflation after World War I had eradi-
cated, from the mind of the people, the illusion that more money brings
more prosperity. In designing the charter of the ECB, the Bundesbank
model was adopted.
The abandonment of the idea that central banks could, or should, choose
between inflation and unemployment paved the way to a de-politicization
The Roads to the Euro: A Historical Overview 19

of monetary policy and hence to greater emphasis on the technical rather

than political role of central banks. This in turn made it easier to accept
the idea that monetary power could be transferred from member states to
a common European institution, with the achievement of price stability
as the common objective.
In a nutshell, the period between 1957 and 1998 led from the signing
of the Treaty of Rome to the single currency. It was also a period when
people learned to manage an entirely fiduciary currency whose purchas-
ing power is based on trust rather than intrinsic value. The Treaty of
Maastricht sanctions principles of central banking and monetary policy
that were identified through scholarly research and policy experience.
These principles have gained growing support in the public opinion, and
were finally adopted by a wide component of the political spectrum. In a
sense, the Treaty embodies what was learned about central bank policies
throughout the twentieth century.
The three foundations on which the Treaty of Maastricht built the
charter of the single European currency and its central bank are the
outcome of the long search briefly summarized in this section. The first is
the indication of price stability as the primary objective of monetary
policy, the second is the guarantee of full independence of the central
bank, and the third is the constitutional status of the charter of the central
bank and the currency. In no other central bank charter are these three
founding principles spelled out as clearly and strongly as in the Treaty of
Maastricht. The Maastricht Treaty indeed represents the first constitution
of money that entirely replaces old anchors with new ones. It has moved
the printing press from the twin anchors of gold and the sovereign gov-
ernment to the anchor of a constitutional mandate complemented with
institutional independence.
This evolution could, of course, have happened in a setting other than
the European Union. It is worth noting, however, that an important factor
contributed to the meeting of the European and the monetary paths. An
entity such as the European Union, which does not retain the traditional
powers of the state, appeared to governments as a favorable ground on
which to place a monetary power they were ready to abandon.
2 A Profile of the Eurosystem: The Newest Central Bank

In the history of central banking, the Treaty of Maastricht is a milestone

comparable to the Federal Reserve Act of 1913 and the Bundesbank Act
of 1957. The former created the first central bank with a federal structure
and collegial decision-making. The latter led the way toward institutional
independence.
In this chapter, I present the new European central bank created by
the Maastricht Treaty. I first examine its functions, structure, and organi-
zation (section 2.1), as well as the “center versus periphery” relationship
(section 2.2). I then analyze its key institutional aspects: decision-making
(section 2.3), independence, and accountability (section 2.4). I close
with a reference to the wider context of the European Union (section 2.5
and appendix).

2.1 The Eurosystem

The Eurosystem is the entity that performs the central banking functions
for the euro and the euro area. It is for the euro what the Federal Reserve
System (the Fed) is for the US dollar and, until 1998, the Bundesbank was
for the Deutsche mark. The name “Eurosystem” was chosen to indicate the
construct formed by the European Central Bank (ECB) and the national
central banks (NCBs) of countries that have adopted the euro. The Treaty
of Maastricht gives no name to this entity and refers only to the wider
European System of Central Banks (ESCB) that includes also the central
banks of the EU countries not adhering to the euro, namely Denmark,
Sweden, and the United Kingdom. However, the prospect of all EU member
states—including the ten that joined in 2004—adopting the euro remains
a remote one.1
Before illustrating the way the Eurosystem is organized, makes decisions,
and relates to other EU institutions, it is necessary to cast its functions in
22 Chapter 2

the light of modern central banking. The discussions in subsequent

chapters will attend to these functions in greater detail.
Central banks originate from two fundamental changes in monetary
systems over the past two hundred years. The first was, at the turn of the
nineteenth century, the replacement of commodity currencies with paper
currency. The second change was, about a century later, the development
of commercial bank money (or bank deposits), which largely replaced
notes and coins as a means of payment and store of value. To ensure the
efficiency and safety of paper currency systems, most countries gradually
entrusted one bank—which became the central bank—with the exclusive
task of issuing banknotes. Today the general public considers central and
commercial bank money (banknotes and bank deposits respectively) as
equally safe and fully interchangeable.
These two changes were innovations in the payment practices. However,
they have been decisive in shaping the other two central banking func-
tions that gradually developed over the last century, namely the supervision
of banks and, later, the conduct of monetary policy. The control of com-
mercial banks originated from the need to ensure full acceptance of bank
deposits as the perfect substitute for banknotes. This in turn required
central banks to assess the quality of the assets of commercial banks (for
a qualification and wider discussion of this point, see chapter 5). As to
monetary policy, which is today the foremost function of a central bank,
it fully developed as the link between banknotes and gold was gradually
loosened and eventually severed.
Nowadays the total value of banknotes in circulation is quite small
compared to total bank deposits. The overall stock of money is determined
by the central bank, not by the availability of gold. In such a setting the
confidence in the currency ultimately rests on two foundations: one is the
convertibility of commercial bank money into banknotes at par at any
time; the other is the ability of the central bank to manage the quantity
of money in a way that keeps stable the value of the currency.
In a modern market economy, based on exchange, division of labor, and
a profit-driven banking industry, the triadic function of central bank—
related to the payment system, banking supervision, and monetary
policy—is crucial for the quality of money. The three functions are linked
to three inseparable functions of money as means of payment, unit of
account, and store of value. Operating and supervising the payment system
refers to money as a means of payment; ensuring price stability refers to
money as a unit of account and a store of value; pursuing the stability of
banks refers to money as a means of payment and a store of value. These
A Profile of the Eurosystem: The Newest Central Bank 23

linkages explain why the three functions have most often been entrusted
to the same institution, which is the central bank.
The paradigm of the triadic function provides the key to reading the
Treaty of Maastricht from a central banking point of view. In the follow-
ing sections of this chapter, and in chapters 4, 5, and 6, the functions of
the Eurosystem will not be presented in the order derived by the historical
development just reviewed. Rather, a reversed order will be followed to
reflect the fact that monetary policy is today the dominant function.
The Treaty unambiguously assigns to the Eurosystem the task of con-
ducting the single monetary policy. It states that its primary objective
“shall be to maintain price stability” and also indicates that “without
prejudice of the objective of price stability, the [Eurosystem] shall support
the general economic policies in the Community.”2 In the field of pay-
ments, the Treaty gives the Eurosystem the task to “promote the smooth
operation of payment systems”3 and states that “the ECB and national
central banks may provide facilities, and the ECB may make regulations”
to this end.4 As to prudential supervision, it is left to national authorities,
but, in view of the link and complementarity between prudential supervi-
sion and other central banking functions, the Eurosystem is asked to “con-
tribute to the smooth conduct of policies pursued by the competent
authorities relating to the prudential supervision of credit institutions and
the stability of the financial system.”5 The ECB also has a consultative
and advisory role when new legislation and regulation are adopted in
the financial field.
The Eurosystem, like any central bank, also conducts other activities
related to the public interest of maintaining a sound currency, trusted by
both the market and the general public. These activities include the exer-
cise of operational and regulatory powers, relationships with other public
authorities and the financial community, contacts and cooperation with
other central banks, participation in international fora and institutions
responsible for monetary and financial matters.

2.2 Center and Periphery

Being monopolists and being placed at the center of the monetary system,
central banks have historically been characterized by a high concentration
of power and a centralized organization. A central bank with a federal
structure and a collective decision-making only appeared more than a
century after modern central banks first took shape (Federal Reserve Act
of 1913).
24 Chapter 2

The Treaty is unambiguous in ensuring the unity of the Eurosystem, in

making it a single entity rather than a constellation of coordinated enti-
ties. It does so by means of two provisions. First, by attributing the central
banking functions to the Eurosystem as such, not to its separate com-
ponents. Second, by stating that the Eurosystem “shall be governed by the
decision-making bodies of the ECB,” namely by casting it under a single
command.6 The ECB is not another central bank operating alongside the
NCBs, nor a competitor of them. Rather, it is the head of the system.
Yet, when they have a federal structure, central banks always exhibit a
combination of, and sometimes a tension between, centralized decisions
and decentralized actions. The Eurosystem is no exception. Actually in the
Eurosystem the combination is characterized, and the tension enhanced,
by historical, constitutional, and organizational factors that determine
a rather special “center versus periphery” relationship. These factors can
be described as follows.
The national central banks that on January 1, 1999, became part of the
Eurosystem were not new entities created by the Treaty of Maastricht to
serve as “components” of the new system. They were ancient institutions
with long-established traditions and diverse charters. For many genera-
tions, each of them had performed the full range of central banking func-
tions as a prominent institution of the nation-state. Public opinion
perceived, and often still perceives, them as national entities. They were
seen as the repositories of the people’s confidence in the currency, for
which they were accountable to, and often dependent on, the political
authorities of the state. Even after the euro, their tasks, organizations,
statutes, and cultures preserve clear differences.7 Moreover, since they have
retained tasks that the Treaty does not transfer to the European level,8
the NCBs combine a federal with a national role.
From a constitutional point of view, NCBs are dual institutions:
national, for tasks not attributed to the Eurosystem; peripheral to a federal
institution, for the Eurosystem’s tasks.
Two concepts—subsidiarity and decentralization—are relevant here.
Subsidiarity is, in the European lexicon, the general criterion for
deciding whether a policy function should be national or European.9
According to the Treaty, action is taken by the Community “only if and
insofar as the objectives of the proposed action cannot be sufficiently
achieved by the Member States” and can be “better achieved by the Com-
munity.”10 Decentralization is the criterion the Treaty indicates to the
Eurosystem for exerting the functions attributed to it, which are, by defi-
nition, European functions. In this respect the Treaty stipulates that “to
A Profile of the Eurosystem: The Newest Central Bank 25

the extent deemed possible and appropriate, the ECB shall have recourse
to the national central banks to carry out operations that form part of the
tasks of the [Eurosystem].”11 This distinction shows that the “center versus
periphery” relationship has two features, both based on the Treaty. Fol-
lowing subsidiarity, NCBs perform functions that do not fall within the
jurisdiction of the Eurosystem, and indeed remain rooted in national
legislation.12 Following decentralization, they have a claim “to carry out
operations” of the System, acting “in accordance with the guidelines and
instructions of the ECB.”13
Subsidiarity and decentralization are quite different concepts and should
not be confused. The constitutional decision, whether a particular policy—
such as the prudential supervision of banks—should be national or Euro-
pean (state or federal in the US constitutional vocabulary) was made by
the authors of the Treaty. It was not left to the discretion of the Eurosys-
tem. On the contrary, the organizational decision whether “the operations”
related to a particular Eurosystem (i.e., federal) function—be it the print-
ing of banknotes or the management of foreign exchange reserves—
should be carried out by the center or by the periphery was left to the
Eurosystem. The Treaty recommends decentralization “to the extent
deemed possible and appropriate,” but this recommendation of course
does not impinge upon the European nature of that activity, which indeed
remains directed by the ECB.
In practice, defining the relationship between center and periphery is a
crucial challenge for the Eurosystem at this early stage of its life. NCBs,
specially the largest ones, tend to preserve the role, functions, and struc-
ture they had before the euro, and to operate outside the authority of the
ECB. To this end they gear the interpretation of both subsidiarity and
decentralization. Except for tasks directly related to monetary policy, they
tend to read the Treaty as, first, conferring only minimal functions to the
Eurosystem and, second, favoring decentralization over overall efficiency
in the conduct of the conferred functions. The “possible and appropriate”
formula used by the Treaty is thus interpreted extensively, and what is
decentralized is often seen as still belonging to a national responsibility
rather than a European one. The distinction between the constitutional
and the organizational issue (i.e., between subsidiarity and decentraliza-
tion) is thus often blurred, as numerous examples will show in chapters 5
to 8.
In defining the working process of the policy-making, the Treaty of
Maastricht uses three different words for successive steps: decision, imple-
mentation, and execution. It assigns decisions to the Governing Council
26 Chapter 2

of the ECB (ECB Council), implementation to its Executive Board (ECB

Board), and execution to the NCBs and the ECB. The notion of decentral-
ization is reserved to the execution of ECB Council’s decisions, not to the
two other steps of the policy process.
Although the Treaty does not provide an explicit definition of the three
words, for monetary policy the interpretation of the “center versus periph-
ery” relationship is rather straightforward. Decision concerns the strategy
and instruments of monetary policy, the setting of interest rates, or the
adoption of minimum compulsory reserves. The operations whereby
monetary policy works in practice (e.g., buying and selling securities on
the market) are directed by the ECB Board (implementation) and carried out
by national central banks (execution). NCBs have no discretion about how
to conduct them, although the proceeds affect their balance sheets. Thus
implementation is centralized and execution decentralized.
Paradoxically, the main reason for centralizing the implementation of
policy is the multiplicity of money centers in Europe. Since so many
central banks conduct, in different countries, monetary policy operations
that are part of the same single policy, a strong direction from the center
is imperative. In practice, every dealing room of NCBs receives direct
orders and authorizations from the ECB headquarters in Frankfurt for each
operation.
It may be useful to compare the center versus periphery issue in the
Eurosystem and the Fed, because the latter not only is the leading central
bank in the world but also was the first to adopt a federal structure.14 The
Board of Governors and the Federal Reserve District Banks are for the Fed
what the ECB and the NCBs are for the Eurosystem. However, unlike the
NCBs, the Fed’s District Banks did not preexist the creation of the System
in 1913, nor do they have the dual character (state and federal, in the US
terminology) described above for the NCBs.
In both the Fed and the Eurosystem, monetary policy decisions are taken
by a collegial body—the US Federal Open Market Committee and the ECB
Governing Council respectively—which involves both the center and the
periphery. In the execution of policy, the Fed operates through one
District Bank only (the New York Fed), the Eurosystem through all
NCBs. Partly as a result of that, larger discretion is left to the New York Fed
in the actual conduct of operations than to the NCBs. Indeed the New York
trading desk does not work under direct instruction from Washington.
For other policy areas and for administrative and organizational matters
the ultimate decision-making is an entirely “central” body in the Fed (the
Board of Governors), while it is a “center plus periphery” one in the
A Profile of the Eurosystem: The Newest Central Bank 27

Eurosystem (the ECB Council). The authority of the Board of Governors

includes oversight of the Reserve Banks’ services to, and their supervision
of, the banks. Moreover each Federal Reserve Bank must submit its annual
budget to the Board of Governors for approval. Within the Eurosystem, it
goes the other way around because the ECB budget has to be approved by
the ECB Council, where NCB governors constitute the majority. Mean-
while, in the Fed, the center does not operate directly, and attributes to
some District Banks certain systemwide activities, such as functions related
to payments, certain open market and foreign exchange operations, and
information systems. In the Eurosystem, instead, the ECB has operational
capacity (e.g., it has its own dealing room) while no systemwide activities
are located in any of the NCBs.
Important differences between the Fed and the Eurosystem derive from
the fact that the former is a mature institution while the latter has just
begun its life. In its early years the Fed’s periphery played a very large role
and decades after its founding, the institution was still grappling with the
“center versus periphery” issue.15 Only a very gradual process of rational-
ization led to the present setting. As to the Eurosystem, it is quite natural
that just few years after the start, NCBs have the full central banking
infrastructure they had when they were stand-alone institutions and try
to favor slowness in the move toward a more integrated, systemwide
organization.

2.3 Decision-Making in the Eurosystem

The ECB Council and the ECB Board are the two decision-making bodies
of the Eurosystem. Both are part of the ECB and chaired by its president.
Both derive their authority directly from the Treaty of Maastricht. The
Board consists of six members (including the president and the vice pres-
ident) appointed for a nonrenewable eight-year term of office.16 The
Council is composed of the six members of the Board and the governors
of all the national central banks that have adopted the euro. National
governors are appointed according to national laws.
The Council takes the decisions that are necessary to perform the
tasks of the Eurosystem, notably to “formulate the monetary policy of
the Community” and to “establish the necessary guidelines for [its]
implementation.”17
The Board manages the day-to-day business of the ECB, prepares the
decisions of the Council, and looks after their implementation. It has the
charge to “implement monetary policy in accordance with guidelines and
28 Chapter 2

decisions laid down by the ECB Council.” Doing so means that the Board
should give the necessary instructions to national central banks. In addi-
tion the “[Board] may have certain powers delegated to it where the
[Council] so decides.”18
Decision-making was the stake around which the struggle for central
bank independence developed over much of the last fifty years. For the
ECB, as for any other central bank, it lies at the heart of the institution.
Its credibility ultimately depends on its ability to make decisions that
achieve the assigned objectives—price stability in the first place—and
hence to convince the markets and the general public that the efficiency
and stability of the currency are assured, and will continue to be assured.
The Treaty provisions undoubtedly embody all the institutional precon-
ditions for good decisions to be possible. The quality of decisions, however,
depends on many more factors than just institutional provisions. Particu-
larly for collective bodies, it depends on traditions, procedural rules, prac-
tices, “social” behavior, personalities, and so on. And if the institution
is young and the tradition yet to be established, all outcomes, good and
bad, are possible. Every episode or act may have a lasting constitutional
influence, even those that in a mature institution would be immaterial.
In central banking, independence has meant different things in differ-
ent periods, depending from whence the main threat to achieving the
public interest of a sound currency came. At an early stage of the debate
over the single currency, the founders of the Maastricht Treaty understood
that independence had to be safeguarded not only from such familiar
contenders as the financial and business community, labor organizations,
and fiscal and political authorities. Being the central bank of a group of
countries with deeply rooted national—and sometimes even nationalis-
tic—traditions, retaining their sovereignty in a number of relevant fields,
the Eurosystem needed, first and foremost, independence from national
interests or, more broadly, from national interpretations of the public inter-
est. For the Eurosystem, “public” had to unambiguously mean the euro
area, not just the interest of one nation, or some combination of national
interests, each represented by a member of the ECB Council.
In the Treaty, two important principles shelter the decision-making
process of the ECB from the risk of becoming hostage to national interests
being negotiated against each other. The first is that the ECB Council can
act by a simple majority; the second is that each member of the ECB
Council has one vote.19 From a conceptual standpoint, these look like
obvious stipulations. Politically, however, they were not. Seen in the
framework of the still nationally oriented EU institutions, it is remarkable
A Profile of the Eurosystem: The Newest Central Bank 29

that they were easily agreed upon in the preparation of the Treaty of
Maastricht.20 As it will be explained in chapter 8, neither of the two
principles have been challenged by the reform of voting modalities in an
enlarged ECB Council.
The majority principle marks the divide between a true union and occa-
sional agreements, between a domestic and an international order. If a
single policy line is only possible when all the parties involved agree on
the same course of action, a “true union” does not exist. What exists under
the unanimity rule is a “spurious union,” one formed on a case by case
basis, in which only ex post can it be ascertained whether the precondi-
tions for a single policy have been met. Rather than a better way to take
all views into consideration, unanimity is a way to nondecisions or to
decisions biased by the motivations of a minority or, possibly, a single
member; two evils that any central bank should avoid. Like the Fed and
any other central bank, the Eurosystem has been constructed to function
on the basis of the majority rule.
As to the principle “one person, one vote,” there is no doubt that with
its adoption the authors of the Treaty took the decisive step in establish-
ing the independence of the Eurosystem.
To fully appreciate its fundamental significance, a distinction should be
made between the motivation underlying two very different types of
collegial decisions, which could respectively be called interest-based and
wisdom-based. The former are collegial because different interests have to
be reconciled and hence represented. The latter are collegial because—
although all participants are entrusted with, and share, the same interest—
the wisdom of more than one person is needed to reach the best decision.
In an interest-based collegial body members have different objective func-
tions and negotiate; in a wisdom-based collegial body all members maxi-
mize the same objective function and simply discuss how best to do it. In
the former, people bring their problems to the meeting and there are as
many problems as persons or interests. In the latter, there is only one
problem and everyone is addressing it to the best of his or her judgment.
At the decision-making table of an interest-based forum members are
not, and should not be, independent from the interests they represent and
to which they are accountable. As interests can be weighted, votes can, and
indeed should, be weighted. No one would recommend, for example, the
one person, one vote principle for the shareholders assembly of a listed
company.21 In contrast, since wisdom cannot be weighted, each person has
one vote in a wisdom-based forum. No one would imagine that the jury
in a court could decide on a murder case otherwise than on the basis
30 Chapter 2

of that principle. If a jury is deemed necessary in a court, it is because

one may not be sure that one single person has all the wisdom and inde-
pendence required. Collegiality with the one person, one vote rule is a safe-
guard of independence also because a collegial body is much more difficult
to influence than a single person. An individual can be put under pressure,
be psychologically weak, or even be blackmailed; for a group of persons
these dangers are more remote. A group can defend itself better than a
single person from various pressures and influences, be they economic,
political, psychological, or intellectual.22
According to these principles, the members of the ECB Council are
mandated neither to defend a “local” interest, nor to secure the best com-
promise for their country. All are mandated, in an equal and same way, to
serve the general interest of the euro area. When they meet in Frankfurt,
national governors just happen to be the governors of a particular NCB,
in reality they are members of the ECB Council, governing the whole
Eurosystem.23
ECB Council meetings are organized accordingly. Members sit at the
table by the alphabetical order of their names, with no distinction between
national governors and Board members. Name tags do not carry the indi-
cation of countries or institutions (it was Hans Tietmeyer who requested,
at the beginning of the first ECB Council meeting in June 1998, to replace
Bundesbank with ECB on his name tag at the meeting table).24 The docu-
mentation for the meeting is prepared in the ECB, sometimes with the
assistance of experts of NCBs. Documents look at the euro area, not a
patchwork of national economies or systems, and hardly contain any
country-by-country breakdown of the relevant information. The focus is
on performance, structure, and efficiency of the area as a whole. Propos-
als are designed to achieve an optimum, not an average. The economic,
not the political, map of euroland is considered.
In the field of monetary policy cross-country comparisons are simply not
relevant to the decision. By contrast, typical analyses of international orga-
nizations, such as the International Monetary Fund (IMF) or the Organi-
zation for Economic Cooperation and Development (OECD), are exercises
in comparative economics.
As far as the economic outlook is concerned, it should be further con-
sidered that economic situations are often highly heterogeneous within
countries. Germany and Italy, for example, exhibit differences between
regions (east versus west for Germany; north versus south for Italy) that
are almost as pronounced as those between the richest and the poorest
countries of the European Union. It would indeed be quite difficult, if not
A Profile of the Eurosystem: The Newest Central Bank 31

impossible, to trace the political borders separating countries within

euroland by simply looking at an economic map. How to separate, for
instance, Belgium from the Netherlands or the northeast of Italy from the
southeast of Germany?
Does the practice of ECB Council discussions conform to the principles
described here? Indeed even sophisticated observers sometimes wonder
whether the decision-making of the Eurosystem really passes this particu-
lar test of independence. Is it really true that governors leave their national
hat in the wardrobe and let their hearts and minds only look at euroland
when sitting in the ECB Council?
The answer to this question is that the shift from an interest-based to
a wisdom-based attitude has been accomplished in the monetary policy
function, while it proves more difficult to achieve in other central banking
fields analyzed in this book.25 The previous section reviewed the main
factors influencing the “center versus periphery” relationship at this early
stage of the EMU. Here it may be useful to explain why the emergence of
a system-oriented approach is more laborious in nonmonetary than in
monetary policy matters.
Nonmonetary policy matters include a wide range of activities, like the
printing of banknotes, the structure and operations of money transfer
mechanisms, the management of the assets held in the balance sheets, the
representation in international organizations and in foreign countries, the
monitoring of the large banking institutions, the restructuring of the EU
financial industry, and the policies concerning the international monetary
and financial system. In all of these areas central banks generally have their
own position, public message, and policy action, all proceeding from a
single decision-making process. The Eurosystem, instead, is still in the tran-
sition from the pre-euro situation when each NCB used to define its own
policy independently, referring to the national context.
The move toward a single Eurosystem policy is relatively slower in
nonmonetary than in monetary policy camps because in the latter the struc-
tural and organizational implications of a fast integration and rationaliza-
tion of the System would be deeper. These are indeed the areas of activity
that absorb most of the human and technological resources of a central
bank. Moreover, having lost their role in monetary policy, central banks
resist a further drain of their prerogatives. As explained in the previous
section, this often leads to a far-reaching interpretation of the principle of
decentralization and to attitudes, in the ECB Council, where the periphery
is given more consideration than the total system. We will return to this
theme in various chapters of this book and particularly in chapter 8.
32 Chapter 2

2.4 Independence and Accountability

Over the last two decades the debate over monetary policy has resulted in
a consensus that the central bank must be at the same time independent,
accountable, and transparent. In this section attention will be confined to
the first two of these notions which, unlike the third, identify the institu-
tional profile of the Eurosystem and are therefore directly addressed by the
Treaty. Although independence, accountability, and transparency inter-
relate and even overlap, their conceptual distinctiveness should not be
ignored. Independence and accountability form a critical pair, the latter
being the natural complement and counterweight of the former. As to
accountability and transparency, they are often seen as interchangeable,
disregarding that they originate from rather different requirements. Trans-
parency will be discussed in chapter 4, devoted to monetary policy.
In a society where the polity and the economy are based on the two
principles of democracy and the market, the institutional profile of the
central bank has to satisfy two different and even partially conflicting
requirements: policy effectiveness and democratic control. Between them,
the authors of the Treaty, like other legislators before, had to strike an
appropriate balance.
First and foremost, the Eurosystem had to be put in the position to effec-
tively fulfill its mission to “safeguard the currency.”26 This postulates inde-
pendence from politics. Independence should not imply the absence of
democratic control, but the need to effectively fulfill the assigned policy
tasks qualifies, and limits, the way in which democratic control is
exercised.
It should also be borne in mind that, until the 1990s, central bank inde-
pendence was, in Europe and elsewhere, the exception, not the rule. In
France, Italy, and Spain the central bank became legally independent only
after the stipulation of the Treaty of Maastricht. The Bank of England was
granted operational independence only in 1998, the Bank of Japan in 1997.
The Treaty states that “neither the ECB, nor a national central bank, nor
any member of their decision-making bodies shall seek or take instructions
from Community institutions or bodies, from any government of a
member state or from any other body.”27 In recognition of the specific
requirements of policy effectiveness the Treaty thus removed monetary
management from the realm of actions directly conducted by govern-
ments, and hence from the pressures of the day-to-day political process.
Moreover, through its inscription in the Treaty, central bank independence
was given the most solid constitutional basis. Its repeal not only would go
A Profile of the Eurosystem: The Newest Central Bank 33

beyond the power of individual member states, it would also have to pass
the hurdles of the procedure designed for amending the Treaty.28
Independence is a means to a circumscribed end, explicitly assigned to
the institution. Just as the military may be assigned a strategic objective
and given discretion in the conduct of operations, so the specific decisions
pertaining to the actual management of the currency can be considered as
instrumental to the effective attainment of the assigned objective. The
objective has been previously agreed upon in a constitutional process,
when stipulating and ratifying the Treaty.
The intellectual and political consensus on the primacy of price stabil-
ity thus underpins the consensus on the independence of the central bank.
It is not accidental that the two have emerged in parallel in the same his-
torical phase. Independence would indeed be harder to justify if monetary
policy, instead of being entrusted with the task of pursuing one primary
objective, were given the power to balance two objectives, say price sta-
bility and full employment. In this case the decisions of the central bank
would cease to be predominantly technical and would become eminently
political. It would then be natural, and perhaps justified, for elected politi-
cians to reserve those decisions to themselves.
The above suggests that there is a nexus between the institutional
arrangement and the economic paradigm underlying the action of the
central bank. The era when central banks were not independent was indeed
an era when it was deemed possible for monetary policy to promote effec-
tively, and lastingly, growth and employment in ways other than by ensur-
ing price stability.
The current nexus could change again if the present consensus on the
primacy of price stability were to vanish, and the old paradigm to come
back. If this should happen, the ECB Council could be seen as a genuinely
political body and the claim that monetary policy should be taken away
from independent nonelected officials to be given back to the politics
could regain ground.
Independence has, as stated above, a counterweight in accountability.
As a precondition for the successful pursuit of the given mission indepen-
dence shields the Eurosystem from short-term political considerations, but
it is by no means the same as the absence of democratic control. In a demo-
cratic system independence and accountability are two sides of the same
coin.
Accountability means that institutions with the power to affect the lives
of the people are subject to the scrutiny by the elected representatives of
the people. As such it is an essential and constituent element of our
34 Chapter 2

political order, and indeed this scrutiny is necessary also in those fields—
such as central banking—where policy decisions are consciously removed
from the day-to-day influence of the political arena. The entrustment of
such momentous decision-making power to independent, nonelected
central bankers could be considered legitimate only on the condition that
a form of democratic control also be put in place.
Thus accountability pertains to a civic and moral obligation inherent in
the political order and is not exclusively related to the economic order. It
is because it has been given a precise statutory mission and granted inde-
pendence to pursue it effectively, that the Eurosystem has to be held
accountable for the fulfillment of its mandate, and is obliged to explain
and justify its decisions.
Ultimately the Eurosystem is accountable to the European people at
large. They are the ultimate addressee of accountability because they are
the true interested party in the Eurosystem’s ability to “safeguard the cur-
rency” and to “defend their savings.”29
In practice, the provisions of the Treaty make the Eurosystem account-
able to the European Parliament, because this is, in the EU political order,
the only body that derives its role and legitimacy directly from the people.
It is elected by a popular vote, and its deliberations are public. Unlike
national governments or parliaments, it is mandated to pursue the inter-
ests of the people of Europe. Although the dialogue with the European Par-
liament represents the principal means to fulfill the duty to be accountable,
the ECB is also engaged in a dialogue with other European institutions.
Comparing the ECB with the Fed, one should note that the similarity of
the two formal procedures for relating to an elected Chamber conceals a
difference in substance. Compared to the US Congress, the EU Parliament
lacks the power to change the charter and mandate of the central bank, a
difference that makes the ECB more independent than the Fed (and, in the
view of some, even too independent). Such difference depends on the
nature of the political construct of the European Union, not on a deliber-
ate choice concerning the status of the central bank. Accountability is thus
limited today by the incompleteness of political union in Europe.
Independence sets a limit to the role that can be played by the political
bodies to which the central bank is accountable. If, say, the European Par-
liament could exercise a direct influence on specific monetary policy deci-
sions, this would lead to a shared responsibility for the actual conduct of
policy. Consequently the Eurosystem’s obligation to explain and justify its
action would lose meaning, as the Parliament itself would have determined
the actions for which the central bank is accountable to it.
A Profile of the Eurosystem: The Newest Central Bank 35

2.5 A Polity in the Making

From an economic and monetary point of view, the Eurosystem is the

central bank of the euro and its “country” is the euro area. However, while
the Eurosystem can be described and assessed entirely on the basis of the
model of a modern central bank, the model of a sovereign state cannot be
regarded as an accurate description of the European Union. The European
Union is definitely not a state in the same way in which the United States
are the “state of the dollar.” The expression “a currency without a state”
indicates the special position of the euro with respect to the political and
institutional entity to which it belongs.30
The European Union can be defined as a polity in the making; it is much
more than a conventional international organization but clearly less than
a full-fledged federal state. It is so much a sui generis political system that
an entire branch of political science has developed, in the last decades, to
deepen its understanding.31 To come to grips with it, it is necessary to look
at what the European Union actually does, which powers it disposes of,
how powers are distributed among its institutions, and how this compares
to conventional political systems in federal states. While a brief descrip-
tion of the institutions of the “country of the euro” and of their tasks
is given in the appendix to this chapter, here a few general remarks are
made.
The European Union’s tasks comprise the creation and management of
the economic and monetary union, including its trade and competition
policy, the embryo of a common foreign and security policy, a coopera-
tion in justice and home affairs. The two chambers of the Union are the
Council of Ministers and the European Parliament. Its main executive
branch is the European Commission. Its Supreme Court is the European
Court of Justice. The budget to which the ECB staff pays taxes is the EU
budget. The “embassies” of the Eurosystem around the world are the rep-
resentative delegations of the EU Commission.
So described, the European Union seems clearly inspired from the clas-
sical constitutional order of a state. However, major elements, in both the
tasks and the institutions, differentiate it from even the loosest federal
state.
As far as the tasks are concerned, the Union has no power to decide and
act in the fields of internal and external security that are the very essence
of any state. Moreover it lacks the power to “tax and spend.” Also it does
not hold an autonomous power to allocate policy functions among the
various levels of government (European, national, and subnational).
36 Chapter 2

As far as the constitutional design is concerned, the Union is still far

from complying with key principles that form the heritage of western con-
stitutions. First and foremost, the majority rule is not universally applied
to decisions and actions required to pursue the objectives set for the
Union.32 Second, it is still possible to adopt legislation without a positive
vote by the only European body elected by the people (the Parliament).
Third, equilibrium of powers is still lacking among the various institutions
of the Union, with the Council of Ministers playing a predominant role,
so that national interests often prevail over the common interest.
The European Union today is a polity in the making and the move
toward a single currency, important as it is, is by no means the final step
in the process.
The same Treaty of Maastricht that completed the economic and mon-
etary union also marked the intended start of a political union, in the fields
of foreign and security policy as well as in internal affairs. Further attempts
were made with the Treaties of Amsterdam (1997) and Nice (2000).
However, neither of these attempts led to meaningful results. In June 2003
the European Convention adopted a draft Constitution for Europe that was
submitted for discussion to an EU Intergovernmental Conference.33
As long as further steps toward a genuine political union are not taken,
the Eurosystem will be the central bank of a currency without a state, and
hence be confronted with a challenge that no other central bank has.
Through history the strength and success of a currency have been closely
related to the strength and success of the economic, social, and political
entity of which it was an expression, and not just to the skills and pro-
fessionalism of its central bank. The Deutsche mark, for example, owes the
international reputation it gained in the second half of the twentieth
century to the dynamism of the economy, the stability of the social struc-
ture, and the good performance of the political institutions as much as to
policies of the Deutsche Bundesbank. Applied to the euro area, this sug-
gests that further progress toward the construction of a political union
would, over time, be critical for the potential and ultimate success of the
single currency.

2.6 Appendix: Institutions of the European Union

In this appendix we take a brief look at the quasi-state institutions that,

mainly from Brussels, rule the European Union. These are the European
Commission, the European Parliament, the EU Council of Ministers, and
the European Council.
A Profile of the Eurosystem: The Newest Central Bank 37

The European Commission is composed of one commissioner from each

member state (until November 2004 the large countries have two com-
missioners). The president of the Commission is chosen by the EU heads
of state or government for a five-year term but can only take office after a
vote of confidence of the European Parliament. The same applies to the
full college of commissioners, all of whom are committed to act in the
general interest of the whole Community and in full independence from
outside instructions.
The Commission plays the central role in making, maintaining, and
developing the economic union. Legislation is entirely based on its initia-
tive, as no European Union law can be passed unless proposed by it (called
an “exclusive right of proposal”). Its primary executive functions consist
in looking after the proper implementation of the common rules and in
acting as the EU administration in such policy fields as the single market,
external trade, competition, agriculture, regional policy. The Commission
is also responsible for the execution of the EU budget.34 For other crucial
noneconomic fields, such as foreign and defense policy or internal secu-
rity, the Commission has only marginal functions. In the judiciary process,
it promotes actions against infringements of Community law. Finally, it
plays the key role in shaping EU policy by providing proposals, initiatives,
and representation. The Commission is widely perceived as the embryo of
the European government and its president as “Mr. Europe.”
The European Parliament is an assembly of 732 directly elected represen-
tatives of the people. As such it is the depository of the European “popular
will” and the basis of the European (as distinguished from national or
regional) democratic process. Unlike the House of Representatives in the
United States or most national parliaments, representation in the European
Parliament strongly favors small states. In Germany it takes 820,000 citi-
zens to elect a member of the European Parliament, while 770,000 are suf-
ficient in France and 65,000 in Luxembourg.
With the Council of Ministers, the European Parliament co-decides on
a substantial proportion of EU legislation. Furthermore it exercises control
over the European Commission and holds accountable other EU institu-
tions, including the ECB. Even though the powers of the European Par-
liament have grown significantly over the past decades, there are still
limitations that do not exist in any normal state. For instance, a large part
of the EU budget (i.e., the funds dedicated to agriculture) are outside the
scope of its budgetary competence. Only since 1993 has the possibility for
the Council of Ministers to overturn a negative European Parliament vote
on a legislative measure been abolished.
38 Chapter 2

The EU Council of Ministers brings together the ministers from all the
member states and works under the rotating presidency of a member state.
Like the US Senate, it comprises the representatives from the states.
However, unlike the US Senate, and more comparable to the upper house
of the German parliament (the Bundesrat), it brings together the govern-
ments of the member states. Moreover the diverse size of the EU member
states is taken into account and embodied in provisions for weighted
voting. Thus, unlike the Commission and the Parliament, the Council acts
more as a body where national interests are represented and reconciled
than as an institution truly entrusted with the “European general inter-
est.” This is due not only to the fact that its members’ quasi-full-time job
is to work, at home, on a national agenda but also to the still widespread
inclination to base decisions on consensus.
The Council has both legislative and executive functions. In operational
terms, although it is a single institution, it works in many formations. For
different policy areas respective ministers in charge (economic and finan-
cial matters, trade, agriculture, telecommunications, environment, etc.)
meet, negotiate, and decide as the EU Council of Ministers. It is the upper
chamber of a bicameral legislature, with the European Parliament repre-
senting the lower house. Beyond its role as legislator, the Council also ful-
fills substantial executive functions.
The national heads of state or government and the president of the Com-
mission form the European Council, which meets on average four times a
year and acts as the principal guiding body of the Union. It provides the
main strategic orientations for the political development of the European
Union and has been, for more than twenty-five years, the principal driving
force of European integration. It indeed constitutes the highest level of
governance of the European Union.
The European Court of Justice is akin to a Supreme Court for Europe. Its
twenty-five judges and eight advocates general ensure that the law is
observed in the interpretation and applications of the treaties and the
provisions adopted by the EU institutions. It adjudicates, upon appeal,
whether a European institution has overstepped the limits of its responsi-
bilities or whether the public authorities or private undertakings in the
member states fail to obey the EU rules. Its judgments take precedence over
those of national courts. It has the power to impose fines and sanctions
(e.g., payback of illegal state subsidies).
The European Union has a budget of almost €100 billion (2004) to
finance its activities. Some 80 percent of funds is spent on the common
agricultural policy and aid for regional development, with the rest going
A Profile of the Eurosystem: The Newest Central Bank 39

to external development aid, administration, preparation aid for new

member states, and so on. On the revenue side, the European Union dis-
poses of so-called own resources, such as agricultural levies and customs
duties collected at the EU external borders. In addition the member states
transfer to the Union’s coffers 1 percent of their VAT revenue and a con-
tribution calculated in proportion to each member state’s gross national
product. Overall, however, the EU revenue is capped at 1.27 percent of EU
GDP. In order to allow for better financial planning, the member states
regularly agree—after much haggling—on a set of financial perspectives
that map the Union’s revenue and expenditure for the next seven years.
This appendix describes the institutional setup as laid down by the Treaty
of Nice, which entered into effect on February 1, 2003. At that moment
the so-called Convention for the Future of Europe was already preparing a
fundamental revision of the legal framework of the European Union rela-
tive to the institutional setup. The draft Constitution that the Convention
finally presented in June 2003 strengthened the powers of the European
Parliament and restructured the European Commission and the Council.
Several limitations on the budgetary controls of the European Parliament
were removed and European Parliament’s role as co-legislator was rein-
forced. The Convention also proposed a reduction in the size of the College
of Commissioners to fifteen, but allowed for the nomination of additional
nonvoting Commissioners for those member states not represented in the
College. Moreover, a reform of the current system of half-yearly rotating
presidencies, was put forward, whereby the heads of state or government
would elect a president of the European Council for a (once renewable)
term of two and a half years. Individual member states would chair the
different formations of the Council of Ministers of at least one year. Most
decisions of the Council of Ministers would be taken by qualified major-
ity defined not any longer on the basis of weighted votes, but as a major-
ity of member states representing 60 percent of the EU population. Finally,
the post of an EU foreign minister was introduced. The foreign minister
also would be vice president of the Commission, chairperson of the Foreign
Affairs Council, and member of the European Council.
3 Economic Policies: A Special Economic Constitution

In the years that preceded the introduction of the euro, the powerful incen-
tive of the Maastricht process helped Europe restore macro stability in all
respects but one, indeed a most important one, growth and hence unem-
ployment. This is illustrated in an appendix to this chapter, which com-
pares the European overall economic performance with that of the United
States. For the “land of the euro” (often called euroland1, or euro area),
the challenge for the years to come is not simply to preserve nominal
stability but to couple it with sustained growth and the re-absorption of
unemployment.
To meet this challenge all the levers of economic policy will be called to
action. Although the economic performance of a country or region is due
to a wide number of causes, not all susceptible to economic analysis, the
crucial importance of economic policy is undeniable. Economic policy, in
turn, is crucially dependent on the institutional framework within which
it is conducted.
This chapter discusses whether the economic policy framework of
euroland is a suitable basis to match, in the years to come, the economic
dynamism that the American experience of the 1990s has proved to be
possible even for a mature economy.
The chapter starts with an illustration of the assignment of policy func-
tions to different levels of government: European, national, and regional
(section 3.1). Sections 3.2 and 3.3 are devoted to a discussion of the special
interplay of policies in the euro area, namely the issue of policy coordina-
tion. In the four sections that follow (sections 3.4 to 3.7), I examine
policies one by one: market, monetary and exchange rate, fiscal, and
employment policies. My overall assessment concludes the chapter
(section 3.8).
42 Chapter 3

3.1 Policy Assignment

Why use the expression “economic constitution” to define the order

created by the Treaty? The reason is that just as the constitution of a state,
the Treaty provides the boundaries within which public authorities (central
and local) exert their powers.2
The EU economic constitution is not the outcome of a single founding
act, like the 1787 Philadelphia Convention, nor is it a complete social con-
tract derived from the first principles of politics. Rather, it is built in the
form of an international treaty and has taken shape step by step in a still
ongoing process. Also it consists of a bulky text of over 300 articles and
almost 30 protocols, going into many matters that normally constitutions
ignore: for example, transport safety and vocational training of workers,
interoperability of networks, and a campaign against poverty in develop-
ing countries.
The Treaty stipulates, as is characteristic of any constitution, who does
what in the area of economic policy. A matrix (table 3.1) is provided that
connects the “what” with the “who” in a simplified manner that disre-
gards the diversity of national constitutional structures.
Five policies are identified: market, monetary, exchange rate, fiscal, and
employment.3 Market policies—which are the founding element of the EU
economic constitution—preside over the production and exchange of
goods and services in a decentralized system of free economic decisions.
Market policies concern not only the opening of national markets but also

Table 3.1
Matrix of policies in the constitution of euroland

Levels of government

Policies European National Subnational

Market
Single market rules ¥¥¥ ¥ ¥
Other structural policies ¥ ¥¥¥ ¥¥¥
Monetary ¥¥¥ — —
Exchange rate ¥¥¥ — —
Fiscal ¥¥ ¥¥¥ ¥
Employment ¥ ¥¥¥ ¥

Note: Importance of the role played by various levels of government: — = no role;

¥ = low; ¥¥ = medium; ¥¥¥ = high.
Economic Policies: A Special Economic Constitution 43

the structure, regulation, and formation of the resulting single EU-wide

market. The meaning of monetary and exchange rate policies is straightfor-
ward and requires no explanation. Fiscal policies embrace both the macro-
and the microeconomic aspects of taxing and spending activities. Employ-
ment policy—the actions (public and private) whereby the cost and the use
of labor services are determined—ranges from wage determination, to
prescriptions and restrictions on the use of manpower, to unemployment
benefits.
The five policy areas overlap. The tax system and public expenditures,
for example, influence the functioning of markets for products and factors
of production. Similarly employment conditions are affected by market
policies. Exchange rate and monetary policy cannot be set independently.
Employment policy has been singled out because it has in the member
states unique social relevance. Instead of being determined by the re-
presentative of the people at large (i.e., by the legislative and executive
branch of government), it is largely the outcome of agreements between
representatives of workers and employers.
Turning to the levels of government, the matrix includes European,
national, and subnational levels (in the US terminology, federal, state, and
local levels). However, no further distinction is shown between regional
and municipal governments, because this is not relevant to the present
discussion.4
In effect what the table does indicate is that in the European Union, (1)
market policy is largely European but leaves room for national policies, (2)
monetary and exchange rate policy are entirely European, (3) fiscal policy
is national with a European macro constraint, and (4) labor arrangements
are national.
The EU economic constitution not only states who does what, it also
indicates for what purpose. The goals of economic policy are declared by
the Treaty to be “a harmonious, balanced and sustainable development of
economic activities.” These are to be achieved by a high level of employ-
ment, noninflationary growth, a high degree of competitiveness, and con-
vergence of economic performance.5 The economic policy it prescribes is
one that operates on the principle of an open market economy with free
competition. The guiding principles for the member states and the entire
Community are stipulated to be stable prices, sound public finances and
monetary conditions, and sustainable balance of payments.6
The economic goals just recalled accord well with the three categories
of efficiency, stability, and equity mentioned in chapter 1. Indeed in the
European Union, as in any society of interdependent agents, economic
44 Chapter 3

policy pursues high employment and the preservation of the purchasing

power of money (macroeconomic stability), rational allocation of resources
(efficiency), and “fair” interpersonal as well as interregional income and
wealth distribution (equity, often called social justice). The fact that effi-
ciency, stability, and equity are recognizable goals in the Treaty provisions
is a reflection of the fact that they correspond to three human aspirations
that modern democratic societies regard as socially valuable.7
A comparison with the economic constitution of an ordinary state shows
some analogies mainly in the narrowly defined economic objectives. The
differences are primarily of a political rather than economic nature.
The similarities are found in the range of policies and assignments of
certain functions to the highest level of government. Both EU and state
economic constitutions contain a general formulation of objectives that
recognize the end points of efficiency, stability, and equity.
The differences lie in the EU policy’s peculiarity of a high dispersion and
an ample sharing of responsibilities among levels of government. Policy
functions are widely scattered across levels of government and the
maximum concentration of power is at the national level. In a full-fledged
state, on the other hand, policy functions are strongly concentrated at the
top of the power structure, as they are predominantly, and often exclu-
sively, performed at the level of the central government.
The most important differences, however, are political, not economic.
They derive directly from the fact that, first, the EU economic constitution
is in the form of an international treaty and, second, the European Union
is not a political union. Although the differences are political in nature,
they do have major economic consequences.
In the EU Treaty the very detailed formulation of objectives combines
constitutional provisions with basic legislation and a program for further
action. This approach, which is due to the desire to precisely define the
limits of the transfer of power to the Union, has the important, albeit unin-
tended consequence, of elevating to constitutional status policy actions
and objectives that in most countries belong to the legislative and execu-
tive fields. For the countries adopting the euro, for example, it is a true
novelty that the primacy of price stability and the independence of the
central bank are given constitutional status. It is also a novelty that fiscal
discipline is no longer one among many political options but a legal duty
set above politics.
As the European Union is not political, the responsibility for the main
public goods, whose provision constitutes the very essence of a state, is
the domain of the member states.8 The provision of goods like defense,
Economic Policies: A Special Economic Constitution 45

security, stability, justice, and environmental conservation, for example,

requires a sizable amount of resources. The member states, and not the
Union, have therefore the budgets and the tax-raising powers to generate
a macroeconomically relevant fiscal policy. This is the reason why fiscal
policy and monetary policy are not at the same level of government.
On purely economic grounds, this arrangement contradicts both the
principle of subsidiarity and the very wording of the Treaty. If, following
subsidiarity, each public good were assigned to the government level,
which is competent for the domain where the good is “public,”9 there can
be little doubt that, today, defense, security, environmental protection
would be EU competences. Indeed, they are goods for which the jurisdic-
tion of individual European states has become insufficient. The Treaty lists
among the objectives of the European Union “to assert its identity on
the international scene, in particular, through the implementation of a
common foreign and security policy including the progressive framing of
a common defence policy” (Article 2). The same Treaty, however, fails
to endow the Union with the decision-making capacity and with the
resources that would be necessary to pursue such stated objectives.
Another major consequence of the European Union not being a politi-
cal union is the fact that its procedures retain many of the characteristics
and limits of the model of international organizations. The example that
stands out is the unanimity requirement for taking decisions in many
areas, which hampers the emergence of political union and also under-
mines the functioning of the economic constitution. Thus, although the
EU economic constitution presents all the ingredients, and complies with
the logic, of the model of an ordinary federal constitution, it falls quite
short of the model. Only if what is still a polity-in-the-making moved to
a full-fledged political union would the EU economic constitution become
perfect.

3.2 Interplay

The overall performance of an economy depends not only on the assign-

ment of policies to different levels of government, but also on their inter-
play and actual conduct. The interplay is the theme of this and the next
section of this chapter.
Generally, in the highly interdependent system of an advanced indus-
trialized economy, where many public actors and many levels of govern-
ment are involved, the overall economic performance is the outcome of
countless decisions taken by different and often independent bodies
46 Chapter 3

with differing jurisdictions. Successful economic performance can only be

obtained by virtue of an interplay—“coordination” is the word used—of
such decisions. The constitutional question is how to shape the interplay
in such a way as to have the best chance to produce a good overall eco-
nomic performance.
Euroland’s peculiarity, in comparison with ordinary states, is the widely
dispersed shape of its policy matrix. Consequently the coordination
problem is particularly complex. The entire matter of the EU economic
constitution’s effectiveness hinges on the effectiveness of its policy
coordination.
Before presenting and discussing the specific features of policy coordi-
nation in euroland, a conceptual clarification is given of the meaning,
rationale, and modalities of policy coordination.
Two different meanings of the word “coordination” are often implied in
different contexts. In a macroeconomic context, coordination is usually
referred to the interplay between policy makers in charge of different poli-
cies (fiscal, monetary, etc.) or of the same policy for different countries. In
a microeconomic context, coordination refers to the interplay between all
sorts of private agents, be they individuals, firms, or households. In this
context the market is the prime and most efficient coordinative mecha-
nism. In euroland an adequate analysis of policy coordination has to
involve both meanings because of the host of national or even subnational
public economic agents that interact within a common institutional frame-
work. As to the rationale, coordination is required whenever, due to inter-
dependence, the actions of an economic entity (private or public) can be
made more effective by cooperating with other entities. In the private,
profit-driven production and exchange activities of a market economy the
benefits of coordination are epitomized in the form of a contract, namely
by the mutual advantage that a freely stipulated contract procures to each
party. In public, policy-driven activities the rationale for coordination lies
in spillover effects. By this we mean that each policy-maker tries to affect
an economic system that is also affected by the behavior of other policy-
makers. In the case of euroland the scope for policy coordination is par-
ticularly large because the number of levels of governments is specially
high and the concentration of power at the top specially low.
Finally, turning to the modalities, the comprehensive notion of coordi-
nation suggested above leads to identifying the following four:
䊏
Single institution Many decision-makers are replaced by a single one,
which amounts to a full internalization of externalities and spillover
effects.
Economic Policies: A Special Economic Constitution 47

䊏
Common rule The rule acts as a permanent constraint on independent
decision-makers. This is sometime referred to as “hard coordination” as it
effectively limits potential negative externalities.
䊏
Consultative forum Independent actors meet in a forum where joint
decisions are possible but not obligatory. This is often referred to as “coop-
eration” or “soft coordination.”
䊏
Policy competition Policy-makers pursue the interests of their local con-
stituencies and do not consider the wider interests of the entities of which
they are a part.

From the point of view of the extent of coercion they entail for a dis-
senting party, the first two modalities are hard and the second two soft.
In the European context there are often heard calls for separate actors
to comply with joint decisions. This so-called “ex ante coordination”
among separate policy actors may be identified, depending on the cir-
cumstances and the precise procedural arrangements, with either the single
institution or the consultative forum. If rigorously interpreted, it ends
up in the “single institution.” If loosely interpreted, it is a “consultative
forum.” Either the coordinative procedure is so strong that the joint deci-
sion is always taken and implemented, in which case the many actors have
effectively been replaced by a new, single, albeit collegial, one; or joint
decisions are only taken occasionally, if and when consensus is reached.
Because of its ambiguity and even contradictory character, ex ante co-
ordination does not explicitly appear in the taxonomy.
The proposed taxonomy does not suggest that the joint institution mode
is always the optimal solution for the problem of interdependence. The
reason is that there is no guarantee that the outcome of a joint decision
will be superior to that resulting from separate and even competing
decisions.

3.3 Coordination

In euroland, the need for coordination exists across countries, and across
policies, because spillover effects may result within a given area (e.g.,
between fiscal and monetary policy) or between countries (e.g., between
different employment policies in different countries).10 Table 3.2 shows the
ways policy is being coordinated in euroland.
As the table shows, the single institution mode applies first and foremost
to market policy, where the European Union has the power to legislate
the four freedoms, to enforce compliance, and to repress anticompetitive
48 Chapter 3

Table 3.2
Modes of policy coordination in euroland

Modes of coordination

Policies Across countries Across policies

Market

}
Single market rules Single institution
Other structural policies Policy competition
Monetary Single institution
Consultation
Exchange rate Single institution
Fiscal Common rule
Employment Consultation

practices. It now also applies to monetary policy. The common rule mode
is exemplified by the fiscal rules introduced in the Treaty of Maastricht and
further specified through the so-called Stability and Growth Pact (SGP).
The consultative forum mode is adopted for a number of structural policies,
such as reforms of tax and benefit systems, and research and development,
where nonbinding common positions are being taken.11 Last, policy com-
petition plays a large role because of the many functions left to the national
level.
The four modes are not mutually exclusive. In market policies, for
example, the common rules (called Directives) adopted through the single
institution mode (the EU legislative process) leave wide room for compe-
tition among policies.
A distinctive feature of the EU policy coordination scheme is that it is
internally consistent. For many years the inconsistencies in free trade,
capital mobility, stable exchange rates, and the autonomy of national mon-
etary policies had hindered the full establishment of the four freedoms
and relapse was an eminent threat to the integration already achieved. By
explicitly recognizing that a single market could only be sustained by a
single currency, a single monetary policy, and a single central bank, the
Treaty of Maastricht corrected the lame constitution founded in Rome.
This has put the edifice of European economic integration on two solid
legs, “one market” and “one money.”12
The four modes outlined above represent the full set of possible
approaches to policy coordination both within most countries and in their
relationships with other countries. Within a country policy arrangements
indeed combine a full set of these approaches to varying degrees: (1) central
Economic Policies: A Special Economic Constitution 49

institutions are endowed with the power of command, such as a central

bank or a central government, (2) rules exist to set limits on public spend-
ing, (3) nonbinding consultations exist between the government and the
labor organizations, and even (4) policy competition is at work, for instance
between regional or municipal governments. In the international sphere,
the IMF Articles of Agreement lay down common rules governing inter-
national monetary and financial relationships while, at the same time,
looser coordination operates, in the form of consultations among policy
makers (in the IMF itself or in forums such as the G7).
That said, the European Union has special features that place it in
between a national and an international model. In general, the soft modes
(consultative forum and policy competition) have a much wider applica-
tion than in a domestic system. In particular, the scope of its policy com-
petition is much wider than that of any single state. This feature requires
some further explanation.
In a typical domestic setting, competition is recognized as an efficient
form of coordination for private, profit-driven, economic agents, whereas
the field of policy is seen as the domain of monopoly, coercion, and con-
centration of power. In the field of international economic relations, where
governments are driven by strategic motivations that resemble those of a
large corporation, policy and competition are interlinked.
Nevertheless, policy competition does exist in domestic spheres. The
governments of California and Massachusetts were behind the develop-
ment of high-tech centers in Silicon Valley and on Route 128, just as
Bavaria and Hesse were behind the competing international airports of
Munich and Frankfurt. In many countries local governments use economic
incentives to attract businesses, good university teachers, tourists, and
public works that are paid out of the national budget.
Policy competition takes many forms, ranging from fair contest (coop-
eration) to unrestricted conflict (warfare). While the former produces
economic benefits, the latter generates inefficiency and waste. In a con-
solidated domestic setting, where the singleness of the market is undis-
puted and the legal framework strong, policy competition is constructive
and easily accepted. In an international setting, constructiveness is less
straightforward and needs to be assessed case by case. Exporting copied
products without recognizing the rights of intellectual property is un-
doubtedly economic warfare, but it would also be economic warfare for an
advanced economy to bar access to its market to products of an emerging
economy that are cheap because worker protection is low. Policy compe-
tition in the European Union today corresponds to the domestic model to
50 Chapter 3

a large extent, but not entirely. Member countries still pursue the strategic
objective of self-sufficiency and hence protect national champions in many
sectors, ranging from energy, to finance, to key industries. Often they use
meetings in Brussels to implicitly or explicitly agree on delaying the full
opening of their respective markets.
The high degree of policy competition in the European Union is regarded
by some as a fundamental weakness, the sign that the EU construct still
falls short of the requirements of a typical “domestic economy.” There is
ground, however, for a more balanced view.
In general, competition provides a stronger incentive to optimization
than monopoly, not only in the field of business but in that of policies as
well. In society and communities, collective ambitions and community
bonds are stronger on a local than on a continental scale. If this is the case
in the United States, as one rises from county, to state, to national level,
even more it is the case in Europe, where regional (or even town) loyalties
have long roots and the nation-state a strong historical tradition. The
overall quality of policies may thus benefit from an environment in which
policies are set to compete and national ambition acts as an incentive.
Policy competition also permits useful experimentation and corrections.
As it is often difficult to design the “right” policy from the outset, and to
avoid introducing perverse incentives, the simultaneous implementation
of alternative approaches may trigger feedback from the market and thus
help policy-makers. This applies to areas like regulation, taxation, incen-
tives to business investments, and research. Policy competition is, on the
whole, closer to the domestic cooperative model than to the international
conflictual one. That said, the European Union is not immune from the
inefficiencies and drawbacks of conflictual rather than competitive rela-
tionships. For example, the nurturing of national champions in public util-
ities, energy, public procurements, and financial markets is undoubtedly
harmful to the consumer. It is still widespread and insufficiently discour-
aged by the European Union, which has only limited rule making and
enforcement powers.
In sum, the modalities of policy coordination in euroland exhibit, just
as the assignment of policy functions discussed in section 3.1, a twofold
characteristic. For one thing they are a blend of the same archetypes that
can be found within an ordinary federal system. For another they reflect
the fact that the European Union is only a polity in the making, lacking
important functions and constitutional characteristics of a political union
and retaining some features of an old model of strategic contest between
independent states. Despite its limits and incompleteness, this framework
Economic Policies: A Special Economic Constitution 51

does not suffer from fundamental inconsistencies; it provides a solid basis

for the development of a unified market and for monetary and fiscal
discipline.

3.4 Market Policy

This and the next three sections examine the policies one by one, focus-
ing on their missions and on the interplay between different actors. We
will see how, under their current design, these coordination mechanisms
can contribute to the pursuit of the three goals of efficiency, stability, and
equity.
As we saw before, the responsibility for market policy is predominantly
entrusted to the European Union, although national (and even subna-
tional) governments also play a critical role. The European Union has the
task of ensuring the singleness of the market, and the other levels of gov-
ernment are free to act within that constraint. In practice, the EU task has
been defined and interpreted as requiring very detailed uniform EU legis-
lation to avoid distortions in trade and the maintenance of nontariff bar-
riers. Rules are enforceable by national courts. Since the market is one, the
competition policy is a responsibility of the Union.
For this reason the vast body of legislative and regulatory provisions con-
cerning the production and exchange of goods and services now mainly
originates from Brussels. Such provisions range from safety standards of
electric appliances to brandname labels on wines and cheeses, to minimum
periods of maternity leave.
Despite the vast spread of EU legislation, the economic conditions of
countries and regions in euroland continue to be largely influenced by
national and local governments. In the first place national governments,
in implementing EU rules can, by variously combining efficiency with
equity considerations, enhance or undermine the competitive position of
their economy.13 They have ample residual regulatory powers rooted in the
principle of mutual recognition of national regulations, whereby any
authorization or license issued by one country to a local producer grants
access to the entire EU market.14
Mutual recognition of national regulations thus generates competition
among rules, and rewards the countries and producers with the “best
rules.” Over time this process raises the standards of all countries and pro-
ducers, and gradually levels the playing field.
Finally, and more generally, all national authorities—be they central,
regional, or municipal—are free to “do what they want” provided that
52 Chapter 3

what they do is compatible with the EU framework. The levers thus left to
them are sufficient to attract or, on the contrary, discourage new invest-
ment, businesses, workers, tourists, and students. Examples of such levers
are the tax structure and the practices of national administrations or super-
visory authorities, the planning of the territory and the efficiency of the
judiciary in settling litigation, the preservation of law and order and the
climate of industrial relations.
In sum, EU market policy is firmly committed to the allocation efficiency
in the Europe-wide single market. To achieve this goal, the EU economic
constitution assigns the primary policy role to itself. National and local
governments, however, retain significant discretionary power to shape
business conditions within this policy and are free to pursue other objec-
tives than pure allocation efficiency. Competition is the coordination
mode that applies to the market policies of national and local authorities.
The purpose of the Treaty and the single market is not to eradicate national
ambitions but rather to channel them in a system of agreed rules, where
competition replaces conflict and the animal spirits of private and public
ambitions service wealth and prosperity.

3.5 Money and Exchange Rate

Monetary policy is an exclusive responsibility of the European level. While

fiscal federalism is a possible, and indeed a recurrent, feature of most
economic systems, the singleness of the currency leaves no room for
monetary federalism. Monetary policy is indivisible and, by implication,
exchange rate policy is also an exclusive responsibility of euroland.
For monetary policy (which will be fully examined in the next chapter)
the responsibility is entirely entrusted to the ECB. For exchange rate policy,
both the central bank and the Treasury or the Ministry of Finance are
involved, in euroland just as in all countries. There are two reasons for this
shared responsibility. The central bank is the necessary operational arm of
any direct or indirect action on the exchange rate, such as the buying and
selling of foreign currency in the market or moving interest rates. The Trea-
sury also traditionally has a say (and often the decisive say) on the exchange
rate, both because the exchange rate has a strong influence on the exter-
nal competitiveness of the economy and because the Treasury is often the
owner of the reserves of the country.
In euroland, the shared responsibility takes the form of a relationship
between the ECB and the college of Ministers of Finance of the participat-
ing countries, which meets regularly in the so-called Eurogroup.15 The ECB
Economic Policies: A Special Economic Constitution 53

has the exclusive responsibility for the operational side, namely for the
buying and selling of foreign exchange, and cannot be obliged by the Min-
isters to intervene in the market even less to put exchange rate considera-
tions above monetary policy considerations. The central bank thus plays a
greater role in the European Union than in the United States and Japan,
where the Treasury decides and the central bank only advises and executes.
Concerning the policy objectives, the Treaty explicitly prescribes price sta-
bility as the priority, not only for monetary policy but also for exchange
rate policy. It indeed stipulates that in all circumstances the Community
will conduct an “exchange rate policy the primary objective . . . of which
shall be to maintain price stability.”16
The Treaty also implicitly recognizes that in a large, relatively closed
economy there is virtually no room for an independent exchange rate
policy. It thus leaves to the ECB the task of integrating exchange rate con-
siderations in the conduct of monetary policy, as well as the decision on
whether and how to operate in the foreign exchange market.
The Treaty, however, also envisages the possibility of more activist
approaches to the exchange rate.17 In particular, it does not exclude such
arrangements as a system of target zones, or the periodical formulation of
coordinated exchange rate objectives by the authorities of the major cur-
rencies of the world. The European Council, however, after discussing these
Treaty provisions, decided in 1997 and 1998 to leave the external value of
the euro to be determined by the market. It declared the exchange rate of
the euro to be “the outcome” of all relevant economic policies, rather than
an independently set objective. It also decided that “general orientations”
for the exchange rate policy of the euro area would only be formulated
in “exceptional” circumstances, for example, in the case of clear
misalignment.18
In sum, and again in terms of the objectives of efficiency, stability, and
equity—monetary and exchange rate policies, which are an exclusive euro
area responsibility, are both geared to macroeconomic stability. The EU
economic constitution leaves no room for stimulating growth and employ-
ment through monetary expansion or currency devaluation. Moreover it
recognizes that exchange rate policy cannot be set independently of, or in
contradiction with, monetary policy.

3.6 Fiscal

In the fiscal field, the European Union sets a rule that limits the magni-
tude of public deficits and public debts, while national authorities decide
54 Chapter 3

about the size and composition of public budgets. This section will first
describe such two-tier responsibility, then discuss its aptness to pursue the
policy objectives set for the Union.
The European budgetary rule results from the combined provisions of
the Treaty of Maastricht19 and the Stability and Growth Pact of 1997.20 The
rule orders that national budgets, which are the major component of
the EU fiscal framework,21 to be “close to balance or in surplus” over the
medium term, a period interpreted as the length of a business cycle. In the
event of a recession, the deficit is allowed to grow to 3 percent of GDP.22
The ratio of public debts to GDP must be kept below 60 percent and, when
in excess, reduced.
To ensure that the rule is enforced, national fiscal policies are subject to
a detailed procedure of multilateral surveillance, and specific sanctions
apply in case of noncompliance.23 The political procedure is comple-
mented by the disciplinary effect of the financial market, which differen-
tiates, albeit in a muted manner, among sovereign borrowers.24
While subject to European rules, budgetary policy remains predomi-
nantly national. Because of their large size relative to other public budgets,
national budgets provide for almost the totality of fiscal impulses. National
authorities are also free to choose the overall dimension of their budgets
and the structure of their expenditure and taxation.25
The Treaty emphasizes national responsibility for fiscal policy in various
ways. There is a “no-bail-out-clause” that states that under no circum-
stances will the Union intervene in support of a country or other public
body that fails to meet its financial obligations. It prohibits credit institu-
tions from granting public authorities privileged access to credit, and
it forbids any form of monetary financing of fiscal deficits by the
Eurosystem.26
Will this fiscal structure meet the challenges facing the European
economy? At this early stage of EMU, only a very preliminary assessment
is possible, and only in terms of the three policy objectives of stability, effi-
ciency, and equity.
As for stability, the fiscal framework of the Stability and Growth Pact
seems to be searching, in these early years of the euro, for an adequate
combination of discipline and flexibility in the conduct of effective fiscal
policies. In many countries fiscal discipline has worked in a fairly satisfac-
tory way so far. At the end of 2001 seven of the twelve euro area members
had reached the “close to balance or in surplus” condition prescribed by
the Pact. In 2002 most countries remained below the 3 percent limit
despite significantly lower growth. However, Portugal exceeded the limit
Economic Policies: A Special Economic Constitution 55

in 2001, and so did Germany and France in 2002. The budgetary positions
of Germany and France deteriorated further in 2003, leaving little
prospects for a significant improvement before 2005. The disciplinary
effect of the Pact is thus still uncertain.
With regard to flexibility, the question is whether the EU rule grants suf-
ficient compensation for the loss of national levers in the monetary and
exchange rate fields. Additional fiscal flexibility is needed, for example,
to stem inflationary pressures while the rest of euroland is faring below
capacity. Such a shift from monetary to fiscal stabilization is undoubtedly
permitted by the rules of the Pact. Indeed, once the transition is completed,
the Pact allows a country to counter—within the 3 percent limit—cyclical
fluctuations with automatic stabilizers as well as with discretionary
measures.27
The Stability and Growth Pact has been intensely discussed by policy-
makers and within academic circles since it was proposed and negotiated
in 1995 to 1997. In 2002, the slowdown in the EU economy and the con-
sequent difficulty encountered by France and Germany in complying with
the Pact opened a new round of discussion. Radical critics of the Pact, such
as Wyplosz (2002), advocated a complete overhaul of the EU fiscal frame-
work. Others, including Fitoussi (2002), de la Dehesa (2002), and Horn
(2002) suggested replacing the existing rule—which targets the nominal
overall budget balance—with one focusing on a cyclically adjusted balance
or some form of a golden rule that computes the balance net of invest-
ment expenditures. After discussing these issues in some detail, the policy-
makers concluded that the rules of the Pact should remain unchanged.
They also determined that the Pact should be implemented in a way that
takes account of the effects of the cycle, the need for appropriate structural
budget adjustment, and contingencies.28
The discussion was re-opened when, in November 2003, the ECOFIN
Council decided not to follow the procedures foreseen in the Treaty and
the Pact for bringing the deficits of Germany and France back below the
3 percent limit. Earlier that year the ECOFIN Council had issued recom-
mendations to the two countries requiring them to correct their excessive
deficits in 2004. When it became clear that these recommendations had
not been fully complied with, the ECOFIN Council should have proceeded
to the next step of the procedure. As this would have brought France and
Germany only one step away from sanctions, the Council instead opted
for the much softer approach. The Council “conclusions” adopted new
recommendations giving France and Germany until 2005 to bring their
deficits back below the 3 percent limit.
56 Chapter 3

The action taken by the ECOFIN Council led to immediate reactions of

concern on the part of many countries, the Commission, and the ECB. The
Commission even took the step of legally challenging the ECOFIN
Council’s action before the European Court of Justice with the aim of estab-
lishing legal clarity. It also announced its intention to formulate new pro-
posals to improve the Pact and its implementation, indicating that it was
even considering a revision of the Pact itself. It is too early to tell whether
the setback of November 2003 will mean a lasting weakening of the EU
fiscal framework, or be just one episode in the life of an ambitious and dif-
ficult policy instrument.
Turning from the country level to the euro area, it may be asked whether
the Stability and Growth Pact should be complemented with a capacity to
decide a concerted fiscal expansion if needed. This would correct an asym-
metry that now exists between the hard-line disciplinary and the soft-line
discretionary measures. There is, however, reason to believe that any
attempt at proposing a binding procedure for areawide discretionary fiscal
policies would meet serious constitutional and political difficulties.
Any binding fiscal orientations that go beyond the Pact may raise ques-
tions of legitimacy. Whereas the policy requirements of the “sound
money–sound finances” principle embodied in the Pact have a firm foun-
dation in the Treaty, the foundation to sustain discretionary and binding
EU-level fiscal decisions seems too generic.29 Moreover such new procedure
would touch what in all countries is a high moment of the national
political process. Any budgetary commitments made by the finance min-
isters in Brussels would be seen as an undue limitation of national pre-
rogatives. Budgetary procedures are in fact so complex, lengthy, and
fraught with uncertainty that no final decision can be fully controlled by
all of the many parties involved.
While the institutionalization of common fiscal decisions binding
national policies may not be feasible, occasional coordinated responses to
shocks symmetrically affecting the area may be possible and even desir-
able. Already the practice of frequent meetings and informal discussion
among finance ministers has led to a progressive “internalization” of euro
areawide concerns, and allowed the European perspective to be strength-
ened in national political discourse.
Another crucial issue concerns the interaction between fiscal and monetary
policy. Critics of the EU policy framework see the lack of coordinative pro-
cedures as an impediment to the achievement of an appropriate so-called
policy mix. Along the same lines, the Commission and the European Par-
liament have from time to time advocated a “right policy mix” between
monetary and fiscal policies.30
Economic Policies: A Special Economic Constitution 57

Joint decisions on fiscal and monetary policy used to be taken in coun-

tries such as the United Kingdom or France, when both policies were in
the hands of their Treasuries. This is not the case wherever central bank
independence is in place. The division of responsibilities in euroland does
not differ from what we find in pre-euro Germany, the United Kingdom,
the United States, or Canada. In these countries, just as in the European
Union, neither mutual public commitments on either side, nor bargaining
processes, nor joint decisions are part of policy-making.
Although the lack of hard coordination between fiscal and monetary
policy is not specific to euroland, there are aspects that are unique. First,
the singleness of monetary policy is not matched by anything like the
budgetary procedure of a country.31 Moreover the ECOFIN Council or
the Economic and Financial Committee are not really suitable bodies for
the confidential, but often effective, consultation between monetary and
fiscal authorities that normally exists at the national level. Compared to
the quiet weekly breakfast of the Chairman of the Fed with the Secretary
of the Treasury, euro area meetings can be quite chaotic. There are a great
many people in the meeting room, the machinery for preparing the meet-
ings is too heavy and too formal, and there is too much media exposure.
Thus, even if there were to be a more structured euro area fiscal policy, an
appropriate “consultative forum” procedure to facilitate the discussion of
monetary and fiscal policy in an effective, nonbinding manner would still
have to be developed. All in all, the Eurosystem is missing the fiscal and
political counterpart that usually mediates for a central bank. This harbors
the risk of the Eurosystem being seen as the only macroeconomic policy-
maker in euroland, and hence to be held responsible for any adverse
development in the European economy, not only inflation but also
unemployment and slow growth.
So far we have dealt with fiscal policy from the point of view of the
pursuit of macroeconomic stability. Historically, however, public budgets
were created, and grew in size, to produce public goods and to help the
needy with resources of the wealthy. These are the allocation and redistrib-
ution functions of fiscal policy, respectively, related to efficiency and equity.
The two functions are—like stabilization—mostly left to the jurisdictions
of the member states and thus subject to their national political processes.
This, in turn, has implications for the overall policies and economic per-
formance of euroland.
As for allocation, a rational approach to policy-making should distinguish
among European, national, and local public goods, following the princi-
ple of subsidiarity, and assign each to the respective level of government
58 Chapter 3

and budget. Correspondingly, there should be local, national, and

European taxes. Deviations from the assignment guided by subsidiarity
would entail losses in terms of both effectiveness and efficiency. The strong
concentration of budgetary functions at the level of member state is the
legacy of the political and military history of Europe, where power was
concentrated in the hands of national governments and military strength
was a major objective. Most, if not all, public goods were “public” for
the jurisdiction of the state, not for the various regions or for the
continent.
In a constitution based on the principle of subsidiarity, a number of func-
tions would be shifted up to the EU budget and down to regional and
municipal budgets. A more rational allocation of resources would allow for
a more satisfactory overall economic performance throughout euroland.
In Europe the redistribution, or equity-oriented, function, represents a
sizable portion of the public budget, much larger than that in the United
States or other parts of the world. These redistribution functions—
pensions, health care, unemployment benefits, and so on—are largely con-
centrated in national budgets.
There are reasons for the budgetary functions aimed at equity—unlike
those aimed at the production of public goods—to remain largely entrusted
to national or regional levels of government. Social solidarity develops
within communities. The smaller the community, the tighter are the bonds
of compassion and the disposition to accept giving part of one’s income
in order to help the needy: indeed, charity begins at home.
The higher and more distant levels of government, up to the whole
European Union should only be in charge of redistribution from wealthier
communities (rather than persons) to more indigent ones. This is in
effect the purpose of the structural funds and the Cohesion Fund men-
tioned in chapter 1. Although these funds are small in size (only 0.3 percent
of GDP), their importance is significant for the receiving countries and
regions.
Should the overall configuration of fiscal policy in the European Union
be held responsible for the disappointing economic performance of Europe
in the last decade? The answer can hardly be encapsulated in a single
sentence.
First, if EU-driven fiscal consolidation has temporarily dampened growth
in Europe, this is to be regarded as a fair price for a highly desired objec-
tive. As the fiscal rule embodied in the Treaty and the Stability and Growth
Pact was introduced only in the 1990s, it is too early to gauge how it will
be interpreted and managed in a steady state that has not yet been reached.
Economic Policies: A Special Economic Constitution 59

Only time will tell if policy-makers will be able to avoid both excessive
laxity and excessive rigidity.
Second, so far the allocation and redistribution of resources have remained
predominantly national functions that are being performed in ways that
do not foster economic efficiency and growth. For one thing, certain classic
public goods, such as security or protection of the environment, have not
been moved from the national to the European domain, entailing a dupli-
cation of resources. For another, the traditional continental European
strata of politically active society, with only minor variations, deliberately
forgoes even a quantum of efficiency and growth in favor of greater equal-
ity and social protection.
EU economic and monetary integration has extended the scope of com-
petition from private to public agents, from products, services, and factors
of production to policies and, more generally, administrative, political, and
legal systems.32 To the extent that slow growth depends on structural rigidi-
ties rooted in the social, political, and cultural tradition of Western
European nation-states, it can be said that European integration has been
a corrective factor. With more determined implementation of both sub-
sidiarity and policy competition, some dynamism might be imparted to
the European economy.
As for the EU budget, only a new transfer of policy tasks from the
member states may in time increase the size and make it a suitable instru-
ment for macroeconomic policy. For example, in time internal security and
defense may become EU responsibilities, requiring common budgetary
resources. In the case of equity and solidarity, the existing EU regional and
structural funds may be increased or a system of intercountry fiscal trans-
fers, comparable to the German Länderfinanzausgleich, may be created.33
Historically public budgets were not created to make macro fiscal policy
possible but to provide goods and services recognized as “public” by a given
political community. Their usability as macroeconomic policy instruments
came as a by-product. There is no reason to think that the European Union
will follow a different path.

3.7 Employment

The fourth and final policy area is employment policy, namely the actions
(public and private) whereby the remuneration and the use of labor ser-
vices are determined. In the European Union this policy is overwhelmingly
national, largely entrusted to the social partners (employers and labor
unions) and subject only to a consultative European framework.
60 Chapter 3

In most European countries negotiations between employers and labor

unions determine wages and salaries, as well as the main nonpecuniary
aspects of labor contracts. Negotiations can occur at various levels, from
government to firm or factory, with the former still retaining a strong
role. The agreements stipulated between workers and employer organiza-
tions are generally maintained by force of law. Parliaments and govern-
ments intervene through social legislation and regulation, as well as by
taxes and spending. Normally, however, they use their powers only after
extensive consultations with social partners and refrain from open con-
frontations with them, a practice that further extends the influence of
social partners on employment policy. This largely consensual model,
often termed corporatist,34 significantly distinguishes Europe from the
United States.
The corporatist model also applies at the EU level. Labor unions,
employers, and trade associations, for example, are represented in the EU
Economic and Social Committee,35 which is consulted on many aspects of
European legislation. The Treaty itself contains a social policy chapter that
allows the Community to undertake “complementary actions” in fields
such as social protection of workers, representation and collective defense
of both sides of industry, as well as vocational training. The Treaty also
provides for a social dialogue between labor and management at the EU
level, including the possibility to accord the status of European law to the
contractual agreement reached.
In reality this EU framework is much weaker than it looks, and almost
nothing is determined at the European level in a binding way. In employ-
ment policy, EU procedures are of the soft “consultative forum” type
described in section 3.2. Despite the stated common objective of a high
level of employment, the EU economic constitution leaves employment
policies almost entirely to the discretion of national and subnational
entities.
The fact that monetary policy is European and employment policy
national has been criticized as an potential impediment to the smooth
functioning of EMU.36 Wage settlements and other arrangements affecting
labor costs (whether detailed in labor contracts, in regulations, or in ordi-
nary legislation) are indeed likely to be the principal remaining source of
country-specific inflationary shocks. In a monetary union such shocks,
which were previously corrected by devaluation, can prolong unemploy-
ment and lead to economic decline.
The antidote is, and can only be, an alignment between the dynamics
of labor cost and that of productivity. This requires agreements that keep
Economic Policies: A Special Economic Constitution 61

the cost of labor close to the production unit. By contrast, industrywide

and countrywide stipulations when uniformly applied to diverse produc-
tion units inevitably generate an excess supply of, or an excess demand
for, labor; the result is unemployment or price increases. Only with a very
flexible labor market can employment policies avoid generating asym-
metric shocks that monetary policy cannot cure. The need for labor market
flexibility is all the more strong in the European Union, where significant
cultural and social barriers limit geographical mobility of workers. If wage
bargaining processes in the various countries, regions, sectors, and firms
closely reflected disparities in productivity among workers, regions, and
sectors, then geographical mobility would be less needed for the proper
functioning of monetary union.
Euroland wage bargaining for a single wage rate is being sometimes advo-
cated. This, however, would aggravate, not alleviate, the unemployment
problem. The high unemployment in southern Italy, the Mezzogiorno, and
in eastern Germany is largely due to such premature wage equalization.37
The allocation of employment policy to sub-federal levels means that,
in this field, policy competition is the predominant coordination mode.
This does not preclude, however, useful cooperation among EU policy-
makers in the present soft mode, combining the benefits of discretion and
flexibility with those of peer review and emulation of best practice.
Common policy objectives may be set, time tables given, and progress
jointly monitored also to push through unpopular reforms.38 As part of
this cooperation, the European Council, meeting in Lisbon in March 2000,
has set the objective to raise the labor force participation rate in the
European Union from 63 percent in 2000 to 70 percent by 2010.39

3.8 While the Jury Is Out

In sum, the special features of the EU policy constitution are the strong
emphasis on macroeconomic stability, the ample role left to subfederal
levels of government, a practice of guidance through consultation forums,
and an unusually large scope for policy competition. Euroland has emerged
from a decade of mixed results. Success in reducing inflation and fiscal
deficits has been countered by defeat in fostering growth and employment.
The question is whether the EU economic constitution embodied in the
Rome–Maastricht Treaty is conducive to the policies needed to combine
price stability with growth.
The jury is still out. The EU constitution is too recent for a considered
judgment to be possible. Like any constitution it will be shaped through
62 Chapter 3

years of interpretation and practice. The potential effects of the innova-

tions it has brought about, particularly, the single currency, need time to
unfold.
As economic constitutions leave ample room for discretion in the
conduct of policy, it may not be easy even years from now to assess how
much of the performance was due to constitutional framework and how
much to practice of policy. Indeed, no economic constitution can ensure
the precision with which its stated goals are met. Unforeseen events, the
free democratic spirit of the people, and the discretion necessarily left to
future policy-makers prevent arranging an automatic pilot that sets the
economy on a golden path and keeps it there thereafter. In the long run
the economic performance of any country or region is only in part
amenable to the influence of economic policy.
Yet, there are good and bad economic constitutions. And the good
quality of the constitution, albeit not a sufficient, is undoubtedly a neces-
sary condition for a good economic performance. While the jury is out,
we can, thus, try an assessment on the basis of what we know today. The
structure of policy instruments, the design of the institutions, and the
assignments of tasks to various levels of governments are, in the European
Union, rather different from the model of other large modern economies.
In many ways it is a system of incentives that can be equally, and even
more, effective than the one of other federal systems. However, for the con-
stitution to operate successfully a change in policies is needed.
To reduce unemployment and raise growth potential calls primarily for
the proper functioning of the labor market, and also for a removal of
remaining rigidities in product, services, and capital markets. In areas
where national responsibility and even policy competition prevail, coop-
eration among the member countries can deliver value added by raising
the growth potential of euroland as a whole.
While a mere consultative method without a powerful European eco-
nomic policy actor may appear as a weak and insufficient policy process,
it sets in motion a learning process. Participants are guided to internalize
the requirements of a monetary union, and their awareness is raised of the
euro dimension of national policies. This structure is gradually conferring
to the table of cooperative action topics that used to be jealously guarded
prerogatives of national politics, such as the design of tax-benefit systems,
the structure of public pension systems, and the financing of public health-
care. While it may be neither efficient nor politically feasible to design
uniform solutions, regular exchanges foster a convergence of ideas. The
result may be adoption of common guidelines or, at some point, even
binding rules, in accordance with the Community’s legislative process.
Economic Policies: A Special Economic Constitution 63

No doubt, in time the articles of the Rome-Maastricht constitution will

undergo amendments. The example of the US Constitution shows how, on
the basis of a single constitutional clause (granting freedom to interstate
commerce), a transformation of the activities of the federal government in
the economic realm can develop.

3.9 Appendix: Euroland’s Economic Structure and Challenges

Comparisons help our understanding of reality. The facts and figures for
euroland are in this appendix matched with those of the United States.
While the two economies are broadly similar in economic size and struc-
ture, some immediate noteworthy differences are recognized (table 3.3).
Euroland and the United States have populations of 308 and 289 million,
respectively, and account, respectively, for 16 and 21 percent of world GDP,
converted on the basis of purchasing power parities.40 Average per capita
income in the euro area, calculated in purchasing power parity terms, rep-
resents 71 percent of the US level.41 The industrial sector of the euro area
is somewhat larger (27 against 23 percent of GDP) and the service sector
(70 against 76 percent) smaller. In euroland agriculture produces 2.3
percent of GDP and occupies 5.2 percent of the labor force, against 1.6
percent and 1.7 percent, respectively, in the United States.
The government sector presents significant disparities between the two
economies, reflecting differences in history, tradition, social structure, and
attitudes toward the role of the state. Total public expenditures amount to
48 percent of GDP in the euro area, against 34 percent in the United States,
reflecting the fact that the role of government in the economy is consider-
ably larger in the former than in the latter.42
The financial sector in euroland is mainly centered on banks: bank
deposits and loans amount, respectively, to about 81 and 107 percent of
GDP in the euro area, significantly more than the shares in the United
States (63 and 52 percent). In contrast, debt securities amount to only 99
percent of GDP, while in the United States the same ratio reaches 156
percent. In the United States stock market capitalization, in relation to the
GDP, is around double that in euroland, where it reaches around 51
percent.
Looking at the external sector, we see that both euroland and the
United States are relatively closed economies, with openness measured
by the average of exports and imports of goods and services relative to
GDP.
Within euroland, Germany accounts for about 30 percent of the area’s
output, followed by France (22 percent), Italy (18 percent), and Spain (10
64 Chapter 3

Table 3.3
Structural comparison of euroland with the United States

Euroland United States

Demography
Population (millions) 307.7 288.6
Gross domestic product
GDPa 15.7 21.1
GDP per capitab 23.8 33.4
Sectors of the economy
Agriculture, forestry, and fishery 2.3 1.6c
Industry (including construction) 27.3 22.8c
Services 70.4 75.6c
General government sector
Total revenue 46.0 30.8
Total expenditure 48.3 34.2
Net lending (-) or borrowing (+) -2.3 -3.4
Gross debt 69.0 61.4
Financial sector
Amounts outstanding of debt securitiesd 99.4 156.3
Stock market capitalizatione 51.5 103.0
Bank deposits 81.1 63.5
Bank loans 107.5 51.8
External sector
Current account balance 0.9 -4.7
Opennessf 14.6 11.7

Sources: ECB, European Commission, OECD, BIS, IMF-WEO, Federal Reserve,

International Federation of Stock Exchanges.
Note: 2002; unless otherwise stated, figures are expressed as a percentage of GDP.
a. As a percentage of world GDP, converted at purchasing power parities.
b. In thousands of euro, converted at purchasing power parities.
c. 2000 figures.
d. Issued by residents in national currency.
e. January 2003 figures.
f. Average of exports and imports of goods and services.
Economic Policies: A Special Economic Constitution 65

Table 3.4
Euroland and US performance over the long term

Euroland United States

Real GDP (average annual growth)

1951–1990 4.2 3.5
1991–2002 1.9 2.9
Real GDP per capita (average annual growth)
1951–1990 3.5 2.3
1991–2002 1.5 1.7
Population (average annual growth)
1951–1990 0.7 1.2
1991–2002 0.4 1.2
Net job creation (millions)
1950–1990 18.3 65.5
1991–2002 8.9 21.7
Employment rate (average)
1961–1990 63.1 69.7
1991–2002 62.3 79.4

Sources: European Commission, OECD.

percent); the two smallest economies are Portugal (1.8 percent) and Lux-
embourg (0.3 percent).43 Germany, France, and Italy are members of the
Group of Seven (G7) leading industrial nations.44
Economic and structural differences exist also within countries, for
example, between western and eastern Germany or between northern and
southern Italy. Moreover cross-country differences have declined over
time. Actually, in many respects, the euro is the currency of an entity that
is not significantly less homogeneous than some of its members were
before its introduction.
The economic policy challenges with which euroland will be confronted
in the years ahead become more visible when moving from photographic
stills to cinematography.
If one compares the behavior of the euro area and the American
economy over the last decade, a sharp difference in dynamism stands out.
While, during the 1991 to 2002 period, the United States grew at an
average annual rate of 2.9 percent, euroland has only achieved 1.9. In per
capita terms, the difference is smaller but still exists (1.7 and 1.5 percent,
respectively). Over the same period 22 million new jobs were created in
the United States, against 9 million in the euro area (table 3.4).45
66 Chapter 3

If one looks farther back, however, it is clear that the 1990s mark a pause
in a four-decade-long trend that followed World War II. From the early
1950s to the early 1990s, the European economy performed as well as, and
sometimes even better than, the United States in terms of GDP per capita
growth. In purchasing power parity terms, euroland’s GDP per capita was
at 41 percent of the US level in 1950, when a remarkable catch-up phase
started, reaching 70 percent in 1991. Since then the gap in GDP per capita
terms has remained broadly constant, as it stood at 71 percent in 2000.
4 Monetary Policy: As Strong as the Deutsche Mark

This chapter is devoted to monetary policy in euroland, its framework and

implementation, and the debates it has raised.
In the 1990s the slogan “A euro as strong as the Deutsche mark” was
used to indicate the ambition the Eurosystem should set for itself. For the
German people, who were reluctant to abandon their highly stable cur-
rency, the slogan was a promise of continuity. For people of other coun-
tries, it was a promise to finally eradicate the inflation that had plagued
them for years. Germany had undoubtedly been most successful in learn-
ing how to manage a fiduciary currency, as its average inflation was 2.9
percent for a half-century (in the years 1949–1998: 4.0 percent in the
United States, 5.7 percent in France, 6.2 percent in the United Kingdom).
The Deutsche Bundesbank’s institutional independence, concentration
on price stability and on the medium term, and tireless education of the
public opinion became the features of a monetary policy that gradually
spread over Europe and eventually became the model for the EMU.
Nevertheless, euroland is not Germany, and the Eurosystem is not the
Bundesbank. The German legacy can only be used as a reference, and not
as a blueprint.
When the ECB Board and Council met for the first time, in June 1998,
they were confronted with a meagre seven months for setting up the reg-
ulations, analytical instruments, statistical apparatus, technical infrastruc-
ture, decision-making practices, operating procedures, communication
protocols that constitute the indispensable basis of any policy-making.1 By
the end of December 1998 the ground was laid for a single monetary policy.
The subsequent five years became a critical, albeit short, testing period.
In this chapter the various aspects of euroland’s monetary policy are dis-
cussed. Sections 4.1 to 4.3 are devoted to the mandate and strategy of the
Eurosystem. In sections 4.4 to 4.6, the operations, transmission, and com-
munication of policy are reviewed.
68 Chapter 4

4.1 Mandate, Strategy

The Treaty of Maastricht leaves no doubt as to the direction in which the

compass needle should steer the course of monetary policy. The primary
objective is price stability. Only insofar as price stability is not endangered,
is the Eurosystem mandated to support the general economic policies in
the Community, aiming at growth and employment. Although the Treaty
recognizes that monetary policy is part of a broader set of policies, this
clear order of priority bars the ECB from disregarding the compass, and
governments from influencing the ECB.
In October 1998, just a few weeks before the start of the euro, the ECB
adopted its strategy for a monetary policy. This consisted of (1) an inter-
pretation of the mandate imparted by the Treaty and (2) an analytical
framework for fulfilling the mandate, which is based on two pillars. This
became known as the “ECB two-pillar strategy” for monetary policy.2
The interpretation of the mandate consisted in a quantitative definition of
price stability: “a year-on-year increase in the Harmonized Index of Con-
sumer Prices (HICP) for the euro area of below 2 percent,” complemented
with the proviso that monetary policy would maintain price stability “over
the medium term.”
With this definition, the ECB indicated not only the upper threshold
beyond which price stability is no longer in place but also its intention to
oppose symmetrically inflation and deflation (hence the choice of the word
“increase”). The focus on the medium term allowed the ECB to hedge the
impossible, or undesirable, “instantaneous” enforcement of price stability.
The logic was clear in this regard. Monetary policy’s impacts upon the
economy come with long and variable lags.3 It was at the same time also
undesirable, because the cost of immediately countering certain price
shocks hitting the economy can result in disproportionate effects overall.
For example, the desirability to offset an adverse temporary supply shock
(such as an increase in the price of oil or other primary commodity) has
to be assessed on the basis of its intensity, tendency to influence price and
wage-setting behaviors, and thus tendency to perpetuate itself.
The ECB gave no elaboration for the Treaty’s provision to “support the
general economic policies of the Community” (Article 2 of the ECB
Statute), in order to retain flexibility in the interpretation of this part of
its mandate. On the one hand, the ECB recognizes that money is neutral
only in the long run, and that the effectiveness of monetary policy rests
on its ability to produce effects on the real economy. On the other hand,
the ECB has declared itself unwilling to engage in policy activism because
Monetary Policy: As Strong as the Deutsche Mark 69

of the risk entailed in attempts at overexploiting the trade-off between

growth and price stability in the short or medium run.
Turning to the analytical framework, a forward-looking assessment was
made of two elements, or pillars: a prominent role for money and a wide
range of indicators of future prices. The variables used for the two pillars
were respectively nominal and (mainly) real variables.
The first pillar consisted primarily of an assessment of the current and
prospective behavior of monetary aggregates, and in particular, of M3,4 for
which the desired rate of growth was treated as a reference value for the
monetary policy. The dynamics of the monetary aggregates provided useful
information about future prices given the long-term neutrality of money.
That is, any prolonged or persistent deviation of the actual rate of M3
growth from its reference value is likely to mean that the monetary policy
is out of line with the requirement of price stability.5 The argument that
prices respond proportionately to changes in money in the long run goes
way back to Hume in 1752. As Robert Lucas has emphasized in his Nobel
Lecture, it has received ample validity over hundreds of years and in many
places.6
The second pillar consisted in a range of indicators of the current and
prospective state of the economy to assess the outlook for price stability.
The variables included the dynamics of economic activity, the components
of aggregate demand, surveys of business and consumer confidence, fiscal
developments, price indexes, prices of oil and other standard commodi-
ties, the exchange rate, and the prospect of forthcoming wage negotiations.
Such variables have a more immediate and direct impact on prices than
money supply. Periodic staff projections of GDP growth and consumer
price inflation, which in December 2000 started to be published twice a
year, are part of the information set used by the ECB.
The two-pillar strategy was designed to ensure that, at the moment of
taking decisions, the ECB organized the use of all relevant information
about economic, monetary, and financial conditions.7
To help readers form their own views, it may be useful to compare the
ECB strategy with some alternative approaches to monetary policy adopted
by other major central banks over the last two or three decades prior to
the launch of the euro. The approaches can be traced back to four arche-
types, three of which are characterized by an explicit and public posting
of a single variable as the target of policy, and one by discretion, namely
by the central bank “letting its actions speak.”
In the first three approaches the exchange rate, the stock of money, and
the inflation rate are the variables by which monetary policy is committed
70 Chapter 4

to pursue a quantitative target. The target is sometimes set by the central

bank itself, as in 1975 to 1998 in Germany. In other cases the government
assigns the objective to the central bank, as in the United Kingdom for the
inflation target.8 In the EMS, the Ministers of Finance collectively decided
the central rates. In the fourth approach—largely followed, among others,
by the US Fed over the last decades—the monetary policy is not to post a
single variable nor formulate an explicit and formal strategy. Among these
monetary policies, all of which were adopted at differing times by the G7
countries in the quarter-century that preceded the euro (a total of 175 years
of policy), discretion emerged clearly on top in terms of the frequency of
distribution (90 years), followed by exchange rate targeting (39 years), money
targeting (32 years), and inflation targeting (14 years) (table 4.1).

Table 4.1
Approaches to monetary policy in the G7 countries in 1974 to 1998

Exchange rate Money Inflation

pegging targeting targeting Discretion

United States 1979–82 1974–78

— — 1983–98
Number of years 4 21
Japan 1974–98
— — —
Number of years 25
Germany 1975–98 1974
— —
Number of years — 24 — 1
France 1979–98 1974–78
— —
Number of years 20 — — 5
United Kingdom 1990–92 1980–83 1993–98 1974–79
1984–89
Number of years 3 4 6 12
Italy 1979–92 1974–78
1997–98 — — 1993–96
Number of years 16 — — 9
Canada 1991–98 1974–90
— —
Number of years — — 8 17
Total years 39 32 14 90
Monetary Policy: As Strong as the Deutsche Mark 71

In the view of some, counting years of policy may give too much weight
to the past and not do full justice to more recent developments in policy-
making and academic research. In particular, it does penalize inflation tar-
geting, which, since its introduction by New Zealand in 1989, has been
adopted by about 20 countries (depending on how strictly one defines
inflation targeting), has gained the support of academic consensus, and
is actively recommended by the IMF to many countries. One should,
however, not underestimate the value of a strong long-term record as well
as the uncertainties inherent in an approach like inflation targeting that
has not yet withstood the test of time.9 (We will return to inflation tar-
geting in the next section.)
Against this background it is possible to assess the choice made by the
ECB in 1998. The exclusion of exchange rate targeting should be no sur-
prise. Since the collapse of the Bretton Woods fixed exchange rate system,
no leading currency has subordinated its monetary policy to an external
anchor. For the ECB the exchange rate is merely one of several indicators
in the second pillar, given the information it offers about future price
developments.
As to money targeting, inflation targeting, and discretion, it may be said
that while not choosing any of these strategies, the ECB drew something
from each. It did not choose money targeting, but recognized in the first
pillar the prominent role of money in the preparation, transmission, and
communication of decisions. Likewise, while not pursuing an inflation fore-
cast that is conditional on a certain (usually constant) policy rate time
path, the ECB adopted a quantitatively defined objective of price stability,
one of the key features of inflation targeting. As to discretion, the ECB
rejected the unwillingness to publicly disclose a decision-making method
but nevertheless took much of the analytical substance.
The ECB strategy may effectively be seen as one that combines two views.
The first is avoidance of tying monetary policy to a single variable as the
decision driver. The ECB recognizes in this way the merits of the rather
eclectic approach prevailing over a quarter century among leading indus-
trial economies and notably preferred by the US Fed. Indeed, the nature
of the ECB strategy (i.e., the role attributed to a wide range of nominal and
real variables) is primarily supported by the desire to base monetary policy
on a broad set of indicators, rather than on a restricted number of
pre-selected indexes. Inflation expectations, in particular, which are the
dominant driver of policy decisions in inflation targeting, were not seen
as sufficient to exhaustively depict the state of the economy. Furthermore,
to secure the robustness of monetary policy actions, the ECB felt that
72 Chapter 4

monetary policy decisions should be taken on the basis of a plurality of

models, not a single model or paradigm. Finally, the Bank regarded as desir-
able to retain a margin of flexibility to cope with exceptional circum-
stances. All these arguments led to favor wide discretion over a simple rule.
The second component of ECB strategy is the recognition of the merits
of making explicit the intellectual framework underlying the policy delib-
erations. Historical, political, and intellectual arguments led the ECB to
rule out the option of not formulating and publicly announcing any
approach. The new central bank came to life at a time when the intellec-
tual climate was adverse to the undisclosed style traditionally followed by
the experts of the discretionary view. Moreover nondisclosure was not the
method of the Deutsche Bundesbank, the central bank whose legacy was
taken by most as the benchmark against which to judge the ECB. Nor was
it what the public, markets, and analysts were overwhelmingly hankering
for. Coupled with the lack of track record, a nondisclosure method would
have made ECB actions almost impossible to read and interpret.
For a novel and rather special central bank such as the ECB, the choice
of the strategy had to be seen also in the light of the internal functioning of
the institution. In order to shape the monetary policy process of euroland
rapidly and effectively, the deliberations of the new, collective policy-
making body needed the discipline of an agreed discussion method. The
strategy thus served the purpose of organizing an orderly discussion within
a Council largely formed by governors coming from heterogeneous back-
grounds and different monetary policy frameworks.

4.2 Debates on the ECB Strategy

The ECB policy strategy stirred a debate that is still ongoing. Both criti-
cism and appreciation have been voiced.10 Appreciation was expressed for
the breadth of the assessment on which policy decisions are based and for
the ample communication.
Key features of the strategy have received positive recognition. First,
market reactions to the establishment of the new rules of the game were
swift, a sign that the new monetary policy environment was perceived as
transparent and operational. For example, since 1999 overnight rates have
limited their fluctuations on the dates of monetary policy announcements
to less than five basis points on average, a sign that policy was reasonably
predictable.11
Second, the ECB’s systematic avoidance of short-term economic fine-
tuning has been found consistent with a renewed interest in the academic
Monetary Policy: As Strong as the Deutsche Mark 73

debate for less activist approaches to monetary policy. The idea behind
these approaches is simple. The more drawn out the central bank’s reac-
tion to a given shock, namely the more persistent its compensating reac-
tion to the original perturbation, the quicker private expectations—
discounting this persistent reaction—will adjust to the shock in an equili-
brating direction. As private expectations are incorporated in long-term
yields, and demand conditions are influenced primarily by changes in
long-term interest rates, persistence in monetary policy strengthens the
central bank’s leverage on the economy via an expectation channel.12
Third, the notion that price stability should be maintained over the
medium term has made some headway among other central banks, once
committed to shorter and more rigid forms of quantification concerning
the horizon relevant for policy.13 Having to compensate adverse shocks to
inflation over the medium term allows a more measured response to the
original source of disturbance, which avoids injecting unnecessary volatil-
ity into economic activity.
Finally the important but not all-encompassing role assigned to infla-
tion forecasts within the strategy has gathered consensus among those
observers who are more alerted to the risks of elevating a single summary
indicator to the sole guide for policy (e.g., see Vickers 1999).
Along with this appreciation, criticism has persisted and, to some extent,
intensified. In one way or another, the failure to opt for full inflation tar-
geting seems to have constituted in the eyes of some observers the fatal
sin in the ECB’s original experiment in mechanism design. It should be
recalled that the ECB strategy was adopted at a moment when both the
academic consensus and the choice of central banks were heavily leaning
toward inflation targeting.
This source of criticism has taken various forms and has been articulated
at various levels. At a less fundamental level, the ECB has been accused of
imprecision in the communication of those elements of its strategy that it
shares with inflation-targeting central banks. For example, the quantita-
tive definition of price stability has been described as “ambiguous and
asymmetric” and less than effective in anchoring expectations if compared
with the numerical targets adopted by inflation-targeting central banks.
Likewise the lack of precision in the characterization of the time horizon
over which monetary policy ought to restore price stability has been found
incompatible with the best practices of inflation targeting. These would
impose a binding form of commitment to a detailed time frame for action.
Lars Svensson, in a series of interventions, has heralded this technical form
of dissatisfaction among academics.14
74 Chapter 4

But the dissonance in reasoning that has emerged between the ECB and
sympathizers of strict inflation targeting has a deep-seated origin. It was
the ECB’s idea, embodied in the dual-pillar approach, that monetary policy
needs a diversified (as distinguished from unified) analytical framework. The
underlying fact is that there exists a great deal of uncertainty regarding the
correct specification of the transmission mechanism of monetary policy.
Because of uncertainty about which specification best reflects the true
structure of the economy and the true transmission mechanism of mone-
tary policy, a unified reference model to inform policy decisions was con-
sidered to be hazardous. Hence arose the need for a diversified perspective
of the economy.
It is precisely this diversification that many critics reject. They see no
justification for it and seem to opt for a unified-perspective approach. Jordi
Galí, a prominent contributor to the unified-perspective model, has been
a representative voice expressing scepticism about the ECB strategy.15
One could venture to say that the unified-perspective approach uses as
its reference model of the economy a re-interpreted version of the tradi-
tional Keynesian IS-LM-plus-Phillips curve model that was the fundamen-
tal analytical workhorse in macroeconomics for much of the postwar
period.16 To be sure, the framework advocated by ECB critics such as Lars
Svensson and Jordi Galí differs from its postwar predecessor in one impor-
tant respect. Unlike its original Keynesian prototype, the new Keynesian
model is fundamentally forward-looking. Indeed, the model derives its
structural conditions for demand and supply from the optimizing choices
of a representative agent and a representative firm, both of which enter-
tain expectations about the future and over time smooth out demand and
production decisions accordingly. This forward-looking dimension lends
the model a center of gravity, which the old Keynesian version lacked: the
natural rate of unemployment. In other words, the model allows a short-
term form of nonneutrality of monetary policy, in the sense that a non-
systematic (i.e., unexpected) monetary policy impulse can have an impact
on real activity in the short term. Nevertheless, the model has a tendency
to return to a long-run equilibrium situation, which is independent of the
monetary policy. This means that the model incorporates neutrality in
the long run.17
This is, of course, an important difference with respect to the old Key-
nesian model, which assumed that the structure of the economy was essen-
tially static, that expectations about the future (including future policy
moves) played no role in determining the private economy’s behavior in
the present. This assumption, joined with the wide conviction that the
Monetary Policy: As Strong as the Deutsche Mark 75

economy could be moved around toward the most preferred equilibrium

by systematic policy intervention, is now considered responsible for the
most severe policy mistake that economic history has recorded since the
Great Depression: the Great Inflation of the 1970s.18 By systematically pro-
longing expansions and checking contractions in a quest for “maximum
employment,” monetary policy resulted in an upward drift in prices. By
contrast, the new version of the Keynesian model has a built-in natural
attractor, namely a maximum amount of resources that is compatible with
inflation being constant at the level targeted by the central bank. The
economy cannot depart from this so-called natural level of activity except
in the short run, and at the cost of generating pressures on prices and infla-
tion expectations.
So, if the vintage Keynesian framework was, in a sense, a standing invi-
tation for policy action (and thus possibly policy excesses), the present gen-
eration’s model has a built-in mechanism that warns policy-makers against
being too ambitious about fine-tuning the economy through monetary
impulses. Furthermore, within the new version of the model, unlike the
old one, discretionary policy is constrained by a clear objective, involving
inflation stabilization around a target and output stabilization around a
level, which is consistent with the maximum amount of resources that rep-
resents the natural attractor of the economy. This can indeed remove one
of the primary causes which promoted the large policy mistakes of the
1970s: the erroneous attempts to “buy a little bit more employment” in
exchange of “a little bit of inflation.”
But, that being said, the two model vintages share a fundamental
common feature. They both reflect the primacy of real sector forces in the
determination of spending decisions and price-setting behaviors. The new
version of the model even goes a step further in this direction, as it pro-
vides monetary policy with a “rule” that prescribes policy action entirely
as a function of the current state of the real economy.19 Such a rule would
have the central bank change the short-term interest rate in a manner that
tracks at every moment, and as closely as possible, the so-called natural
equilibrium real rate of interest. This is the real interest rate that would
prevail in the hypothesis of an output consistently at its long-term
“natural” level.
Now the primacy of real sector forces in the determination of spending
and pricing decisions in the structural model, and the predominance of
real sector indicators as drivers of policy decisions in the prescribed policy
rule have one important implication and one risk. The implication is that
by stressing solely real sector forces, alternative channels of monetary
76 Chapter 4

policy transmission may be overlooked. In fact data prove to be consistent

with models in which money quantities play an important role as deter-
minants of price developments. But this evidence, establishing a close link
between liquidity conditions and price inflation, cannot be entirely
explained by the new-Keynesian paradigm.20
The risk is that a successful outcome of policy is made exceedingly
dependent on getting “right” the natural equilibrium real interest rate—
that is, the level that can be maintained in the long run without giving
rise to an accelerating rate of inflation. This is a particularly hazardous
condition because this variable, like the so-called natural level of output,
is not directly observable to the central bank. It has to be estimated by
various statistical techniques that may err in one way or another in real
time. Actually some observers have argued that the Great Inflation of the
1970s was made possible, among other things, by a severe real-time
mismeasurement of the natural level of output.21
Seen from this perspective the unified new-Keynesian framework, the
reference model for many critics of the diversified strategy of the ECB, pro-
vides no insurance against real-time misperceptions about fundamental
parameters of the economy, which policy is nevertheless advised to target
in the short run. A diversified approach to macroeconomic analysis is
preferable. By putting less emphasis on one set of indicators, on one par-
ticular sector of the economy, on one single perspective over the workings
of the transmission mechanism, the ECB’s diversified strategy is designed
to avoid major policy mistakes.
In conclusion, large part of the dispute over the ECB strategy can be
traced to a differing appreciation, of the ECB and some of its critics, as to
whether monetary policy should rely on a diversified, or else a unified, all-
encompassing model of the economy. The rationale for a discretionary
policy label, such as that widely used in the quarter century before the start
of the euro, is not only for a simple desire to be free at the moment of
policy decisions, it is also in recognition of the risk associated with an
unconditional adoption of a single model without conclusive evidence
that it is the best model. Discretion, which implies some eclecticism, in
turn confers some robustness to policy-making.
More generally, the debate has been pervaded by a lack of clarity, and a
lack of agreement, on what an adoption of a strategy, or a policy rule, really
means. Policy-making may be likened to a process whereby an initial set
of degrees of freedom is gradually being “spent” until, at the instant of the
decision, the set is empty.22 Most of the academic debate about monetary
policy can be seen as a debate about how and when those degrees of freedom
Monetary Policy: As Strong as the Deutsche Mark 77

should be spent. The adoption of the ECB strategy in 1998 was just one
step into that process. It was preceded by the stipulation of a mission in
the Treaty and followed by the monthly preparation of documents by ECB
staff, their discussion and approval by the Board, the discussion, and finally
the decision, by the Council.
Seen in this way, a strategy is not a tool that mechanically links action
to information, thereby exhausting the set of degrees of freedom. Even
“tighter” policy rules, such as the unified model approach of inflation or
monetary targeting, do not mechanically make such a link. They leave
degrees of freedom, that is, room for discretion, up to the moment of
action. For example, judgment enters in the specification of the relevant
behavioral relations that best describe the working of the economy. Judg-
ment and discretion also guide the assumptions concerning the exogenous
variables, namely those economic variables, like foreign demand, that are
considered as given in a policy simulation exercise. Finally judgment is
crucial in the interpretation of the results and, in particular, in the assess-
ment of risks.
A strategy, useful as it is for good decisions, does not yield decisions. Its
role is to identify relevant information, help interpret it, and connect it
with possible actions, but not to mechanically produce a decision. Ulti-
mately this is due to the fact that a decision is an act of will, not an act of
knowledge.23 No strategy can change the voluntary nature of decision-
making. An act of will is not only required by imperfect knowledge, nor
is it only a remedy to ignorance and risk. It is the very nature of a deci-
sion on any matter. After all, just as scholars debate about research issues,
policy-makers debate about policy issues. No matter the field, humans hold
different views, and they also weigh arguments differently and rarely
adhere to a conclusion without some residual doubt. In areas of policy the
questions of how to act and when to act are not, and cannot be, unam-
biguously prescribed by a rule. The strategy of the ECB leaves room for dis-
cussion, judgment, and disagreement, and it would be insufficient if it did
not. If information were as perfectly connected to action as it is sometimes
hoped, why involve a decision-maker, and why create a council, where
differing views, based on shared adherence to a strategy, can be aired
to consent to an action?
A final point to be stressed before concluding this section is that in the
monetary policy field, the deliberation style of the ECB Council fully cor-
responds to that of the collegial decision-making that led to the Maastricht
Treaty and described in chapter 2. From the very start, in hammering out
a single monetary policy, each participant brought to the table his or her
78 Chapter 4

own view of how best to effect price stability in euroland, and not the par-
ticular needs of his or her country of origin. The dynamics of prices of
course, is not the same in every euro country, just as it is not the same in
every region of a country. It was thus tempting for a national central bank
governor of a country with lower than average inflation to resist an inter-
est rate hike that might be called for by the overall state of the euro
economy. Indeed, we will see, in other chapters, that, in areas other than
monetary policy, national or “periphery” considerations still very much
influence the Eurosystem’s deliberations. That this is not happening in the
exercise of monetary policy, which is the central and foremost function of
the System, is all the more remarkable. The collective view by now estab-
lished is that an introduction into a discussion of national bias would be
very badly received by the peers gathered at the table. This is a significant
achievement in this early stage of the new institution.

4.3 Practice and Evaluation of the Strategy

In December 2002 Willem Duisenberg, the then president of the ECB,

announced that a “serious evaluation” would be made of the monetary
policy strategy of the ECB. The announcement created an expectation
of substantial change. In fact the evaluation was decided as a matter of
good maintenance, and not because of the need for change. Being an
innovative design, it had to be evaluated for its effectiveness, like a motor
vehicle going back to the shop for a tune-up after four years of running
on a road on which no vehicle had ever traveled.
From the start, the strategy was to reconcile the different biases and intel-
lectual inclinations that coexisted in the ECB Council. The strategy was
used to organize the documentation and analyses presented to the policy
meetings to impart order and consistency to the deliberations, and to struc-
ture the communication and explanations of the ECB decisions. In the
January 1999 to February 2004 period, monetary policy had been on the
ECB Council agenda in 98 meetings. Until October 2001, the ECB Council
discussed monetary policy twice a month, thereafter only once a month.
The interest rate was changed 15 times (compared with 19 times by the
Fed over the same period).
In four years out of five the annual inflation rate went above the criti-
cal threshold of price stability as defined by the ECB: 1.1 percent in 1999,
2.1 percent in 2000, 2.3 percent in 2001, 2.3 percent in 2002, and 2.1
percent in 2003. Also the 41/2 reference value for the growth of M3 was per-
sistently exceeded, with 5.6, 4.9, 5.4, 7.2, and 8.0 percent growth for the
Monetary Policy: As Strong as the Deutsche Mark 79

five years. In the ECB’s view the specific causes of both of these trespasses
were such that no specific corrections were needed. Inflation had been
pushed up by a rather unusual sequence of supply price shocks in 1999 to
2003.24 The notion that price stability is “to be maintained over the
medium term” had been expounded precisely to acknowledge that mon-
etary policy cannot be expected to counter the first round effect of a supply
shock. With regard to M3, the main cause of the very high expansion was
found to be protracted portfolio shifts. Investors showed a sustained pref-
erence for liquidity because of the high uncertainty in financial markets
and in the general macroeconomic outlook.
Over the first four years, a gradual change occurred both in the conduct
of monetary policy and in communication. First, in early 2002, the ECB
ceased to claim that it was aiming at an inflation rate “safely below 2
percent.” It can be observed today that initially the aim reflected the special
circumstances of the economy during the second part of the 1990s, when
inflation was exceptionally low and no fears of deflation or a liquidity trap
had yet plagued any of the major economies, with the exception of Japan.
Second, month-to-month monetary policy decisions became increasingly
related to the real sector analysis of the indicators of future price develop-
ments as captured by the second pillar of the strategy, instead of to the
dynamics of monetary aggregates. The ECB had to consistently explain
why failing to react to money growth above 41/2 percent, albeit prolonged
in time, did not contradict its belief that “money matters.” However, the
Bank did show, in both words and deeds, that the analysis of the first pillar
was more a controlling device than an operational guide for short-run
decisions. Third, the consideration of the important role of money was
gradually broadened beyond M3, to include a full range of indicators of
the liquidity conditions of the economy, in the form of money and
credit aggregates.
The 2002 re-evaluation concentrated on the quantitative definition of
price stability and the role of money. As to the former, three main con-
cerns arose from the experience of the early years, and they were amply
debated in the course of the re-evaluation. First was the concern that an
underlying, or core, inflation should be preferred to the HICP. In its favor
was the argument that if one removes the more volatile components of
prices, the core inflation provides a better assessment of the trends. Second
was the concern that a less ambitious upper threshold than 2 percent
should be adopted. As 2 percent had been chosen at a moment when infla-
tion was particularly low in many European countries, and shortly after
the Bundesbank had lowered from 2 percent to the 1.5–2.0 percent range
80 Chapter 4

its stated “price norm,” it was below the long-term average inflation in
Germany (2.9 percent in 1949–98) and had been repeatedly exceeded in
the early years of the euro. Third was the concern that the 1998 defini-
tion, which lacked the explicit indication of a lower bound, was asym-
metrical and ill-suited to deal with the risk of deflation. From 1998 to 2002
several critics had claimed that the ECB seemed to wish an inflation rate
as low as possible in the zero to 2 percent range and that it was insensi-
tive to the difficulty of conducting monetary policy in such a very low
inflation environment.
The second focus was on the role of money. Here the critique was based
both on the instability shown by the money demand function in the early
years and on a recent trend in academic literature that considered money
to be largely irrelevant as an indicator of inflationary pressures. In these
theoretical models the transmission mechanism was shown to operate pri-
marily through aggregate demand (e.g., see Svensson 1999).
With the announced outcome of the evaluation in May 2003, the ECB
affirmed again the importance of HICP to the definition of price stability
based on its transparency and reliability, but it indicated that measures of
core inflation were to be used as indicators in its policy-making. The Bank
also expanded its 1998 definition of price stability (“below 2 percent . . . to
be maintained over the medium term”), but at the same time specified that
it will aim to maintain inflation rates close to 2 percent. It confirmed that
its monetary policy will continue to be based on two pillars, but at the
same time specified that monetary analysis would mainly serve as a means
of cross-checking, from a medium to long-term perspective, the short to
medium-term indications coming from economic analyses. Moreover, the
ECB announced a new structure of the monthly Press Statement, whereby
the economic analysis would be presented first and the monetary analysis
second (figure 4.1).25
All in all, the re-evaluation did not lead to a change in strategy, but rather
to a clarification, which made explicit the evolution occurred in the early
years.
All along the issue whether the strategy needed a change or a clarifica-
tion was debated extensively within the ECB. Of course, a change in strat-
egy would have been effected if the ECB Council had felt that by a different
strategy better decisions could have been taken in the previous years.
Rightly or wrongly, the ECB did not have such regrets, which of course
does not preclude the fact that better decisions could have been taken with
the given strategy. The Council thus did not see any compelling reason for
change; it only found the need for clarification.
Monetary Policy: As Strong as the Deutsche Mark 81

Primary objective of price stability

ECB Council takes

monetary policy decisions
based on a unified assessment
of the risks to price stability

Economic analysis Monetary analysis

Analysis of economic Analysis of
Cross-checking
shocks and dynamics monetary trends

Full set of information

Figure 4.1
Monetary policy strategy

The change versus clarification issue, however, had also deeper implica-
tions. Just as legislation operates as a blend of written law and jurispru-
dence, so the policy profile of every central bank is a combination of a
posted strategy and a track record. Depending on the history and practice
of each institution, the two components weigh in different proportions.
In the case of the Fed, for example, the track record has traditionally had
the dominant role, with the exception of the 1979 to 1982 Volcker years
when, partly to correct the negative track record of the previous decade, a
monetary target was adopted to halt inflation. In contrast, because the ECB
had no track record, it had to rely almost entirely on a posted strategy from
its start. In part the ECB borrowed the track record of the Bundesbank by
the adoption of some features of its strategy (M3 in particular), the Frank-
furt location, and by relying on some of its high officials. When the
re-evaluation took place in 2003 a track record, though of only four years,
did exist, and it was very positive to the point of curbing the early scepti-
cism from many quarters. What is truly remarkable was that long-term
inflation expectations, as measured both by Consensus Forecast and the
ECB Survey of Professional Forecasters, have been consistently below 2
percent since the start of the euro, and that this was achieved despite the
actual figures often exceeding 2 percent (figure 4.2).
Moreover, from the distribution of the inflation rates across countries in
the euro area, it was clear that the first years of single monetary policy had
82 Chapter 4

5.5 5.5

5.0 5.0

4.5 4.5

4.0 4.0

3.5 3.5

3.0 3.0

2.5 2.5

2.0 2.0

1.5 1.5

1.0 1.0

0.5 0.5

0.0 0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

HICP inflation (y-o-y rate Upper bound definition Long-term inflation

of change) of price stability expectations

Figure 4.2
Euro area inflation expectations since 1990. Sources: Consensus Forecasts; ECB
calculations.

not induced any noticeable increase in the dispersion. Since the start of
the euro, the degree of inflation dispersion in the euro area countries has
remained in line with that of US regions where the common currency has
had the benefit of centuries of experience (figure 4.3). Clearly, any change
in strategy would have meant a restart of the jurisprudence and hence
some waste of the little, and all the more precious, capital of a track record
built in the early years. Had the ECB Council been convinced that the strat-
egy was flawed, a change would have no doubt imposed itself. Since,
however, this was not the case, continuity was seen as a positive factor.
A segment of the academic community was disappointed to see the ECB
willing only to clarify, and not alter, its strategy. In view of the large intel-
lectual support for inflation targeting, that segment of academe had wished
the ECB to follow its preferred approach and abandon the two pillars. As
I explained in the previous section, the divide between the Bank and this
academic group ran deep, and beyond a purely scholarly dispute. The Bank
has maintained its approach not so much, and not only, because of a
difference as to what might be the “right” model, but rather because of
Monetary Policy: As Strong as the Deutsche Mark 83

Euro area
6 (12 countries)

3 Stage I of EMU Stage II of EMU Stage III of EMU

2
United States
(14 MSAs)
1

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Figure 4.3
Dispersion of annual inflation across euro area countries compared with fourteen
US metropolitan statistical areas (MSAs). Note: Data up to February 2003 for the
euro area and to January 2003 for the US MSAs. Sources: Eurostat and US Bureau of
Labor Statistics.

an unwillingness to abandon its diversified approach in favor of tying

itself to a single model. Ultimately, this is and remains a difference of
view on the robustness of what the scientific laboratory can offer to the
practitioner.
The press, the market, and the general public were much less critical of
the results of the re-evaluation. They understood that the re-evaluation
had led to no fundamental change, but just, as one put it, to “aligning
words with actions.” For most recipients this was neither a surprise nor a
disappointment. Markets, in particular, had already well understood that
M3 and other monetary or credit aggregates were not main triggers of
policy decisions and that the “safely below” had been replaced by “below,
but close to.”

4.4 Operations

Central bank operations—the term of policy that follows the mandate and
the framework—is where NCBs come into play. Like the framework, oper-
ations were decided in 1998, just before the start of the euro. They consist
of (1) the operational target, (2) the instruments, and (3) the mechanics of
policy implementation and execution.
84 Chapter 4

The operational target is the economic variable monetary policy seeks to

control, the closest to its end of the transmission process. For the Eurosys-
tem this is the overnight rate, meaning the rate of interest at which banks—
for one working day—borrow and lend euro held on the accounts of
national central banks. For the ECB, choosing to control a price (an inter-
est rate) rather than a quantity (bank reserves) was relatively easy,26 because
all NCBs—like most central banks throughout the world—had for many
years adopted the same approach. Yet the choice is not quite trivial, nor is
it a once-and-for-all affair, because there are circumstances in which the
control of bank reserves may be a more effective policy tool. This may be
the case where monetary policy is confronted with a protracted deflation,
interest rates have reached a historical minimum, and the provision of an
extra stimulus to the economy overrides any other objective.27
To achieve the desired overnight rate, the ECB uses three instruments:
open market operations, standing facilities, and a reserve requirement.
Open market operations mainly take the form of repurchase agreements
conducted by means of weekly tenders.28 Through these operations the
banking system borrows from the Eurosystem an amount of euro that
satisfies its transaction and liquidity needs and, at the same time, is deemed
by the ECB apt to keep the overnight rate on target. The second instru-
ment—two so-called standing facilities—allows each commercial bank to
deposit its surplus of liquidity with (deposit facility), or to borrow liquid-
ity from (marginal lending facility), the Eurosystem on an overnight basis,
at its own initiative, and without limits. This provides the banking system
with a simple and demand driven tool for the management of liquidity.29
The third instrument is a reserve requirement, meaning the obligation for
credit institutions to hold a certain amount of funds on accounts with the
Eurosystem. Minimum reserves are fully remunerated, as their purpose is
not to “tax” the banking system but first and foremost to stabilize short-
term rates.30 The stabilizing role of minimum reserves is key in allowing
the Eurosystem to conduct open market operations only on a weekly
basis.
The choice of instruments just described was not straightforward. Due
to a diversity of traditions, and perhaps more important, of financial envi-
ronments, there was no homogeneity across NCBs prior to the euro.31
The third and last step in setting up the operations of monetary policy
concerned the mechanics, meaning the arrangements to act in practice. The
execution of policy is mainly done by NCBs. Unlike the two other steps,
the mechanics of central banking entail no policy decisions. Entering into
an operation with a particular bank is a systemwide decision independent
Monetary Policy: As Strong as the Deutsche Mark 85

of the location of the bank. The central bank counterparty of a bank estab-
lished in Italy is Banca d’Italia, while, for the same operation, it is the
Finnish central bank for a Finnish bank.
It is often asked whether the implementation and execution of mone-
tary policy in euroland are as “single” as the framework and the decision-
making. The answer is unambiguously positive. There is in fact no single
instrument of policy left to the discretion of national central banks. In this
way the Eurosystem is more integrated than the Fed.32 In the weekly tender,
as in occasional operations, national central banks act as collectors of the
bids and formal counterparties of commercial banks, but they cannot add
to, subtract from, nor change the distribution of the liquidity provision
decided in Frankfurt.33 It is at the ECB that the allotment is distributed
after ranking the bids in a single ordering, which disregards the national
origin and location of the bidding banks. The singleness of the operational
phase results—ex post—from the fact that there is a single overnight rate
across euroland.34
The decentralization of the mechanics has had, so far, no negative impli-
cation for the effectiveness of monetary policy. Indeed, in the few instances
experienced so far, in which an extra provision of liquidity had to be
urgently decided, the Eurosystem has operated as effectively and promptly
as the Fed (e.g., in the aftermath of 9/11). Yet decentralization may com-
plicate the logistics and bring some extra cost. For example, the monitor-
ing of the overall liquidity situation requires a potentially cumbersome
aggregation, in the early hours of each working day, of twelve (and, in the
future, up to twenty-seven) national central bank inputs.
That the execution of policy operations is done via the NCBs reflects not
only the principle of decentralization but also the fact that despite the sin-
gleness of the currency, euroland is still a fragmented area. It has many
financial centers, and still largely country-based banking communities,
that relate to the Eurosystem through the local central bank and via local
channels of communication in which the national language is essential.
The legal and technical instruments required to settle the operations
remain national. It should also be noted that decentralization of policy
execution is not unprecedented in central banking, nor is it an exclusive
characteristic of a central bank with a federal structure. In the past decen-
tralization was practiced in many countries, where discount operations
were decided by the local branch of the central bank. In its early years the
Deutsche Bundesbank fully decentralized the execution of policy.
On the operations of the Eurosystem, the Statutes set another, and
potentially a more important, constraint than just decentralization. They
86 Chapter 4

require the Eurosystem to “act in accordance with the principle of an open

market economy with free competition, favouring an efficient allocation
of resources.”35 This implies, among other things, equal access to the oper-
ations of the central bank, which means that all credit institutions fulfill-
ing certain standards are eligible counterparties of the Eurosystem. Such
an approach contrasts with the operating procedures of other central
banks, among them the Fed and the Bank of England, that select a limited
set of counterparties on a discretionary basis. Similarly the Treaty forbids
the Eurosystem from granting privileged financial treatment to public
issuers, and this implies that in its credit operations, the Eurosystem must
accept a very broad range of assets as collateral, issued by both public and
private bodies.
In shaping monetary policy operations, the role of the financial
environment is not less important than the charter. In the United States,
for example, the Fed can implement monetary policy by trading a
small range of securities with a limited number of counterparties, and
this function derives directly from the US financial structure.36 In
euroland a complication came from the fact that the structure of financial
markets, and in particular, the money market, was not precisely known
at the time the operational framework had to be decided. Indeed,
while the introduction of the euro could be expected to—and actually
did—foster an unprecedented consolidation of the financial system, the
pace and the scope of that process could not be fully comprehended in
advance.

4.5 Transmission

The effectiveness of monetary policy ultimately depends on the way

central bank impulses are transmitted to the economy. Unlike the frame-
work and the operations discussed earlier, the transmission mechanism is
received, rather than created, by the central bank. Although the Bank may
influence it in time, in the short run it can only strive to understand its
workings and to utilize it to the best advantage.
The Eurosystem could, of course, draw from a rich body of theoretical
knowledge and empirical evidence about the transmission mechanism in
member countries prior to the euro. None, however, refers to that special
and newly created “country” that is euroland.
In the textbook case, based on the one-to-one correspondence between
countries and currencies, the economy exhibits a high cohesiveness of the
social, economic, and financial structure. This is the outcome over a nor-
Monetary Policy: As Strong as the Deutsche Mark 87

mally very long period during which economic, social, cultural, political,
and legal life develop within a single state. Cohesiveness is the crucial
factor because, in the economy as in any other field, “transmission” from
one part (in this case the central bank) to the whole (the economy)
presupposes, by definition, a “sticking together” of the parts. In the case
of euroland the transmission mechanism is complicated by the fact that
cohesiveness, and hence the transmission mechanism, is in a process of
change, partly due to the advent of the euro and the single monetary
policy.
The special features of policy transmission in euroland can be better
understood by taking a closer look at two of its aspects concerning the
financial and the real side of the economy respectively.
Consider financial aspects first. Prior to the euro there were significant
cross-country differences in the way movements in central bank rates pro-
duced changes in the overall structure of interest rates. In Germany, for
instance, where the Deutsche Bundesbank used to set its rates very much
in the same way in which the ECB does today, interbank interest rates
directly reflected changes (and expectations of changes) in the main policy
rate. By contrast, in France, the most relevant rate for banks, corporations,
and households was not the official policy rate but the overnight rate,
which was tightly controlled by the central bank and usually different from
the official rate. In Italy the deposit and lending rates of commercial banks
continued to respond to changes in the official discount rate, so that the
liquidity and rate conditions on the money market, determined by the
daily operations of the Banca d’Italia, had little bearing on the real
economy. Likewise in Finland a large proportion of bank loans were
indexed on an interest rate set administratively and not relevant to mon-
etary policy operations.
Important diversities appear also for the business and household sectors.
Across Europe, for example, investment decisions are unequally dependent
on external finance and hence unequally responsive to monetary policy
due to the diversity of the balance sheet structure of firms. The importance
of credit rationing, namely the tendency of credit institutions to set
quantitative limits to the credit supplied to individual clients, depending
on their standing, was high in certain economies and low in others. In
Belgium or Italy, where households were large holders of government secu-
rities, the wealth effect produced by the central bank via changes in the
price of government bonds was more sizable than elsewhere. Similarly
a highly indebted household sector is more responsive to a change in
monetary and credit conditions than a balanced one.
88 Chapter 4

Different patterns of household savings and debts also result in differ-

ent responses to monetary policy impulses. In France, for instance, house-
holds traditionally held a large part of their savings in the form of money
market funds, so part of their income was positively correlated with mon-
etary policy rates. Meanwhile French households typically finance home
purchases through long-term, fixed-rate loans, so this part of their liabili-
ties was not directly sensitive to movements in official rates. By contrast,
in Ireland, Spain, and Finland, where residential mortgage rates are
indexed on short-term rates, monetary policy decisions have a direct
impact on households’ wealth.37
Over time the features described above can be expected to converge,
partly as a result of the euro itself. In these early years, however, monetary
policy has to cope with a financial structure that lacks the cohesiveness
typical of mature unions.
The second peculiarity of the transmission mechanism concerns the real
aspects of the economy. It lies in the fact that the domain of the single
monetary policy does not correspond to the one in which many decisions
that strongly influence the inflation rate are taken. While the former is
euroland, the latter is still predominantly national.
With some simplification one could say that price-setting decisions
in the economy are taken in two different modes that correspond to a
competitive and a noncompetitive paradigm. Both modes are normally
present in any economy, albeit in proportions that vary from country to
country.
In the competitive mode all prices, including the interest and the wage
rates, result from the “atomistic” interactions of profit-maximizing firms,
workers, consumers, and savers. Here the chief mechanism by which mon-
etary policy ensures price stability is the effect of interest rates on spend-
ing (investment and consumption) decisions. In the extreme case, where
a whole economy functions in this mode, no economic agent would be a
price setter and all price decisions would be completely impersonal. The
key variable monetary policy seeks to influence—the consumer price
index, which is a statistical abstraction—would be entirely made of indi-
vidual prices that “no one” sets. Monetary policy would not need to speak
to anybody, and money would be neutral not only in the long but also in
the medium or even short run.
In the noncompetitive mode there is an identifiable decision-maker, with
ample power to influence the market price of many goods and services. A
single decision taken by the supply side of the market, or through a col-
lective bargaining process, sets a price that is then adopted in a wide range
Monetary Policy: As Strong as the Deutsche Mark 89

of individual transactions and exchanges. Wage setting is the foremost, but

by no means the only, case where such mode applies. Other prominent
examples are prices of mass-produced goods or services (air or train trans-
port, cars, computers, books, newspapers, food, etc.), administratively set
prices, tariffs set by professional orders or public utilities.
Of course, the fundamental economic laws of scarcity and self-interest
that preside over the competitive mode also work, over time, for the part
of the economy where the noncompetitive mode applies. Over time, the
level at which the price is set triggers responses in terms of quantities sold
or produced. In the short or medium run in which monetary policy works,
however, the distinction between the two modes is relevant. In the first
mode, monetary policy tends to work through markets that act and react
relatively quickly. In the second mode, it must address itself more directly
to price setters in an effort to influence them before their decisions are
taken, knowing that rigidities and inertia make corrections slow and costly.
In the first mode, the central bank could simply act by buying and selling
assets in the money market. In the second mode, it must also speak, per-
suade, scare, be credible.
Both modes are reflected in the economic literature, and indeed, differ-
ences of views as to the role of monetary policy largely depend on the
relative importance attributed to the two modes.38 The intellectual para-
digm of the first mode is general equilibrium with perfect competition,
game theory is the paradigm of the second.
The general equilibrium paradigm rests, first, on the assumption that every
quantity and economic variable has an impact on all other variables.
Furthermore it assumes that economic agents are unable to exert an impact
on the formation of prices. This model of the economy, known in its essen-
tials since Walras (1874), has received a systematic treatment in Debreu
(1959).39 Game theory reverses the assumption that agents are atomistic and
formalizes the strategic behavior of “big players” who interact and influ-
ence each other. Unlike in the general equilibrium paradigm with perfect
competition, here the issue is whether, in making their economic
decisions, agents internalize the expected reaction of their counterparts to
their moves. Game theory was inaugurated in a celebrated book by von
Neumann and Morgenstern (1944) and has since blossomed into one of
the main fields of theoretical economics. Its emphasis on strategic inter-
actions has made this framework of analysis particularly amenable to the
study of situations where a large economic institution (e.g., a central bank)
makes policy decisions in a context in which another large player (e.g.,
trade unions) can influence the final outcome of that policy.40
90 Chapter 4

Any economy—and euroland is no exception—is a blend of the com-

petitive and noncompetitive modes, and this is why any central bank acts
and speaks, is simultaneously engaged in hard action and in the game of
influencing collective behavior. Prior to the euro, the most successful coun-
tries in maintaining price stability were not necessarily those where the
competitive mode prevailed over the noncompetitive one. Brilliant per-
formances were achieved where the game played between the central bank
and the collective price setters was cooperative rather than disruptive. This
is why the rigid and largely corporatist structure of the German economy
has not been an impediment, and might have even been conducive, to
price stability.
Where the speciality of the euro lies is in the fact that the competitive
mode is largely euro area wide, while the noncompetitive mode is still pre-
dominantly national. The most important price set in the collective mode,
namely the price for labor services, is set—as explained in the previous
chapter—through negotiations between employers and labor organizations
whose outcome applies nation wide. The same is true for the services of
public utilities such as energy, transportation, and telecommunication.
Even the price of such mass products as cars, laptops, dishwashers,
spaghetti, and mineral water—each offered to the whole euro area by a
relative small number of mass-producers—today is often uniform within a
country and diversified only across countries. Although suppliers are
overall fiercely competing, they are able to exploit a market power that
differs from country to country.
At the start of the euro, the economy of euroland was in an inter-
mediate position, in which integration had gone too far to allow a
plurality of currencies and monetary policies but not far enough to exhibit
the financial, economic, and social cohesiveness of a mature single
economy. Euroland is thus characterized by an uncommon relationship
between the central bank and the price-setting mechanism. On the
one hand, the central bank (the Eurosystem) is facing a plurality of
national price setters. On the other hand, the national price setter, be it
the labor union or a large public utility, is no longer confronted with,
and disciplined by, a national central bank endowed with the country-
specific instruments that were used, or threatened, before the monetary
union.
The challenge involved in the adoption of a single currency is twofold:
first, to firm up the part of the integration process that had already
occurred, and second, to foster the process by means of the single currency,
thus reaping additional benefits. Success requires a number of long-run
Monetary Policy: As Strong as the Deutsche Mark 91

strategies, of which some pertain to the Eurosystem, some to nonmone-

tary—national and European—actors.
For the Eurosystem it is crucial to be conscious of the peculiar features of
its mission and to actively follow all useful paths. The policy challenge
transcends the normal task of a central bank in the pursuit of price
stability. It extends to the structural transformation that the euro area
economy has still to accomplish, partly as a result of the very adoption of
a single currency. Beyond monetary policy this challenge embraces—as we
will see in the next two chapters—the other central banking functions,
related to the financial and payment systems. Because the various aspects
of central banking form a single whole, it would be illusory to think that
over time the Eurosystem could adequately perform its monetary policy
function while neglecting the other aspects.
Moreover the Eurosystem must mobilize all of its components, notably
its NCBs, to the task of overcoming and compensating the peculiarity of
the transmission mechanism it faces. The policy message accompanying
monetary decisions must be consistent throughout euroland, but need not,
and should not, be phrased identically everywhere. It is for national gov-
ernors to give country specific warnings where public administrations are
about to increase publicly set prices above euroland’s inflation rate, or
social partners to stipulate excessive wage increases, or governments to
deviate from the Stability and Growth Pact. In the past, national gover-
nors used to flash the threat of refusing monetary accommodation to
discourage decisions incompatible with price stability. Today, they can
explain that collective price decisions running counter to the overall eco-
nomic conditions and monetary policy stance of the area would, by
definition, not be accommodated and hence would inevitably produce
competitive losses and decline in employment.
Other strategies pertain to nonmonetary actors, along the lines reviewed
in the previous chapter. Indeed, at the national level the loss of monetary
policy requires more active use of other policy levers, both micro and
macro. As to the former, economies where competition is wider are better
equipped to cope with a single monetary policy. It is therefore an
implication of the euro that the area of the noncompetitive mode should
be reduced, which largely amounts to a reduction in structural rigidities.
As to macro aspects, the desirable strategy is full preservation of budgetary
discipline (mainly based on compliance with the Stability and Growth
Pact requirement for a budget “close to balance or in surplus”), coupled
with increased flexibility in the structure and size of budget revenues and
expenditures. This is indeed the condition that allows a country to respond
92 Chapter 4

with fiscal instruments to disturbances that were previously corrected with

monetary policy.

4.6 Transparency, Communication

While the decision, the operations, and the transmission of monetary

policy form a temporal sequence, transparency and communication run
parallel to the whole sequence. They are probably the most controversial
aspects of the Eurosystem activity.
The background is the 180-degree change in the approach to trans-
parency that has occurred over the short span of one generation. For
decades, silence, secrecy, opaqueness, and surprise were praised as the
pillars of central bank wisdom.41 The general public had very limited inter-
est in monetary policy, and even financial markets were not watching the
central bank on a continuous basis. Such an old world is not so distant if
we consider that until 1994 the Fed did not announce its target interest
rate, leaving the markets to find this out.
All has changed. Like most public institutions, central banks have come
under close scrutiny by the general public, professional observers, and the
media. Higher living standards, demographic trends, and the spreading of
private pension systems have made financial developments crucially rele-
vant for the masses. Innovations allow millions of individuals to directly
manage their savings, shifting funds from bank accounts to fixed income
or to equities. In the name of openness, transparency, and predictability
central bankers are under a continuous and insatiable request to “say
more.” The request is sometimes so strong that the central banker’s only
defense is to deliberately choose words that are hard to decipher.42
Yet monetary policy itself has an interest in transparency, which was fos-
tered by an increasing awareness of the game-theoretic aspect of the trans-
mission mechanism described in the previous section as well as by a strand
of academic research highlighting the importance of rational expectations.
Communication has thus become an indispensable tool to improve the
transmission of monetary policy by managing expectations in financial
markets and guiding the behavior of wage and other price setters. For some
central banks, direct communication with, and support from, the general
public has also been a way to counterbalance subordination to govern-
ment. For others, it was a way to honor an acquired independence status.
The present practices of the ECB can be summarized as follows. Once a
month the president holds a press conference, which consists of an intro-
ductory statement explaining policy decisions, followed by a questions and
Monetary Policy: As Strong as the Deutsche Mark 93

answers session. The transcript of the press conference appears on the ECB
Web site. The ECB also publishes a monthly bulletin, containing an analy-
sis of economic and monetary developments as well as longer-term studies
and other background information. Quarterly the ECB president appears
before the European Parliament. Twice a year staff forecasts on inflation
and growth are published. The president and other members of the Board
speak frequently in public and, occasionally, on television. Through their
own publications, speeches, and interviews, NCBs explain monetary policy
to a national audience in the national language.
There are differences between the ECB and other main central banks of
the world, the Fed, the Bank of England, and the Bank of Japan.
The Eurosystem provides real-time information that no other major
central bank offers today. The day of the meeting, the Fed and the Bank
of England issue a brief press release without meeting the press. The Bank
of Japan holds a press conference one to two days after the second
monetary policy meeting of the month. On the other hand, minutes of
meetings and individual voting behavior are published by the three other
central banks but not—for the reasons explained below—by the ECB.43
Macroeconomic forecasts are published quarterly by the Bank of England
in an inflation report. They represent the “best collective judgment” of the
Monetary Policy Committee and staff. Consistent with the fact that the
policy-making body takes responsibility for the inflation forecast, the Bank
of England is required by statute to publicly justify—in a letter to the Trea-
sury—marked deviations from it.44 For the ECB the projection of growth
and inflation rates, which is published twice a year, does not involve the
responsibility of the Board or the Council and is merely an element in the
second pillar of the strategy. As to the Fed, it treats the subject as very
confidential and refrains from publishing either forecasts or the underly-
ing models, while members of the Federal Open Market Committee
members are not entitled to witness the process by which the staff
forecast is derived.
If monetary policy is dubbed as an art rather than as a science or a tech-
nique, this is largely due—in our days—to the difficulty and nature of
its communication. The never equal circumstances, the multiplicity of
purposes, its unavoidable personalization, the diversity of channels and
addressees make it an arduous task for any central bank and for the
Eurosystem in particular.
In the euro area both the sending and the receiving side of communi-
cation are still in the process of learning the features that differentiate them
from ordinary countries and central banks.
94 Chapter 4

As to the receiving side, the general public in Europe is still divided in

national segments, accustomed to different languages and types of
messages, and focused on different concerns. Moreover traditions differ
across countries in the way the central bank relates to the government. For
example, the Banque de France has been strictly dependent on the Trea-
sury until the eve of the euro, whereas the Deutsche Bundesbank and the
Banca d’Italia had a large degree of independence. Such segmentation per-
sists, but at the same time money and financial markets rapidly consolidate
and react to ECB communication in an integrated way.
Another feature of the receiving side is its still rudimentary information
about the euro and the Eurosystem, clearly inferior—as surveys show—to
the pre-euro standard. Even such sophisticated media as wire services, for
example, have continued for some time to give wide coverage to declara-
tions of regional presidents of the Bundesbank, well after they had ceased
to have any say in monetary policy.
Turning to the sending side, the Eurosystem is the only major central bank
operating with a plurality of (eleven) official languages. Moreover, even
when perfectly translated, one and the same message often carries differ-
ent meanings and is perceived differently in the various national contexts,
due to differing traditions and conventions. For example, the German
public has been educated by the Bundesbank to be continuously warned
against the risk of inflation and would perhaps take a change in
communication practice as a disquieting sign that, with the euro, price sta-
bility has become less important for the central bank. In other countries,
with a price stability record only slightly inferior to the German one, the
style of communication of the central bank was less grim, and the
adoption of the Bundesbank style might raise inflationary expectations
rather than reassure the public.
Given the two-sided nature of the communication process, it is not
always easy to establish whether possible misunderstandings depend on
the sending or on the receiving side. A foremost example concerns the
“one voice versus many voices” issue. In the case of the US Fed or the Bank
of England, a free expression of multiple—and sometimes diverging—views
tends to be perceived by the markets and the media as a positive sign. It
indeed reassures that in policy-making a wide spectrum of points of view
is considered, which is conducive to better decisions.
By contrast, in the case of the Eurosystem even small differences in tone
and wording by members of the ECB Council have often been criticized
as signs of confusion and lack of a clear policy line. In fact the inherited
traditions of the NCBs, the plurality of languages and communication
Monetary Policy: As Strong as the Deutsche Mark 95

protocols, and—last but not least—the nature of the policy transmission

process described in the previous section actually compel the Eurosystem
to speak with many voices. In euroland communication cannot be as
concentrated onto the person of the president as it is onto the chairman
of the Fed for the United States or the governor of the Bank of England.
When discussing “how central banks talk,”45 it should be borne in mind
that communication serves both transparency and accountability, or, in
other words, both policy effectiveness and democratic control, two non-
coincident, and at times even conflicting, objectives. Utterances aimed at
effectiveness need to be forward-looking and easily understandable to
economic agents and financial markets. The optimum does not consist in
maximizing the amount of information but rather in a targeted selection
of messages and clear command of the interpretative keys used by the
receivers. If appropriately managed, the communication of intentions
can raise policy effectiveness enormously. Utterances aimed at democratic
control, in turn, have a mainly backward-looking content, need primarily
to explain how the institution has fulfilled its mandate and how its actions
relate to the interest and welfare of the citizens.46
Always central banks must speak the language of ordinary citizens and
beware that elected politicians have only recently renounced conducting
monetary policy themselves. Meanwhile, in weighing the requirements of
transparency and accountability, namely in assessing the respective roles
of political control and policy effectiveness, the Eurosystem has, quite
understandably, decided to take no risk on the side of policy effectiveness.
Of course, since effectiveness and democratic control do not use
specialized channels of communication, information, analyses, and com-
ments provided by the central bank are interpreted interchangeably in the
light of both purposes. This is reinforced by the fact that a truly European
public opinion is slow to emerge and the European Parliament is not
widely perceived by the people as the key democratic body that represents
them.
Two much debated issues highlight the difference between transparency
and accountability: the release of the minutes of policy meetings, and the
publication of economic forecasts. In both cases the request to increase
disclosure is often supported with mixed, and even opposite, arguments.
For example, parliaments ask for the publication of forecasts in the name
of accountability, while analysts request the disclosure of voting behavior
in the name of transparency.
In the light of the distinctions above, the publication of forecasts
should be related to policy effectiveness, rather than political control.
96 Chapter 4

Correspondingly the release of the minutes of policy meetings can hardly

be justified with the need for effectiveness.
An example shows how accountability and transparency may occasion-
ally conflict. If minutes with attribution of opinions to individual partici-
pants were to be released some weeks after the meeting, it could become
more difficult to agree on an elaborate press statement on the day of the
decision. The reason is that the discussion of this statement, which is nec-
essarily brief, could preempt the subsequent lengthier discussion of the
precise wordings of the minutes. Also in view of this possible dilemma, the
Eurosystem has deemed more useful to offer to the market and the general
public a “same day” extended statement and a candid “questions and
answers” session. Indeed, delayed publication of extensive minutes and
voting records would not help markets and the general public to take
informed decisions in the immediate aftermath of ECB meetings. Mean-
while publishing detailed minutes with attribution of statements and votes
would encourage an interpretation of the ECB Council as a collection of
“national factions” and expose some of its members to the risk of undue
political pressure.
5 Financial System: The Euro as Unifier

Banks are the creators of the largest component of the money stock and
the main providers of payment services. Together with financial markets,
they play a key role in central bank operations and in the transmission of
monetary policy. Crises in banking and finance may disrupt both the
economy and monetary policy. These are the reasons why, as described in
chapter 2, financial stability is an integral part of the tasks of central banks.
The Eurosystem can be no exception. However, the task is specially chal-
lenging for it because of two, potentially conflicting, developments trig-
gered by the advent of the euro. On the one side, euroland’s financial
markets and institutions are receiving an impressive impulse to consoli-
dation, prompted by the disappearance of currency segmentation. On the
other side, at the very moment in which such impulse is imparted, national
competence is preserved in the field of prudential supervision.
This chapter reviews both market developments and policy arrange-
ments. After an explanation of why currency specificity is crucial to iden-
tify a single banking and financial system (section 5.1), in section 5.2, I
outline the features of the continental European model and in section 5.3
the impact of the euro. In sections 5.4 and 5.5, I then examine the exist-
ing arrangements for financial regulation and supervision and in section
5.6 the role of the Eurosystem. For the purpose of this chapter, I define the
financial system as encompassing all financial intermediaries and markets,
as well as the market infrastructures and the regulatory and supervisory
system impinging on their functioning.

5.1 Single Market and Currency Segmentation

Conceptually, economically, and geographically the single market and the

single currency are two distinct entities. The distinction is particularly rel-
evant when discussing the financial system, since a frequent error is to
98 Chapter 5

argue that all that really matters for the policies concerning the financial
system is the single market, and not the single currency.
In January 1999, at the launch of the euro, the single market had already
produced many of the intended effects. From the 1980s onward the finan-
cial system had gone through a massive legislative change and reorgani-
zation. Already before the euro, capital could move freely across the
European Union and financial institutions were allowed to provide services
in all member states, with a single license and under the sole supervision
of the home-country authority.
However, harmonization of rules and lifting of barriers to entry in
national markets were not enough to create a single “domestic” market.
The permanence of different currencies was a powerful factor preserving
national segmentation.
Currency segmentation prevents neither the free movement of capital
nor the free provision of financial services across national frontiers. Yet,
for financial intermediaries and markets, the currency is a crucial element
in the organization of activities. In fact in the single market financial activ-
ities remained segmented by currencies even within a single bank, and
institutional investors used to allocate their global portfolio to currency
lines. Accordingly financial centers were specialized in financial products
denominated in their national currency.
With the advent of the single currency and the Eurosystem, this seg-
mentation started to fade away. The extensive restructuring of the finan-
cial system in euroland—the wave of mergers and acquisitions and, what
is more important, the reorganization of activities at an areawide level
within large financial groups—is a major demonstration that currency seg-
mentation mattered. The introduction of the euro also affected the cur-
rency composition of the business undertaken with residents outside the
euro area. While at the beginning of 1999 dollar denominated assets of
euro area financial institutions towards non–euro area counterparts were
almost twice as large as euro-denominated ones, the gap narrowed sub-
stantially by end-2002. Significant effects are also visible in those segments
of the European financial market where issuance in US dollars was dom-
inating (the so-called euro-dollar market). For instance, in the European
commercial paper market the share of euro-denominated debt instruments
increased from less than 20 percent at the beginning of 1999 to almost
50 percent in 2003, while the dollar-denominated share fell from almost
60 percent to less than 30 percent in the same period.
Regardless of the empirical evidence, it might be argued that, at least for
banks, the very creation of the Eurosystem has ipso facto determined the
Financial System: The Euro as Unifier 99

emergence of a unified system. Why is it appropriate, in the case of banks,

to refer to a “system” while no one would dub the steel or the chemical
industries as “systems”? All the answers to this question have to do with
the singleness of the currency and the central bank. First, banks are inter-
connected through payments. As I will further show in chapter 6, this
undoubtedly constitutes a system, linking participants in a network that
is also a vehicle for quick propagation of risks. Second, banks have collec-
tively the function of channeling liquidity to the rest of the financial sector
and to the economy as a whole. In performing this basic task, they are
strictly dependent on the access to central bank liquidity. Third, confidence
in the currency and the central bank influences all parties operating in a
single currency area. The financial market may remain segmented, but if
a liquidity need emerges in a segment of the financial industry, it is always
the central bank that bears the ultimate responsibility for it.
Hence the shared framework for accessing central bank liquidity ties
together the banks and, through them, the other components of the finan-
cial system. The singleness of the currency is indeed, more than it is usually
recognized, the factor that justifies the notion of a system in banking and
finance. This applies, as we will see, to euroland, but it also applies to any
other country. In the United States, for example, even when interstate
banking and branching still faced strict limitations, the financial system
was a single entity. A single monetary policy and a single regulatory frame-
work implied that the structural trends and systemic disturbances cut
across state borders. The jurisdiction of the central bank by itself defines
the geographic borders of the financial system.

5.2 The Continental European Model

The blurring of frontiers between financial contracts, intermediaries, and

approaches to regulation and supervision have somewhat attenuated what
used to be the distinctive features of a continental European model. The
internationalization of finance has further harmonized the financial fea-
tures of the major industrialized countries. Nonetheless, due to a degree of
path dependency intrinsic in structural developments, some specific
aspects of financial intermediation that took shape in the past still affect the
present, not only in Europe but also in the United States.
The salient characteristics of the continental European model are (1) the
dominant role of banks, (2) universal banking, (3) bank-assurance, (4)
public ownership, and (5) a “hands-on” approach to regulation and super-
vision. I will briefly review these characteristics.
100 Chapter 5

In continental Europe banks have traditionally played a dominant role

in channeling savings toward investment opportunities. In the United
States and the United Kingdom market-based finance, namely the issuance
of securities by the investing sectors, has traditionally played a much larger
role. The recent deepening of securities markets in Europe has changed,
but not suppressed, the bank-based feature of the European financial
system.
Euro area stock markets developed steadily during the 1990s, and
notwithstanding the significant drop in stock prices since 2001, the ratio
between stock market capitalization and GDP is still more than double
than in the early 1990s. Issuance of corporate bonds also grew remarkably
for several years, before the recent slowdown of primary market activity.
The deepening of securities markets has proceeded hand in hand with
the widening role of institutional investors. And this role is bound to grow
further with the gradual move from pay-as-you-go to funded pension
schemes.1
Developments of the last decade, however, did not marginalize banks in
the euro area. Either directly or through closely controlled entities, banks
still play the leading role in the provision of services for the issuance
of securities and in the asset management industry. This reflects their
“universal” nature.
Universal banking is the term used to define the ability of banks to
engage directly in the full range of securities activities and to establish close
links with nonbank firms, through equity holdings or board participation.
Even though universal banking was, and still is applied, in many countries
around the world, it surely is a most prominent feature of banking in
continental Europe.
The difference between the United States and euroland can be best
understood by referring to the boundaries of what banks can do. Both juris-
dictions define banks as institutions that couple deposit taking with the supply
of loans. However, this shared notion of the core function of banking is
accompanied by a clear difference in the range of activities that a bank is
allowed to conduct. In the United States, banking has been essentially
limited to the core function, with a very narrow range of additional activ-
ities. The EU banks, while holding an exclusive license to perform the core
function, do not face major restrictions of the range of further financial
services they are allowed to offer.2 In the United States the traditional bar-
riers separating banks from securities and insurance were partially released
only with the Financial Holding Companies Act of 1999. Also Japanese
Financial System: The Euro as Unifier 101

banks’ activities are limited to core functions, but a wider range of finan-
cial services may be provided by a banking group by means of subsidiaries.
Bank-assurance, the third distinctive feature, may be viewed as a further
extension of the universal banking model. Operational linkages between
banks and insurance companies have traditionally been more developed
in Europe than in either the United States or Japan. Ownership linkages
between the two sectors used to be subject to several constraints in
Belgium, France, and the Netherlands, but the restrictions were generally
alleviated at the beginning of the 1990s and also previously they did not
prevent the establishment of close operational relations. More recently
close linkages between banking and life insurance have further developed
in fully integrated groups providing the whole range of financial services,
the so-called financial conglomerates.
The freedom enjoyed by European banks in developing their business
beyond traditional deposit taking and lending was often balanced by the
strong involvement of government in the financial sector, through both
public ownership and a “hands-on” regulation and supervision.
In continental Europe, public ownership of banks is rooted in history
and predates the industrial revolution and the development of modern
market economies. It originates from the often nonprofit and charitable
nature of lending and pawnbroking. Public ownership was further
extended in the last century as a way to rescue banks that failed in the
crisis of the 1930s, or, later, as part of nationalization programs imple-
mented by leftist governments.3 In many European countries the wide-
spread presence of central or regional governments in the ownership
structure of banks was also seen as a way to alleviate the risk of systemic
instability in the financial system.
In the last decade of the twentieth century, public ownership of banks
became less relevant in Europe and privatization programs were adopted.
This reflected a change in prevailing economic ideas as well as the creation
of the single market, which dismantled regulatory barriers, tightened com-
petition rules, and eroded the “game reserves” of public banks, usually
endowed with special charters.4 Admittedly, however, privatization does
not per se create a smoothly functioning market for corporate control,
where inefficient owners and corporate governance structures are replaced
through shifts of control rights, such as via a takeover bid. The ownership
structure may be engineered in such a way as to prevent shifts in control,
and public authorities may continue to interfere to some extent with moral
suasion or other instruments.
102 Chapter 5

The last distinctive continental European feature of the financial system

is the “hands-on” approach to regulation and supervision. This feature has
been only partially corrected by the trend toward a more market-friendly
approach that has emerged worldwide at the end of the last century. This
trend has developed also in Europe, where the creation of the single market
has fostered a lighter regulatory and supervisory approach. However, the
distinct “hands-on” features of the continental European approach have
persisted.
The recent wave of financial and technological innovations has actually
revived the difference between the continental European attitude and the
“hands-off” approach typical of the US tradition. Following this latter
approach, which can be traced back to the free banking regime of the nine-
teenth century, recent technological developments can be seen as depriv-
ing banks of the special features that justified extensive prudential rules.5
Financial institutions should therefore be treated as any other corporation
and any entrepreneur should be left free to enter the industry, without
public regulation influencing their behavior and ability to innovate. Thus
bank regulation should not prevent the private, nonbanking sector
from trying out new solutions, with a greater role to be played by
self-regulation.6
The continental European approach maintains, instead, that the public
policy concern generated by the core function of banks is not wiped away
by the fact that it can be conducted by means of new technologies. All
entities performing such function therefore need to be under the safety
net consisting of prudential controls, deposit insurance, and access to
emergency liquidity in case of distress. This is why a strict licensing pro-
cedure has to be in place, so that all entities engaged in banking activities
are subject to the same rules and controls.7

5.3 The Shock of the Euro

The disappearance of currency segmentation brought about by the euro

was a shock to a European financial system already pressed to change and
in search of a new equilibrium. Has a unified market for banking and other
financial services already emerged? Although, as argued above, the juris-
diction of a central bank by itself defines the borders of a system, a more
concrete review of recent developments is necessary to fully answer this
question.
It is frequently argued that a single system will only emerge if and when
cross-border mergers among financial institutions occur.8 This assertion
Financial System: The Euro as Unifier 103

identifies the domain of a market with the ownership structure of the firms
operating in it, and fails to adequately consider the integration of activi-
ties. In reality the ownership structure has only a modest significance for
assessing the degree of market integration. For example, in key manufac-
turing industries, which are undoubtedly competing in a European-wide
market for much longer, only few cross-border mergers have taken place.
That cross-border mergers are not the decisive indicator of the emergence
of a single industry, is also suggested by the US experience. After the
removal of barriers to inter-state banking in 1991 mergers and acquisitions
mainly took place within states, while concentrations across states were
rare and generally confined to neighbouring states.9 Only at a later stage
did nationwide operations become more frequent. This resembles what is
happening in Europe today, with a large number of intrastate mergers and
very few interstate cross-border mergers between banks in close proximity
to one another (e.g., in Scandinavian countries and in the area including
Belgium, the Netherlands, and Luxembourg).
To assess whether the removal of currency segmentation has unified the
market, attention should focus on financial products and services, rather
than on the ownership structure. To this end, the simple, most frequently
used, criterion is the so-called law of one price, stating that if the same
product is sold at different prices within a competitive market, arbitrage
activities will eliminate price differences.10 A market is thus identified as
the space where, under the forces of competition, the same good or service
is sold at the same price. In the field of finance, however, the law of one
price is—for two reasons—of limited help.
First, finance is a field where a given product is often not sufficiently
homogeneous for its price to be equalized through arbitrage. Quality com-
petition—as distinguished from price competition—is crucial for most
financial products and services. Second, in finance there is a plurality of
products and services, ranging from asset management to insurance policy,
from loans, to mergers and acquisition (M&A) services, to privatization.11
This implies that markets where different products and services are
exchanged differ in size and geographical span.
These features make it very difficult to apply the law of one price and,
more generally, to find a unifying empirical measure of the degree of inte-
gration of the market. To overcome the difficulty, the discussion of overall
financial activity will be divided in three main categories—wholesale,
capital market, and retail—to be considered separately.
Wholesale activity is the one where the two sides of the transaction are
not the end users—say, households or firms—but financial institutions. It
104 Chapter 5

constitutes the inner core of the monetary and financial system and also
the part closest to the central bank. It is the main channel for transmis-
sion of both monetary policy and potential financial instability. In this
segment of the system product standardization is high and the law of one
price can be applied.
The key component of the wholesale market is the transfer of liquidity
among banks, which takes place mostly in the market for unsecured
deposits (almost 50 percent of total interbank activity).12 In this market the
law of one price began to work almost immediately after the launch of the
euro, on January 4, 1999, when interest rates became virtually identical in
all countries, signaling that market segmentation had disappeared. Market
integration was somewhat less prompt for secured transactions, where legal
discrepancies and practical difficulties in the cross-border management of
collateral tend to obstruct the arbitrage mechanism.13
The second set of products and services comes under the heading capital
market activity. It is so denominated because the counterparty of the finan-
cial institution is the capital market. This activity—constituting the essence
of investment banking—comprises corporate finance and asset manage-
ment services. The former consists of services offered to firms, which are
in a position to tap capital markets, such as bond and equity issuance,
privatization, syndicated lending, mergers and acquisitions, and corporate
restructuring. The latter relates to managing asset portfolios of savers,
which can be individuals, corporations, pension funds, or other institu-
tional investors. It should be noted that the management of assets is kept
distinct from the distribution of the products to final investors (i.e., the
collection of savings), which is a retail activity, to be considered below.
In capital market related activity, quality competition is very strong,
since the reputation of the intermediary and its relationship with other
market participants—for example, in terms of placing power—play a major
role. Hence the law of one price applies only to a limited extent.
Bond issuance is the field of corporate finance where both prices and
amounts show that the unification of the market has come about rather
quickly after the start of the euro. Indeed, the volume of funds denomi-
nated in euro raised by private entities (i.e., nongovernmental, but includ-
ing banks) doubled in the first year of EMU and international operations
grew consistently more than domestic ones. This reflected the fact that
international bonds could be issued in the debtor’s own currency, the euro.
The spreads narrowed significantly, demonstrating increased liquidity.
More difficult is to gather evidence for other corporate finance services
such as underwriting services, syndicated lending, structured finance for
Financial System: The Euro as Unifier 105

start-ups, and the various advisory services relating to mergers and acqui-
sitions and corporate restructuring. However, it should be noted that, since
these services are highly sophisticated and clients large in size, the market
was already tending toward a high integration before the euro.
Turning to asset management, important economies of scale and bene-
fits from spreading risks push toward the concentration of actual man-
agement of assets and trading activity, while enhancing international
diversification. To show how fast asset management has moved away from
purely domestic investments, suffice it to recall that from 1997 to 2002 the
share of domestic stocks in European equity mutual funds fell from 49 to
29 percent.
Both in corporate finance and asset management services, currency seg-
mentation has been an impediment to exploiting the high potential for
economies of scale. The advent of the euro has thus triggered a significant
movement toward consolidation. More than twenty of the largest forty
banks in euroland have been involved in important mergers as the euro
was being introduced, between 1998 and 2000. While rarely on a cross-
border basis, mergers were largely triggered by the fact that markets—in
particular, capital markets—were no longer national in any meaningful
sense.
For the financial system of the euro a particular aspect is the role of
London. Not surprisingly a bulk of wholesale and capital market activities
in euro, involving euro area investors, issuers, and intermediaries takes
place in London, which is the prime financial place in Europe as well as
the center where most US and other non-European institutions are located.
For example, large value interbank flows are about equally shared between
London and Frankfurt, and even many large euro area banks conduct
investment banking activities through specialized subsidiaries located in
London. Strong cooperation between the Eurosystem and the Bank of
England alleviates the anomaly that a significant portion of financial busi-
ness denominated in euro takes place outside the area of jurisdiction of
the central bank issuing that currency.
The third set of products and services goes under the heading of retail
activity. This is the most visible part of the financial system and the one
that reaches the largest number of clients, mainly households and small
firms. The retail market maintains a strong geographical segmentation
because, with counterparties scattered and not very mobile, the crucial
factor is proximity. The high visibility of retail banking contributes to the
erroneous impression of a persistent division of euroland into national
markets. It is interesting to note that euroland and the United States have
106 Chapter 5

similar features. According to a survey conducted by the Fed, more than

90 percent of banks’ clientele is located within a distance of less than 20
miles of the banks’ premises.14 Proximity is an intrinsic characteristic of
the retail market, which remains relatively unaffected by the single
currency.
The significant market integration already achieved does not warrant the
conclusion that no relevant impediments remain.
First, there are obstacles, which are a historical legacy rather than the
making of private agents or the effect of deliberate policies. The very
existence of eleven languages, for example, still makes euroland a sharply
divided economic space and makes the emergence of truly transnational
undertakings rather difficult. Traditions in corporate culture and manage-
ment styles are quite different across countries. The still predominantly
national dimension of labor contracts is another factor. Moreover some
relevant differences in legislation still exist, which are the outcome of
the incompleteness of the European Union. For instance, there still is no
common regulatory framework on takeover bids, while legislation defin-
ing the statute of an EU company, as distinct from nationally based under-
takings, has been only recently introduced after a long debate.
Private agents too may interpose obstacles to market integration. Inter-
mediaries, or managers of market infrastructures, that enjoy, individually
or in agreement with other firms, monopolistic rents in domestic markets
will strongly oppose integration. They may also put in place anticompet-
itive practices, for instance, through local mergers or agreements.
Finally, and not last in importance, there are the attitudes of national
authorities, which naturally favor and support their domestic marketplace
just as the regional governments of Bavaria or Cataluña support the for-
tunes of Munich or Barcelona within Germany and Spain. A “local” public
authority (whether regional or national) pursues the quite legitimate goal
of maximizing the welfare of “its” constituency. In the financial field it
does so by favoring the access to funding by local corporations and by
maintaining or increasing sources of income and employment for local
intermediaries.
As was noted in chapter 3, competition among national policy authori-
ties is an integral part of the EU economic constitution and a beneficial
factor to foster efficiency and growth oriented regulation. To the extent
that emulation produces a spreading of best practices, it also contributes
to the harmonization of regulatory approaches, which in turn facilitates
the integration of the market.
Economic contest ceases to be beneficial and becomes outright protec-
tionism when efficiency is sacrificed to an “unwarranted” strategic objec-
Financial System: The Euro as Unifier 107

tive.15 In the pursuit of such strategic objective, a “tax” is imposed upon

consumers or other producers in the form of inferior quality of the service,
higher prices, and barriers to entry, for example.
The effect of competition is higher overall efficiency, increase in the con-
sumer surplus, and further integration of the market. The effect of protec-
tionism is the opposite of all that. For the benefit of policy competition to
be reaped, therefore, a line has to be drawn separating competition from
protectionism, allowing the former and sanctioning the latter. This in turn
requires a strong arbiter, superior to the contenders, regardless of whether
they are private or public.
Here is where the limit lies in the analogy between the national and the
regional use of a local power in the competitive arena. In member states
the central arbiter has much more power over regional governments than
the European arbiter over national players (be this arbiter the European
Commission in Brussels or the ECB in Frankfurt). National authorities
retain the instruments and the mentality of a time in which the economic
contest between nations looked more like a conflict than like a game. It
may thus happen that the preservation of a strong nationally owned
banking industry, or of a “local” capital market, is seen as a strategic rather
than economic objective. Self-interested objectives, such as favoring
national control over financial institutions or preserving jurisdiction on
major domestic intermediaries, is persistently presented as an objective on
its own right, regardless of the benefits for the users of the service. Simi-
larly, in a not distant past, self-sufficiency in food or steel production was
regarded as a vital safeguard of national independence.
Several tools can be, and indeed are, activated to pursue national objec-
tives, ranging from fiscal instruments to moral or political pressure, to the
preservation of public ownership, to a distorted use of authorization
powers. If national policies or private actions substantially hinder market
integration, the European Commission—in its capacity to maintain a level
playing field in EU competition rules—should have the strength and the
instruments to intervene and undertake corrective action.16

5.4 Regulation and Supervision

To the extent that a single system is emerging, public control through

financial regulation and supervision also becomes a euro area issue. This
section illustrates the regulatory and supervisory system that euroland
inherited from the single market and reviews the debate that has recently
developed on the subject. This debate was largely triggered by the start of
the single currency, but other factors contributed to it, such as the reform
108 Chapter 5

of regulation and supervision in the United Kingdom, and the rapid pace
of change of the financial industry.
Before entering the subject, a clarification in the terminology may be
useful. Regulation and supervision are the two words commonly used to
name the intervention of public authorities in the financial system. Regu-
lation consists in issuing rules for banks, other intermediaries or other
market participants. Such rules can be written in national or EU law, or in
so-called secondary legislation, namely in norms issued by technical com-
mittees or agencies. Supervision is the activity aiming at ensuring compli-
ance with the rules. It has an executive and judiciary (as distinguished from
legislative) nature and is concerned with implementing and enforcing—
often with a large degree of discretion—the rules. The two main public
interests pursued through regulation and supervision are financial stabil-
ity (for which the comprehensive term of prudential controls is often used)
and protection of the investor. Depending on institutional arrangements,
regulation and supervision may be entrusted to the same authority or be
assigned to different authorities.
Against this background, the regulatory and supervisory framework set
up for the single market of banking and other financial services was based
on coupling European regulation with national supervision. More specifi-
cally, the following four arrangements were adopted: (1) essential EU-
harmonized regulation; (2) mutual recognition of nonharmonized,
national, rules; (3) national competence for supervision in the implemen-
tation and enforcement of the rules; and (4) close cooperation among
national authorities.
Of the four, the first two are the general arrangements that preside over
the whole structure of the single market. They were adopted in the mid-
1980s to accelerate the program of establishing freedom of circulation of
goods, services, capital, and persons in the European Union. Taken
together, they have permitted to combine a simplification of the legisla-
tive program required to launch the single market with the benefits of
policy competition.
According to the third principle—national competence for supervision—
every financial institution (which has the right to do business in the whole
area on the basis of a single license) operates under the authority of the
country where the license was issued. This principle, called home-country
control, allows the unambiguous identification of the supervisor responsi-
ble for each institution.
Cooperation among national authorities is the fourth and last principle.
Clearly, in an integrated market that retains a plurality of “local” (national)
Financial System: The Euro as Unifier 109

supervisors, only active cooperation can safeguard, on a EU rather than

only on a national scale, such public goods as openness, competition,
safety, and soundness of financial intermediaries. EU directives state the
requirement of such cooperation and remove the legal obstacles that pro-
fessional secrecy in the conduct of supervision could pose to the exchange
of confidential information among national authorities. It should be
noted, however, that removal of obstacles is not the same thing as creat-
ing a firm obligation or an institutional arrangement that makes such
cooperation happen in practice.
The framework just described was inherited by euroland from the single
market, for which it was designed. The question is whether it is sufficient
to cope with the enhanced regulatory and supervisory requirements of a
single currency area. Today the almost unanimous answer is that the frame-
work is not quite adequate.
Outside observers, representatives of the industry, national governments,
the EU Commission, and the ECB agree that there are persisting discrep-
ancies and inconsistencies in both national rule books and supervisory
practices, as well as differences in the legal standing, organization, and pro-
fessional expertise of national supervisors. Some also argue that the dis-
cretion of supervisors is too often used for protecting local markets or
institutions. Even when it does not undermine safety or soundness, this
situation deprives end users of better services and increases the burden
for groups operating at an areawide level, especially in terms of costs of
compliance.
Thus it is widely agreed that an overhaul is needed, although the debate
is open as to its extent and direction. The debate has proceeded in waves,
touching in turn different sectors of the financial systems (banking and
securities in particular) and different aspects of the framework (regulation,
supervision, and the structure of public agencies).
The field of banking attracted attention shortly after the start of the euro.
A first appraisal was marked by a rather conservative attitude of the parties
involved. Fearful that the move to the single currency could trigger a trans-
fer of competence also in the field of prudential controls, national super-
visors—particularly when they were central banks—mounted a strong
defense of the status quo. In 2000 a report to the Economic and Financial
Committee (the so-called Brouwer I report) basically blessed the framework
inherited from the single market. The report acknowledged remaining
differences in national supervisory practices and only advocated enhanced
cross-border cooperation, with greater convergence in supervisory practices
and more exchanges of information.
110 Chapter 5

A second wave of the debate focused on securities, a field where little

preparation had preceded the launch of the single market. Here differences
in regulation and supervision were found particularly pronounced
because—much more than in banking—national rules had been only
mildly harmonized and no clear structure for cooperation among national
supervisors was in place. Moreover, as most of the rules were carved in the
stone of EU directives rather than in the clay of secondary legislation,
regulation could hardly adjust to the rapid pace of financial innovation.17
Furthermore, where general principles had been harmonized, the
implementation often preserved wide differences across countries.
These multiple shortcomings—which had the twofold consequence of
thwarting the integration of the market and imposing an extra burden on
the regulated entities—led the Ministers of Finance to set up a committee
of experts called the “Committee of Wise Men” with the task of propos-
ing ways to improve the situation. The consequent report (known as
Lamfalussy report) in 2001 proposed a new approach for regulation and
supervision respectively.18 As to regulation, it recommended that the direc-
tives be made more flexible by inscribing in them only principles and
leaving to secondary legislation (entrusted to an ad hoc committee, com-
posed of high level representatives from member states) more detailed pro-
visions. This would make it possible to more easily update regulation to
keep pace with changes in the marketplace. As to supervision, the report
recommended that cooperation be improved among national authorities
(by way of another, more technical, committee) to allow more homoge-
neous implementation and enforcement of common rules. The report
argued that if this approach did not prove effective in removing regula-
tory obstacles to securities market integration within a reasonable time
horizon, a change in the Treaty should be considered, possibly attributing
more responsibility to the European level. What came to be called the
Lamfalussy approach started to be implemented in 2001, when the two
ad hoc committees were created.
The agreement reached in the field of securities opened a third phase in
the debate, which concerned the other sectors of finance, namely banking
and insurance. The orientation is to fundamentally stick to the four prin-
ciples described at the beginning of this section and simply to improve
their functioning. To this end regulation would be made more flexible
(along the lines suggested by the Lamfalussy report), cooperation among
national authorities would be enhanced, and the configuration of existing
committees would be completed and streamlined.
The process for establishing the new regulatory and supervisory com-
mittees for banking and insurance has been lengthy and full of contro-
Financial System: The Euro as Unifier 111

versy. The delicate institutional balance between the European Parliament

and the European Council by which to delegate powers to the new regu-
latory committees is yet to be completely settled. Also the issue of the
composition and location of the supervisory committees proved to be
controversial. Eventually the decisions were made and the new structure
is almost completely operational at the time of writing. The arrangements
will be subject to very important tests. Both in banking and in insurance
the regulatory framework for capital adequacy is being extensively revised,
and a major effort is needed to ensure consistent implementation and
enforcement in the single market. European institutions have set up a
monitoring framework in order to ensure that the new arrangements are
effectively delivering a regulatory and supervisory environment adequate
for an integrated currency area.

5.5 The Institutions of Supervision

As indicated earlier, a much debated issue triggered by the euro was the
structure of supervisory agencies or, in simpler terms, “Who does what.”
In some ways this was the hardest and most complex part of the whole
debate, because not a single, but a cluster of often entwined issues was
involved and because any assignment of policy functions stirs hot con-
troversy. In the background there was the fact that the institutions of
supervision differ widely from country to country (see table 5.1) and that
no conclusive theoretical argument points to a single optimal setup. Trans-
formation of the industry called, at any rate, for a reconsideration of exist-
ing arrangements. Moreover the adoption of a quite new approach by such
a major financial center as London in 1998, and the active efforts to sell
the formula around the world undertaken by the new UK agency, have
further moved the spirits.19
Giving Europe a single currency and a single central bank naturally leads
one to ask whether supervision should remain national or become itself
European. This was the question explicitly addressed in 1988 to 1992 when
EMU was designed and inscribed in the Treaty of Maastricht. In recent
years two other issues were added to the debate on the institutions of
supervision. To see the overall picture, let us begin by adumbrating these
other questions.
The first question is whether the various sectors of the financial system—
banking, securities, and insurance—should be supervised by a single
agency or by separate agencies. Advocates of the creation of the Financial
Services Authority (FSA) as an all-purpose supervisor stressed that sector
segmentation is increasingly disappearing. Critics emphasize that the
112 Chapter 5

Table 5.1
Institutional arrangements for supervision in euroland

Number of
supervisory Supervisory
authorities modela Role of the central bank

Belgium 1 Single Some operational involvement

Germany 1 Single Some operational involvement
Spain 3 Sectoral Full responsibility for banks
Franceb 6 Sectoral Some operational involvement
Greece 3 Sectoral Full responsibility for financial
intermediaries
Irelandc 1 Single Full responsibility for all
financial intermediaries
Italy 3 Twin peaks Full responsibility for banks
and some nonbank financial
intermediaries
Luxembourg 2 Sectoral No operational role
Netherlands 2 Twin peaks Full responsibility for the
prudential supervision of all
financial intermediaries
Austria 1 Single Some operational involvement
Portugal 3 Sectoral Full responsibilities for banks
and some nonbank financial
intermediaries
Finland 2 Sectoral Some operational involvement

a. “Sectoral” denotes authorities with sectoral responsibilities; “single” denotes

single authority for the whole financial sector; “twin peaks” denotes responsibilities
divided by objectives (i.e., prudential controls versus enforcement of conduct of
business rules).
b. Close cooperation and administrative support exist between the supervisory
authorities and the central bank. Additionally the chairman of the Commission
Bancaire is the deputy governor of the Banque de France.
c. The Irish Financial Services Regulatory Authority is a constituent but autonomous
component of the Central Bank and Financial Services Authority of Ireland.
Financial System: The Euro as Unifier 113

requirements and approaches to prudential controls still differ widely

across sectors and that Chinese walls as well as internal coordination are
also needed within a single organization. Conflicts of interest may arise
between the stability-related tasks and investor protection activities,
namely the enforcement of disclosure and conduct of business rules.20
The second question was whether supervision (in particular, of banks)
should be located inside or outside the central bank. Advocates of separa-
tion observe that concerns on the profitability and solvency of the banking
industry may—in certain circumstances—lead monetary policy to exces-
sive softness in fighting against inflation. They also point to the risk of
moral hazard, since banks may take up excessive risks in the belief that the
central bank would support them in case of difficulties.21 In the opposite
sense, the information-related synergies between supervision and other
central banking functions are arguments for concentrating the two func-
tions in the central bank.22
In general, there are no conclusive theoretical or empirical arguments
showing that a separate agency is a better supervisor than the central bank.
Both approaches can function effectively or fail, depending on how they
are managed.
In the specific case of the Eurosystem, however, the balance may shift
in favor of a continued, and even reinforced involvement of national
central banks. With the introduction of the euro, the interbank market,
the securities and derivatives markets, and the payment, clearing, and set-
tlement infrastructures—which are the most relevant channels of conta-
gion—have become euro area wide. Meanwhile the potential conflict with
monetary policy should no longer be a concern, because the two functions
are assigned to different levels and distinct decision-making bodies.
The third question was whether supervision should be a national or a
European competence. We have seen above that the combination of
European regulation with national supervision, chosen for the single
market, has been confirmed in the Maastricht Treaty. We examine here
briefly the arguments for and against the appropriateness of this approach.
If we rely on the experience of the past, in which there was coincidence
among the geographies of currencies, supervisors, and financial institu-
tions, the creation for a supranational, areawide agency would seem imper-
ative. In fact the case of a unified financial system, where supervisory
responsibilities are split among a large number of local authorities, is
almost unprecedented. In the United States, banking supervision, albeit
divided among different federal and state authorities, attributes to federal
agencies (the Fed and the Office of the Comptroller of the Currency) the
114 Chapter 5

responsibility for large banks and financial groups with a nationwide busi-
ness. It is somewhat surprising, then, that the transfer of supervisory com-
petencies to the euro area level has not been put forward more strongly in
the recent debate.
The drawbacks associated with a plurality of national supervisors go from
slowness in responding to problems, to use of national discretion for the
protection of the national industry, to aggravation of the regulatory
burden. It is not by accident that in past historical experience, a single cur-
rency area with a single financial system has almost always been comple-
mented with a single supervisor.23 For large intermediaries with significant
cross-border business a “one-stop only” relation with public authorities sig-
nificantly reduces the costs of compliance. Also the changing dimension
of systemic risk speaks in favor of shifting supervisory competence to
euroland. Indeed, financial institutions are increasingly exposed to shocks
originating outside national boundaries, while channels for contagion
imply enhanced cross-border spillover effects in case of crises. Individually,
national supervisors—which by construction lack the whole picture of the
industry—may neglect important developments in the risk profiles of the
entities they supervise. Collectively they may fail to provide an optimal
control of systemic risk.
On the other hand, defenders of national competence observe that since
the final responsibility to decide whether to intervene with taxpayers’
money in case of a crisis lies with national governments, a supranational
agency would lack clear lines for reporting and accountability. They also
stress the benefits of proximity to the financial institutions, which grants
supervisors a closer access to information and market rumors. Furthermore
they observe that some policy competition between national systems may
favor experimentation and comparison of different approaches. Finally
they maintain that a European agency could hardly function without
further harmonization of the legal and regulatory framework. This should
include, in addition to traditional prudential rules, such fields as company
laws and corporate governance rules, judiciary system for appeals against
supervisory decision and settling controversies.
Only time will tell whether the chosen approach will meet the euro
areawide public interests generated by the emergence of euroland’s finan-
cial system. At this stage it can only be observed that a time measurable in
years, not in months, will be needed for amending the existing framework.
This requires redrawing the dividing line between primary and secondary
legislation, which in turn involves rewriting the existing directives (there
are about forty of them for the various sectors of finance) and, after that,
Financial System: The Euro as Unifier 115

adopting a whole new body of secondary legislation. Such a bulky under-

taking would only be worthwhile if the resulting revised framework were
kept in use for many years. This means that what is planned today is the
regulatory and supervisory framework for a decade or more, a period in
which the EU financial system is bound to undergo a substantial transfor-
mation and even face situations in which its stability may be under stress.
Combining the preservation of national supervision with a rapid process
of financial integration thus means accepting a major challenge and even
taking a risk. Therefore one may wonder whether going for a refurbish-
ment rather than for a new construction is the best approach. Few indeed
deny that in the end a single market with a single currency requires a single
supervisor, not just harmonized regulation.
In this matter the principle of subsidiarity assigns the onus of the proof
to the advocates of a supranational agency. Thus the capability of national
authorities to establish a close network through cooperation and to deliver
a unified functioning of the present institutional framework should be
fully tested before considering any transfer of responsibilities to an EU (or
euroland) supervisor. A single supranational agency could and should at
any rate preserve, as far as possible, proximity to the supervised entities as
well as the variety and richness of present structures.

5.6 The Eurosystem and Financial Stability

This final section deals with the specific role and concerns of the Eurosys-
tem, the central bank that identifies the financial and banking system of
euroland.
Past and recent systemic crises show that financial strains developing
outside the banking field can only be overcome if banks are capable of sup-
porting the liquidity needs of other intermediaries, letting the insolvent
ones face their own destiny and countering the risk of the whole financial
system collapsing. As to the central bank, it has to be in a position—as
“last” lender to banks—to ascertain the real financial conditions of its
counterparts and to actively intervene if needed. Having a responsibility
for the stability of the system as a whole, the central bank must carefully
assess the impact of bank insolvency. This is why all central banks monitor
the state of health of the financial system and strive to prevent adverse
developments.
Since, in case of a crisis, they are the ultimate line of defense before bank-
ruptcy, central banks are subject to come under strong pressures to inter-
vene and bail out ailing institutions and markets. For this reason they need
116 Chapter 5

to be assured that prudential controls are effective enough to make this

occurrence as remote as possible. Thus there exists an unavoidable “central
bank track” to financial stability, ultimately stemming—as explained in
chapter 2—from the need of central banks to preserve the store of value
and means of payment functions of money. This track is strictly inter-
mingled with the “supervisory track” even when the latter is entrusted to
a separate agency. Historically the two tracks were one, born with the fail-
ures of the free banking era, which showed the inability of private clear-
inghouses to effectively provide emergency liquidity to banks under stress
and to monitor their behavior on a regular basis.
The central bank track to financial stability is expounded in the Treaty,
which asks the Eurosystem to “contribute to the smooth conduct of
policies pursued by competent authorities relating to the prudential super-
vision of credit institutions and the stability of the financial system.”24
Given the separation between monetary and supervisory jurisdictions, this
provision is clearly intended to ensure a smooth interplay between the
two.25
The Treaty approach establishes a double separation—geographical and
functional—between central banking and banking supervision. Functional
separation holds even in countries where the supervisor is the national
central bank, because the latter no longer controls money creation. Geo-
graphical separation is, as noted in the previous section, a not uncommon
arrangement. It should be noted, however, that the Treaty also establishes
a simplified procedure to entrust specific supervisory tasks to the ECB
without recourse to the burdensome procedure of Treaty amendment.26
This is a “last resort clause,” which might be activated one day if the
present arrangements proved ineffective. The Treaty thus implicitly indi-
cates a preference for banking supervision to be entrusted to the central
bank rather than a separate agency. Of course, activation of such a provi-
sion would make both the geographical and the functional separation dis-
appear at once.
Like any central bank without direct responsibilities for prudential
supervision, the Eurosystem needs to monitor the banking and financial
system in its jurisdiction. Similarly it needs to follow developments in
the regulatory and supervisory policies and practices. Naturally the
Eurosystem would have a role to play in the management of a crisis. Coor-
dination mechanisms between the Eurosystem and supervisors must
ensure efficient exchanges of information and contribute to an agreed
stance on financial stability issues of common interest.27
Crisis management is the issue on which most of the criticism of the
present arrangements has concentrated in the early years of the euro. It
Financial System: The Euro as Unifier 117

has been argued that in euroland responsibilities to manage a banking (or,

more broadly, financial) crisis are neither clearly assigned nor openly
disclosed, and that the sheer number of authorities potentially involved
would make the efficient provision of emergency liquidity unmanage-
able.28
A crisis—just when cooperation between central banks and prudential
supervisors is most needed—is the situation where the double separation
arrangements of euroland may prove most problematic.29
When assessing the existing mechanism for crisis management, it should
be borne in mind that lending-of-last-resort (i.e., the provision of central
bank money) represents just one solution to a crisis.30 Two other solutions
are the provision of taxpayers’ money into ailing or insolvent financial
institutions and the injection of private money by banks or other market
participants. These three solutions must not be confused and should be
considered one by one.
The private money solution is market based and is the preferable option,
not just to save public funds but also to reduce moral hazard. For it to
materialize, public authorities often have to play an active role, since
private parties may otherwise be unable to act for lack of information or
coordination. In the euro area the coordinators would normally be
national supervisors and central banks. The Eurosystem and the relevant
supervisory committees would become involved whenever the crisis had
relevant cross-border dimensions.
The taxpayers’ money solution comes into play in case of a significant
insolvency. Politically liable Ministries of Finance may feel that the failure
of a large portion of a country’s banking system, or of a single large insti-
tution, would cause too negative macroeconomic and social consequences
and hence may decide to provide support from the public budget. Crisis
management procedures involving taxpayers’ money are left practically
unaffected by the introduction of the euro. The European Commission
would be directly involved, since any state aid must be compatible with
the Community’s competition legislation. Central banks usually play a role
in such cases, either because bridge finance is needed while the rescue gets
organized, or, more generally, because they sometime intervene in the
market place helping in ring-fencing the ailing institution, thus prevent-
ing contagion.
Only the central bank money solution is the specific lender-of-last-resort
function, a notion dating back more than 120 years and referring to emer-
gency lending to institutions that, although solvent, suffer a rapid liquid-
ity outflow due to a sudden collapse in depositors’ confidence, such as a
classic bank run.31 Nowadays, in our industrial economies, such classic runs
118 Chapter 5

are to be found more in textbooks than in reality, because of the many

antidotes developed since the late nineteenth century.32 Deposit insurance,
the regulation of capital adequacy and large exposures, improved licens-
ing and supervisory standards, all contribute to the preservation of depos-
itors’ confidence and minimize the probability that a modern bank is
solvent, but illiquid, and at the same time lacks sufficient collateral to
obtain regular central bank funding. What if this rare event was never-
theless to occur and cause a systemic threat? The answer is that national
arrangements would continue to apply, including those concerning the
access of central banks to supervisors’ information. National central banks
would bear the responsibilities and the costs for such operations. In case
the amount of liquidity creation required was significant, the ECB Council
would be involved. Full exchange of information should ensure that any
potential liquidity impact is managed in a manner consistent with the
single monetary policy.
The provision of emergency liquidity to a bank is not the only case where
central bank money may have to be created to avoid a systemic crisis. A
general liquidity dry-up may also be caused by a gridlock in the payment
system or a sudden drop in stock market prices. The actions of the Fed in
response to the stock market crash of 1987 or those jointly conducted by
the ECB and the Fed in the aftermath of September 11 are examples of a
successful central bank operation used to prevent a dangerous marketwide
liquidity shortfall. These actions are close to the monetary policy function.
That the Eurosystem is prepared to handle this kind of market disturbance
has already been proved on some occasions, such as the operations in the
aftermath of September 11, 2001.
6 The Payment System: The Plumbing of Euroland

The payment system consists of the set of instruments, networks, rules,

procedures, and institutions that ensures the circulation of money. It is a
vital infrastructure for the proper functioning of a market economy, much
like the legal or the transport system. It is also a key component of the
transmission mechanism of monetary policy. Its safe and smooth opera-
tion is indispensable for the stability of the currency, the financial system,
and the economy in general.
To show the importance of what Gerald Corrigan, former president of
the Federal Reserve Bank of New York, once called the “plumbing” of the
monetary system, consider January 4, 1999. This was the first day the euro
was introduced as a medium for transactions in the money and securities
markets. Had the newly built euroland payment system failed to function,
the whole world would have sniggered and scornfully concluded that the
much-celebrated project of a single European currency was a bust. The
metaphor of the “plumbing” is appropriate because it hints at the circula-
tion of liquidity, but also because it refers to the humble back-shop of logis-
tics rather than to the noble realm of policy.
After providing a general background in sections 6.1 and 6.2, I present
the key issues of making euroland a single payment area in section 6.3.
These issues are further explored for the three fields of retail payments
(including banknotes), large-value payments, and securities settlement
systems (sections 6.4 to 6.6). I end the chapter with a review of the chal-
lenges looming ahead (section 6.7).

6.1 Historical Background

Payment practices are as old as the exchange of goods and services among
human beings. Since ancient times their evolution has been driven by the
search of ever more efficient ways of organizing trade, leading from barter
120 Chapter 6

to monetary exchange, namely to invent and perfect a special good called

“money.” Money has taken many forms, going from stones, to salt, and to
shells before gold and other precious metals took over about 2,600 years
ago.1 Then quite recently, about 200 years ago, commodity (metal) cur-
rencies were gradually replaced by paper currency, and thus started the
development of modern monetary systems. Still more recently, about a
quarter of a century ago, paper gave way to electronics.
In the early years of paper currency, any bank, and even commercial
enterprise or shop, used to issue paper notes, as promises to convert them,
on the bearer’s demand, in an equivalent amount of metal currency. This
situation generated confusion and instability, as it was very difficult to
gauge the reliability of the promise without knowing the issuer. The
value of paper currency could therefore collapse whenever doubts arose
about the solvency of a major issuer. Moreover, since different notes had
different values depending on the issuer’s creditworthiness, there were
exchange rates between them. In sum, those were not single currency
systems.
To overcome the precariousness of such systems and firmly maintain the
public’s trust in paper currency, the state made the right to issue notes an
exclusive prerogative granted to a particular bank. This was the central
bank, or bank of issue. Banknotes became legal tender, that is to say, the
sole settlement means that market participants are legally obliged to
accept.2
The finely designed banknote, printed in chalcography on watermarked
paper, carrying the effigy of revered national figures and the profile of his-
torical monuments or famous landscapes of the country, certified by the
signature of the central bank governor, became the epitome of money.
Despite the expanding role of its various substitutes, the banknote still is
a fundamental instrument of economic life. Touched repeatedly every day
by almost every person, it is, by far, the most universally handled manu-
factured good in society. Being an intrinsically worthless piece of paper
that everyone accepts from a stranger in exchange of worthy goods and
services, its circulation testifies, more than any other social habit, the
bonds of confidence that tie together the members of a community. Like
the flag, the House of Parliament, or the color of military uniforms, the
banknote is, par excellence, an expression of the modern state.
For reasons of safety and convenience, banknotes came to be increas-
ingly deposited at commercial banks, which stood ready, on demand by
the client, to convert the deposit back into banknotes. The transfer of such
deposits (i.e., of entries in the books of commercial banks, also called
The Payment System: The Plumbing of Euroland 121

commercial bank money) thus gradually replaced—for a number of rela-

tively large value transactions—the physical handover of notes.
As commercial bank money developed, the value of money became again
dependent on the solvency of the depository banks. In theory, following
the same evolution as paper money, the issuance of deposits could have
been progressively entrusted to one bank only, as a way to maximize the
safety and efficiency of the system. This path, however, was not taken and
the total stock of money thus became a composite aggregate, formed by
the central banknotes and the demand liabilities of the commercial banks.
Payments between commercial banks became a necessary part of the
payment circuit whenever the payer and the payee were not depositors of
the same bank. They were made in legal tender, meaning in central bank
money rather than commercial bank money. In order to economize the
holdings of non-interest-bearing banknotes, so-called multilateral netting
and clearing procedures were devised, as well as institutions called clear-
inghouses.3 In clearinghouses payments due to, and to be received from,
each bank were canceled out and an actual transfer of notes only took place
to settle net balances. Moreover the transfer of deposits with the central
bank gradually replaced the physical handover of banknotes.
An essential feature of a payment system is its currency specificity, the
fact that it comprises the circulation of one and the same money. This in
turn means that the various components of the money stock are com-
pletely fungible throughout the plumbing; that is, they share the same
nominal value and are accepted as fully interchangeable forms of one and
the same currency. Indeed, one of the key public interests associated to the
monetary system is precisely the preservation of fungibility as a sine qua
non condition for keeping its unitary, or system, character. The central
bank is the institution to which this mission is entrusted.
To sum up, the technology of payments in place at the beginning of the
twentieth century can be summarized as follows. The stock of money was
made of notes issued by the central bank and deposits with commercial
banks. The transmission of money occurred through physical handover for
the former and, for the latter, via an order (in the form of a check or a so-
called giro) given by the depositor to the bank to settle with the payee.
Orders to banks were mainly written on paper, the handwritten signature
was the authentication, and the mail was the dominant instrument to
transmit them at distance. Multilateral netting and settlement in central
bank money were the key features of that model.
This technology remained basically unchanged through most of the
twentieth century, despite an increasing use of electronic data processing
122 Chapter 6

in the second half of it. The payment system became gradually a non-
strategic front for central banks, an area rarely looked at by governors or
board members.

6.2 New Risks, New Technologies

The long standstill ended in the 1980s, mainly as a result of two develop-
ments. The first was the growing risk of a collapse in netting systems due
to the exponential increase in the number and value of financial transac-
tions; the second was the advent of new money transfer techniques com-
bining electronic data processing with telecommunication technology.
In traditional netting systems the problem posed by a participant’s
inability to settle at the end of the day used to be solved by excluding from
the netting the payments due by the defaulter and recalculating net bal-
ances. As the total volume of payments grew much faster than the amount
of central bank money necessary to settle it, this solution (called “unwind-
ing”) became unworkable. The exclusion of one participant increasingly
risked changing the net position of other participants, thus triggering a
chain reaction of defaults. Settlement risks became liable to cause finan-
cial crises.
Central banks were concerned by these developments because the
increased vulnerability of netting arrangements—so-called systemic risk4—
was a potential threat for the orderly functioning of the monetary system.
In 1990 efforts to improve the resilience of netting systems led the major
central banks to set minimum standards for their functioning. Netting
systems were asked to adopt provisions ensuring that the settlement phase
would be completed even in the case of the failure of the participant with
the highest debit position.5 Following this initiative, most systems
amended their operational rules and procedures.
Meanwhile a historical change was made possible by the revolution in
information and communication technology (ICT). By allowing to trans-
fer money in real time from one account to another, ICT increased almost
without limit the velocity of circulation of central bank money. This dra-
matically reduced the need to economize holdings of fruitless balances in
central bank money, namely the rationale for using netting procedures.
Settlement in central bank money on a “gross” basis, namely by ensuring
immediate finality of each and every payment, became economically
possible, and thereby eliminated the intra-day balances between banks
and radically reduced systemic risks.
The Payment System: The Plumbing of Euroland 123

The move from net to gross settlement started with a pathbreaking

initiative of the Fed, which in the 1980s upgraded Fedwire to make it an
integrated, electronic system.6 In the 1990s all EU member states followed
that example and developed electronic real-time gross-settlement (RTGS)
systems. With RTGSs the “ubiquitous presence of unsecured and some-
times uncontrolled credit in net settlement systems” was substituted by
the provision of intra-day credit by the central bank.7
For central banks, the developments of the last twenty years have given
rise to a new function called payment systems oversight. While sharing
the objective of financial stability with prudential supervision, oversight
looks at systems rather than institutions. It spans from setting standards
to monitoring systems and assessing compliance. In the 1980s the over-
sight function developed mostly on a nonstatutory basis. Later it became
recognized in law.
As shown in chapter 2, the issuance of central bank money is the seed
from which all the functions of central banks stem. Although, in all
modern economies, the total stock of money has become a composite of
commercial and central bank money, the latter has retained a superior
combination of safety, availability, efficiency, neutrality, and finality,
which ensures it a unique position in the monetary system.8 As we saw
above, the payment system has evolved into a sort of layered pyramid,
with the central bank at the top, commercial banks in the middle, and
end-users (households and firms) at the bottom. In this construct central
and commercial bank money coexist in a delicate equilibrium, where they
are substitutable and complementary at the same time.
Substitutability is what makes the singleness of the currency. If central
and commercial bank monies were not perfectly fungible, the monetary
system would not be one, the public’s confidence would not be sustained,
and financial stability would be permanently at risk. Two substitutable
goods normally compete. Yet the degree of competition here is limited
by the convention that central banks refrain from competing with com-
mercial banks. This generates the dichotomy between banknotes, which
are available to all, and central bank accounts, which are available only to
some. While most segments and functions of the monetary system are not
entered by central banks, others are reserved to them. Hence the require-
ment that certain systems systemically important for the economy should
settle in central bank money.
Here is where complementarity meets substitutability. Central bank
money complements commercial bank money because the trust created by
124 Chapter 6

the central bank refers to the totality of the money stock and the entirety
of the monetary mechanism, and not just to the parts the central bank
directly issues or runs. In a regime of fiduciary currency, where both the
money and the payment services are simultaneously supplied by a public
interest-driven central bank and by profit-driven commercial banks, trust
and stability rest on the complementary and mutual reinforcing character
of the two roles.
Against the historical and functional background described in this and
the previous section, the rest of this chapter will illustrate the issues and
challenges the Eurosystem is facing in the field of payment systems. It will
consider in turn the three components into which modern payment
systems usually are classified, namely retail, large-value, and securities
settlement systems.
Between retail and large-value payments the distinction should be made
on the basis of the entity making or receiving the payment, rather than on
the size of the payment. Retail payments concern the circuit of consumers
and businesses, while large-value payments are mainly exchanged between
banks. Since the respective requirements are different, these two categories
of payments have different architectures and supporting systems. In par-
ticular, payments between banks have to be settled on a specific day, and
increasingly even in a specified time slot of the day, in order to allow for
the settlement of interdependent operations. Retail payments are less time
critical. As to securities settlement systems—used to discharge the mutual
obligations assumed by market participants when buying or selling bonds
or equities—they provide for the final delivery of securities from the seller
to the buyer and of money from the latter to the former. They are the
“plumbs” on which both securities and cash flow. Due to the phenome-
nal pace at which financial transactions have grown, both in volume and
number, they have become, in the last three decades, a critical area where
risks, as well as the requirement of a speedy and reliable service, have risen
at the same pace.9

6.3 One Currency, One System

In the course of the 1990s, prior to the launch of the euro, payment and
securities settlement systems underwent fundamental changes everywhere
in the European Union, under the financial and technological impulses
described above. Central banks played a key role in promoting and guiding
the change; they restructured and modernized their own operations, pro-
moted cooperative arrangements among market participants, introduced
The Payment System: The Plumbing of Euroland 125

Table 6.1
Key indicators on payment instruments in euroland and the United States, 2001

Euroland United States

Volume Value Volume Value

(million) (billion euro) (million) (billion US$)

Banknotes and coinsa — 240.3 — 584.9

Cashless payment 39,438 202,899.4 77,041 794,205
instruments
Checks 5,871 6,122 41,223 38,909
Credit/debit cards 9,413 522.1 29,543 2,086
Credit transfers 13,597 189,898 3,890 744,578
Direct debits 10,453 6,356.9 2,385 8,632
E-money 104 0.4 — —

Sources: Payment and securities settlement systems in the European Union (Blue
Book), Addendum incorporating 2001 figures, ECB, September 2003. Statistics on
payment and settlement systems in selected countries (Red Book), figures for 2001,
BIS, April 2003.
a. In circulation outside credit institutions.

regulatory requirements for the minimization of systemic risk, and devel-

oped national RTGSs.
Throughout this reform and modernization process, and despite further
economic integration, the organization of payment services in Europe
remained country based. On the eve of the euro, the payment landscape
was still a patchwork of national systems, reciprocally segmented by their
currency specificity. In no sense was euroland a single payment area.
Although the term is still used to refer to payments across national
boundaries, within a single currency area the very notion of “cross-border”
payment has lost economic relevance. A payment in euro between Milan
and Brussels is “domestic,” while it is “cross-border” between Milan and
London, as long as the United Kingdom is not in euroland. Thus for
euroland to be a single payment area the cost, speed, and safety of a
payment between, say, Milan and Brussels had to be the same as between
Milan and Rome. We can call this a “condition of indifference.”
At the start of the euro in January 1999, euroland was quite far from
meeting the condition of indifference. Surveys showed that retail money
transfers between countries of the euro area were structurally, and often
sensationally, more expensive, slower, and less reliable than transfers
within countries. As to large value payments, the TARGET system ensured
126 Chapter 6

the transferability of central bank money in real time across euroland, but
the condition of indifference was not met either, as the price of a transfer
was very different from country to country. Euroland was largely seg-
mented in twelve country-specific components, with seventeen large-value
payment systems, twenty-three securities settlement systems, and count-
less overseers. This compares with two large-value payment systems, two
securities settlement systems, and two overseers in the United States.
Only with the advent of the single currency have the conditions, the
incentives, and the need arisen for the emergence of a single payment
system for euroland. As shown in the previous sections, the first and fore-
most condition is the singleness of the currency. The incentives consist of
the enormous increase in economies of scale and network externalities
offered by the move from a high number of systems of limited size to a
single, huge, euro areawide space. The need is strong for the private sector,
which requires payment services to be rapid, safe, and inexpensive. More-
over there is a need from the point of view of the public interest, because
a single and efficient system is part of the Eurosystem’s mandate and a con-
dition for the efficient transmission of monetary policy.10 This is the back-
ground against which to assess the strategies and perspectives of euroland’s
payment system.
Despite the needs and the incentives, and despite the provisions of the
Treaty, in the early years of EMU the movement toward a single, efficient,
and secure payment area for the euro has been slowed by difficulties and
impediments. One could wonder why market forces did not smoothly lead
to the optimal configuration. Historically the evolution of payment systems
has never been driven by competition alone, but by a peculiar combina-
tion of cooperation, public action, and competition. Moreover cooperation
among market participants rarely materializes without the public authori-
ties actively playing the catalyst role. And the task of drawing the bound-
aries between the respective camps of the three driving forces has rarely
been fulfilled by the invisible hand of market forces.
Now, while none of this would be a problem in a “normal” country, it
is one in euroland, where the initial segmentation of financial systems and
infrastructures is strong and the vested interests defending the status quo
are often as powerful as the advocates of change. An efficient and safe
single payment system of euroland would immensely benefit all the users,
but it would advantage only some of the service providers now operating
in the field. Even in a positive sum game there may be losers. The payment
industry is not made of a mass of small operators individually unable to
influence market conditions. It is made of powerful entities, often semi-
The Payment System: The Plumbing of Euroland 127

public in their ownership structure and capable of influencing private

sector decisions.
In these circumstances only great determination and powerful initiatives
by the Eurosystem could promote change at the speed required by the
interests of often voiceless end users. Given their dual profile, however,
national central banks themselves are caught in this tangle. While the ECB
Council is mandated to optimize the single overall system of euroland, and
national central banks, as components of the Eurosystem, are “governed”
by the ECB Council, as national institutions they tend to be defenders of
the status quo. All this makes their position awkward.

6.4 Banknotes and Other Retail Payments

The efficiency and safety of the medium of exchange function of money

in everyday life is, for the general public, an integral part of the quality of
money. Slow, unsafe, cumbersome, or technically faulty money transfers
undermine confidence in the currency just as inflation does. In the Euro-
pean Union the free movement of goods, services, capital, and people
would not yield all its potential benefits if individuals could not receive
and send money within the whole area as rapidly, reliably, and cheaply as
within any member state.
Making euroland a single retail payment area, namely a “normal”
country from a monetary point of view, implies the accomplishment of
three circumstances. First is replacing all national notes denominated in
the pre-euro currencies with a single stock of notes and coins denominated
in euro (the so-called cash changeover). Second is making the cost and
speed of a money transfer indifferent to national borders, namely by
achieving the condition of indifference. Third is preserving fungibility,
that is, making the various forms of money used for retail payments fully
interchangeable.
While, prior to the start of EMU in January 1999, European central banks
devoted all effort in the field of retail payments to the preparation of the
new banknotes, after that date payments in commercial bank money drew
increasing attention.11
The cash changeover was a huge logistical operation that started on
December 16, 1995, when the European Council decided that “euro”
would be the name of the new currency and ended on February 28, 2002,
when national notes and coins were no longer legal tender.12
Once the name was chosen, the preparation went on with the planning
of the new notes and coins, their denomination, subject, design, colors,
128 Chapter 6

security features, type of paper, and metal. It continued with the decision
of the amount to be printed and minted, and then with the actual pro-
duction. Around 14.9 billion banknotes and 51.6 billion coins were pro-
duced. Banknotes were produced in fifteen printing works, of which five
are owned and run by central banks. Complex quality control procedures
were put in place to ensure that the same, say, 10 euro banknote produced
in fifteen printing works would be identical. On a given banknote there are
no recognizable signs allowing the bearer to understand whether it was
printed in Italy, or Finland, or any other country.
Prior to, or immediately after, the actual changeover over two hundred
thousand cash dispensers and about ten million so-called vending
machines (supplying food, gasoline, train or parking tickets, and other
goods or services against cash) had to be converted to the euro. Moreover
notes and coins were pre-distributed to banks and retailers for them to be
adequately supplied from day one.
Since national currencies also circulated abroad, an important cash
changeover had also to be organized outside euroland. It was estimated
that between 30 and 40 percent of the total Deutsche mark currency in
circulation was outside Germany. In some countries or territories, like
Bosnia or Kosovo, the Deutsche mark was the legal tender. Other national
currencies such as the Austrian schilling, the French franc, and the Spanish
peseta also circulated outside the respective countries, albeit in much
smaller proportions.
The changeover implied a change in unit of account, not only in the
medium of exchange. Indeed, although goods and services could have
been priced in euro as of January 4, 1999, for goods and services widely
traded by the general public the new pricing (unit of account) came only
with the change in payment practices (medium of exchange). Although
less visible, the logistics of the change in unit of account was a not less
complex operation than the change of notes and coins, as it required
millions of producers and shopkeepers to convert accounting practices,
computer programs, forms, price lists, and so on.
Even more subtle is the change in unit of account that has to occur in
the mind of every person (be it a consumer, a retailer, an industrialist, or
a Minister of Finance). Indeed every person—including the author of this
book—carries in his memory a sort of price list for a vast number of goods,
services, and magnitudes. On the basis of such list reflexes have been
trained to gauge the adequacy of a price or the realism of a figure. The
“changeover” of this human memory from the old to the new unit of
account is slow and presumably still far from completed.
The Payment System: The Plumbing of Euroland 129

After years of preparation the final act (the actual replacement of notes
and coins), initially planned to spread over a six-month period, then short-
ened to two months, was consummated in a matter of days if not hours.
In a majority of countries the changeover was virtually completed in the
first days of January 2002. By the end of January national currencies had
practically disappeared from everyday use. In all countries ordinary people
proved keen to enter the new standard as rapidly as possible.
In the foreign exchange market, in monetary policy, in stock exchanges,
in the denomination of public debts, national currencies had ceased to
exist three years before the cash changeover. For economists and central
bankers the euro had started then. Yet, in the imagination and psychology
of the people, the much talked about single currency became a reality only
when it could be seen and touched in the form of notes and coins. That
was a moment of enthusiasm and emotion, marked by the popular senti-
ment that a major step in the half century long process of constructing a
united Europe was then accomplished.
Turning to the condition of indifference, the second requirement for a
single payment area, while for central bank money this was achieved in
early 2002, it was still unfulfilled for commercial bank money. The speed
and fees of transfers of deposits remained grossly different depending on
whether the transfer was made within or across countries.13 This is despite
the fact that the banking industry was given the opportunity to run ahead
of the central bank with its own form of money. As the spontaneous play
of market forces failed to provoke any perceptible movement toward the
formation of a single payment area, the ECB gradually stepped up its
pressure, acting as a catalyst for change rather than getting operationally
involved. In 1999 it set as an objective for the year 2002 that in parallel
with the introduction of the new notes and coins, the banking commu-
nity should substantially improve cross-border payment services in terms
of cost and execution time.
Since the situation was not improving, by mid-2001 the European Com-
mission proposed a Regulation on Cross-Border Retail Payments in euro,
obliging banks to bring their cross-border charges down to the level of
domestic ones. Only then did banks present a proposal for a stepwise
elimination of the additional charges for cross-border credit transfers. The
Regulation was nevertheless adopted in December 2001.
As to the third accomplishment—the preservation of fungibility—the chal-
lenge did not come from the advent of a single currency in euroland but
from innovation brought about by new technologies in the field of retail
payments. The 1980s had seen the spreading of automated teller machines,
130 Chapter 6

debit and credit cards, point-of-sale terminals, and home banking. Trans-
action costs in commercial bank money shrank, and the share of cashless
payment instruments grew at the expense of banknotes and other paper-
based instruments. However, important as these developments were, the
retail payment industry did not modify its fundamental feature of being
based on commercial bank money.
More recently the challenge of innovation has come under a new form—
called electronic money or e-money—whereby, for the first time, money
can circulate independently of any book entry in the banking system in a
form differed from notes or coins. Electronic money can in fact be defined
as a payment instrument allowing monetary value to be electronically
stored on a technical device; the amount stored is decreased or increased
whenever the owner uses the device to settle a transaction. This new form
of money has the potential to become an attractive alternative to both
bank deposits and banknotes. The spreading of its use could change sub-
stantially the traditional structure of retail payments based on commercial
bank money. It could also challenge the provision of payment instruments
and settlement services by banks.
Although its spreading has so far been slow, the use of e-money could
accelerate, once a critical mass is reached. If redeemability of e-money into
commerical bank money and central bank money were not guaranteed,
monetary systems would go back to where they were before a single issuer
of banknotes was established. If the same path is followed, multiple units
of account would emerge, competition between them would give rise to
excessive circulation, leading to the collapse of the value of the overissued
currencies, crises of public confidence, and systemic contagion through the
rest of the financial system. A policy to address these concerns was set out
by the ECB in 1998. The core of this policy was that issuers of electronic
money should stand ready to redeem e-money in commercial bank money
or in central bank money at par. The ECB urged that to ensure this, only
credit institutions should be entitled to issue e-money. This requirement
became the cornerstone of the new Community regulatory framework pro-
posed by the European Commission in 2000.14

6.5 Large-Value Payments

In the field of large-value payments, two conditions had to be fulfilled

for EMU to start: the existence of a single, area wide RTGS system and
the safety of the other systems which were also to process large-value pay-
ments in euro.
The Payment System: The Plumbing of Euroland 131

TARGET (Trans-European Automated Real-time Gross settlement Express

Transfer) is the system that satisfies the first condition. By linking together
all national RTGS systems of the EU member states, it constitutes de facto
a euro areawide RTGS. As such it provides an overall infrastructure for the
processing of both domestic and cross-border payments in euro. Without
TARGET, the euro area money market would remain segmented in national
markets, interest rates would differ across financial centers, and the single
monetary policy would stumble at the first step of the transmission mech-
anism. The Eurosystem needed a mechanism to transfer liquidity between
the books of the NCBs just as the Deutsche Bundesbank or the Fed had
previously done for the Landeszentralbanken (regional central banks) or
Federal Reserve District banks.
TARGET has the unique feature of being open to EU central banks not
participating in the euro. These are the central banks of the United
Kingdom, Denmark, and Sweden, and of the ten new members of the
Union. Although justified by the special features and circumstances of the
EMU, this was a possibly pathbreaking decision, because it was the first
time that a central bank allowed its own currency (the euro) to be offered
for settlement facilities by central banks issuing different currencies.15
Given the special circumstances justifying the decision, the ECB comple-
mented it with a confirmation of the general rule, according to which, as
in other monetary systems, central bank money in euro can only be created
by the central banks of the Eurosystem.
The second condition to be met before the launching of the euro con-
cerned the netting systems operating in parallel with TARGET. There were
five such systems in 1999, with only three processing significant amounts.
They all had to be made compliant with the minimum standards set in
1990 by the G10 governors.
TARGET started its operations on January 4, 1999. The average daily
volume of payments represents about 55 percent of the volume and 100
percent of the value processed by Fedwire, which is the equivalent US system.
In 2002 TARGET processed about 85 percent of the value of the interbank
payments in euro and served as the settlement vehicle for other systems.
The rest of interbank payments were made via net settlement systems.
In the mid-1990s, when TARGET was designed, the single currency was
still a distant and somewhat uncertain event. As the main focus of each
central bank in Europe was to develop a national RTGS, it was decided not
to build a common infrastructure but simply to connect national systems,
subject to a minimum harmonization. Satisfactory as it may have been for
the early years of the euro, TARGET is not a sustainable arrangement over
132 Chapter 6

Table 6.2
Evolution in the value of transactions in euroland and the United States, 1990–2001

1990 2001 Increase,

Euroland (billion ECU) (billion euro) 1990–2001

Large-value payment systemsa 46,387 440,152 849%

Mixed payment systems 76,691 NAb NAb
Retail payment systems 5,898 15,392 161%
Total 128,976 455,544 253%

1990 2001 Increase,

United States (billion US$) (billion US$) 1990–2001

FEDWIRE 199,100 423,867 113%

CHIPS 222,100 311,707 40%
Retail payment systems 17,815 32,855 84%
Total 439,015 768,428 75%

Sources: For euro transactions: Payment systems in EC member states, Committee of

governors of the member states of the European Economic Community, September
1992. Payment and securities settlement systems in the European Union (Blue
Book), addendum incorportating 2001 figures, ECB, September 2003. For US trans-
actions: Payment systems in the Group of Ten countries. BIS, December 1993. Sta-
tistics on payment and settlement systems in selected countries (Red Book). Figures
for 2001, BIS, April 2002.
a. Included TARGET.
b. Not applicable. Because of a methological change in statistical collection,
payment systems from 1999 are distinguished into large-value and retail.

the longer run. From a technical point of view, composed as it was of

fifteen national systems and as many devices to interconnect them with
each other, it was bound to encounter more frequent difficulties than an
organically designed system. From an economic point of view, the system
was not cost effective and very few of its national components recovered
a reasonable fraction of their expenses.
The future of TARGET was also brought into question by the approach-
ing widening of its area of jurisdiction. Ten countries were to join the
Union in 2004, and many of them were likely to adopt the euro before the
end of the decade. The expansion of TARGET would have exacerbated
the current efficiency and cost problems and accelerated the search of
innovative solutions for the system as a whole.
Not long after the start of the euro, it thus became clear that TARGET
was confronted with a hard trilemma. Either it continued to fail meeting
The Payment System: The Plumbing of Euroland 133

the condition of indifference described above for retail payments, as fees

were widely different from country to country. Or, it moved toward a
uniform fee, which would entail over- and/or underpricing compared to
costs. Or else, it adopted a rather odd model of full-fledged competition
among national RTGSs, namely among its very components. As none of
these routes was really viable in the long run, and since, at any rate, tech-
nical obsolescence was approaching, the second generation of TARGET was
planned on the basis of a new approach.16
The trilemma was overcome in fall 2002 when the ECB Council designed
a second-generation TARGET, with a new technical infrastructure and a
new set of rules and pricing criteria. It was decided that a single shareable
platform would be developed, with all NCBs free to join it or to continue
running an own platform. NCBs would maintain their business relation-
ships with their banks. A uniform set of services and a single fee structure
would be adopted. Cost recovery would become mandatory for all
components.
In the field of large-value payments the Eurosystem, just like the Fed, is
also confronted with new developments concerning the settlement of
foreign exchange transactions. Because the two currencies involved in any
such transaction flow through different systems, the participant paying out
one currency has no guarantee to receive the other currency in return. This
risk is known as “Herstatt risk,” from the name of the bank that defaulted
in 1974 and materialized it for the first time.
In 1996 the central banks proposed that the banking industry should
provide multi-currency services.17 The response of the industry was to
develop a so-called continuous linked settlement (CLS) system, whose
purpose is to eliminate Herstatt risk by ensuring the simultaneous settle-
ment of both currencies linked to a foreign exchange trade.18 CLS started
to operate in September 2002.

6.6 Securities Settlement Systems

In recent years securities settlement systems have become the most

dynamic component of the overall payment system and a major concern
for central banks. As the final settlement of the securities leg and the cash
leg of a transaction increasingly tend to become simultaneous (so-called
delivery versus payment), payment flows generated by securities transac-
tions are part of the banks’ intra-day liquidity management. If securities
are not delivered, or not delivered on time, payments are equally delayed,
and ultimately a gridlock can arise.
134 Chapter 6

The Eurosystem is a regular user of securities settlements systems because

the provision of liquidity is conditioned to the prior or simultaneous deliv-
ery of adequate collateral (which normally takes the form of securities). If
securities settlement systems were not available or were not functioning
efficiently, the Eurosystem would not be ready to implement its monetary
policy operations, nor would it be ready to provide the intra-day liquidity
needed for the smooth functioning of RTGS systems.
In the area of securities settlement systems, as in retail and large-value
payments, the central issue facing the Eurosystem is the transformation of
euroland into a single “domestic” payment area, with a degree of effec-
tiveness, efficiency, and safety equivalent to mature currency areas. This
process of change is driven, but at the same time hindered, by a combi-
nation of market and policy forces.
Securities settlement systems have some features of natural monopolies,
such as network externalities, economies of scale, and economies of scope,
which have led, in most countries, to consolidation into one or two
systems only, often established by the law. Euroland, instead, retains a
highly fragmented infrastructure, inherited from pre-EMU time, when the
natural domain of the monopoly was the national jurisdiction of the cur-
rency and the central bank. Although the single currency denomination
for all securities makes euroland a single securities market, an integrated
settlement system for securities denominated in euro is still struggling to
emerge.
For one thing the advent of the euro and economies from information
technology have enhanced competition between national systems and
financial centers in a way that could lead to sharp consolidation. The com-
petitive process, however, has encountered obstacles, in both the private
and the public sphere. There is no competition, for example, when end-
users cannot freely choose which system to utilize. Free choice could only
be provided by an open architecture, where the use of a particular clear-
ing or settlement facility would not be compulsory for the users of a par-
ticular trading platform. Similarly trading platforms should not prevent
trades concluded on other platforms from accessing their own clearing and
settlement systems. Interoperability should allow a Spaniard and an Italian
trading BMW shares on the Deutsche Börse to settle the accounts they hold
in Iberclear (the Spanish SSS) and Monte Titoli (the Italian SSS) under the
same conditions as if they were trading, clearing, and settling in their own
domestic system(s).
The Eurosystem has so far remained neutral in the competition between
systems, financial centers, and categories of users. However, as the central
The Payment System: The Plumbing of Euroland 135

bank of euroland, the Eurosystem has a strong interest in the achievement

of a coherent “domestic” (i.e., euro area) securities infrastructure for the
euro. Such an infrastructure is actually necessary to ensure an efficient
transmission of monetary policy, to achieve efficiency in securities
markets, and to address liquidity problems that may be triggered by
payment, clearing, and settlement systems.19
The Eurosystem operates to foster a safe and efficient securities infra-
structure. In 1998 it defined standards from a user perspective. An inte-
grated regulatory and oversight framework is now being developed. At a
global level the Committee on Payment and Settlement Systems (CPSS)
and the International Organization of Securities Commissions (IOSCO)
developed, in 2001, “Recommendations for securities settlement systems”
from an oversight perspective.20 The ESCB and securities regulators of the
European Union are in the process of adapting and implementing these
standards.

6.7 Main Challenges

The move to the single currency has not produced, in the payment system
field of central banking, the sharp break in continuity that has character-
ized monetary policy. While an instantaneous regime shift occurred in
monetary policy on the night of December 31, 1998, in the financial
system and in payment services change has been much slower and even
uncertain.
In the field of payments, the Eurosystem is now facing a specific chal-
lenge, unlike other challenges it shares with other central banks of the
world. This challenge consists in shaping itself as a single—albeit decen-
tralized and federally structured—central bank, reaching the highest stan-
dards of effectiveness, efficiency, and safety. To successfully meet this
challenge, years, rather than annual quarters, will be needed. We have seen
in the previous sections how the Eurosystem is dealing, in the early years
of its life, with this challenge, which is specific to the peculiar nature of
its charter and of the “country of the euro.”
At this historic juncture the Eurosystem also faces more general chal-
lenges, which it shares with other central banks in the world. Four of them
are particularly relevant.
The first arises from privatization. Most monetary and financial systems
are encountering a rising trend to shift the dividing line between the public
and the private sector toward an enlargement of the latter area. Systems
that used to be seen as public utilities have been transformed into privately
136 Chapter 6

owned, profit-driven service providers. Banks that used to be owned by the

state have been privatized in many countries. More generally, the idea has
gained ground that public bodies should refrain from a number of their
regulatory and operational functions, which were for long considered their
prerogative.
A second challenge is consolidation. Pushed by competition and techni-
cal progress, financial institutions and markets strive to increase the scale
of their operations. In payment and settlement systems this is leading, for
example, to the progressive concentration of correspondent banking in a
few large banks acting as quasi-central banks as well as to the consolida-
tion of securities settlement systems. This may progressively reduce the
need for central bank money and at the same time increase systemic risk.
A third challenge comes from e-money. For the first time a type of money
appears, that the central bank (and, in the view of some, even commercial
banks) does not issue. To the extent that e-money might replace a signif-
icant and increasing portion of banknotes, a fundamental prerogative of
central banks could be eroded.
Fourth and last, these three challenges arise in the context of globaliza-
tion, which entails the emergence of global systems operating in multiple
currencies. In the absence of a global institution, no central bank alone
can cater the needs of a global system; each bank can, in principle, only
provide settlement in its own currency.
Each of these challenges has specific technical features and needs a spe-
cific policy response. Every central banker is nowadays already dealing with
each of them in its currency area, while cooperating with fellow central
bankers in the relevant international forums. Taken together, however, the
four challenges raise a more general and fundamental question of whether
there can be central banking without central bank money or, even more
radically, a monetary system without a central bank.21 Where does the
central banking community stand in this debate?
One certain point is ruled out: the two polar solutions of either no
central bank money at all or only central bank money. Beyond these
extremities different blends are conceivable to define an optimum as an
intermediate solution. One strongly rooted solution is the so-called Anglo-
American tradition, which leans toward letting the market decide, and
avoids the risks of policy interference in profit-driven choices and in the
innovation process. Implicit in this approach is that public intervention
should occur ex post and only after market failure in order not to distort
private incentives. This way, if alternatives to central bank money exist,
the market should—in the first instance—be free to use them. Another pos-
The Payment System: The Plumbing of Euroland 137

sible solution, one closer to the traditions of continental Europe and Japan,
leans toward setting up ex ante a firm regulatory framework within which
market forces are free to play. It is based on the conviction that the
payment and settlement services, the rules, and the oversight offered by
central banks are indispensable to the smooth functioning of the economy
and cannot be supplied by the market alone. The harmful effects of market
failure have been sufficiently experienced in the past and cannot be
allowed a chance to recur.
The Eurosystem brings to the debate its continental European tradition,
which is based on two components: the distinct role of central bank money
and the strict requirement of a license to conduct banking business.
A look at past monetary systems without central banks may help in dis-
cerning the future. As we saw earlier in this chapter, the plumbing was a
factor from the start of modern monetary systems. In Europe, central banks
developed when the production and management of a new medium of
exchange—paper currency—was recognized as a public function and
entrusted to an institution oriented to the public interest rather than profit
making. Earlier experiences indicate that in a free banking regime the
payment system overtakes the other central bank functions, including
monetary policy and banking supervision. In the absence of a formal
central bank, the plumber becomes the governor.
7 The Eurosystem in the Global Arena: A New Actor in a
New Play

The Economic and Monetary Union was not conceived to address an exter-
nal challenge. The challenge was rather intra-European. It meant comple-
menting the single market with a single currency, setting price stability on
a EU basis, and bringing forward the unification of Europe. Preparations
for the single currency were inwardly focused and the euro came to life
without program, ambition, or doctrine for its international role. Yet the
implications of EMU go well beyond the borders of Europe.
This chapter is devoted to the international role of the euro and the
Eurosystem in the current global architecture for monetary and financial
cooperation. After assessing the quantitative relevance and the policy
issues related to the role of the euro as an international currency (section
7.1), I move to exchange rate relationships, which—as the primary link
between currencies, economies, and countries—constitute the main
theme of the chapter. Four sections deal, respectively, with the perfor-
mance of the euro in the foreign exchange market in the first years (section
7.2), the exchange rate relationships between the three key world curren-
cies (section 7.3), and the role of the euro for those third currencies, which
seek an external anchor (sections 7.4 and 7.5). In the final section (section
7.6), I discuss cooperation for financial stability.

7.1 The Euro outside Euroland

The role of an international currency may be assessed by the extent to

which nonresidents use it as a store of value, medium of exchange, and
unit of account (table 7.1). And since public authorities and market par-
ticipants are driven by different motives, it is convenient to distinguish
nonresidents into official and private.
When examining the international use of a currency, one should also
bear in mind that, unlike its domestic use, the international one entirely
140 Chapter 7

Table 7.1
Functions of international currencies

Use by residents of an area other than where

currency is issued

Functions of money Private use Official use

Store of value Investment and financing Reserve currency

currency
Medium of exchange Payment/vehicle currency Intervention currency
(1) in exchange of goods
and services
(2) in currency exchange
Unit of account Pricing/quotation Pegging currency
currency

Source: ECB.

lacks an institutional underpinning. While the domestic use of money

is fundamentally determined by institutional arrangements, the inter-
national use is driven by habit and reflects political as well as economic
considerations. For the international use the pace of change is the nor-
mally slow pace at which market practices and network externalities
change. Thus the British pound still had an important international
role decades after the United Kingdom had ceased to be a global economic
and political superpower. The international use of a currency is driven
neither by decrees, nor by institutional arrangements. Growing liberaliza-
tion and globalization of financial markets further limit the bearing
policy makers could directly have on such a use. Precisely because it is
habit-driven, the international use of a currency does not evolve at the
same speed for the three functions, nor for the two categories of official
and private users. Evolution is slowest for the unit of account function, as
this is most dependent on the inconvenience of changing standards of
measurement. At the opposite extreme, the store of value function can
move at the same high speed at which portfolio decisions are taken and
reviewed.
Official holders outside euroland use the euro, as indicated above, for the
three purposes of reserve currency (store of value), external anchor (unit
of account), and intervention vehicle (medium of exchange). As to the first,
at the end of 2002, the euro accounted for 18.7 percent of the world foreign
exchange reserve assets. This share is close to that observed for the national
currencies prior to the introduction of the euro (mainly the Deutsche
The Eurosystem in the Global Arena: A New Actor in a New Play 141

mark) and compares with 64.8 and 4.5 percent for the US dollar and the
Japanese yen.
As to the anchor role, at the end of June 2003 about fifty countries in
the world had an external anchor where the euro played some role, a fact
that will be further analyzed in section 7.5. Finally the intervention role
is mainly related to the anchor role, although, also for currencies not
pegged to the euro such as the Japanese yen, the euro was partly used for
intervention purposes.
Turning to private users, they have been quite active in borrowing or
investing in euro, namely in the store of value function. Since it holds a
total amount of financial assets far exceeding official reserve holdings, and
since it usually adjusts its asset and liability positions more frequently than
central banks, the private sector exerts a dominant influence on market
developments.
In 1999 to 2002 the average share of the euro in bond issuance by non-
residents was around 28 percent, while pre-euro currencies had a share of
19 percent in the period 1994 to 1998. The key driver of this expansion
has been the greater liquidity of the euro-denominated bond market
arising from the pooling of demand from the twelve member states as well
as the desire by non–euro area borrowers to enlarge their investor base for
the euro. In the same four years the performance of the euro in the issuance
of paper on the international money market has been even stronger.1 As
to investors, at the end of 2002 the euro accounted for an estimated 26
percent of bond portfolios of major global asset managers (against 51 and
14 percent for the US dollar and the Japanese yen respectively). At the same
date, equity holdings accounted for 22 percent (52 and 8 percent for the
United States and Japan).2
Turning to the uses as a unit of account and medium of exchange, the
available evidence suggests that, at the global level, the euro currently plays
a more limited role. Internationally traded goods and services are pre-
dominantly priced and paid in US dollars, regardless of their origin or
destination. Foreign exchange operations between not widely traded cur-
rencies are largely conducted via the US dollar, namely by splitting the
trade in two transactions against the US dollar. The predominance of the
dollar is unshaken, mainly because of inertia in market practices, network
externalities, and economies of scale.
What is the Eurosystem policy concerning the international use of the
euro? Part of the public opinion frequently holds the view that the inter-
national role of a currency is the result of a deliberate strategy. To many
people around the world, the dollar is the very epitome of the American
142 Chapter 7

superpower. To many Europeans, the adoption of a single currency was

seen as a means “to match the might of the dollar.”
Despite this popular view the reality of today’s world is that there is no
deliberate policy behind the expansion or the contraction of the interna-
tional use of a currency. The international use of a currency is mainly
“demand driven,” determined by independent decisions of private end
users. Even if the Eurosystem wanted, it could neither directly foster nor
directly hinder the international role of its currency in a significant way.
Both public policies and politics, however, do have an indirect influence.
Market participants and official authorities of third countries take the eco-
nomic and financial policies of a country into account when considering
denominating their liabilities, allocating their portfolios among different
currencies, or invoicing external trade. Moreover they do look at political
and strategic factors. At the technical end of the spectrum, measures pro-
moting an efficient and fully integrated financial market are likely, if suc-
cessful, to make the euro more attractive to international borrowers and
investors, thereby increasing its role as a store of value. At the political end
of the spectrum, progress—or lack thereof—toward EU political union
influence private and public decisions taken outside euroland about the
euro. Clearly, if the People’s Bank of China increases the proportion of the
euro in its reserve holding, it is on the basis of a political, not only of a
financial, decision.
The Eurosystem’s attitude toward the internationalization of its currency
can hardly be compared with that of other countries in the past, because
historical and political factors are so different. The rise in the international
role of the pound sterling and the dollar was inseparably linked to the rise
of United Kingdom, first, and the United States, later, to the status of
leading global power. After the Second World War, in particular, the dollar
was formally assigned the pivotal role in the Bretton Woods system and
the United States enjoyed the benefits of, and bore the responsibility for,
that role for more than twenty-five years.
As to the Deutsche mark, the development of its international role fol-
lowed a completely different path. On a global scale, Germany resisted the
internationalization of its currency for reasons that were both political
and economic. Politically, it was because of the low profile attitude taken
by Germany after 1945 in international relations, as a consequence of the
disastrous events of the previous years. Economically, it was for fear that
the internationalization of the national currency would interfere with the
conduct of its price stability oriented monetary policy. This reluctance,
however, could not prevent the Deutsche mark from becoming increas-
The Eurosystem in the Global Arena: A New Actor in a New Play 143

ingly used internationally by virtue of the excellent domestic performance

and the growing role of Germany as a trade partner. Nor did it make
Germany unwilling to let its currency play the anchor role for a large
portion of Western Europe.
None of these past examples fits euroland’s case. The political factors
that played so strongly in those other historical experiences are not there
today, and at the same time, the economic size of euroland is such that
the international role of the euro is both hard to avoid and unlikely to
unduly influence domestic stability. The Eurosystem is concentrated on the
successful implementation of the price stability mandate imparted to it by
the Treaty and regards the internationalization of the euro not as a policy
goal but, if anything, as a reward of a good domestic performance of the
currency. On the one hand, the fact that a widely used international cur-
rency grants extra seigniorage to the issuer and facilitates the financing of
external deficits is not an inducement to foster the internationalization of
the euro. On the other hand, there is no ground, for the Eurosystem, to
inherit the traditional Bundesbank mistrust toward an international role
of the currency, for fear that this could thwart a price stability oriented
monetary policy.

7.2 Fall and Rise of the Euro

Well before the launch of the euro, its exchange rate developments started
to attract some interest among both the specialized and the general public.
Among specialists, speculations abounded about the most likely course of
the euro and a widespread view was that the exchange rate would have
appreciated in its early years, mainly because international portfolios
would have been diversified from US dollars into euro.3 The general public
was led to share this expectation. To many ordinary people the promise of
“a euro as strong as the Deutsche mark,” to which we referred in chapter
4, was interpreted as the promise of a strong exchange rate.
Actual developments rapidly contradicted these expectations. For an
initial period of about seven quarters, the euro declined, losing 23 percent
in nominal effective, trade-weighted, terms between January 1, 1999, and
October 26, 2000. The decline vis-à-vis the US dollar—which accounts
for 25 percent of the trade-based basket used to calculate the effective
exchange rate of the euro—has been, over the period, in the order of 30
percent (figure 7.1).
The long descent of the euro produced wide disappointment. When the
euro went below parity to the US dollar on January 27, 2000, part of the
 144 Chapter 7

1999q1 = 100 USD/EUR

125 1.5

120 1.4
115 1.3
110
1.2
105
1.1
100
1.0
95
0.9
90

85 0.8

80 0.7

75 0.6
1975 1980 1985 1990 1995 2000

Euro real effective exchange rate (lhs) (average 1975–2003)

Exchange rate vis-à-vis the US dollar (rhs) (average 1981–2003)

1999q1 = 100 JPY/EUR

125 350

120
300
115

110 250

105
200
100

95 150

90
100
85

80 50
1975 1980 1985 1990 1995 2000
Euro real effective exchange rate (lhs) (average 1975–2003)
Exchange rate vis-à-vis the Japanese yen (rhs) (average 1978–2003)

Figure 7.1
Exchange rates. Sources: ECB and BIS.
The Eurosystem in the Global Arena: A New Actor in a New Play 145

press and analysts talked of a scorching defeat of the new currency by the
market. Put on the racetrack, the announced winning horse did not seem
fit to run. The unsophisticated public considered that the promised strong
currency was not being delivered.
It is not quite surprising that perceptions about the strength and quality
of the new currency have been—and to some extent still are—strongly
influenced by the exchange rate. In most European countries the general
public used to consider the exchange rate as the prime indicator of overall
stability and strength of the national currency. Moving from the Bretton
Woods regime, to the snake, to the EMS (see chapter 1), most countries in
Europe—the relevant exception being Germany—had lived almost perma-
nently in a world of fixed exchange rates. Because of the very large size of
the external sector compared to the overall size of the national economy,
the price dynamics of most countries was largely determined by the
exchange rate. In most European countries, a devaluating or depreciating
currency was considered a sign of general weakness, a defeat, an event asso-
ciated with inflation, often coupled with wage restrictions and budgetary
austerity.
The transition to the single currency should have wiped out these “open
economy” or “fixed exchange rate” instincts, which were no longer sub-
stantiated by the new economic reality of euroland, much less open than
its component states. Not surprisingly, however, the change of instincts
did not come immediately, as entrenched habits and the absence of a float-
ing exchange rate culture could hardly be corrected in a few quarters.
The early reaction also explains the asymmetry between European and
American attitudes. The concerns for the weak euro indeed failed to be
matched by an equivalent concern for the strong US dollar, although the
US economy was running a sizable external deficit, while euroland was in
balance, and despite the similarities between the two economies. Euro-
peans look at the external value of their currency much more closely, and
even anxiously, than the Americans. For Americans “a dollar is worth a
dollar.” For a French or an Italian citizen a franc or a lira used to be worth,
first, “that many dollars” or, since the mid-1970s, “that many Deutsche
marks.”
In the host of explanations brought forward while the euro weakened,
the one to which analysts and market participants returned most fre-
quently was the actual and expected growth differential in euroland and
the United States.4 However, also fancier arguments were put forward, such
as the claim that an “invisible currency,” meaning a currency that did not
circulate in the form of notes and coins, could not generate confidence
146 Chapter 7

among the people and was therefore bound to fall. In a similar vein it was
suggested that the decline came from sales of stocks of illegally held and
earned, or simply circulating outside euroland, banknotes to be converted
in dollars for lack of euro notes.5 It was also noted that the decline of the
euro was magnified by the fact that euro started from a position that, com-
pared with its average over 1997 and 1998, was relatively high in nominal
effective terms.6
In spring 2000, Wim Duisenberg, the then president of the ECB,
publicly commented that “The exchange rate of the euro does not reflect
the ongoing improvement in domestic fundamentals in the euro area
economy.” In less diplomatic language, this could be interpreted as meaning
“the market is wrong,” in more academic language that the market was
“overshooting.”7 The view that the market was going too far was repeated
by the ECB in subsequent months and was widespread also among analysts
and observers, although most did not expect the trend to reverse soon.
The Treasuries and central banks of the G7 took the same view in Sep-
tember 2000 and jointly intervened in the foreign exchange market,
buying euro and selling other currencies, at the end of that month. A
second round of intervention was made by the ECB at the beginning of
November 2000.
Seen in retrospect, part of the decline of the euro appears just as another
episode of exchange rate overshooting, a type of event periodically exhib-
ited by the post–Bretton Woods floating regime. That the market “over-
shoots” does not mean, of course, that it has no story to explain its
behavior, nor that its story is factually false (in the case of the euro, as we
noted, there were quite real differentials in income and productivity
growth). Rather, it means that the story is partial; it overlooks factors that
over time do concur in the determination of the exchange rate but, for
some reason, are temporarily disregarded. Market participants are often the
first to be aware of their “partiality,” but they also know—or believe—that
putting their money on a bet with stronger and more complete analytical
foundations would cause a loss.
It is thus not surprising that the “traditional” determinants of exchange
rate developments—focusing on fundamental and permanent factors of
influence—did not succeed in providing a satisfactory explanation. For
example, compared to the United States, the euro area had better price sta-
bility and no significant macroeconomic imbalances like the exorbitant
accumulated US external debt and deficit.8 Similarly several econometric
models, tested to link the exchange rate to a range of macroeconomic fun-
The Eurosystem in the Global Arena: A New Actor in a New Play 147

damentals, were generally unable to account for the full decline of the
euro.9
The long descent of the euro ended shortly after the concerted G7 inter-
vention, in the fall of 2000. The descent was followed, for about five quar-
ters until spring 2002, by a prolonged stability in a range comprised
between 0.85 and 0.95 to the US dollar, a level that most analysts still
judged “low.”
In April 2002 the euro started to move sharply up vis-à-vis the US dollar
and passed the parity on July 15, 2002. Over a period of fifteen weeks—
between April 1, 2002, and July 15, 2002—it gained 6 percent in nominal
effective terms and 14 percent to the US dollar. Following another phase
of relative stability, the euro strengthened again between November 2002
and January 6, 2004, when it reached its historical record at 1.2858 against
the US dollar.
One could say that with the rise back above parity the euro had come
of age. Its movements are now likely to be seen as those of a normal cur-
rency, not as indicators of whether or not it was a good idea to adopt a
single currency, whether or not euroland is a success story. Markets have
accepted that a currency, rather than being the expression of a full-fledged
state construct, can be issued and managed by the central bank of what in
previous chapters I called a polity-in-the-making.
It should be recalled, once again, that measuring the success of the new
currency on the yardstick of the exchange rate is a misconception. The
adoption of this yardstick was a prolongation of the fixed exchange rate
mentality that had characterized most euro area countries before the single
currency, and also reflected the desire of the media and communication
system for a daily indicator. However, it was not the yardstick used for
major international currencies, including the Deutsche mark prior to EMU,
which in the 1980s had fallen well under the low level later reached by
the euro. Nor was it a goal set by the Treaty.

7.3 Three Floating Currencies

For a largely accidental reason, the advent of the euro coincided with a
new round in the international debate over the appropriate exchange rate
regime among the main international currencies. The debate was triggered
in the fall of 1998 by the German Finance Minister Oscar Lafontaine.
Tighter exchange rate arrangements among the US dollar, the euro, and
the Japanese yen were proposed, in the form of so-called target zones,
148 Chapter 7

namely predefined fluctuation bands. Rates would move freely within the
targeted zone, but action should be taken to prevent them from trespass-
ing. The proposal was discussed and eventually discarded.10
The key arguments that won the case can be recapitulated as follows:
Establishing a formal scheme would require the leading industrial coun-
tries to agree on desirable exchange rate levels, which would prove
extremely difficult, in view of the lack of strongly based criteria for esti-
mating equilibrium exchange rates. Indeed, while for price stability (the
value of money in terms of goods and services) there exists a sufficiently
precise and widely accepted quantitative measure, for the value of money
in terms of another money there is no reliable compass. Assessing the equi-
librium exchange rate on the basis of the underlying fundamentals is
difficult and controversial.11 Moreover, while there is little disagreement
about the desirability of stable prices, exchange rate variations are regarded
by many as a useful, even indispensable, adjustment mechanism for an
economy.
Perhaps more important is the argument that none of the leading central
banks—mandated as they are to pursue domestic objectives for which they
are accountable to their domestic constituencies—would now be willing
to forgo domestic policy objectives in order to keep the exchange rate
within the agreed range. The experience with what, in chapter 1, I have
called the inconsistent quartet (i.e., the incompatibility between free trade,
capital mobility, stable exchange rates, and independent monetary poli-
cies) has repeatedly indicated that conflict can hardly be avoided. Difficult
to reach, an agreement on the level of the exchange rate would be
even more difficult to enforce in today’s highly integrated international
capital markets. In theory, the system could function if all countries agreed
to give one of them the anchor role, as it happened under the Bretton
Woods and EMS regimes. Such a hierarchy, however, would be economi-
cally unfeasible and politically unacceptable in today’s circumstances. This
is why both the Eurosystem and the US authorities expressed serious reser-
vations about any scheme to enforce stability between the three main
currencies.
That early debate has shown that the advent of the euro is unlikely to
lead to new attempts to take back from the market—to which it has been
entrusted in the early 1970s—the task of determining the exchange rates
of the key currencies. Yet this conclusion, which tends to be accepted with
greater or smaller satisfaction depending on one’s degree of “market opti-
mism,” does not cross out exchange rates from the list of policy concerns.
Nor does it exonerate monetary authorities and economists from the task
The Eurosystem in the Global Arena: A New Actor in a New Play 149

of reflecting about the strengths, weaknesses, and possible improvements

of the present regime. Several questions have to be addressed.
The first question is: Will the exchange rate of the key currencies con-
tinue to exhibit the high variability of the past twenty-five years?12 A con-
clusive answer is difficult to formulate because different arguments point
in opposite directions. European attitudes toward exchange rate develop-
ments could become more detached because euroland is a far less open
economy than its national components were.13 In the opposite sense,
however, the relatively new fact that all the three leading economies—
United States, euroland, and Japan—clearly gear their monetary policies
toward medium-term price stability could favor more stable exchange rate
relations.
The proposition that price stability should lead to nominal exchange rate
stability is far from accepted in theory and, in practice, is not supported
by the experience of the early years of the euro. As in the past the foreign
exchange market seems to remain prone to episodes of over- and under-
shooting like the one observed for the euro in 1999 to 2000 and, before
then, for other currencies. All in all one could hardly expect, for the years
to come, a significant decline in exchange rate variability, in the form of
both short-term volatility and—what is more important—prolonged
misalignments.
This leads to a second question: Should persistent exchange rate vari-
ability be a cause for concern? In my view, the answer is yes. Although
little can be done to avoid them, the costs and damages that high exchange
rate variability inflicts on economic activity, financial stability and the
climate of international relations can not be denied altogether.14 Large and
prolonged misalignments negatively affect macroeconomic stability, gen-
erate uncertainty, distort the allocation of real and financial resources,
determine shifts in competitiveness, and foster trade conflicts and pres-
sures for protectionism.15
Thus, a third question arises: Are there policy remedies to excessive
exchange rate variability? Here is where the main difficulties are. If the
exchange rate is unlikely to become an objective for the major economic
players, international cooperation can only pursue exchange rate stability
indirectly, and the instruments available to this end are limited.
When inadequate macroeconomic or structural policies are seen as the
cause of large exchange rate movements, international cooperation may
try to mount peer pressure for adoption of the corrections needed to restore
stability. When misalignments are seen to arise from market uncertainties
or misperceptions of actual or future policies, cooperation may be used to
150 Chapter 7

try correcting market perceptions by way of coordinated information

and communication. Stronger measures, aiming at building more stability
into the market mechanism, such as through restrictions on capital move-
ments, are much harder to design and their effectiveness is at best
doubtful.
Thus, for the undesirable exchange rate variability that will persist even
if no fundamental policy mistakes are made, only symptomatic cures are
available, in the form of declarations and occasional interventions. This is
indeed what key industrial countries have resorted to since the collapse of
the Bretton Woods regime, and it is fair to say that such symptomatic cures,
while producing some effect on some occasions, have not fundamentally
corrected the imperfections of the market mechanism.
In conclusion, and looking at the years to come, the relationships
between the dollar, the yen, and the euro are likely to remain left to market
determination, with only occasional and limited interference by public
authorities. As there are no signs that other currencies will soon achieve
the status of international currency, the world will remain one of three
floating currencies, with a clear ranking between the three.
All in all, the policy side of the present exchange rate relationships is
quite limited, it has no rules, and is largely handled by the G7. Whereas
the Bretton Woods system was based on a combination of firm rules with
an institution empowered to ensure their implementation (the IMF), in
today’s exchange rate relationships the IMF does not play a significant role
any longer. Discussions on the three key currencies and their respective
economies take place within the small circle of the G7. In that group no
formal decision-making procedures exist and the IMF is relegated to the
role of a technical secretariat. The agreed G7 communiqué rarely modifies
policies that would have been followed anyway. Implementation of the
conclusions is voluntary.
This very soft governance of the three key currencies and areas is con-
sistent with the “hands-off” attitude of today’s public authorities. Such atti-
tude, in turn, results from a combination of factors like the overwhelming
power of the private sector, the dominant intellectual paradigm of market
optimism, and the strong reluctance of national powers to share sover-
eignty internationally. Obviously no mechanism of this kind would be
effective if its ambition was to effectively influence exchange rates, as it
lacks the basic decision-making procedures and action tools that consti-
tute the very essence of any policy-making. The mechanism hardly func-
tions otherwise than as an instrument for crisis management, because only
a crisis or a near-crisis provides the extra incentive to reach agreements
that go beyond exchanges of views and information.
The Eurosystem in the Global Arena: A New Actor in a New Play 151

In the foreseeable future, the configuration of major players, institutions,

market structures, cooperation practices, and intellectual paradigms
described here is unlikely to change. If, however, one looks beyond the
so-called foreseeable future (whose length nobody knows), it cannot be
excluded that the present configuration may suddenly come under
discussion. The absence of the IMF from any meaningful role in policy
discussion can be hardly justified. The composition of the G7 fails to cor-
respond to monetary realities. The allegation that the market is always
right and always stronger than the policy-maker is just an allegation. The
affirmation that wide misalignments are impossible to assess and do little
harm is pervaded by complacency.
Moreover new changes may be incubating. As countries like China,
India, and Russia become more open, more market oriented, and more
financially relevant, the number of key currencies can be expected to
increase. Market structures and practices could evolve toward greater insta-
bility and volatility. The pendulum of academic and expert opinion might
swing away from the pronounced market optimism that has prevailed in
the last two decades.
The question of how to manage a more complex multi-currency system
could thus be reopened, although it is very hard to speculate about the
direction a “return to policy” could take. Our conclusions on the exchange
rate debate are therefore permeated with awareness that the future is open.

7.4 Pegs and Corners

Besides the three countries discussed so far, many of the nearly two
hundred countries remaining have a good many reasons to pursue an
exchange rate objective. These reasons range from the size and openness
of the economy, to the quest for credibility, to the strong trade links with,
and financial dependence on, a large neighboring country.
For many decades the instrument most frequently chosen to integrate
the exchange rate objective in the monetary policy strategy consisted in
anchoring or “pegging” the national currency to a major currency, gener-
ally the US dollar.16 The instruments used to this end included setting
domestic interest rates, buying and selling the national currency against
the anchor currency, and imposing restrictions on foreign exchange trans-
actions. Of course, in a wider sense, all domestic macro- and microeco-
nomic policies contribute to the determination of the exchange rate and
hence to sustain, or to undermine, the pegging strategy.
With a large global financial market, capital easily flows into, and out
of, countries, in pursuit of high returns but retreats as soon as it detects
152 Chapter 7

default in the debtor. Obviously, the countries that offer high return are
precisely those for which the risk of default is sizable, so-called emerging
or transition economies. The former seek to take off as fast growing, export-
oriented economies, and the latter seek to construct a market economy
after the collapse of the Soviet system. Both types rely heavily on external
trade, both are capable of high-growth performances and prone to sudden
crises, given their fragile economic and political institutions and the weak
and weakly regulated financial system.
In such circumstances pegging the national currency to another currency
is no longer the simple and powerful strategy that it used to be when
the international financial market was small, and various restrictions on
foreign exchange transactions worked effectively. Indeed, in the last
decade, financial crises such as those in Mexico (1994–95), East Asia
(1997–98), Russia (1998), Brazil (1999), Turkey (2001), and Argentina
(2001–2002) have shown that the requirements for sustaining pegged
exchange rates have become increasingly demanding. A pegging strategy
is under the constant risk of defeat because, in the present world, the
policy-maker often lacks the instruments to win the confrontation, and
pegging is, relative to the market, considerably weaker than it used to be
under Bretton Woods.17
It should be pointed out that what is said here for a pegging strategy
applies also—albeit in a lesser degree—to other strategies in which, mon-
etary policy, while retaining a degree of discretion, pursues an exchange
rate objective and adopts an external anchor. Among such strategies are
the so-called crawling pegs, exchange rates within crawling bands, and
managed floats.18 All of these strategies fall under the rubric of intermedi-
ate strategies, however.
Recently the view has gained ground that intermediate strategies are very
vulnerable and so should be avoided in all circumstances. Policy-makers
must therefore restrict themselves to free floating currency or completely
abandon any idea of monetary sovereignty, that is, to implicitly or explic-
itly adopt a currency of another country (so-called hard pegs in the form
of currency board arrangements, dollarization, or euroization). This view
has become popular in academe, and in some international circles, where
it is termed “corner solution theory.”19 Corner solution theory invokes the
same inescapable logic as that behind the “inconsistent quartet” proposi-
tion illustrated in chapter 1 of this book.
It is undeniable that in a world of capital mobility, intermediate strate-
gies, which are harder to sustain, should be handled more carefully and
may not be practicable in all the cases in which they were successful in
The Eurosystem in the Global Arena: A New Actor in a New Play 153

the not so distant past. The merit of intermediate regimes, however, for
many countries still is that a float is often seen as too destabilizing and a
hard peg as unacceptable.20
Mainly a floating strategy can incur perverse cycles of bubbles and bursts
caused by the alternating over- and undershootings to which markets are
prone.21 This is the reason behind a so-called fear of floating present in
many emerging markets experiencing weakness, and it cannot be disre-
garded. Openness of the economy, hence key role of the external sector in
promoting both economic activity and price stability, and the risk of too
rapid financial integration with the outside world are reasons to reject
the option of pure float. Moreover, as exemplified by euroland and the
European Union vis-à-vis other European and Mediterranean countries,
regional integration of neighboring countries may determine the emer-
gence of a predominant trade partner with a stable currency, which may
induce countries with free floats to move to a peg.
The complete surrender of a national currency and monetary policy,
however, may be economically unsound and politically unacceptable.
Many countries are too large and their economies too dependent on
endogenous impulses for blind adoption of a monetary policy designed for
a different economy to be a rational solution. Even when a country is very
open and foreign-dependent, there may be no single outside economy to
which it is so tightly integrated for the currency and monetary policy of
that outside economy to be the optimal choice. Argentina is a case in point.
Short of completely adopting the name and the banknotes of another cur-
rency—a process called dollarization—no hard peg may be hard enough to
prevent a crisis. It also suggests that for a medium-sized country dollar-
ization—or euroization—can be politically and technically bad for either
side.22 What is unavoidable, or works, for Panama or Monaco is not nec-
essarily good or applicable for Brazil or Russia.
Not many countries are ready to surrender monetary sovereignty alto-
gether and accept an external anchor. While there may be the claim that
a “hollowing out” of the middle range of the fixed-flexible continuum in
favor of extreme solutions is the trend, this is only partly borne out by
evidence. The majority of studies of actual regimes have discredited the
notion that the middle ground has been abandoned, and that exchange
rate policies are shifting outward from the middle of the continuum. Espe-
cially in East Asia, many of the countries declaring to pursue a float policy
in fact manage, in varying degrees, their exchange rates.23
The discussion of country attitudes toward exchange rate strategies
should not minimize the importance of a change in strategy or, as it is
154 Chapter 7

called, a “regime shift.” In the moment of crisis, a strategy can be aban-

doned because of an inconsistency with other policies, because it led to
the evils being experienced, or else because a better strategy is on the
horizon. Any of these motives can, and actually do, appear in any crisis
and under any exchange rate strategy. Rarely does this imply that a strat-
egy alone is the cause of a crisis. When economic policy and economic
behavior are not sound, no strategy is sustainable indefinitely. At the
moment a crisis erupts, it must be changed. Often it is not the intrinsic
quality of the new strategy but the drama associated with change that
catalyzes the political will, for lack of which the tensions and the crisis
originated. A peg, even a hard one, may not survive the pressures of the
market. However, as the experience of Brazil in 2002 shows, also a float
may not be sustainable, for countries that float currencies are not per se
immune to macroeconomic instability. In such situations the shift to a
harder regime may help import credibility and restore stability.
In sum, exchange rate strategies must be viewed in terms of overall poli-
cies as they also influence the design and effects of such policies. This inter-
grative aspect of policy should dispel the fallacy that the exchange rate is
a kind of automatic pilot, that once a regime is adopted the policy-maker
is exonerated from the task of attending to its route. No single formula
ever meets the needs of all countries at any one time. A strategy has to be
consistent with country-specific characteristics, in the main, the size of the
economy, its trade and financial linkages, the extent of liberalization of
capital movements, and the maturity and soundness of its financial sector.

7.5 The Euro as an Anchor

Euroland and the Eurosystem are not only (with the United States and
Japan) part of the triad of key currencies and economies, they have also
engaged bilateral relations with a wide range of other currencies and coun-
tries, both inside and outside Europe. The exchange rate has special impor-
tance for the Eurosystem as it is the prime monetary link to these other
countries.
For the reasons explained in the preceding section, many countries still
choose an intermediate regime, hence entered the role for the euro as
anchor. In the spring of 2004, about fifty countries world wide had an
exchange rate regime involving the euro (see table 7.2.). These countries
were distributed over a well-defined part of the world, which covers
Europe, the Middle East, and Africa, and comprises around 100 countries,
not counting the 25 EU member states. It can be named as the European
The Eurosystem in the Global Arena: A New Actor in a New Play 155

Table 7.2
Exchange rate regimes involving a link to the euro

Number of
countries/
territorial Countries/territorial and
Exchange rate regime communities overseas communities

Exchange rate arrangements 2 French territorial communities

with entitlement to use the of Saint-Pierre-et-Miquelon and
euro as the official currency Mayotte
3 The Republic of San Marino, the
Vatican City, the Principality
of Monaco
Euroization 3 Andorra, Kosovo, Montenegro
Currency board arrangements 4 Bosnia-Herzegovina, Bulgaria,
Estonia, Lithuania
Peg arrangements (including 20 Pegging to the euro only:
pegging to the SDR and other Cyprus, 14 African countries of
currency baskets including which the CFA franc is the legal
the euro) tender, French Polynesia, New
Caledonia, Wallis and Futuna,
Cape Verde, Comoros
6 Pegging to the SDRa: Botswana,
Jordan, Latvia, Libyan Arab
Jamahiriya, Morocco, Vanatu
4 Pegging to other currency
baskets including the euro:
Israel, Malta, Russia, Seychelles
Managed floating with the 7 Burundi, Croatia, Czech
euro used as a reference Republic, FYR Macedonia,
currency Slovak Republic, Slovenia,
Yugoslavia
Total 49

a. Since January 1, 2001, the euro has accounted for 29 percent of the SDR basket.
156 Chapter 7

hemisphere since, for virtually all of them, the European Union is by far
the largest trading partner, the base of their financial systems, and is coun-
terparty to important agreements in the fields of trade. It also is the source
of technical assistance and support for economic development. To the
extent that these countries have sought an external monetary anchor, the
euro has become the natural choice. The anchorage strategies range from
very close or even full links—such as through currency boards, euroiza-
tion, or formal entitlement to use the euro as legal tender—to loose
forms—such as pegs, crawling pegs, or managed floating.
What is remarkable is that no such comparable regional clustering is
observed around the United States, and even less around Japan, in their
respective parts of the world. In the American hemisphere, regional coop-
eration is still at an early stage, and mainly confined to trade arrangements.
So far only a loose institutional structure exists and does not involve
binding legislation or supranational decision making. The US dollar, of
course, plays and will continue to play a strong role, although differently
than in the European hemisphere, where adoption of the euro has become
the aspiration of medium-sized economies such as Poland. In the Ameri-
can hemisphere only very small countries (e.g., Ecuador and El Salvador)
have opted for full dollarization thus far. As to the East Asian and Pacific
region, the prospects for the Japanese yen to play the role of a reference
currency are still remote, despite some progress already being made in
regional integration in that part of the world.24
The present attitude of the Eurosystem toward the euro’s role of anchor
is cautious and even reluctant. The euro may be an anchor currency due
to unilateral decisions by third countries, but not as a result of any con-
tractual relationship with the ECB. This attitude arises from different con-
cerns, and is partly rooted in the historical misgivings of the Bundesbank
about any form of external commitment. The main concern that the objec-
tive of price stability could be weakened by any constraint deriving from
a contractual relationship is pushed to the point of shying away from any
such relationship. The culture of floating rates of the Bundesbank is much
more in line with the present prevailing view over exchange rate regimes
than the traditional French attitude, which was much more inclined to see
the advantages of enacting policy discipline over exchange rates.
Such concerns, however, should not be blown out of proportion as the
experience of postwar Germany bears little resemblance with today’s
world. The Eurosystem is incomparably stronger and even more indepen-
dent, and the euro area incommensurably larger, than any European pre-
decessor. Hence the ECB is more equipped to cope with the euro’s increased
The Eurosystem in the Global Arena: A New Actor in a New Play 157

role as an anchor currency. Today the aggregate GDP of countries anchored

to the euro is small, less than 4 percent of world GDP and 16 percent of
euroland GDP. Euro anchoring has therefore virtually no bearing on the
transmission mechanism of monetary policy, and should be mainly con-
sidered from the perspective of the potential net benefits in the overall
relationship between euroland and the anchoring country.

7.6 Cooperation for Financial Stability

For many long years monetary policy through exchange rate relationships
was virtually the only policy field where international cooperation was
firmly established. Over time, however, the two other central banking
functions described in chapter 2—financial stability and payment
systems—became relevant internationally as a new international monetary
system emerged out of the collapse of the Bretton Woods regime. This
section traces the profile of such a system and shows how the Eurosystem
participates in the related policy functions.
Understandably, as the world has moved rapidly toward global capital
mobility, global regulation has lagged behind. The asymmetry between the
market, which is world wide, and policy making, which is national, reflects
the fact that with Europe excluded, economic and political realities have
not evolved in parallel. Such an asymmetry can impair financial stability,
and therefore calls for increased cooperation.
Unlike the Bretton Woods regime, the present global system is neither
the outcome of a formal conference nor does it correspond to a grand
design. It has evolved unplanned, driven by continual interaction between
policy decisions and market forces. Although it has often been dubbed
a nonsystem, it can be better defined as a market-led system, unlike the
previous system, which was government led.25
The benefits of the market-led system can hardly be underestimated.
World economic relations have been freed from the macroeconomic
inconsistencies that undermined the fixed exchange rate regime with the
advent of capital mobility. Greater efficiency has been gained in the inter-
national allocation of resources. The practice of financial repression, used
to shelter domestic economies from competitive pressures and national
policies from market discipline, has been largely discarded.
Such a system, however, has also brought with it new challenges and
new requirements. The dominant forces of the market in both the deter-
mination of exchange rates and the international allocation of savings has
extended from the national to the international arena the whole range of
158 Chapter 7

public policy concerns associated with monetary and financial activity.

First and foremost is the challenge to the stability of the global capital
market and banking system. It is not by accident that a series of financial
tensions and crises has hit industrial and emerging economies, from the
early 1980s onward, after almost four decades of substantial stability.26
Financial stability has thus become a key item in the international agenda
of ministers and central bankers, often a more prominent item than the
traditional topics of monetary and exchange rate relations. The risk of
instability has been heightened by a combination of inadequate supervi-
sion and contagion effects.27
The response has been international cooperation in various fields of
financial regulation and supervision, as well as in payment systems. The
areas of policy reviewed in chapters 5 and 6 have gradually complemented
monetary and exchange rate matters on the international agenda. It can
be said that in today’s market-led system, the restrictions to capital move-
ments, characteristic of the Bretton Woods era, have been replaced by the
promotion, at the international level, of financial stability.
Cooperation in the supervision of banking started in the mid-1970s. For
many years it was driven almost entirely by central banks and conducted
under the aegis of the Bank for International Settlements (BIS), which is
Basel based and owned by the central banks of major countries around the
world.28 Over time, this cooperative arrangement spread to other fields of
finance and to the payment system. The emphasis has progressively shifted
from crisis management to what is known as crisis prevention, and the
involvement of forums and institutions other than the BIS has grown. The
financial tensions, or crises, that have periodically hit the market-led
system were a powerful incentive to more cooperative effort.29
By the end of the 1990s international cooperation in the field of finan-
cial stability had reached a configuration that can be described as follows.
In the extent of coverage, international cooperation is active in virtually
all fields of finance where public policy actions are undertaken at the
domestic level.30 Besides banking, these include securities, insurance,
payment systems, accounting standards, and more specialized fields such
as derivatives or primary markets. The relevant groups are normally com-
posed of representatives of the national agencies in charge. Their compo-
sition, size, organization, and authority vary widely from field to field.
Cooperation has a three-level framework. Political impulse is provided
mainly by the G7. This Treasury-dominated forum takes the key decisions
in time of crisis, sets the agenda for global cooperation, and monitors the
overall process. Rule making and standard setting is generally made by spe-
The Eurosystem in the Global Arena: A New Actor in a New Play 159

cialized committees and organizations, arising out of the relevant branches

of the financial sector. Implementation and enforcement of international
rules and standards are mainly promoted by the IMF and the World Bank,
whose charters and special knowledge ensure influential contacts with
virtually every country of the world.
International coordination works—to use the terminology used in
chapter 3—in the “soft mode,” whereby decisions cannot be taken unless
consensus is reached, and even then are not legally binding. This soft mode
is not supranational but international in nature.
On the basis of this description, the validity of the present system of
cooperation for financial stability and the role of the Eurosystem can be
assessed. Cooperation for financial stability—developed over years of
ad hoc decisions driven by needs and opportunities—has undeniably
achieved important results. The repeated financial crises of the last two
decades have been managed and overcome. Several fundamental regula-
tory instruments have ceased to be purely domestic and, after some har-
monization, have become internationally agreed standards. The system of
rules has begun to spread from the restricted circle of the leading indus-
trial countries to the whole world. Recent encouraging signs suggest that
the global financial system has become more resilient and less prone to
contagion.
The system has produced useful results because, over local interests and
entrenched practices of regulatory laxity, have prevailed such positive
factors as the compelling need for an international discipline, the leader-
ship of the key countries, the desire of national authorities to be credible
outside their borders, and the aspiration of financial institutions to gain
international reputation.
Cooperation for financial stability has also enhanced, in recent years,
the role of the IMF and the World Bank. The former has complemented
its traditional macroeconomic surveillance with a periodic review of finan-
cial systems, and a regular monitoring of compliance with international
codes and standards for financial regulation and supervision.
These positive results, however, should not obfuscate the congenital
weaknesses of the present system. One of them is a cumbersome structure
whose logistics is difficult, and not all the countries are present in all the
roles. As a result frictions are bound to arise. Table 7.3 shows the present
composition of the main groups, organizations, and institutions involved.
Another weakness is the lack of a strong, transparent, and accountable
institutional structure. Unlike the European Union or the IMF, the G7 is a
self-appointed body led by a group of Treasury officials and, within it, by
Table 7.3
Standard-setting bodies in the financial field
160

IOSCO IAIS CPSS IASB

BCBS (International (International (Committee on (International
(Basel Committee on Organization of Association of Payment and Accounting
Banking Supervision) Securities Commissions) Insurance Supervisors) Settlement Systems) Standards Board)

Area of work Internationally Securities firms and Insurance companies Payment and Accounting
active banks markets settlement systems
Members G10 countries, Spain 84 countries, with Over 100 G10 countries, Hong 14 accounting
and Luxembourg ordinary or associate jurisdictions Kong SAR, Singapore, experts, whose
(central banks and member status (insurance ECB (central banks) selection is not
other institutions with (securities commissions) supervisory based on
banking supervisory authorities) geographical criteria
responsibilities), FSF
Other Observers: ECB, Affiliate members: 7 Observers: 60 Non-G10 central banks —
participants European Commission international including are associated on an
organizations and 53 international ad hoc basis
national organizations organizations,
(mainly stock industry and
exchanges) professional
associations,
companies,
consultants
Year of 1974 1983 1994 1990 2001, as a result of
establishment the restructuring of
IASC (established in
1973)
Decision-making Committee in regular Presidents’ committee Association in Committee in regular Board
Chapter 7

body meetings General Meeting meetings

Other bodies Working groups; task Executive Committee; Executive Committee; Subgroups and Trustees;
and secretarial forces; network of four regional Standing several committees, working groups Standards Advisory
resources regional committees Committees working groups and Small Secretariat Council;
Large General Large General task forces located at the BIS International
Secretariat located Secretariat located in Small Secretariat (Basel) Financial
at the BIS (Basel) Madrid hosted Reporting
by the BIS (Basel) Interpretations
Committee
Large Secretariat
located in London
Frequency of the 4 meetings per annum, Annual conference Annual conference 3 regular meetings “At such times as
general meetings on a regular basis per annum the IASB determines”
(usually monthly)
Main areas of Setting regulatory Setting standards; Setting standards; Setting standards; Setting standards;
work standards; exchanging exchanging promoting coordinating oversight cooperating with
information; information; cooperation; functions of central national rule-
encouraging the surveillance of providing training; banks; monitoring makers to achieve
adaptation of banking international cooperating with developments; convergence in
regulation at the transactions other regulators cooperating with other accounting standards
national level; regulators around the world
cooperating with
other regulators
Main Basel Capital Accord Capital Adequacy Insurance supervisory Real-time gross International
The Eurosystem in the Global Arena: A New Actor in a New Play

achievements (1988, amended in Standards for principles (1997) settlement systems accounting
1996; a new Accord Securities Firms Principles for the (1997) standards
is expected to be (1989) conduct of insurance Core principles for
finalized in 2004) Objectives and business (December systemically
Core principles for principles of 1999) important payment
effective banking securities regulation systems (2001)
supervision (1997) (1998)
161
162 Chapter 7

the United States. Ineffective in the traditional monetary and macroeco-

nomic field, where deliberations virtually never influence policies, the G7
in recent years has fostered some positive results in financial stability.
However, a number of problems and shortcomings remain. Treasury offi-
cials lack the statutory authority and the technical expertise to make dif-
ficult decisions whenever a lack of willingness or a lack of consensus
emerges in the sectoral groups and organizations. Moreover the G7 has no
authority over non-G7 countries.31
The crux of the matter is that as economic and financial interdepen-
dence deepens, the global financial system is increasingly being con-
fronted—just as Europe has been on a regional scale—with a new
challenge. The logic of growing interdependence calls for a gradual tran-
sition from the issues, needs, and procedures typical of international rela-
tions to those that are typical of a domestic setting. This was indeed the
path consistently, albeit not entirely, followed by the European Union, up
to the major step of creating a single currency and its own central bank.
The way forward is easy to see but extremely difficult to follow. It con-
sists in hardening the soft mode by strengthening the authority of
international standard-setters, deciding even when consensus is lacking,
providing adequate instruments to act, organizing a more acceptable rep-
resentation to all countries of the world, and enhancing rule enforcement
and inter-agency cooperation. This is an extraordinarily difficult task when
applied to a multitude of about 200 sovereign countries. Implementing
such a design, for which only limited inspiration can be drawn from
national or even regional constitutional models, is politically arduous
because effectiveness can only be obtained by accepting some limits to
national sovereignty.
What is the role of euroland and the Eurosystem in this complex and
rapidly changing framework of policy cooperation? It is potentially sig-
nificant but in point marginal. It is potentially important because of the
economic and financial size of euroland, the stability of its overall macro-
economic position, the soundness of its financial system, the high level of
technical expertise, and the large network of contacts and relationships
with countries around the world. It is factually marginal because neither
euroland nor the Eurosystem have been willing, so far, to pool their forces
and to act as a system.
In the groups, committees, and organizations constituting the three-
level policy process described earlier neither euroland nor the Eurosystem
normally participate as such, and when they do, they do so in an observer
capacity.32 In terms of substance, the national governments of euroland are
The Eurosystem in the Global Arena: A New Actor in a New Play 163

unwilling to adopt the stringent decision-making procedures that would

be required to systematically adopt a single position on the key issues on
the agenda of G7 or IMF deliberations. National central banks of the euro
area are themselves keener to act as parts of a national constituency than
as parts of the Eurosystem. The latter thus fails to play the role of catalyst
of a single policy platform that would otherwise be possible and consis-
tent with its institutional interest.33
In sum, the very same characteristic of the Eurosystem we have encoun-
tered in the policy realm (other than monetary policy) examined in earlier
chapters can be found in the field of cooperation for financial stability. In
these early years neither the Eurosystem has acted as a full-fledged central
bank nor euroland as a “country.” The latter still lacks the constitutional
structure to do so. The former is endowed with such structure but has not
yet enlivened its charter with the necessary determination and political
will. The result is that in the global arena an important player is missing
from the field and another—a “central bank without a state”—stays on the
field but does not fully play.
8 The Trials Ahead: From Infancy to Maturity

At the age of five an institution is, like a human being, just out of infancy.
It is impossible to predict how the adult will turn out and how he will look
back on his early years. To shape the adult, childhood and adolescence are
as important as infancy. How the euro and its central bank will mature
over time will depend greatly on factors and events that are outside the
control of the Eurosystem. Economic developments in euroland, person-
alities at the top of the ECB and the national central banks, the further
constitutional change of the European Union, the overall evolution of the
state of the world, are among such factors.
The euro and the Eurosystem have overcome the risky trials of infancy
in a matter of weeks and months. The design of the strategy and opera-
tional framework for monetary policy, the construction of a euro areawide
payment circuit, the road test of these arrangements, the production and
distribution of the new banknotes, are among the things that could have
gone wrong at the very beginning with catastrophic consequences.
Predicting the future is impossible, but looking ahead is necessary for
both the analyst and the policy-maker. This final chapter is an attempt to
look ahead on the basis of the few things we know. We know that the euro
and the Eurosystem are only children. We know that it is an unprecedented
experience for which no ready-made manual exists. We know that the
forthcoming trials will take years or even lusters, not just weeks or months.
We finally know, or presume to know, what the main trials for the years
to come are likely to be, although we do not know precisely what conduct
of affairs will permit to win. The following five sections review the trials I
regard as most decisive for the years to come.

8.1 Price Stability and Growth

The foremost standard on which the ECB and the Eurosystem will be
judged in the years to come will continue to be the ability to maintain
166 Chapter 8

price stability. On the other hand, the success of EMU and euroland will
be judged on a different and more ambitious standard: the combination
of price stability with growth, and the creation of enough new jobs to reab-
sorb unemployment and reach the forefront of economic and technolog-
ical progress. The problem lies in the fact that the noncoincidence of these
two standards represents, in itself, a challenge and a potential risk for the
Eurosystem.
In the 1990s the United States showed to the world that growth rates of
the order of 4 percent a year are not the preserve of catching-up economies
but can be achieved by the leading countries.1 By contrast, we saw in
chapter 3 that the same decade was, overall, disappointing for Europe
despite the success stories of some countries.
Is a golden decade within Europe’s reach? Pessimists point to the rigid-
ity of the social structure, the high unemployment benefits, the generous
provisions of the social safety net, the ageing population, the high cost of
the welfare system, the overexpanded role of the state, the persistent eco-
nomic nationalism, and the defense of inefficient national industries.
Under the influence of these factors—they say—the old continent has lost
its drive and its economic energies have atrophied. Only with a thorough
change in mentality, economic incentives, and social institutions can old
Europe emulate young America.
Optimists think that a substantial improvement in the overall European
economic performance is possible without changing the nature of the
European model, and perhaps is not so far away. They point to the fact
that all the factors recalled by the pessimists were already in place in a not
distant past, in which the European economy outperformed the American
economy. If anything—they say—the last ten or fifteen years have been
marked by substantial, albeit admittedly insufficient, structural reform that
may bear more fruits. Rigidities in the labor market were generally stronger
in the 1980s and early 1990s than today in most countries. The launch-
ing of the single market, the adoption of the euro, and the structural cor-
rection of public budgets were, after all, no small structural reforms. To
enter a golden path the Europeans do not have to adopt an American
model any more than the Americans had to copy the Japanese model in
the early 1980s—as some suggested at the time—in order to redress the for-
tunes of their economy.
The debate is inconclusive because knowledge over the ultimate deter-
minants of economic growth is not sufficiently complete for economists
to predict—and for policy-makers to engineer—the growth process of a
country or region. What matters here, however, is to explain why keeping
The Trials Ahead: From Infancy to Maturity 167

the rate of price increase consistently “below 2 percent over the medium
term” is to be regarded as a necessary, but not as a sufficient, condition for
the new institution to feel comfortable. Major real imbalances do disquiet
a central bank also when its statute unambiguously ranks price stability as
the top objective. The reason is that if a current account deficit, or a fiscal
deficit, or the unemployment rate reach such a large dimension as to be
unsustainable, the adjustment that will eventually be set in motion is likely
to have adverse implications for the central bank and its policy.
Adjustment of any imbalance of course will involve in the first place the
economic variables that were out of equilibrium. However, it will normally
also involve key economic variables whose values looked previously in
good shape, and may even reach institutional arrangements, policy orien-
tations, and political processes. Inflation, for example, may shoot up, if,
for too long, the market mechanism had been repressed or the exchange
rate held artificially stable. Similarly the exchange rate may collapse and
capital may take flight out of the country, when the market suddenly real-
izes that the external debt had gone too far. Or, a perverse combination of
current account deficit and high unemployment may arise in a country
that had for long insulated itself from international trade and competition.
Unemployment can also soar as a result of a privatization process. Popular
and political support for fiscal discipline may vanish if public services are
too deficient and economic activity stagnates.
The unsustainable imbalance from which euroland has been suffering
now for many years is high unemployment with slow growth. And, if such
imbalance were to persist, risks for the Eurosystem would grow regardless
of its ability to maintain price stability. The ultimate reason is that the state
of health of the currency cannot, in the end, fundamentally diverge
from the state of health of the economy. For the central bank the risk
with insufficient growth and prolonged unemployment is functional and
institutional.
On a functional ground, a chronically weak economy is one in which
expectations deteriorate, investments stagnate, and spending declines.
Structural unemployment also increases the risk of a deflationary spiral
because a longer than expected duration of unemployment may lead
households to respond more conservatively to a deflationary shock. And
we know that monetary policy is much less effective in countering defla-
tion than it is in countering inflation.
The most insidious threat, however, arises on the institutional ground,
through a possible chain of causation involving social, economic, politi-
cal, and cultural factors. Attitudes of society respond to economic
168 Chapter 8

situations and policies, which in turn are influenced by economic ideas.

Institutions, on their part, respond to attitudes of society. The Great
Depression lastingly changed both the course of economic thought and
the practice of policy. Similarly the pain of prolonged inflation in the 1970s
and 1980s molded consensus about the value of price stability and central
bank independence. It cannot be taken for granted that such a consensus
would last if high unemployment and slow growth in euroland lasted for
many more years. Nor can it be taken for granted that the position of the
central bank would remain unchanged if that consensus faltered.
What can the Eurosystem do to pass the trial of slow growth and high
unemployment in euroland? The answer is “very little,” because there is
no miraculous medicine that monetary policy can provide to these two
evils.
The Eurosystem faces the risk that in the future its mission may not
receive, from the public, governments, and parliaments, the same strong
support which resulted from two decades of high inflation. Since unem-
ployment is what concerns the voters and youth most, it may be very dif-
ficult for the central bank to convince a future generation of the benefits
of stable prices if it has not directly experienced the cost of inflation.
The Eurosystem must also be sensitive to the fact that a new environ-
ment may offer less forgiveness for excessive monetary restriction than the
inflationary environment of the past two or three decades. Independence
does not mean infallibility. The central bank could find itself in an
awkward position if it should appear to seek a ceiling for growth rather
than for inflation. Instead, it has to make it clear that it welcomes, and is
ready to accommodate, any rate of noninflationary growth, the higher the
better.

8.2 A Perfect Central Bank

The word “perfect” evokes both completeness and excellence. If the

Eurosystem is in future years to become a perfect central bank, it is in this
double sense of the word. The road to perfection is long and the Eurosys-
tem, like every newly founded central bank of the past, will need years to
reach its destination.
We saw earlier (chapter 2) that modern central banks originated from
fundamental changes in the technology of payments. We also saw that
the three central banking functions related to monetary policy, financial
stability, and payment systems, (chapters 4 to 6) have most often been
entrusted to the same institution. This is because they are inextricably
The Trials Ahead: From Infancy to Maturity 169

linked and refer to the roles of money as means of payment, unit of

account, and store of value.2 In performing its functions the central bank
exerts operational and regulatory powers, interacts with other public
authorities, practices a special magistery over the financial community,
intervenes in crises, works with other central banks, and cooperates in
international monetary and financial matters. Each central bank does all
that in one way, with one style, under a single command, and not in a
variety of ways across its organization. From the point of view of the per-
ceptions of people and markets all such activities refer to one and the same
public good, called confidence. In a modern market economy confidence,
rather than intrinsic value, is the foundation of the value of money.
The textbook on central banking, and not the Treaty, should be the road
map to perfection. It would be unrealistic to expect a full and satisfactory
guide solely from a legal interpretation of the charter. Past experience of
international organizations have shown that the narrowly legalistic course
can be a paralyzing trap. Although ECB decisions must comply with the
Treaty, whose statutes provide the foundation of its activities, those who
must manage the euro and be accountable for its stability have long been
aware how the vague wording of the central bank statutes compares his-
torically with the actual workings of a central bank. In the end the test
of the Treaty’s effectiveness will be in the accomplishment of the basic
mission within the paradigm of central banking functions.
Against this background two leitmotivs have run through the book. The
first is the need to establish and assess the Eurosystem as a single central
bank across the whole spectrum of functions, interests, and activities that
characterizes a full-fledged central bank. The second is the need to achieve
these objectives and do so at minimum cost, that is, to become efficient
as well as effective. While we can conclude from the preceding chapters
that in the field of monetary policy perfection is already within reach, in
most other activities the Eurosystem is still striving to fully establish itself.
In the effort to reach perfection, it is imperative that the Eurosystem
does not fall short of the classic paradigm of a central bank. The public,
the markets, and international institutions and organizations would not
understand. However, the road to perfection is not only imperative, it is
also arduous, because the steps required are multiple and complex from
both a conceptual and a practical point of view. Moreover, they meet resis-
tance within the system itself.
So far most components of the Eurosystem have kept in place the full
infrastructure of a stand-alone central bank and are keen to keep it active.
Each NCB has its own banknote printing process, each has a proprietary
170 Chapter 8

system for transferring central bank money in real time across its banking
community, and each maintains its own dealing room and foreign
exchange reserve management capacity. Each NCB offers (or can offer) to
other central banks around the world to manage their reserves in euro,
each entertains (or can entertain) its own representative offices abroad, and
each defines its own position in the main international forums. These
activities are neither shared nor pooled. Each NCB is confronted with a
problem of excess capacity.
The Eurosystem is thus a very special federal and decentralized central
bank.3 The structures of national central banks, historically designed to
perform the full range of central banking functions, underwent only
modest changes when they became integrated in the Eurosystem. Self-
sufficiency is still the style. We could call this the “one-to-one-
correspondence” between member countries and central banking
infrastructures.
Seen from the angle of the Eurosystem, this situation generates simul-
taneously insufficiency and redundancy. Redundancy (i.e., lack of effi-
ciency, or excessive costs), because many of the activities that are
multiplied across the system involve high fixed costs and economies of
scale, that could only be removed by abandoning the one-to-one corre-
spondence. Insufficiency (i.e., lack of effectiveness, or inadequate perfor-
mance), because the present segmentation sometimes leaves out what
could be called “the whole.” For example, there is no comprehensive and
integrated picture of the main financial institutions operating in the euro
area. Because of confidentiality concerns the central banks are reluctant to
regularly pool information about their individual institutions.
While unavoidable at the start, the one-to-one-correspondence model
will likely prove to be unsustainable over time. In many cases it entails not
only a duplication of tasks and coordination problems within the Eurosys-
tem, but also a creeping competition among central banks as well as the
risk of giving contradictory signals to the outside world. Different national
central banks have different practices in such areas like procurements, out-
sourcing, and market relationships. Eventually with the present configu-
ration the Eurosystem will suffer a loss of credibility in its attempts at
efficiency and structural reform in the EU economy.
A traditional central bank is a monopolist, it holds an exclusive fran-
chise for supplying a range of goods and services. Today’s Eurosystem is,
instead, an archipelago of monopolists. As for the ECB, to which the Treaty
entrusts overall authority over the system, it is understandably hesitant on
the course to take as a way to unify the system.
The Trials Ahead: From Infancy to Maturity 171

Conceivably the ECB could protract indefinitely the present archipelago,

with its multiple of centers of activity. Another design may be for the
ECB to actively manage top down transformation of the Eurosystem into
a single monopolist, which is as perfect as a modern central bank could
be. A third design may be to allow a clear and transparent competition
to emerge among national central banks and thus trigger a bottom-up
rationalization process.
It is becoming evident that the ECB will need to make a clear choice on
its direction. However, the evidence points to only a middle course, a
managed rationalization that addresses the fragmentation and duplication
of NCB services and allows the system to perfect itself.
The present configuration of the Eurosystem maintains segmentation
and differentiation that contradict the precept that euroland is a single
monetary area. As many services are de facto subsidized, this contradicts
the basic recommendations that the Eurosystem dispenses on the economy
to governments in favor of efficiency and structural reform.
Conceptually appealing as it may appear, the competition among the
NCBs is unrealistic. Competition is a game in need of rules and a strong
arbiter. The Eurosystem cannot be imagined to either take this role or be
ready to accept guidance from the European Commission, which in the
European Union is the authority in charge of competition. Competition
has winners and losers, and it is hard to imagine that one NCB ceases to
exit, while another will take its place. Therefore outright competition
among NCBs is not a viable solution. Rationalization of the Eurosystem is
a task for the system’s managers, and not for the invisible hand.
The Eurosystem has no choice but a managed rationalization, whereby
the one-to-one-correspondence is phased out in an orderly fashion, in a
way other than full centralization. At the time of writing, managed ratio-
nalization has just begun in the Eurosystem. It is too early to assess whether
it has progressed with the necessary energy and what form the solution
will ultimately take. While a temptation to prolong the present archipel-
ago of central bank services is always lurking, the need for rationalization
pops up with increasing pressure and in a growing number of areas, several
of which were mentioned in this book.
To a large extent there is no single across-the-board formula, and the
optimal approach may be to tailor a solution for every type of activity.
Some criteria, however, can be identified. Centralization of activity at the
ECB whenever economies of scale would speak in favor of a single center
of production, for example, the printing of banknotes or the manage-
ment of third countries’ foreign exchange reserves is both unlikely and
172 Chapter 8

undesirable. It would be hardly acceptable by the ECB Council. It would

also pose very complex implementation problems, and would run counter
to the very architecture of the Eurosystem as well as against the decen-
tralization principle stated by the Treaty.
A middle position between centralization and one-to-one-correspon-
dence seems clearly preferable and is in the process of being developed. In
large-value payments it may mean shifting to a TARGET configuration
made up of fewer RTGS systems than member states. In the printing of
banknotes, it may mean reducing, successively, the number of factories
where euro banknotes can be printed.
The break-up of the one-to-one-correspondence does not mean that the
duplicated activities of the central banks involved will cease at once, nor
does it mean that the changes will be obligatory. It may be gradual, vol-
untary, and guided by rules and incentives rather than command. The
force of reality may lead small and large central banks to different choices.
To the extent that economies of scale are a factor, the incentives and the
constraints cannot be identical across peripheries. In the end the process
cannot be expected to bring the Eurosystem into a far-reaching uniformity.
Diversity is a positive factor and it has always been valued as an attractive
feature of Europe.
The crucial institution for enacting the change is, of course, the ECB and,
at its top, the Board and the Council. The ECB Council is not only the
highest decision-making authority, but also the institution that exempli-
fies the “center versus periphery” tensions and the dilemmas involved in
the road to perfection. National governors are those who have to resolve
the conflict between the local interest they pursue as heads of NCBs and
the Eurosystem’s interest which they are called to serve in sitting on the
ECB Council.
For many decades, national central banks were accountable to, and some-
times dependent on, national politics. Public opinion identified them as
national entities, and to some extent continues to do so. The “public inter-
est” to which they were referring was the “national” interest. Significant dif-
ferences exist in their tasks, organizations, statutes, traditions, and cultures.
The ECB Council will need to be quite a powerful melting pot to produce the
amalgam that is to shape the Eurosystem into a single strong central bank.

8.3 Incoming Countries

A third impending trial for the Eurosystem is the accession of ten coun-
tries to the European Union and subsequently to the euro.
The Trials Ahead: From Infancy to Maturity 173

European integration was never intended to be restricted to the original

six countries. The Paris Treaty of 1951 contained an implicit “accession
entitlement” that provided for any European state to apply to accede to
the Treaty.4 For the first half of its five-decade history, the Community was
confined to the six founding members; for the second half, the number
was continually expanded as nine new members were acquired in four suc-
cessive “enlargements”.5
From 1998 to 2002 twelve countries of central, eastern, and southern
Europe (Bulgaria, Cyprus, the Czech Republic, Estonia, Hungary, Latvia,
Lithuania, Malta, Poland, Romania, the Slovak Republic, and Slovenia)
negotiated membership, and ten—the exceptions are Bulgaria and
Romania—joined the Union in 2004. This fifth enlargement was a special
case as it involved a large number of new entrants. The number of member
states has consequently almost doubled. The largest increase in the past
was three countries at one time. The recent history of the new entrants
also differs markedly from that of the current member states. They were
countries that had reclaimed their identities from communist dictatorships
with planned economies, prolonged misallocation of resources, and no
market rules or institutions. Excluding Poland because of its size, the last
wave of enlargement brought into the European Union rather small states.
Luxembourg apart, in population, eight of the twelve countries joining are
smaller than the smallest EU member, Ireland. Again, Luxembourg apart,
in GDP, all but one joining country are smaller than the smallest of EU
member, Ireland. For all these reasons the enlargement of the European
Union presents a much bigger institutional and political challenge than
ever before.
Already in 1993 in Copenhagen, in recognition of the difficulties
that could arise from such unprecedented historical change, the EU heads
of state or government established some preconditions for EU member-
ship.6 First, candidate countries must have in place stable political
institutions that guarantee democracy, the rule of law, and human
minority rights. Second, they must have in place a functioning market
economy capable to cope with competitive pressure from a single market.
Third, they must have the ability to take on the obligations of member-
ship including adherence to the aims of political, economic, and mone-
tary union.7
All new member states are committed to adopt the euro, and no
“opt-out” clauses, such as those stipulated by the United Kingdom and
Denmark, are accepted. Once a country has joined the European Union,
the Treaty dictates a transformational sequence of its monetary regime in
174 Chapter 8

three stages. These are the very stages that the current members of euroland
experienced over the forty-year history of the European Union. In a first
stage, which is entered on the day of accession, the new member state
agrees to regard its exchange rate policy “as a matter of common interest”8
and participate in the procedures of policy coordination (described in
chapter 3). In a second stage, membership is acquired in the exchange rate
mechanism (called ERM II), which provides a framework for monetary
cooperation with the euro area and prepares the state for the adoption of
the euro.9 At the third and final stage comes membership in the euro,
which is obtainable only after at least two years of tension-free member-
ship in the ERM II and proven compliance with the other convergence
criteria set by the Treaty.
Within this general framework of EU enlargement, the Eurosystem
is being confronted with an important trial in the first decade of its life.
The challenge has to do with economic and policy-making aspects, and
also, more important, with the functioning and organization of the insti-
tution itself. The economic problem due to enlargement lies in the
discrepancies in income and price levels between the new member states
and the euro area. These discrepancies are of a type and magnitude not
observed in previous experiences. On average, GDP per capita in the new
member states is, in terms of purchasing power parity, around 46 percent
of that of the European Union. The least wealthy country that joined
the Union in the past (Greece in 1981) had a per capita income of 62
percent of the community average. The catching up process required
to close this gap is set to be a difficult one and will involve a profound
transformation of both the economic system and the price structure in
the incoming countries. Given the limited growth differentials between
them and the euro area, it will likely be a lengthy process. In the mone-
tary field, the countries in a march to catch up and interact in the pro-
cess toward adopting the euro face unknown economic risks and policy
problems.
From the point of view of the euro area, the equalization of income and
price levels is not a prerequisite of an effective integration of new coun-
tries in the single currency. Indeed, the relatively small economic size of
the group of prospective members suggests that euroland and the ECB
should not see enlargement as a threat to their overall economic and mon-
etary equilibrium. Suffice it to consider that at the moment of German
reunification, Eastern Germany represented, in terms of GDP, 10 percent
of Western Germany, whereas for the ten new entrants, the proportion to
euroland is 7 percent.
The Trials Ahead: From Infancy to Maturity 175

In contrast, from the point of view of the entrants, it is desirable that as

much progress as possible is made, before they join the euro, both in raising
living standards and in converging toward a market-based economic struc-
ture. During the catching-up process their economies will undergo changes
in their price structures, which participation in the euro may render espe-
cially difficult to manage. The process will in fact demand increases not
only in real income levels but also in price levels. While statistically the
swelling of price levels carries the name of inflation, it can hardly be seen
as a pathological phenomenon. It is, much more, a physiological compo-
nent of the catching up and, as such, should not be repressed. Moreover it
may require periodic revaluations of the exchange rate to partially offset the
price rises, which early adherence to the euro would preclude. A further com-
plication is that these are the very countries that will be probably struggling
to prevent their inflation rate from rising over and above the threshold asso-
ciated with catching up. Their main concern and their true fight is for price
stability, which is why, quite understandably, these countries see early entry
in the euro as a guarantee of monetary stability.
The debate around the optimal trajectory toward the euro has to weigh
these arguments. In this debate, which goes under the title of “real and
nominal convergence,” the ECB is called to play a role because, even before
the incoming countries become members of the European Union, the ECB
was seen as their future command post as well as their advisor and senior
colleague. For the ECB the trial consists in helping in a constructive and
competent way the new countries and their central banks’ approach to the
euro.
For the Eurosystem, enlargement further raises institutional and organi-
zational issues. One concerns the decision-making process in the ECB
Council. Under the present Eurosystem Statute this college, today of eigh-
teen, could reach, owing to the enlargement, up to thirty-three members.
The enlargement may encumber the logistics of the meetings so as to make
the deliberations of the Council inefficient. Suffice to think that a simple
tour-de-table in which every Council member speaks, on average, for four
minutes would take more than two hours. Moreover the large proportion
of very small countries among the new entrants could lead to decisions
supported by only a small fraction of total euroland, which, in the view
of some, would render the Council a less credible decision maker than it
is today.
To avoid such drawbacks, a reform of the Eurosystem Statute was
approved in 2003, whereby the number of voting members in the Council
would be capped at 15. At the time when the number of euro area
176 Chapter 8

countries exceed 15, the voting rights in the ECB Council will be shared
among governors on a rotation scheme.10 The reduction in the number of
voting members of the ECB Council will leave unchanged the right to
attend meetings and speak in them, so the amelioration would be modest.
Other changes are needed in the working and deliberation procedures of
the Eurosystem. Such changes could be autonomously decided by the ECB
Council and could address both the rules of procedure for the conduct of
the meetings and the division of labor between the Council and the Board.
Another issue concerns the organization of the Eurosystem and the
“center versus periphery” concept. As was argued in the previous section,
the present system, characterized by self-sufficiency and one-to-one-
correspondence between members and central bank infrastructures, is an
already cumbersome structure. The enlargement with a large number of
small countries aggravates the problem and makes rationalization of the
Eurosystem all the more urgent. In fact almost all of the ten new members
have such small size, and such overall scarcity of national resources, as to
make the costs of a full-fledged infrastructure even more heavy to sustain
than for old members.
Challenges may, of course, be viewed as opportunities. For the Eurosystem
the very trial consists in making challenge an opportunity. The accession of
new members simply makes more acute an already present need for insti-
tutional and organizational reform. While today some members of the
Eurosystem wax nostalgic over past splendors of unrestricted national mon-
etary sovereignty and decry the ambition of perfecting the Eurosystem as
the strong, efficient, authoritative, globally influential central bank of the
European Union, enlargement may compel the young institution to shrug
off reticence and to accelerate its coming of age.

8.4 A Reluctant Global Actor

The advent of EMU not only involves the development of an international

role for the euro and the Eurosystem, it also affects global policy coopera-
tion. The trial confronting euroland and its central bank is to improve the
system taking inspiration from its own regional experience in international
governance.
As was noted in chapter 7, since the collapse of the fixed exchange rate
rule of Bretton Woods, international monetary and economic relationships
have evolved in an unsystematic fashion, mainly under the pressure of
market forces that had overtaken the might of policy makers. Despite the
disappearance of the rule, the institutional arrangements remained those
The Trials Ahead: From Infancy to Maturity 177

laid down between the 1940s and 1960s, only modestly complemented
with ad hoc additions suggested by specific events and urgencies. These
arrangements have coped with the challenges of a number of crises, but
have fallen short of the need to complement the development of a global
market with global, effective, and legitimate governance. What in
chapters 3 and 7 was called the “soft mode” of cooperation, namely vol-
untary and nonbinding statements of policy, is still predominant and
severely limits effectiveness in international governance.
The introduction of the euro brings three concomitant elements to the
existing institutional arrangements: simplification, complication, and a
potential for innovation and reform.11 The simplification consists in reduc-
ing to three (United States, euroland, and Japan) the number of key players,
a change that makes international macroeconomic debates more efficient
and possibly facilitates the formulation of agreements.12 It also contributes
to achieving more balanced relations among the three players.
A complication that looms over the positive effect is the difficulty of
fitting the euro into the present pattern of international representation
and institutional arrangements for policy cooperation. Such a pattern was
appropriate decades ago, when a policy–government–country nexus pre-
vailed and the responsibility for economic policy was almost entirely con-
centrated in the hands of the central governments of nation-states. In
those years no supranational European power existed and central banks
were generally dependent on their own Treasuries.
Although the gradual loosening of the nexus had started before13 the
advent of a common currency, the euro, represents a major step in the
loosening process. Instead of a country, euroland is a regional entity and
has a dispersed matrix of policies (as was shown in chapter 3).
The international representation of euroland and the Eurosystem has
been handled so far in a way that adds to the composition of existing
groups and bodies, without attempting at redesigning them.14 The role
of the European Commission has been downgraded, although it is the
body in charge of EU interests. Only minimal adjustments were adopted
to make existing arrangements compatible with the charters and inter-
nal rules of the relevant international institutions, organizations, and
committees.15
It is somewhat paradoxical that, in the process of stipulating ad hoc
arrangements on who should speak or act on behalf of euroland, the main
advocates of a minimalized role were the Europeans themselves. There
were more divisions among them than between them and the Americans.
Paradoxically, a unified—and hence potentially more influential—
178 Chapter 8

representation was requested by Washington, while the Europeans clung

to their largely symbolic and ineffective individual seats in the various
organizations and committees. Formal representation was clearly preferred
to actual influence. There is little doubt that full accommodation of EMU
in international relations requires radical reforms, going well beyond the
arrangements put in place so far. Complications of an already complex
architecture, rather than simplification and reform, have so far character-
ized the coming of the euro and the Eurosystem on the international arena.
The trial for the coming years is to reverse this trend. And this is not
only a matter of representation or composition of the relevant organiza-
tions, it is much more a matter of taking inspiration from the EU experi-
ence to improve the governance of international interdependence. Indeed,
in the second half of the twentieth century Europe invented and imple-
mented, through its own integration, principles of international gover-
nance, whose validity outdistances the time and space horizon within
which these principles were experimented.
The provision of international public goods cannot be expected to auto-
matically result from the spontaneous interplay of market participants and
national governments, for the same reason for which, inside an economy,
the market cannot produce public goods. The self-centered behavior of
individual agents (be they businesses or governments) is bound to ignore
the externalities that arise at the international level, and international
organizations or groups exist precisely to deal with these externalities. The
European experience shows that despite the entrenched idea of unbounded
power of sovereign countries, a degree of supranationalism is feasible and
that it does not represent the twilight of national policy, allegiance, nor
loyalty. Supranationalism may be in fact the sine qua non for an effective
provision of international public goods, just as a national power is indis-
pensable for the provision of national public goods.
Another key principle concerns the alignment of market freedom with
enforceable rules. The market system is known to be a legal, social, and
institutional order, and not merely an economic one. It is well recognized
that markets need a strong set of public arrangements to function effec-
tively at the national, or domestic, level, but this is still insufficiently rec-
ognized—and often even denied—at the international level. The European
experience shows how private and public that compose the market system
can be developed jointly, in a balanced way, not only within a country,
but also for a group of countries.
Finally, the European Union and the euro suggest that a regional level
of integration may complement and strengthen, rather than endanger, the
The Trials Ahead: From Infancy to Maturity 179

multilateral character of the overall system of international relations.

Regionalism in organizing relations between countries is a precious inter-
mediate layer in a world where the number of sovereign countries has
grown to almost two hundreds. Indeed, following the EU experience,
attempts are now made in other parts of the world to promote the regional
dimension of international cooperation.16
It may be hard for Europe to actively contribute to international reforms
otherwise than in parallel with the further development of its own union,
both in the economic field and in the move from the economy to the
polity. The more euroland and the Eurosystem are consistent in applying
such methods to themselves, the more they are in the position to improve
governance on a global scale.

8.5 Policy, Politics, Polity

We could define the fifth and last trial for the Eurosystem as the practice
of an appropriate relationship between policy, politics, and polity.17 It con-
sists, in other words, in coping with the lack of a full political union.
Whether monetary union can be achieved despite the lack of political
union has been central in the European debate prior to the Delors Com-
mittee and the EMU negotiation in 1988 to 1991. Although throughout
this book the European Union has been defined mainly as a “polity-in-the-
making,” the expression “lack of political union” is also so often used that
a clarification is needed.
It would be a misconception to assert, without any qualification, that
political union is lacking altogether in Europe today. It is not because the
content and the competence of the European Union are mainly economic,
that its nature and historical role are not political. Even before the single
currency, EU competence extended over virtually the whole body of eco-
nomic legislation, from the establishment of “the free movement of goods,
persons, services and capital” (the four freedoms proclaimed by Article 3
of the Treaty) to external economic relationships. To understand how very
political these issues are, it should suffice to consider the place they take
in the US political debate today, or have taken in the politics of our coun-
tries before the creation of the European Community. Moreover the
institutional architecture of the European Union is entirely that of a polit-
ical system, not that of an international organization based on soft coop-
eration: a legislative capacity that prevails over that of member states, a
judicial power, a directly elected—albeit with limited power—Parliament.
Also it would be a misconception to assert that Monetary Union has devel-
180 Chapter 8

oped as the outcome of a technocratic process removed from politics. Quite

the contrary is true. The single currency has been achieved because of the
strong political determination of elected governments over a full decade
(from June 1988 to May 1998). Central bankers have “only” provided
expertise, from the drafting of the blueprint to the preparatory work for
the actual start of the system. For the rest they have accepted the limits of
their role and recognized that the ultimate decisions have belonged to
elected politicians.18
The advent of the euro is a quintessentially political event in its genesis,
and a profound social and cultural change in its nature. Economists and
even central bankers pay limited attention to notes and coins, a minor and
endogenous component of the money stock almost irrelevant for mone-
tary policy. On the contrary, for many politicians monetary union meant
little else than the change in banknotes and coins, described in chapter
6. More than economists and central bankers, they saw that for the people
money has to do with the perception of the society to which they belong
and, ultimately, with their culture. As such, money goes well beyond the
economic sphere of human action. As we have argued before, the act
whereby a person agrees to provide goods or services to an unknown
person in exchange for pieces of paper that have no intrinsic value is
perhaps the most significant and widespread testimony of the social con-
tract that binds people. This is why coinage and money printing have
always been a prerogative of the state.
Nevertheless, it remains that Europe lacks political union. The European
Union is not the ultimate provider of internal and external security, the
two utmost functions of the modern state. EU institutions fail to comply
with the key constitutional principles that form the heritage of western
democracies: foundation of the legislative and executive functions on the
popular vote, majority principle, equilibrium of powers.
Why does the lack of political union constitute a trial for the Euro-
system? In the short span of less than thirty years two anchors of money
were abandoned: metal and the sovereign, namely gold backing and
dependence on political power. It is true that central banks have struggled
for years to free the printing of money from the influence of politics, as
they struggled in the past to free it from the influence of private interests.
It is equally true that the present independent status of the Eurosystem is
exceptionally strong in this respect. However, only superficial thinking
could view the lack of political union as strengthening the central bank
and making it freer to fulfill its mission. It would be unfortunate if inde-
pendence were to be confused with loneliness.
The Trials Ahead: From Infancy to Maturity 181

Ultimately, the security on which a sound currency assesses its role

cannot be provided exclusively by the central bank. It rests on a number
of elements that only the state or, more broadly, a polity can provide.
When, for example, we say that a currency is a “safe haven,” we refer not
only to the quality and credibility of its central bank but to the solidity of
the social, political, and economic order to which it belongs. Historical
experience shows that when that order appears to weaken, the currency
weakens, regardless of the actions of the central bank. A strong currency
requires a strong economy and a strong polity, not only a strong and
capable central bank.19
The problems posed by the coexistence of a single currency with a still
unachieved polity will influence both practical and intellectual activity in
the coming years. Such problems will have implications for both the
central banker and the politician. In the realm of politics the implication
is that the decision to move ahead with the euro in advance of political
union contains an implicit commitment to the completion of the polity.
In the conduct of monetary policy and other central banking tasks, the
implication is a need to adapt to a composite and still changing institu-
tional architecture. This deprives the central banker and its policy from the
simple and well-ordered polity and gives an additional dimension to its
relationship with the political process. The central banker should be pre-
pared for the further evolution of the institutional architecture to which
the Eurosystem belongs.
Abbreviations

ASEAN Association of Southeast Asian Nations

Benelux Belgium, the Netherlands, Luxembourg
BIS Bank for International Settlements
CPSS Committee on Payment and Settlement Systems
CAP Common Agricultural Policy
CBA Currency board arrangement
CHIPS Clearing House Interbank Payments System
CLS Continuous Linked Settlement
DM Deutsche mark
EC European Community
ECB European Central Bank
ECOFIN Council Council of the EU Ministers of Finance and Economic
Affairs
ECSC European Coal and Steel Community
EDC European Defence Community
EEC European Economic Community
EIB European Investment Bank
EMI European Monetary Institute
EMS European Monetary System
EMU Economic and Monetary Union
ERM Exchange Rate Mechanism
ESCB European System of Central Banks
EU or Union European Union
Euratom European Atomic Energy Community
Fed Federal Reserve System
FOMC Federal Open Market Committee
FSA Financial Services Authority
FSF Financial Stability Forum
184 Abbreviations

G7 Group of Seven (includes United States, Japan,

Germany, France, Italy, United Kingdom, and Canada)
G10 Group of Ten (includes G7, Belgium, the Netherlands,
Sweden, and Switzerland)
G20 Group of Twenty (includes G7, Argentina, Australia,
Brazil, China, India, Indonesia, Mexico, Republic of
Korea, Russia, Saudi Arabia, South Africa, Turkey, and
European Union)
GDP Gross domestic product
HICP Harmonized index of consumer prices
ICT Information and communication technologies
IGC Intergovernmental Conference
IMF International Monetary Fund
IOSCO International Organization of Securities Commissions
LTCM Long-Term Capital Management
MERCOSUR Mercado Común del Sur
NATO North Atlantic Treaty Organisation
NAFTA North American Free Trade Agreement
NCB National central bank
OCA Optimum currency areas
OECD Organization for Economic Cooperation and
Development
RTGS Real-time gross settlement
SGP Stability and Growth Pact
SSS Securities Settlement System
TARGET Trans-European Automated Real-time Gross settlement
Express Transfer
Notes

Chapter 1

1. Jean Monnet (1888–1979), French businessman and politician, was the main
architect of European integration in the twentieth century. He was deputy secretary
general of the League of Nations in 1919, and during World War II the chairman of
the committee coordinating Franco-British war production. He also inspired, and
became the first president of the European Coal and Steel Community (1951). In
1955 he created, and led until 1975, the Action Committee for the United States of
Europe, that promoted most of the initiatives taken by governments in the field of
European integration. Altiero Spinelli (1907–1986), Italian politician, was a member
of the European Commission (1970–76), member of the European Parliament
(1976–1986), and founder, in 1941, of the European Federalist Movement. He co-
authored the 1943 “Ventotene Manifesto,” which sought the establishment of a
European Federation to supersede the nation-states that had led Europe into
internecine wars twice within thirty years. Jacques Maritain (1882–1973), French
philosopher and theologian, had already in the early 1940s advocated the unifica-
tion of Europe and the reconciliation between enemies of the two World Wars as
the only way to establish justice and peace in Europe. Luigi Einaudi (1874–1961),
Italian economist and politician was governor of the Banca d’Italia (1945–1948) and
the first president of the Italian Republic (1948–1955). In 1918, and again in 1943,
he advocated the creation of a federal European state and a single European cur-
rency as the solution to the problem of war and economic disorder in Europe.
Helmuth James Graf von Moltke (1907–1945), German lawyer and resistance fighter
against the Nazi regime, founded the “Kreisauer Kreis,” a group of German intel-
lectuals. Together they worked in the 1930s and early 1940s toward the overthrow
of Hitler and the development of a European postwar order based on a Franco-
German understanding.

2. Robert Schuman (1886–1963), French lawyer and politician, was born in Clausen
(Grand-Duchy of Luxembourg) in a family whose roots were in Lorraine. He was a
German national, and then a French national after 1918 when Lorraine reverted to
France. On May 9, 1950, as minister of foreign affairs in the French government,
186 Notes to Pages 3–4

Schuman proposed to Germany that it should join on an equal footing a new body
responsible for the joint management of coal and steel. In 1958 Robert Schuman,
member of the Christian Democrat parliamentary group, was unanimously elected
the first president of the Joint Assembly (EEC, ECSC, Euratom), now the European
Parliament. Konrad Adenauer (1876–1967), a German politician, was opponent to
the Nazi regime. As chancellor of postwar Germany (1949–1963), he reconstructed
the country and led the process on European integration. Alcide de Gasperi
(1881–1954), an Italian politician who contributed to the material and moral recon-
struction of his nation after World War II, was the chief architect of Franco-German
reconciliation after World War II. In foreign affairs he strove to restore an influen-
tial role in international politics for Italy. During his government Italy entered
the NATO. A leading proponent of the formation of a federation of democratic
European states, he helped organize the Council of Europe and the European Coal
and Steel Community (1951).

3. Implementing the freedom of circulation of goods, services, capital, and persons

(the so-called four freedoms) was a very far-reaching objective, going well beyond
the creation of a free trade area or a customs union. To appreciate its importance,
suffice it to say that when the Treaty was stipulated, the four freedoms were not
fully in place within the countries that decided to establish the freedoms among
themselves. In the 1950s, for example, there were countries where customs duties
had to be paid to move goods within national boundaries. Until late in the 1970s,
the provision of banking services was subject to territorial restrictions inside some
countries.

4. Charles de Secondat, Baron de la Brède et de Montesquieu (1689–1755), was a

French lawyer and philosopher. He developed the thesis of “sweet commerce” in his
most important book L’Esprit des lois (1748). He not only pointed out that the pursuit
of profit-making serves as a countervailing bridle against the violent passions of war
and abusive political power but also identified the interdependence inherent in trade
relations as a fundamental force for peace, stating that “Two nations who traffic
with each other become reciprocally dependent; for if one has an interest in buying,
the other has an interest in selling; and thus their union is founded on their mutual
necessities.”

5. In the so-called Schuman declaration of May 9, 1950, when he proposed to place

German and French coal and steel production under a joint authority, Robert
Schuman said: “In this way, there will be realised simply and speedily that fusion
of interest is indispensable to the establishment of a common economic system; it
may be the leaven from which may grow a wider and deeper community between
countries long opposed to one another by sanguinary divisions.”

6. Many European institutions and bodies are located and work in Brussels, so that
Brussels has as its synonym the “capital of Europe.” Outside Brussels are located the
official seat of the European Parliament (in Strasbourg), which holds in Brussels most
Notes to Page 4 187

of its working sessions, the European Court of Justice, the Court of Auditors, the
European Investment Bank (in Luxembourg), and the European Central Bank (in
Frankfurt).

7. Most of the national leaders who created the EEC had little expertise in the eco-
nomic field and were predominantly interested in political and strategic objectives.
On some occasions they even acted against the advice of their economic experts.
For example, German chancellor Konrad Adenauer strongly pressed for the stipula-
tion of the Treaty of Rome despite the negative advice of Ludwig Erhard, his
influential and highly reputed minister of economics. Ludwig Erhard (1897–1977),
German politician, economics minister (1949–1963), and chancellor (1963–1966) of
the Federal Republic of Germany, is widely acclaimed as the father of the German
“social market economy” and the postwar “economic miracle.” Erhard, as a fervent
advocate of global free trade, was originally opposed to the establishment of a
European common market that was limited only to its six founding members,
fearing that this would force the export-dependent German economy into a pro-
tectionist corset, especially given the exclusion, at that time, of the United Kingdom
from the Community.

8. Charles de Gaulle (1890–1970), French general and politician, played a leading

role in twentieth-century French politics. In 1930 he warned, without success, that
France should adopt a professional army and a military strategy based on tanks and
movement instead of defense and trenches. In 1940 his appeal to the French people
after German occupation helped create a French government in exile that allowed
France to rank among the victorious allies of World War II. After a brief period as
prime minister, he retired from power in 1946 but continued to act as a staunch
critic of European integration, contributing to the defeat of the EDC Treaty by the
French Parliament in 1954. He returned to power in 1958, in the middle of the war
Algeria was fighting to gain independence. He adopted a new constitution, granted
independence to Algeria, withdrew from NATO, fought against projects of further
European integration, as part of an attempt to restore a leading role for France in
world politics. He retired in 1969.

9. In a customs union, tariffs and quotas are abolished for imports from partici-
pating countries. In addition all members of the customs union apply the same
duties and other commercial regulations to trade with nonmembers, which implies,
in practice, a common external tariff and trade policy. It therefore represents a step
beyond a free trade area where the tariffs and other restrictive regulations of com-
merce are eliminated between the participating countries, but where each partner
retains its national tariffs and quotas vis-à-vis third countries. A common market
comprises an area with no obstacles to the free movement of goods, persons, ser-
vices, and capital, which is accompanied by a range of common policies, such as
trade and customs policies, and competition policy.
188 Notes to Pages 5–6

10. This practice followed the so-called Luxembourg compromise, which was
stipulated in 1966. This compromise did not have formal legal status but was only
a political text in which the member states essentially agreed to disagree. France
insisted that whenever important national interests were at stake, a unanimous deci-
sion should be sought. The other (at the time) five member states only conceded
that they would “within a reasonable time” try to reach unanimity whenever very
important interests of one or more member states were at stake. If unanimity proved
elusive, they would insist on qualified majority. Over the years, however, the French
reading of the Luxembourg compromise came to be accepted, as also other members
states invoked the veto right.

11. The 1965–66 crisis was an episode that was to go down in history as the “empty
chair crisis,” deriving its name from the refusal of the French government repre-
sentatives to participate in meetings of the Council of Ministers.

12. Under this amendment to the Treaty all customs duties on products imported
from non-member countries, all levies on agricultural imports and resources deriv-
ing from value-added tax go into the coffers of Brussels. In accordance with the
century-old democratic maxim of “no taxation without representation,” the bud-
getary powers of the European Parliament were progressively strengthened. In addi-
tion a Court of Auditors was established in 1977 as a full-fledged Community
institution.

13. The EMS was based on the so-called exchange rate mechanism (ERM). Within
the ERM currencies had to be kept within a fluctuation band of plus or minus 2.25
percent around fixed central rates. Countries were committed to unlimited inter-
ventions in the foreign exchange market once their currencies had reached the
limits of the band. Central rates could not be changed unilaterally but had to be
agreed upon by the partners. A number of mutual credit facilities were established
among central banks to assist participating countries in fulfilling their obligation to
intervene.

14. Helmut Kohl (1930–), German politician, was chancellor of the Federal
Republic of Germany between 1982 and 1998. He was the chief architect of German
reunification in 1990 and a forceful and consistent promoter of European integra-
tion. François Mitterrand (1916–1996), French politician and president of the French
Republic from 1981 to 1995, was, together with Kohl, the main driving force behind
the progress made by European integration in the 1980s and early 1990s.

15. Jacques Delors (1925–), French politician. He was French minister of finance
from 1981 to 1984 and president of the European Commission from 1985 to 1994.
During his tenure at the European Commission he was, with Kohl and Mitterrand,
the chief driving force of European integration. The so-called Delors Committee
(Committee for the Study of Economic and Monetary Union) was created in June
1988, and the Committee presented its report in April 1989. It was formed by the
Notes to Pages 6–7 189

twelve governors of the EEC central banks and three independent members. The
author of this book was co-secretary of the Committee.

16. The Single European Act was adopted after the European Parliament had, in the
years 1981 to 1984, elaborated a new treaty transforming the, still mainly economy-
oriented, EEC into a full-fledged political union. As the European Parliament lacked
the constitutional power to implement it, this project had no direct consequences,
but it created the political climate that paved the way to the Single European Act.

17. Complementing the progress toward the four freedoms, Germany, France, and
the Benelux countries entered in 1985 in the Luxembourg town of Schengen into
an international agreement (i.e., outside the Community’s treaty framework) that
abolished all border controls for people traveling between their countries. By 1997
the “Schengen agreement” had been incorporated into the EU Treaty, and today it
covers thirteen member states (the United Kingdom and Ireland having been
granted an exemption).

18. Giulio Andreotti (1919–), Italian politician, was prime minister in 1972–73,
1976–79, and 1989–91. From 1988 to 1992 he played a decisive role in the prepa-
ration and stipulation of the Maastricht Treaty. Felipe Gonzalez Marquez (1942–),
Spanish politician and lawyer, was prime minister of Spain from 1982 to 1996. He
is widely regarded as having been a key proponent of the institutionalization of the
concept of European citizenship in the Maastricht Treaty.

19. For Kohl, at least, monetary union was not simply about pushing forward, it
was about making integration irreversible, about creating a barrier against a possi-
ble rollback of integration, and more fundamentally, as a kind of “insurance policy”
against intra-European wars.

20. Unlike the other member states of the European Union, the United Kingdom
and Denmark are not subject to the general obligation to adopt the euro once they
fulfill all the necessary conditions. Specific provisions included in protocols annexed
to the Treaty of Maastricht allow these countries to “opt out” of economic and
monetary union.

21. The Treaty had in fact set two dates: an earlier one for January 1, 1997, on con-
dition that a majority of member states fulfill the criteria. If that condition was not
met, monetary union would start on January 1, 1999, even if only a minority of
member states was ready.

22. There was also a one-off devaluation of the Irish punt in early 1993.

23. Ratification was completed in October 1993, when Germany—after a ruling of

its Constitutional Court—signed the Treaty. In most member states, ratification was
the occasion for a profound political debate about the relationship of the country
with Europe and the issue of national sovereignty. Political issues, more than eco-
nomic or monetary ones, were at the center of these debates and decisions.
190 Notes to Pages 9–12

24. The Convention on the Future of Europe was a body of 105 members, which
brought together European parliamentarians and members from the national
governments and parliaments of current EU member states as well as from thirteen
countries expected to join the European Union in the future. The Convention pre-
pared and submitted to the EU governments a draft “Constitution for Europe.” At
the time of writing, this draft was still discussed in view of a final approval by an
Intergovernmental Conference. A first attempt to draw negotiations to a conclusion
failed in December 2003. Among the contentious issues that divided member states,
the definition of the voting modalities in the European Council featured most
prominently.

25. Treaty of Rome, Article 124.

26. Treaty of Rome, Article 99.

27. Bretton Woods is a small town in New Hampshire where, in July 1944, an inter-
national conference was held to design the key features of the international mone-
tary and financial system to be established after the end of World War II. Under that
system, participating countries agreed to keep their currencies pegged to the US
dollar at rates that could be adjusted, but only to correct a “fundamental disequi-
librium” in the balance of payments. The US dollar, in turn, was convertible into a
fixed amount of gold. The Bretton Woods conference also decided to create the
International Monetary Fund (IMF) and the World Bank.

28. The structural funds (mainly, the European Regional Development Fund and
the European Social Fund) allow the European Union to grant financial assistance
to address structural, economic, and social problems. The European Investment
Bank finances investment projects that contribute to balanced growth in the
European Union. The Cohesion Fund finances projects linked to the environment
and transport infrastructure of member states whose GDP per capita is less than
90 percent of the European average.

29. The Bretton Woods regime collapsed as confidence in the convertibility of the
US dollar into gold eroded in the 1960s due to inflationary policies in the United
States and the accumulation of external deficits by that country. The pressure on
the system became such that the United States decided, in 1971, to abandon the
convertibility of the US dollar into gold. The IMF then established a regime with
central exchange rates and wide fluctuation margins (the so-called Smithsonian
Agreement), but that regime was abandoned in 1973.

30. Eichengreen (1990) notes that the literature on the optimum currency areas
does not provide a formal test through whose application the hypothesis that a
group of countries form an OCA can be accepted or rejected. Tavlas (1993) notes
that it is still difficult to weigh and reconcile all OCA properties.

31. After the pioneering contributions of the 1960s, in the 1970s several other
authors brought up several additional OCA properties including the similarity in
Notes to Pages 12–13 191

inflation rates, fiscal and political integration, and the similarity of shocks. In the
1980s and early 1990s several theoretical and empirical advancements led to reassess
the main benefits and costs from monetary integration. The long-run ineffective-
ness of monetary policy was asserted. The issue of credibility came to the fore. The
effectiveness of exchange rate adjustments was questioned. It became clear that
there are lower costs from the loss of autonomy of domestic macroeconomic poli-
cies and more benefits, for some countries at least, due to credibility gains. The view
on currency unions improved, and their borders could be drawn larger than by
mechanically testing for the sharing of OCA properties. A lot of this research was
catalyzed by the very influential One Market, One Money report by the EU Commis-
sion, which was completed in 1990 and published in 1992. In the late 1990s a new
debate started on the effects of monetary integration, namely on whether currency
unions would bring about an “endogeneity of OCA,” meaning that the fulfillment
of the OCA properties could take place ex post even if some properties were not
satisfied ex ante (Frankel and Rose 1998 and Rose 2000). The intuition is that sharing
a single currency is “a much more serious and durable commitment” (McCallum
1995). This line of thinking is still being scrutinized and is being weighed against
other forces.

32. The Mundell-Fleming model was the first to integrate international capital flows
into macroeconomic analysis. In the early 1960s the model had foreseen the impor-
tance of these flows in determining key macroeconomic variables, such as real
national income, unemployment, price level, and the interest rate. By extending the
standard macroeconomic model—the IS-LM model of the Hicks-Hansen synthesis—
to the open economy, Mundell (1963) and Fleming (1962) developed, inter alia, the
basic macroeconomic principle usually named as the “impossible trinity.” With
perfect capital mobility, they argued, only fiscal policy affects output under fixed
exchange rates, while monetary policy serves only to alter the level of international
reserves. In Padoa-Schioppa (1982) this trio has been turned into the “inconsistent
quartet” by adding a fourth element, free trade, which is a pillar of the Treaty of
Rome. As Henry C. Wallich has observed, the incompatibility of these elements is
“a fact well known to economists but never recognised in our institutional arrange-
ments or avowed principles of national policy” (Wallich 1972).

33. Krugman suggested (1987, p. 139) that “as a simple matter of feasibility, Europe
cannot have at the same time (a) stable exchange rates, (b) integrated capital
markets, and (c) independent monetary policies. The experience of the post-1973
period seems to indicate that (a) is not something that can be dispensed with. Given
the already close integration of European markets for goods and services, large
exchange rate fluctuations associated with divergent monetary policies seem to be
unacceptable. Thus creation of a unified capital market will also require adoption
of a common monetary policy.”

34. Given a range of possible outcomes (e.g., the different possible values at which
the exchange rate can stabilize in the long run between two extreme values), a
192 Notes to Pages 13–17

“corner solution” is one that involves either one of the two extremes and excludes
any intermediate solution. In the context of exchange rate regimes, which can span
an interval between full flexibility and irrevocable fixity, a corner solution is either
the abandonment of any exchange rate arrangement or the move toward a currency
union. For more references, see Eichengreen, Masson et al. (1998), Mussa et al.
(2000), and Fischer (2001).

35. The term “snake” is due to the fact that that arrangement resembled a snake
moving within a “tunnel,” the tunnel being the larger fluctuation band vis-à-vis the
dollar. Planned for all European currencies, the snake was soon reduced to the cur-
rencies of some small open economies pegged to the Deutsche mark. By March 1979
only the Dutch guilder, the Danish krone and the Belgian/Luxembourg franc had
remained in the snake.

36. Johann Wolfgang von Goethe (1749–1832), German poet, scholar, geologist,
painter, and politician, became together with Friedrich Schiller the intellectual
figurehead of the classical period of German literature. In his most important oeuvre,
Faust, Goethe produced a drama of remarkable poetic skill, philosophical depth, and
even political vision, including a premonition of the dangers of unbridled prolifer-
ation of paper money. The latter is suggested by Mephistopheles: “Der Zettel hier
ist tausend Kronen wert, ihm liegt gesichert, als gewisses Pfand, Unzahl vergraben
Guts im ganzen Land” (Faust, part II, lines 6057–6062). [Who hath this note, a thou-
sand crowns doth own. As certain pledge thereof shall stand vast buried treasure in
the Emperor’s land (trans. George Madison Priest).]

37. John Maynard Keynes (1883–1946), a British economist, is widely considered

one, if not the most, influential economist of the twentieth century. His General
Theory described how an economic system may fail to coordinate on an equilibrium
in which all available resources are efficiently used. John Hicks (1904–1989), a British
economist, made contributions ranging from the theory of consumer choice to
welfare economics to the systematization of Keynes’s macroeconomics in a coher-
ent analytical framework, which came to be known as the IS-LM model. The IS-LM
model is still in use. Franco Modigliani (1918–2003) was an American, Italian-born,
economist. He was a leading figure in the so-called neo-classical synthesis, which
established itself in the 1950s as an attempt at reconciling Keynes’s ideas about the
rigidities at work in the actual economies with the theory of efficient market and
rational choice by agents. His main contributions were to the theory of consump-
tion and savings. He worked on the first-generation family of the large macro-
econometric models, which are still used in the assessment of policy and for
forecasting purposes.

38. The result that money could have permanent effects on the economy—namely
that money can be nonneutral even in the long run—was driven by the concomi-
tant assumptions that (1) the economy was originally in a state in which factors of
production were not fully employed (i.e., there was equilibrium unemployment)
and (2) expectations did not play a major role in shaping agents’ behavior. If expec-
Notes to Pages 17–18 193

tations are rigid and the economy is not operating at full employment, then an
increase in money supply would help finance the employment of idle resources and
would not put pressure on prices.

39. Although several people had made similar observations before him, Alban W.
H. Phillips, a New Zealander economist, published a study in 1958 that represented
a milestone in the development of macroeconomics. Phillips discovered that there
was a consistent inverse, or negative, relationship between the rate of wage infla-
tion and the rate of unemployment in the United Kingdom from 1861 to 1957.
When unemployment was high, wages increased slowly and, when unemployment
was low, wages rose rapidly.

40. Don Patinkin (1922–1995), an American-Israeli economist, was one of the main
contributors to the theory of money and monetary policy, which was to become
central to the economic debate since the 1970s. Milton Friedman (1912–), an
American economist, is the recognized father of modern monetarism, the theory
that has emphasized the role of central banks’ (mis)management of money supply
as the primary cause of short-run volatility in output. He has argued that monetary
policy, while effective in the short run, can in the long run only affect inflation.
Robert E. Lucas (1937–), an American economist, is the father of the so-called ratio-
nal expectations revolution in macroeconomics. His work has proposed a new model
formalizing the way economic agents form expectations of the future.

41. In an influential paper, George T. McCandless Jr. and Warren E. Weber (1995)
examine data for 110 countries and 30 years. They find that there is an almost-unity
correlation between the rate of growth of money (in three alternative definitions)
and the rate of inflation, but there is no correlation between the rate of growth of
money, on the one side, and real output, on the other. They conclude that: “First,
the fact that the correlation between money and inflation is close to one implies
that we can adjust long-run inflation by adjusting the growth rate of money. . . .
Second, the fact that the growth rates of money and real output are not correlated
suggests that monetary policy has no long-run effects on real output. . . . If the long
run effect of monetary policy on real economic activity is truly zero, then any short-
run successes in reducing downturns can only come about at the expense of reduc-
ing upturns” (p.6).

42. Contrary to previous models, the rational expectations literature builds on the
premise that agents know the basic structure of the economy and solve the “true”
model when constructing their anticipations about key macroeconomic variables.
This has been proved (by Lucas) to imply that only unanticipated changes in policy
can affect economic decisions and thus real economic variables.

43. Paul Volcker (1927–), an American economist, was chairman of the Fed from
1979 to 1987.

44. Margaret Hilda Thatcher (1925–), a British politician, led, as prime minister of
the United Kingdom from 1979 to 1990, the so-called Thatcher revolution that
194 Notes to Pages 18–24

strongly turned the country to more market-oriented policies and less intervention
of the state in the economy.

Chapter 2

1. Two present EU members (United Kingdom and Denmark) have an “opt out”
clause, and the first attempt to remove it was defeated by the Danish voters in 2000.
(Sweden, where adoption of the euro was rejected by referendum in September 2003,
does not qualify, as it does not meet the exchange rate and legal criteria defined in
the Maastricht Treaty.) As to the new EU members, from central and eastern Europe
and the Mediterranean Sea, they will join the euro only some years after joining the
EU. As long as the Eurosystem and the ESCB do not coincide, the latter will remain
a scarcely relevant entity, because neither does it refer to the single currency area
nor does it have significant policy tasks.

2. Treaty of Maastricht, Article 105.1.

3. Treaty of Maastricht, Article 105.2.

4. ECB Statute, Article 22.

5. Treaty of Maastricht, Article 105.5.

6. ECB Statute, Article 8.

7. A discussion of how the national central banks of the Eurosystem may still differ
in their tasks, organizations, and cultures would go much beyond the scope of this
book. One can, however, give a few examples. Within the Eurosystem, not all central
banks are in charge of supervising the banks. The number of branches in relation
to total population differs considerably from country to country. Some central banks
provide services that are private in nature to the general public, the financial
markets, or the public authorities; others do not. This is reflected in the varying
degrees of involvement of the central bank in, or outsourcing of, matters such as
banknote printing, the level of banking services provided to the government, and
retail payment services.

8. For example, national central banks may act as the fiscal agent or debt manager
for their government or they may collect statistical information that is not related
to the tasks of the Eurosystem.

9. The principle of subsidiarity was elaborated by political philosophers in the late

Middle Ages and adopted by the European Union to decide the assignment of policy
responsibilities to different levels of government. In the central banking field, the
most important function that the authors of the Treaty decided to keep at
the national level is banking supervision.

10. Treaty of Maastricht, Article 5.

Notes to Pages 25–30 195

11. ECB Statute, Article 12.1.

12. This is so unless the ECB Council finds that such functions conflict with the
objectives and tasks of the Eurosystem. Article 14.4 of the ECB Statute lays down
that “national central banks may perform functions other than those specified in
this Statute unless the Governing Council [of the ECB] finds, by a majority of two
thirds of the votes cast, that these interfere with the objectives and tasks of the
ESCB.”

13. ECB Statute, Article 14.3.

14. The field of competence of the central bank differs in the United States and
Europe mainly because the Fed, contrary to the Eurosystem, has a key responsibil-
ity for prudential supervision.

15. Friedman and Schwartz (1971).

16. They are appointed by “common accord” of the EU heads of state or govern-
ment, on a recommendation of the EU Council of Ministers after it has consulted
with the European Parliament and the ECB Council.

17. ECB Statute, Article 12.1.

18. ECB Statute, Article 12.1.

19. ECB Statute, Article 10.2.

20. In major policy fields—be they defense, foreign policy, or fighting international
crime—the EU still sacrifices its capacity to act to the rule of unanimity, even when
the solution to problems no longer lies at the individual country level. And where
the majority rule is accepted, the choice of the criterion for vote weighting still stirs
the hottest controversy. The EU system works on the basis of a “qualified majority.”
Each member state is given a number of votes, ranging from 29 for the largest
member states (Germany, France, Italy, United Kingdom) to 3 for the smallest
(Malta). A decision is adopted if a simple majority of the member states support it,
and if this majority also represents a certain threshold number of votes (around 72
percent). Since the latest Treaty revision, there is a third requirement: upon the
request of a member state, it has to be verified whether the assembled majority rep-
resents at least 62 percent of the total EU population. If not, the decision is not
adopted.

21. For patrimonial decisions concerning, inter alia, the capital of the ECB, the
transfer of foreign reserve assets to the ECB, and the allocation of net profits and
losses of the ECB, the votes in the ECB Council are weighted according to the
national central banks’ shares in the ECB capital.

22. In the International Monetary Fund, which is not in charge of a single policy
in the way the Eurosystem is, voting power of the member countries is allocated in
proportion of financial contributions, not on the basis of “one country, one vote.”
196 Notes to Pages 30–36

23. In the European Monetary Institute (EMI), which operated between 1994 and
1998 to prepare the technical and organizational foundations of the Eurosystem’s
policy framework, unanimity was required for any binding decision. Institutions
and countries (rather than persons) were sitting at the table, and meetings were
negotiations rather than deliberations. After the most influential central bank, the
Bundesbank, had firmly stated its position, the course of the discussion was set.

24. Hans Tietmeyer (1931–) was president of the Deutsche Bundesbank from 1993
to 1999.

25. Admittedly there is, beyond the word of an insider such as the author of this
book, little hard evidence that national interests do not prevail in the field of mon-
etary policy. It has to be considered, however, that the opposite contention, made
by some outsiders, also lacks hard evidence. One may argue that publication of the
minutes of the meetings of the ECB Council could resolve the doubt and settle the
issue. The reasons why the ECB has decided not to publish those minutes are
explained in chapter 4, section 4.6.

26. “To safeguard the currency” (“die Währung zu sichern”) was the primary func-
tion of the Bundesbank, as laid down in the Bundesbank Act of 1957.

27. Treaty of Maastricht, Article 108.

28. Amendments to the EU Treaties have to be unanimously agreed by national gov-

ernments and subsequently ratified by all national parliaments. Moreover in many
countries a national referendum is also required.

29. “Defend their savings” derives from the statutory tasks of the Banca d’Italia,
which is “la difesa del risparmio.”

30. Padoa-Schioppa (2000a).

31. There is a plethora of academic texts on European integration studies. A useful

overview of various theoretical approaches is contained in Rosamond (2000). The
history, institutions, procedures, and policies of the European Union are well
explained, inter alia, in Nugent (2002), Dinan (1999), and Wallace and Wallace
(2000).

32. Perhaps the crucial element that makes the European Union a statelike con-
struct rather than a conventional international organization is the increasing (albeit
still partial) recourse to the majority principle in decision-making. When adopting
majority voting, and only then, there is full acknowledgment of a common inter-
est that supersedes the national interests of member states. Conversely, the una-
nimity rule and right to veto decisions mark the gulf that separates the European
Union from a full-fledged union.

33. An Intergovernmental Conference (IGC) is an ad hoc conference of representa-

tives of the governments of the member states. After agreement in the IGC, the Con-
Notes to Pages 36–42 197

stitution needs ratification in all member states in accordance with their respective
constitutional requirements.

34. In 2004 the EU budget amounted to 99.7 bn euro, or 1 percent of the EU GDP.

Chapter 3

1. For so long have currencies been associated with countries that, as soon as the
advent of the euro became certain, a name was invented for the country of the euro.
Euroland was the name chosen by the media, “euro area” the name more often used
in official documents of the ECB. The Académie Française, since 1635 the custodian
of the purity of French lexicon, was concerned that “Eurolande” could sound too
much like a true country and opted for “zone euro.” In the following, the terms
euroland and “euro area” will be used interchangeably to refer to the economic area
formed by the EU countries (twelve at the moment of writing this book) that have
adopted the euro as their currency.

2. The Treaty provides, so stated the European Court of Justice in 1963 in the Van
Gend and Loos judgment (Case 26/62, Van Gend en Loos v. Nederlandse Administratie
der Belastingen), a “new legal order for the benefit of which the States have limited
their sovereign rights, albeit within limited fields.” The “limited fields” essentially
refer to the economy. In the same judgment the Court also established the princi-
ple that certain provisions of Community law—if they are unconditional and suffi-
ciently precise—are directly effective in that they create “individual rights which
national courts must protect” without there being any need for further imple-
menting legislation in the member states (often referred to as the doctrine of “direct
effect”). This direct impact of the Community is also evidenced in particular by the
“establishment of institutions endowed with sovereign rights, whose exercise affects
member states and also their citizens. On the basis of the legislative capacity created
by the Treaty, an ample body of European legislation has been produced. Directives,
regulations, and decisions are the types of legally binding EU acts produced by the
European Union, depending on whether they are applicable directly and in their
entirety in all member states of the Community, or are binding with regard to the
result to be achieved, but allow each member state to choose its own means of
implementation, or are directly binding, but only on the individual(s), enterprise(s),
or member states to which they are addressed. EU legislation is enforced by the
European Court of Justice and by national courts. From the 1960s onward a jurispru-
dence of national constitutional and ordinary courts has stated the supremacy of
European law over national law.

3. Alternative taxonomies could of course be considered, such as a classification by

objectives (e.g., efficiency, stability, equity) or one by instruments (e.g., taxation,
expenditure, regulation, money printing). They would, however, be less suited to
describe a constitutional order in which objectives as well as instruments are, to a
certain degree, entrusted to more than just one level of government.
198 Notes to Pages 43–48

4. The Treaty disregards the internal constitutional structure of member states,

leaving them free to decide whether they should be organized in a federal or cen-
tralized way. In fact the member states of the EU present a variety of approaches
ranging from the highly centralized constitutional structure of France to the federal
structure of Germany. Over the decades since the start of European integration, most
states have progressively decentralized their organization.

5. Article 2 of the Treaty.

6. Articles 4.1 and 4.3 of the Treaty.

7. It is interesting to note that the three goals of efficiency, stability, and equity also
underlie the system of international cooperation developed after World War II.
Indeed the World Trade Organization, the IMF, and the World Bank can be seen as
the three global agencies to which the three objectives are respectively assigned,
with the United Nations acting as the overall political structure. Article 1 of the IMF
Articles of Agreement refers to purposes like “expansion and balanced growth of
international trade,” “promotion and maintenance of high levels of employment
and real income,” and “to promote exchange stability.” A similar threefold involve-
ment can be traced in the stated goals of agreements for regional groups of coun-
tries, like NAFTA (for North America), ASEAN (for Southeast Asia), and MERCOSUR
(for Latin American countries). In international settings, however, the institutional
arrangements created to pursue those goals are softer and looser than in national
systems, where the full power of the state is available. Thus, although efficiency, sta-
bility, and equity are often stated as common objectives, the decision-making capac-
ity, the resources, the direct reference to the citizens, the legal system, and the
enforcement power that characterize international institutional frameworks are
weak and often missing altogether.

8. These features are common to all sovereign states. They are most pronounced in
the highly centralized states that took shape in Europe over the last three centuries
(particularly in France, United Kingdom, and Spain). They are also present in fed-
erally structured states, such as the United States, Canada, and Switzerland.

9. Attribution to a higher or lower level would involve inefficiencies. Each function

should be allocated to the lowest level of government at which the expected welfare
gains can be reaped. Only indivisibility, economies of scale, externalities, and strate-
gic requirements are acceptable arguments to lift powers to higher levels.

10. A number of studies have considered the theoretical rationale for policy
coordination in EMU. See, for example, Buti and Sapir (1998), and Jacquet and
Pisani-Ferry (2001).

11. Deliberations occur in several bodies such as the ECOFIN Council, the
Eurogroup, the Economic and Financial Committee. The Eurogroup is an informal
body within which the Finance Ministers of the euro area meet to discuss issues
connected with their shared responsibility for the single currency. The Commission
Notes to Pages 48–53 199

and the ECB are also invited to participate. The Economic and Financial Commit-
tee is comprised of two senior officials from each member state (one from the finance
ministry and one from the central bank), the Commission and the ECB. It plays an
advisory role and helps prepare meetings of the EU Council when the latter is to
discuss economic and financial issues. For these occasions the EU Council brings
together the specialized Ministers of Economy and Finance and is then referred to
as ECOFIN.

12. Emerson and Gros (1992). In examining the costs and benefits of a single cur-
rency, the Commission pointed out that, with the completion of the single market,
continuing with a peg but adjustable exchange rate system (what it called the “1992
+ EMS” scenario) would not be a stable alternative to economic and monetary union.
This was because “complete capital liberalization requires virtually a unified mone-
tary policy if exchange rates are to be stable.” This argument was captured in the
phrase “one market, one money.”

13. For instance, in Italy workers receive unemployment insurance payout for six
months after becoming unemployed, whereas in France and in the Netherlands such
transfers can continue up to sixty months.

14. This principle was formally adopted in the mid-1980 to ensure the singleness
of the market in a way that would both avoid overextending EU harmonized legis-
lation and impede discriminatory action by national authorities. The principle of
mutual recognition was first applied in a famous ruling of the Court of Justice of
1979 (the Cassis de Dijon ruling of Case 120/78, Rewe-Zentrale v. Bundesmonopolver-
waltung für Branntwein), stating that “[t]here is therefore no valid reason why, pro-
vided they have been lawfully produced and marketed in one of the member states,
alcoholic beverages [i.e., Cassis de Dijon for this case, but, by extension, applicable
to all kinds of products] should not be introduced into any other member state.”
Based on the logic of mutual recognition, the Commission presented a “New
Approach” to lawmaking in 1985, which sought to restrict the harmonization mea-
sures (necessary for the completion of the single market) to “essential requirements”
(e.g., consumer safety), thereby avoiding the need for excessively detailed rules.

15. Prior to the start of the euro the Treasury–central bank relationship differed
between the countries that now form euroland. In France, for example, decisions
were taken by the Treasury, with the Banque de France in charge of an execution
role. In Germany and Italy, by contrast, the key role was played by the central bank.

16. Article 4.2 of the Treaty.

17. In particular, Article 111 of the Treaty contemplates two so-called arrangements
and sets ground rules for the Treasury–ECB shared competence. The first type of
arrangement is “formal agreements on an exchange rate system.” An adjustable peg
or a target zones system—under which exchange rates can move freely but only
within predefined fluctuation bands—would fall into this category. The second type
is the formulation of more ad hoc, less structured “general orientations” for
200 Notes to Pages 53–54

exchange rate policy. With regard to the latter, however, the Treaty itself stipulates
that they should be without prejudice to the primary objective of the Eurosystem
to maintain price stability.

18. Resolution of the European Council on “Economic policy coordination in Stage

3 of EMU and on Treaty Articles 109 and 109b,” annexed to the Presidency Con-
clusions of the Luxembourg European Council of December 12 and 13, 1997.

19. Article 104 of the Treaty states that “Member States shall avoid excessive gov-
ernment deficits.”

20. The idea of a “Stability Pact” was first presented by German Finance Minister
Theo Waigel in 1995. It aimed to ensure that the member states continue on the
path of fiscal discipline (and avoid lapsing into the old profligate behavior of earlier
decades) even after they had reached the 3 percent deficit target set by the conver-
gence criteria for entry into EMU. The Stability Pact was to become an essential com-
plement to monetary union since it represented an “insurance policy” against
negative spillovers on all countries sharing the euro that might arise if overspend-
ing governments generate pressure on the common interest rate. Legally the later
renamed (on French insistence) “Stability and Growth Pact” consists of a European
Council Resolution stating the member states’ commitment to the rules and objec-
tives of the Pact and two Council Resolutions laying down the precise details for
multilateral surveillance and speeding up the Treaty procedure to deal with exces-
sive deficits in particular member states.

21. National public budgets play the largest role in the EU fiscal framework. They
account for about 97 percent of the totality of public expenditures from all levels
of government. The macroeconomic relevance of the EU and the subnational
budgets is, instead, quite negligible. The EU budget is subject to a stringent upper
limit (presently of 1.27 percent of the aggregate GDP of the Union), which can only
be raised through a lengthy and difficult procedure, while deficit spending is pre-
cluded. As to subnational budgets, they vary in size and importance, depending on
the constitutional set up of each country, but are generally small relative to those
of central governments.

22. The Pact also states that in case of a “severe economic downturn” with an
“annual fall of real GDP of at least 2 percent,” this limit would not apply.

23. According to this procedure, member states of the euro area submit every year
so-called stability programs, where the envisaged development of national public
finances for the years to come are set out. The programs are received and analyzed
by the European Commission, then discussed by national Treasury officials in the
Economic and Financial Committee, prior to formal deliberations by the ECOFIN
Council. In the event that the fiscal policy of a member state is seen as incompati-
ble with the Pact, the Council can adopt a recommendation, and make it public.
Member states are also obliged to transmit the relevant data of national public
Notes to Pages 54–55 201

accounts (budget deficit, overall public debt) twice a year to the European Com-
mission in order to assess actual—as opposed to merely intended—conduct of
national fiscal policies. Governments failing to respect the upper deficit limit can
be subjected to the payment of fines of up to 0.5 percent of the offending country’s
GDP.

24. Despite a universal AAA rating small, but persistent, spreads are quoted by the
market among sovereign borrowers. For example, Italian ten-year bond yields were
on average around 20 basis points over the German benchmark in the first half of
2003.

25. This freedom is subject to the sole condition of complying with European
macro rules and with some micro restrictions related to the single market. An
example of the latter is the provisions for harmonized taxation. In 1992 the EU
Council agreed on a revised VAT directive which, among other things, sets a
minimum standard VAT rate of 15 percent for all EU countries (though reduced
VAT rates can continue to apply to a commonly agreed list of specific products and
services).

26. Article 102 of the Treaty states that “Any measure, not based on prudential
supervision, establishing privileged access by Community institutions or bodies,
central governments, regional, local or other public authorities, other bodies gov-
erned by public law, or public undertakings of Member States to financial institu-
tions, shall be prohibited.” Article 101 of the Treaty states that “Overdraft facilities
or any other type of credit facility with the ECB or with the central banks of the
Member States (hereinafter referred to as “national central banks”) in favour of Com-
munity institutions or bodies, central governments, regional, local or other public
authorities, other bodies governed by public law, or public undertakings of Member
States shall be prohibited, as shall the purchase directly from them by the ECB or
national central banks of debt instruments.”

27. Allowing the automatic stabilizers to operate means that little or no action is
taken to counteract the shortfall of tax revenues and increase of government spend-
ing on social benefits which occurs naturally during a downturn. Examples of dis-
cretionary measures are social security spending, lower taxation, and public
spending on infrastructure.

28. A useful overview of the different views and proposals made in the context of
the discussion on the Stability and Growth Pact in 2002 can be found by consult-
ing the briefing papers prepared for the exchange of views between the ECB presi-
dent and the European Parliament’s Economic and Monetary Affairs Committee on
December 3, 2002. While some of the briefing papers, including those prepared by
Guillermo de la Dehesa (Centre for European Policy Research, CEPR), Charles
Wyplosz (CEPR), Jean-Paul Fitoussi (Centre for European Reform, CER), and Gustav
Horn (Deutsches Institut für Wirtschaftsforschung) went in the general direction of
202 Notes to Pages 55–59

making the Pact more flexible, other papers, including those prepared by Sylvester
Eijffinger (CEPR), Giampaolo Galli, Daniel Gros (Centre for European Policy
Studies, CEPS), and Niels Thygesen argued that the rules of the Pact needed to be
strengthened. As far as policy-makers are concerned, the proponents of a more flex-
ible Stability and Growth Pact have included, notably, the British government and
Commissioner Mario Monti.

29. To use the words of Article 2 of the Treaty, the goal of economic policy is to
promote “a harmonious, balanced and sustainable development of economic
activities.”

30. For example, the European Commission (2002) Communication “The Euro area
in the world economy—developments in the first three years” mentions that “the
aggregate policy mix of the euro area is what matters for the rest of the world.”
Recital 9 of the European Parliament’s Report on the 2001 Annual Report of the
ECB states that “a right ‘policy mix’ between monetary and fiscal policy presupposes
sound public finances.”

31. The Broad Economic Policy Guidelines and the Excessive Deficit Procedure are
the two EU procedures. The so-called Broad Guidelines of the Economic Policies of
the Member States and of the Community are adopted by the EU heads of state
or government on an annual basis. They contain a joint analysis of the current eco-
nomic situation and set out the main orientations for the conduct of economic poli-
cies for the coming year, including country-specific recommendations that clearly
identify the policy measures that each national government needs to take in order
to remedy specific economic deficiencies. The Excessive Deficit Procedure regulates
how the EU governments act collectively in the event that a member state breaches
the upper deficit limit of 3 percent of GDP. Over the period of a year, the procedure
foresees a gradual buildup of collective pressure on the offending country to mend
its ways, starting with warnings and policy recommendations, which—in order to
maximize their disciplining effect—can be made public. They can ultimately lead
to the imposition of sanctions, including the payment of fines of up to 0.5 percent
of the respective country’s GDP.

32. In reality, EMU has enhanced not only competition but also cooperation in the
field of budgetary policies, largely because, by cooperating, national budgetary
authorities, and specially Finance Ministers, can better overcome political and social
resistance to structural reforms. Thus, in addition to the monitoring of the macro-
economic profile of fiscal policy, a practice has been started to assess the quality of
national budgets. The structural features of revenues and expenditures are jointly
examined, so as to learn from each other how best to address longer-term challenges,
like the budgetary impact of aging populations.

33. The German Länderfinanzausgleich (Regional Financial Compensation) is a

scheme that provides for a limited redistribution of fiscal revenues between the more
prosperous and less prosperous German regions.
Notes to Pages 60–61 203

34. Corporatism, in this context, refers to a form of social partnership between the
government and centralized interest groups (usually employers and organized labor)
giving the latter a privileged role in economic and social policy making. In return
for favorable policies, the leaders of labor unions and employers’ organizations
undertake the implementation of policy by delivering the cooperation of their
members. Even though generally in retrenchment in Europe since the 1960 and
1970s heydays, this kind of tripartite negotiation also has recent examples, such as
the 1998–2002 “Alliance for Jobs” between the German government, employers, and
trade union organizations or recurrent tripartite agreements under the Italian “Patto
Sociale,” or the (until recently) usual consultation between the Spanish government
and Social Partners on most major social and economic policy initiatives (e.g.,
changes to the labor laws or pension reform).

35. The Economic and Social Committee is an organ of the European Union that
offers advice to the EU institutions on the potential economic and social impact of
pending legislation. It consists of 344 part-time members who are appointed by
national governments and who represent employers, trade unions, consumers, and
other interested groups.

36. The single currency deprives national policy-makers of the key exchange rate
instrument that, until recently, was used to gain (or regain) competitive advantage
and sustain employment. So there will be no way to correct the consequences of
inconsistent labor cost dynamics in different countries (e.g., see Feldstein 1997).
There is, however, disagreement in the literature as to whether EMU would be con-
ducive to labor market reforms that could reduce the risks of lost competitiveness.
Some authors suggest that once the easy option for an EMU country to devalue its
currency is lost, it will have no alternative but to proceed with labor market reforms
(Bean et al. 1998). Others, however, worry about the risks of open-ended transfers
within the euro area, which could serve to stabilize but may finance regional non-
adjustment indefinitely (Obstfeld and Peri 2000).

37. See, for instance, Decressin and Fatas (1995) and Boeri, Layard, and Nickell
(2000)

38. In the run-up to monetary union, the European Union has set up a number of
so-called processes to develop this consultative mode in the fields of employment
and structural policies. Specifically, a new chapter on Employment has been inserted
into the Treaty in 1997, which provides for the elaboration of annual Employment
Guidelines. These Guidelines set out recommendations and priority areas of action,
especially with regard to labor market reform, development of labor skills, and job
creation through the encouragement of business start-ups. National Employment
Action Plans transpose these orientations into policy proposals operable at national
level, taking into account the specific conditions of the country. Together with the
regular exchanges of views and the reciprocal learning from good as well as bad
experiences, this has become known as the “Luxembourg process,” given its elabo-
ration at the European Council meeting in Luxembourg on November 20–21, 1997.
204 Notes to Pages 61–65

39. The labor force participation rate is the percentage share of the economically
active (employed or unemployed) population over the total population.

40. As GDP figures are usually expressed in national currencies, it is necessary to

convert them to a common denominator for cross-country comparisons. In the
figures cited in this appendix, and in line with the convention used, for example,
in the World Economic Outlook, published by the IMF, this is done on the basis of
purchasing power parities (PPP), which measure the real amount of goods and ser-
vices that can be bought with one unit of each currency. This conversion corrects
for differences in national price levels as well as exchange rate fluctuations. When
converted at market exchange rates, the respective shares of world GDP are some-
what higher than in PPP terms, namely 21 percent for the euro area and 33 percent
for the United States.

41. At market exchange rates, GDP per capita in the euro area was at 61 percent of
the US level. This higher gap in exchange rate terms rather than in PPP terms reflects
essentially the relatively high valuation of the US dollar exchange rate in the refer-
ence year (2002).

42. A few examples may be indicative of the difference. In euroland the public sector
pays almost 75 percent of total health care expenditure, whereas in the United States
only 45 percent is carried by the public sector. The respective roles of the govern-
ment and the private sector also differ substantially with regard to the educational
system, especially university education, for which the sector bears around 87 percent
of the costs in euroland against 47 percent in the United States.

43. In cross-country comparisons it appears that the lowest income per capita
(Greece) is at 67 percent of the euro area average, while income per capita reaches
123 percent of the areawide average in Ireland and even 190 percent in Luxem-
bourg. Total government expenditures are 34 percent of GDP in Ireland and 54
percent in France; public debt ranges from 6 percent of GDP in Luxembourg to 107
percent in Italy.

44. The G7 consists of seven major industrial countries—Canada, France, Germany,

Italy, Japan, the United Kingdom, and the United States—that meet annually at the
level of heads of state or government. In addition the ministers of finance and
central bank governors of the G7 hold regular meetings on economic and financial
matters. The presidency of the Eurogroup and the ECB participate in those parts of
the meetings devoted to multilateral surveillance and exchange rate policies.

45. The strong economic performance of the United States in the 1990s can be
attributed to a combination of growing employment with strongly increasing pro-
ductivity. Over the period 1991 to 2000, productivity increases in the United States
were above those in the euro area, especially when measured in terms of total factor
productivity (1.2 percent in the United States against 0.9 percent in the euro area).
Notes to Pages 67–69 205

Chapter 4

1. This was quite a different situation from that of any other financially sophisti-
cated industrial economy, where this highly complex and integrated basis is the
outcome of a long process of trial and error, known to market participants, well
understood by analysts, and familiar to the general public. It is true that the ECB
Board and Council greatly benefited from the preparatory work conducted by the
EMI over the three preceding years. However, since the EMI had virtually no deci-
sion-making power, almost no concrete steps had been taken before June 1998. For
a description of the differences between the setup of central banking and monetary
policy prior to the start of the single currency, see Padoa-Schioppa and Saccomanni
(1994).

2. “Two-pillar strategy” soon came to characterize the monetary policy strategy of

the ECB. Interestingly this catchphrase, which was widely used by the ECB in its
publications, was actually coined by a journalist in a question to the ECB president
when the strategy was first presented. Of course, the phrase fails to indicate that the
components of the strategy are in fact three, and not two.

3. The reason why the lag is long is that while monetary policy has a relatively
quick impact on very short term interest rates, it takes time for this impact to be
transmitted to the entire structure of interest rates and, through this channel, to
consumption and investment decisions. The lag is variable because the institutional
setting (bank regulations, various provisions on financial markets, etc.) may change
over time, thus having an impact on the flexibility of financial intermediaries in
response to policy stimuli and on the sensitivity of other agents vis-à-vis changes
in the interest rate.

4. M3 is a broad money aggregate that includes currency in circulation, overnight

deposits, deposits with agreed maturity of up to three years, deposits redeemable at
notice up to three months, repurchase agreements, money market funds and units,
money market paper, and debt securities with maturity of up to two years.

5. For M3, which is the key variable selected to look at the relationship between
money and prices, a quantitative reference value of 41/2 percent annual growth, to
be re-examined every year, was announced by the ECB in October 1998. The refer-
ence value is identified as the M3 growth rate that would be consistent with price
stability in the medium term. It is derived from a simple quantity relation, linking
money growth to price stability, potential output and changes in the velocity of
money.

6. Lucas (1996).

7. For a more in-depth discussion of the reasoning behind the formulation of the
monetary policy strategy (e.g., see Issing et al. 2001; ECB 1999).
206 Notes to Pages 70–74

8. In 1997 the newly elected British government (led by Prime Minister Tony Blair)
introduced a major institutional reform of monetary policy and financial regulation
and supervision. As a result of this reform the Bank of England was given opera-
tional responsibility for setting interest rates in order to meet the Treasury’s stated
inflation target that had been introduced following Britain’s departure from the
Exchange Rate Mechanism in 1992. With the same reform, the competence for
banking supervision was taken away from the Bank of England and transferred to
a new institution (the Financial Services Authority), where all the competencies for
financial regulation and supervision of individual financial organisations in all
sectors of finance were concentrated. However, the Bank of England continues to
have statutory responsibility for the stability of the financial system as a whole.

9. See, for example, Bernanke et al. (2001), Loayza and Soto (2002), and Bernanke
and Woodford (2003) for further reading on the conceptual issues of inflation tar-
geting, as well as an implementation and evaluation of inflation targeting.

10. See, for example, the annual reports in the series “Monitoring the European
Central Bank” by the Centre for Economic Policy Research (CEPR) in London, or
the reports by the Macroeconomic Policy Group of the Centre for European Policy
Studies (CEPS) in Brussels. In addition Buti and Sapir (2002) provide a collection of
contributions by academics and policy-makers that assess the early years of EMU.

11. See Gaspar et al. (2001) and Hartmann et al. (2001).

12. Some recent studies have focused on optimal policy frameworks for a smooth
and measured response to shocks by the central bank; see, for example, Woodford
(1999).

13. The Policy Target Agreement between the treasurer and the governor of the
Reserve Bank of New Zealand has recently adopted the notion of ‘over the medium
term’ when specifying the time horizon over which the Reserve Bank has to guar-
antee price stability.

14. Svensson (2002) questions the alleged lack of clarity over the ECB’s inflation
objective and suggests to specify a point value within the 0–2 percent region indi-
cated by the ECB as consistent with its definition of price stability. In his opinion,
having a point target is more important than the precise level of the target. See also
Svensson (1999) for an early critical appraisal of the monetary policy strategy of the
ECB, as it was originally conveyed to the public in 1998.

15. See Galí (2003) for a complete description of this position.

16. The Keynesian theory of demand determination was cast into an analytical
framework for policy analysis and became widely known as the IS-LM model. Hicks
(1937) published the original version of the model. During the 1960s and 1970s this
model was enriched by a condition for price determination, which in the original
version had been left unspecified. By this additional condition, which came to be
Notes to Pages 74–76 207

known as the Phillips curve (after a 1958 empirical study by A. W. Phillips), wage
inflation, and implicitly, price inflation, was postulated to be determined by the pre-
vailing situation in the labor market; high unemployment was associated with low
wage inflation, and vice versa. A very influential article by Samuelson and Solow
(1960) interpreted the evidence as indicative of a persistent trade-off between unem-
ployment and inflation, which the policy-makers could exploit. In their own words:
“In order to achieve the non perfectionist’s goal of high enough output to give us
no more than 3 percent unemployment, the price index might have to rise by as
much as 4 to 5 percent per year. That much price rise would seem to be the neces-
sary cost of high employment and production in the years immediately ahead” (p.
192).

17. This nonneutrality in the short term but neutrality over the long term of the
reference model is reflected in the Phillips curve, which has a finite slope in the
short term but drifts in the long run as private expectations adjust to the monetary
policy. Over the long run as adjustments are made to a higher expected rate of infla-
tion, the intercept of the Phillips curve drifts upward, and the trade-off between
inflation and unemployment disappears.

18. See De Long (1997) for a colorful discussion of the attempts to stem high infla-
tion in the 1970s in the United States. In his view, it was the happy reception of
the Samuelson-Solow conception of an exploitable Phillips curve within the politi-
cal circles surrounding President Nixon that introduced in 1969 the permanent
upward bias to inflation.

19. Interest rate rules of this kind are now proliferating in macroeconomics. One
such rule was proposed by John Taylor in 1993. The so-called Taylor rule prescribes
that the short-term real interest rate be set to equal the “natural rate,” on average,
and to deviate from it in response to deviations of inflation from the central bank’s
target and output from the level that is sustainable in the long run.

20. Gerlach and Svensson (2002) and Trecroci and Vega (2001) find, for example,
that a “real money gap,” which is the difference between the actual level of real
money balances and the level that would be consistent with a long-term equilib-
rium money demand, helps predict future inflation in a way that cannot be
explained on the basis of the new-Keynesian real sector model.

21. Orphanides (2000) argues that the high inflation plaguing the 1970s in the
United States was caused by a severe mismeasurement of the economy’s productive
capacity. The dramatic fall in productivity that took place in the early 1970s was
misread by the Federal Reserve as a fall of output below its “natural” level and thus
responded by a reflationary policy.

22. At the two extremes of the “rules versus discretion” spectrum, in the “decisive”
(or decision-making) meeting, the set is, respectively, empty or full.
208 Notes to Pages 77–84

23. Due to the postulate of rationality, the difference between knowledge and will
is not recognized in theoretical economic research. It is, however, a distinction that
is well known in the fields of psychology and philosophy.

24. The exogenous price shocks included an oil price shock in 1999 to 2001 (more
than 60 percent increase in the average oil price of 2001 relative to 1999), the “mad
cow” and foot-and-mouth diseases in late 2000 and 2001 (7.2 percent increase in
unprocessed food prices in 2001), the 1999–2000 depreciation of the euro (16.6
percent in nominal effective terms), the freeze in January 2002 (plus 8.4 percent
increase in the price of unprocessed food), the cash changeover in early 2002 (an
estimated effect of up to 0.3 percent increase in the total euro area HICP), the
increase in indirect taxation in 2003 (sources: ECB Monthly Bulletin and Annual
Report, various issues; Eurostat).

25. For more information on the outcome of the evaluation of the monetary policy
strategy, see the ECB press release “The ECB’s monetary policy strategy” of May 8,
2003. A number of background studies prepared by ECB staff, which served as input
into the Governing Council’s evaluation of the strategy, were also made public
at the same time. These background studies are available on the ECB Web page
(www.ecb.int). For additional information, see also the article entitled “The outcome
of the ECB’s evaluation of its monetary policy strategy,” which appeared in the June
2003 issue of the ECB Monthly Bulletin.

26. Bank reserves are held by the banks at the central bank for the purpose of
meeting the minimum reserve requirement (see below) and for the clearing of inter-
bank balances. With the control of bank reserves, the central bank sets a target for
the amount of bank reserves and is ready to accept whatever interest rate is needed
for the banks to absorb that amount. With the control of the interest rate, the central
bank sets a target for the level of short-term interest rate and stands ready to supply
the market with the amount of bank reserves needed for the market to clear at that
level of the interest rate.

27. A case in point is the decision, taken by the Bank of Japan in 2001, to target
the amount of bank reserves rather than a short-term interest rate.

28. The interest rate applied to open market operations is the most important policy
rate of the ECB. The weekly frequency of the operations, lower than that custom-
ary to several national central banks prior to the euro, and the practice of full
publicity were chosen to enhance the strength and clarity of the signaling effect.
Repurchase agreements are reverse transactions whereby the central bank purchases
a given amount of admissible instruments on the understanding that these will be
repurchased by the counterparty at a specific price on a future date or on demand.

29. The deposit and the marginal lending rates constitute, respectively, the floor
and the ceiling for the overnight interest rate in the money market.

30. Since compliance is determined on the basis of the average of the daily balances
of the banks’ accounts with the Eurosystem over a so-called maintenance period of
Notes to Pages 84–86 209

one month, the reserve funds act as an automatic buffer for liquidity shocks, and
hence as a stabilizer for very short-term interest rates. Banks can postpone the con-
stitution of their reserves in the event of a temporary shortage of liquidity at any
point of the maintenance period; they can also front load the constitution of their
reserves in the event of a temporary surplus.

31. The most obvious example is the situation of countries that followed a stable
exchange rate policy. For those countries the day-to-day control of the interest
rate was key, so they had a practice of daily operations. The Banque de France, for
instance, used daily fine-tuning operations that allowed a tight control of the
overnight interest rate. Another example is that of Portugal, where for historical
reasons the central bank had accumulated massive amounts of domestic assets, gold,
and foreign exchange reserves. Accordingly there existed a large liquidity surplus
and the central bank implemented monetary policy by withdrawing liquidity
(issuance of debt certificates). See Borio (1997).

32. While the charter of the Fed allowed the Federal Reserve District Banks to
provide extra central bank money to the economy via rediscount operations, the
Eurosystem has fully centralized all decisions that have an impact on the overall
liquidity. Originally each Federal Reserve District Bank set its discount rate inde-
pendently, to reflect banking and credit conditions in its own district. Over the
years, reflecting the integration of regional credit markets into a national market,
the discount rate has become homogeneous across the country. Today the discount
rate used by all Reserve Banks is identical, except for the days around a change, as
not all Reserve Banks implement the change on the same day. The decision to
provide liquidity at the discount window remains at the discretion of each Reserve
Bank. The collateral accepted is also decided independently by each Reserve Bank.
However, Regulation A of the Federal Reserve Board of Governors, which defines the
conditions under which the discount window is to be used, specifies that “the
lending functions of the Federal Reserve System are conducted with due regard to
the basic objectives of monetary policy and the maintenance of a sound and orderly
financial system.” In May 2002 the Board of Governors published a proposed
amendment to Regulation A. Under this proposal, each Reserve Bank would retain
its discretion over (1) the type of collateral used and (2) whether it accepts to lend
to bidding banks. See Madigan and Nelson (2002) and Borio (2001).

33. As it will be further explained in chapter 5, each national central bank remains
responsible for the provision of emergency liquidity if a credit institution belong-
ing to its jurisdiction runs into a crisis. Even in this case, if the liquidity to be created
is of an amount that can influence the stance of monetary policy, the ECB Council
will be involved.

34. Dispersion of short-term interest rates in euroland has been negligible from the
very first days of EMU.

35. ECB Statute, Article 2.

210 Notes to Pages 86–89

36. Two features of the US financial structure are relevant in this respect. The first
feature is the huge depth and liquidity of the repo markets in which the operations
are conducted, and the second is the depth and organization of the market for bank
reserves, which ensures that central bank money attributed to few institutions is
channeled efficiently through the entire system.

37. See Angeloni, Kashyap, Mojon, Terlizzese (2001).

38. The importance of central bank credibility was first introduced by Kydland and
Prescott (1977), who stressed the tension between ex ante and ex post optimal mon-
etary policy, and pointed out the importance that central banks are able to pre-
commit to policies. Their key result—and of Barro and Gordon (1983)—is that
discretionary monetary policy (i.e., when a central bank can freely alter its policy)
is time inconsistent and that it therefore produces an inflation bias. In essence, this
problem arises because in a low-inflation environment there may be an incentive
for a discretionary central bank to unexpectedly pursue an expansionary monetary
policy in the short term. This incentive, however, will be known by the public,
which will adjust wages and prices accordingly, thereby introducing an upward bias
in inflation without any positive effects on output. Calvo (1978) focuses on a closely
related credibility problem due to the incentive of increasing inflation in order to
obtain revenue from the private sector in the form of seignorage. In subsequent
development of the literature, the importance of the central bank’s reputation has
been stressed. In particular, the possibility that the central bank will suffer a loss
to its reputation if it deviates from its announced low-inflation policy has been
suggested as a potential solution to the inflation bias problem, since a loss of
reputation will entail significant future costs (e.g., see Backus and Driffill 1985).
Alternatively, Rogoff (1985) suggests that the inflation bias problem may be solved
by appointing an independent “conservative central banker” to conduct monetary
policy. This central banker should be conservative in the sense of having more than
society as a whole preferences placed on maintaining low inflation. Because the
public will realize that this type of central banker has little desire to pursue an expan-
sionary monetary policy, it will also expect inflation to be low in the future. Walsh
(2003) provides a more detailed overview of the academic literature on the inflation
bias and possible solutions to it.

39. The general equilibrium mode of representing the workings of the transmission
mechanism of monetary policy is dominant in today’s macroeconomics. For a com-
prehensive treatment, see Woodford (2003).

40. This is a “game” in which there may be two solutions (i.e., two different, though
plausible outcomes): one in which the rate of growth of money is low, and wage
and price inflation are low; and the other one in which wage inflation is set at a
high level and the central bank accommodates wage claims with a high rate of
money growth, thus yielding high inflation. A “tough” central bank, meaning a
central bank that is consistently committed to an objective of stable prices and is
not prepared to deviate from it under any circumstances, can be shown to coordi-
Notes to Pages 89–100 211

nate expectations (and thus wage claims and inflation) on the low-inflation equi-
librium. See, among others, Horn and Calmfors (1985).

41. This was epitomized by such expressions as “le silence de la monnaie” (the silence
of money) or “Rumore” (noise) used by Jacques Rueff and Luigi Einaudi respectively.
Jacques Rueff (1896–1978), one of France’s most influential liberal thinkers and
economists of the twentieth century, owes his reputation to his career in public
administration (director of Treasury, vice-governor of the Banque de France, magis-
trate of the Court of Justice of the European Communities) and his persuasive talent.
The formula “the silence of money” attributed to him has been used for years in
France to epitomize the appropriate noncommunicative behavior of those in charge
of monetary policy. In his 1960 article “Rumore” (Noise) Luigi Einaudi (see endnote
1 in chapter 1) stated that, rather than acting through policy decisions visible to
the media and the markets, a good central bank governor should seek to influence
monetary conditions through informal advice to bankers on whether to expand or
to constrict credit.

42. This can be illustrated by the following two quotes of what Chairman
Greenspan is reported to have said: “I know you believe you understand what you
think I said. But I am not sure you realize that what you heard is not what I meant.”
And, on another occasion, “If I say something which you understand fully in this
regard, I probably made a mistake.”

43. The Fed and the Bank of England publish the minutes with a delay of respec-
tively around six and two weeks, the Bank of Japan in the week after the next
meeting of its monetary policy committee.

44. The justification is required if for two consecutive quarters the forecast deviates
by more than 1 percent from the inflation target set by the Treasury.

45. Blinder, Goodhart et al. (2001).

46. As Blinder (1998, pp. 69–70) puts it: “In a democratic society, the central bank’s
freedom to act implies an obligation to explain itself to the public. Thus, indepen-
dence and accountability are symbiotic, not in conflict. The latter legitimises the
former within a democratic political structure. While central bankers are not in the
public relations business, public education ought to be part of their brief.”

Chapter 5

1. Pay-as-you-go pension schemes envisage direct transfer of workers’ contributions

to pensioners, while funded schemes entail the investment of the provisions in
financial markets, through pension funds.

2. The harmonized regulatory framework set out in the Second Banking Coordina-
tion Directive combines a general definition of banking with a list of activities that
licensed banks are allowed to conduct. While the definition is narrow, the list is
212 Notes to Pages 100–102

broad. Banks are thus defined, much in the same way as the US legislation does, as
institutions that couple deposit taking with the granting of loans. Meanwhile the
list of activities comprises other financial services, including among others the
trading of financial instruments for own account and for account of customers, par-
ticipation in securities issues and provisions of related services, portfolio manage-
ment and advice, financial leasing and advice to undertakings on capital structure,
industrial strategy, mergers and acquisitions. See Articles 3 and 18 of the Directive
2000/12/EC (so-called consolidated banking directive).

3. The responses by the United States and some continental European countries to
the banking crises of the 1930s are another sign of the difference between two intel-
lectual and policy traditions. While Europe largely responded by extending public
ownership, the United States responded by strictly limiting the scope of banking
activities and by introducing Federal Deposit Insurance. After the Great Depression,
the belief prevailed that the combination of banking and securities business created
much room for conflict of interest and made banks more vulnerable to sharp adjust-
ment in asset prices.

4. In the past publicly owned banks were not chartered as shareholding companies
and were thus not subject to ordinary company law. They often had special tailor-
made charters defining status, field of activity, and controls on an ad hoc basis. They
had special obligations to finance public entities and programs at preferential con-
ditions, while at the same time enjoying privileged market position in the form of
exclusive right to operate in certain geographical or business areas, or in the form
of government guarantees for their liabilities. In recent years this special status has
been gradually reduced under the influence of both a change in national policies
and the pressure of the EU to apply uniform competition to the banking sector.

5. In the American free banking era (1837–1863) entry into the banking industry
was unrestricted. Banks issued their own notes and had to satisfy collateral require-
ments, which differed across states. They were not subject to extensive supervision,
although some public controls (e.g., limits to the aggregate amounts of notes) were
enforced at state level to prevent unsound issues. Accordingly the system did not
include any access to public lending of last resort facilities in times of stress. Fail-
ures and losses on notes differed significantly by state, but have been generally inter-
preted as being excessive.

6. The continental European hands-on approach tends to allow banks to undertake

a certain business only after explicit permission and under strict surveillance from
the public authorities, contrary to the hands-off attitude valued by the US tradition.
It is precisely noninterference policy that can be inferred from the words of no less
influential a person than Alan Greenspan. In his words, “government action can
retard progress but almost certainly cannot ensure it” and “our regulatory roles are
being driven increasingly toward reliance on self-regulation similar to what emerged
in more primitive forms in the 1850s in the United States” (Greenspan 1997, pp.
48–49).
Notes to Pages 102–107 213

7. See Padoa-Schioppa (1999). True to style, an EU directive was passed in 2000 spec-
ifying that the issuance of electronic money should be subject to bank-like licens-
ing and prudential controls, with all new tools for delivering de facto banking
services included in the realm of supervised business. In the United States, in con-
trast, e-money is still viewed as falling outside the area that requires a banking
licence.

8. See, for instance, Danthine, Giavazzi, von Thadden and Vives (1999).

9. The removal of barriers to interstate banking in 1991 with the Federal Deposit
Insurance Reform Act occurred at about the same time as the creation of the single
market in the European Union.

10. Arbitrage is a trading activity aimed at profiting from differences in prices as the
same security, currency, or commodity is traded in two or more markets.

11. Mergers and acquisitions services are the services investment banks provide to
corporations engaged in taking over another corporation or in merging into a single
entity. Included among such services are search of a counterparty, advice on the
required financial package, valuation, and placing new equities on the market.

12. In the market for unsecured deposits, credit institutions exchange liquidity
without the guarantee of collateral. The largest part of the turnover in this market
is represented by very short-term transactions.

13. In particular, repo transactions were conducted on the basis of various local
master agreements, and only recently a European standard has been developed.
Moreover a Directive had to be issued in June 2002 and is presently being imple-
mented at the national level, in order to ensure the legal reliability of collateraliza-
tion techniques and practices, including the validity and effectiveness of the transfer
of title arrangements, especially in cases of insolvency.

14. Federal Reserve Board (1998).

15. The expression “unwarranted strategic objective” is used here to shorten what
would otherwise be a lengthy treatment of a complex issue that goes beyond the
scope of this book. In brief, it can be said that the EU economic constitution, ana-
lyzed in chapter 3, sets common objectives that are incompatible with the pursuit
of economic self-sufficiency as an admissible strategic goal for a member country.

16. The long controversy over state aid to the German Landesbanken epitomizes
the complexity of competitive game in the European Union. A Landesbank is an
institution under public law, often established by a special law of the German
Bundesland or the region concerned. Shareholders are, as a rule, the Bundes-
land and regional savings banks. A Landesbank acts as a central institution for the
local savings banks in matters such as liquidity management and the clearing of
payment transactions, and supplements the banking services of the savings banks.
It further acts as a public sector bank. With a market share of more than a third,
214 Notes to Pages 107–113

the savings banks and Landesbanken represent a very significant proportion of the
German banking market. This strong market position is to a large extent the result
of public support through public guarantee mechanisms, allowing the Landes-
banken to fund themselves cheaply on the market. The large German commercial
banks, such as Deutsche Bank, Commerzbank, Dresdner Bank, and Hypovereins-
bank, had complained for years to both national and European authorities that they
were being victimized by unfair competition. Any swift resolution of the problem
was hampered, inter alia, by the strong political ties of the Landesbanken. In late
1999, the European Banking Federation lodged a complaint with the European
Commission about the unfair state aid. The European Commission confirmed that
the system of public guarantees did not comply with EU competition law. In July
2001, the Commission reached an agreement with the German government on the
gradual phasing out of the public support system. It is expected that this will have
a major structural impact on the German banking sector.

17. The legislative procedure required to adopt or amend a EU directive takes three
to four years. Member states have traditionally preferred to inscribe European rules
in directives rather than in secondary legislation, which is more flexible, in order
to keep closer control over the process.

18. The so-called Committee of Wise Men, chaired by Alexandre Lamfalussy, was
created in July 2000. Its tasks were to assess the conditions for implementation of
EU securities regulation, study how the mechanisms for regulating securities markets
in the EU can best respond to market developments, propose scenarios to adapt
current practices in order to ensure greater convergence and cooperation in day to
day implementation. The Committee’s report, known as the Lamfalussy Report, was
submitted to the Ecofin Council in February 2001. Alexandre Lamfalussy (1929–),
professor emeritus at the University of Louvain-la-Neuve, has been general manager
of the Bank of International Settlements in Basel (1985–1993) and president of the
European Monetary Institute from 1994 until 1997.

19. Before the UK reform, the single-agency approach had been adopted by Norway
(1986), Canada (1987), Denmark (1988), and Sweden (1991). After 1997 Japan and
Korea followed suit. In the United Kingdom, the competencies of eight preexisting
regulatory and supervisory bodies (including the Bank of England) were
concentrated.

20. Full disclosure to the market of information on a bank’s condition was not tra-
ditionally part of the tool kit of a banking supervisor. This potential conflict is not
eliminated by the single-agency approach. To deal with it, certain countries, for
example, Italy and the Netherlands, have preferred the solution of specializing
supervisory agencies by objective: one agency is entrusted with the goal of stability
for both banks and securities firms, while another is assigned transparency and
investor protection. This solution, sometimes referred to as the “twin peaks”
approach, may prove to be effective, as it allows maintaining prudential supervision
Notes to Pages 113–117 215

close to the monitoring of systemic risk and to other functions related to financial
stability.

21. In general, moral hazard is defined as a situation in which an economic agent

misleads or tricks a counterparty in order to pursue his or her own personal inter-
est. For instance, in insurance contracts the concept is used to capture the tendency
of people with insurance coverage to change their behavior in a way that leads to
larger claims against the insurance companies.

22. On the pros and cons of attributing supervisory responsibilities to the central
banks, see Goodhart and Schoenmaker (1995), Ferguson (2000), Briault (1999),
Padoa-Schioppa (2003a), and Goodhart (2002).

23. The word “almost” is used here because there are indeed a few exceptions. One
of them is supervision and regulation of the insurance industry in the US, which
is still a state competence. Another example has been banking supervision in
Germany, which for a short period in the 1950s was a competence of the regions.
It is symptomatic, however, that the latter system was abandoned after few years.

24. Article 105.5 of the Treaty.

25. The Treaty also gives the Eurosystem a twofold (consultative and advisory) role
in the rule-making process. The ECB must be consulted on any draft legislation (both
Community and national) in the fields of banking supervision and financial stabil-
ity. Moreover it can provide, on its own initiative, advice on the scope and imple-
mentation of Community legislation in these same fields.

26. According to Article 105.6 of the Treaty, the Council may, acting unanimously
on a proposal from the Commission and after consulting the ECB and the European
Parliament, confer upon the ECB specific tasks concerning policies relating to the
prudential supervision of credit institutions and other financial institutions with the
exception of insurance undertakings.

27. The main forum to coordinate the central banking function with the supervi-
sory one is the Banking Supervision Committee. Created in 1989 by the then central
bank governors of the EU and re-established by the ECB Council, the Committee is
composed of high-level representatives of banking supervisory authorities and
central banks of the EU countries. It has the task of addressing all the financial sta-
bility issues raised by the introduction of the euro. It so fulfills the twin functions
of bridging the central banking and supervisory tracks to banking and financial sta-
bility in euroland and of working as a forum for cooperation among banking super-
visors. Most of the recommendations issued by the Brouwer report and the demands
for enhanced cooperation raised by the Eurosystem are being addressed within this
committee.

28. See, for instance, Begg et al. (1998), Prati and Schinasi (2000), and Vives (2001).
216 Notes to Pages 117–121

29. As Charles Goodhart and Dirk Schoenmaker (1993) have shown, in most
banking crises central banks have been actively involved.

30. Lending of last resort is generally defined as the central bank facility providing
short-term loans to illiquid but solvent banks hit by a liquidity shock. The term is
often used extensively to include any form of central bank support to ailing banks.

31. The classic theory of the lender-of-last-resort function of the central bank in the
nineteenth century was formulated by the British economist and constitutionalist
Walter Bagehot (1826–1877). According to this theory, the central bank should pub-
licly announce its readiness to provide freely liquidity support in times of need, but
only to solvent institutions, at a penalty rate and assisted by good quality collateral
valued at pre-crisis prices. See Bagehot (1873).

32. A less unlikely event is a rapid withdrawal of deposits and other funds by unin-
sured wholesale creditors, in particular, in the interbank market. However, since
interbank counterparties are much better informed than depositors, this event could
not occur without raising in the market a strong suspicion that the bank is actually
insolvent. If such a suspicion were to be unfounded and not generalized, the breadth
and depth of today’s interbank market is such that other institutions would proba-
bly replace (possibly with the encouragement of public authorities) those that with-
drew their funds. In this regard the emergence of the areawide money market lowers
banks’ liquidity risks because the number of possible sources of funds has become
considerably larger than in the past.

Chapter 6

1. The first monetary use of gold has been traced back to the reign of Pharaoh Menes
in Egypt (2850 BC) by the discovery of small gold bars stamped with the name of
the pharaoh that circulated as money. The first circulation of gold coins is believed
to date from around 635 BC, and was first used in Lydia (Bernstein 2001).

2. This model was not always welcomed as it was viewed as opening a road to
monopoly, and some countries (the United States, in particular) challenged the
model for many years. Over time, however, central banks spring up everywhere.

3. In a multilateral netting system, commitments to transfer funds accumulate

during the day, and each participant transfers only its multilateral position vis-à-vis
all the other participants at the end of the day, settling in central bank money. This
implies that in the course of the day each participating bank extends credit to the
other participants, thus running both credit and liquidity risk vis-à-vis its counter-
parties. Credit risk or exposure is the risk that a counterparty will not settle an oblig-
ation in full, either when due or any time after. In exchange-for-value systems, the
credit risk is generally defined to include replacement cost risk and principal risk.
Notes to Pages 122–124 217

4. Systemic risk is the risk that failure of one participant in a transfer system, or in
financial markets generally, to meet its required obligations will cause other partic-
ipants or financial institutions to be unable to meet their obligations (including
settlement obligations in a transfer system) when due. Such a failure may cause sig-
nificant liquidity or credit problems and, as a result, might threaten the stability of
financial markets.

5. Recommendation to this end were made in the 1990 “Report of the Committee
on Interbank Netting Schemes” (so-called Lamfalussy Report). In 2001, the G10 gov-
ernors endorsed a report on “Core Principles for Systemically Important Payment
Systems,” which complements the 1990 standards and extends their applicability
globally (CPSS 2001a).

6. Fedwire is the Federal Reserve funds transfer system. Fedwire is used for trans-
ferring reserve account balances of depository institutions and government securi-
ties. Fedwire is also used for the settlement of other clearing systems, such as CHIPS.

7. Folkerts-Landau, Garber, and Schoenmaker (1996).

8. Safety is, in the perception of the general public, the foremost attribute of central
bank money. For a regime of paper currency, central bank money is what gold used
to be for a commodity currency regime. People’s confidence in the central bank as
issuer of the currency derives in part from legal tender status, in part from the way
it is managed by the central bank. Availability means that since it “owns the print-
ing press,” the central bank can produce money in unlimited amounts. It should
not be forgotten that for a long time deflation rather than inflation was the major
threat to monetary stability and therefore availability in potentially unlimited
amounts was a key antidote to financial crises. As ultimate provider of liquidity, the
central bank is indeed able to address unexpected liquidity shocks or coordination
failures in the interbank market. Efficiency comes from the fact that instead of estab-
lishing a transactional relationship with every other bank, each bank can hold its
reserves in one place, the central bank, where its debit items are cleared against its
credit items. This is what made central bank money an essential cog of the mone-
tary mechanism. Neutrality consists in the fact that the central bank remains exter-
nal to banking system, does not compete with it, and does not operate directly with
the public. Finality, an economic manifestation of the legal tender status, means
that the discharging of a pecuniary obligation has been completed at the moment
of settlement in central bank money. Since, in a world of fiduciary currency, money
is always a promise rather than a good, the dividing line between money and credit
is both essential and hard to draw. It is the “outside” position in the monetary
system that makes central bank money the final means of settlement.

9. In the past central banks were operationally involved in the field of securities
settlement systems only for the management of government debt. However, as
the trend is for debt and equities to be settled under the same “roof,” securities
218 Notes to Pages 124–130

settlement systems have progressively moved to private hands and tend to be user-
owned or owned by an exchange. Exchange-for-value settlement system is a system
that involves the exchange of assets, such as money, foreign exchange, securities,
or other financial instruments, in order to discharge settlement obligations. These
systems may use one or more funds transfer systems in order to satisfy the payments
obligations that are generated. The links between the exchange of assets and the
payments system(s) may be manual or electronic.

10. As indicated in chapter 2, the Treaty of Maastricht explicitly assigns to the

Eurosystem the task of promoting the smooth operation of payment systems by
means of providing facilities and issuing regulations. As the Treaty makes no dis-
tinction between retail and large-value payments, the Eurosystem closely follows
both, as well as securities settlement systems. Overall, the Treaty is as good a basis
for effective action as that provided to other monetary jurisdictions by the charter
of their central banks.

11. The United States and euroland give similar interpretations to the role of the
central bank in retail payments. In the United States a key provision of the 1913
Federal Reserve Act imposes that all checks should be cleared nationwide under the
same conditions. More recently, in 1998, a committee headed by the then vice chair
of the Board of Governors of the Fed, Alice Rivlin, revisited the role of the Fed in
retail payments and confirmed its operational involvement in the field. It strongly
recommended that the Fed should play a leading role toward enhancing the
efficiency, effectiveness, and convenience of retail payments in cooperation with
market participants (Rivlin 1998)

12. One of the attractiveness of the name “euro” was that it had the same spelling
in all languages of the European Union (apart from the Greek alphabet).

13. While the fees charged to customers for domestic credit transfers rarely exceed
between euro 0.10 and euro 0.20, a survey conducted by the European Commission
in 2001 showed that the average fee for cross-border transfers is euro 24, with peaks
exceeding euro 60 in some countries. As to the speed of execution, while for domes-
tic transfers it is sometimes less than a day, cross-border transfers take several days,
occasionally even more than a week.

14. This approach is not shared by all central banks worldwide. In the United States,
the Fed is inclined to allow e-money to be issued by nonbank entities and to refrain,
for the time being, from setting strict requirements of redeemability. This difference
in approach reflects the more general difference in policy attitudes toward financial
innovation highlighted in chapter 5. Compared to others, the European approach
is liberal in allowing licensed banks to conduct a wide range of activities, but strict
in requiring a license to enter the banking business. As a result reserving the right
to issue e-money to credit institutions is equivalent to inviting its issuers to adopt
a specific legal structure, not a way of creating a privilege for a particular group of
institutions.
Notes to Pages 131–136 219

15. One reason for the decision was that TARGET was developed well before the
start of EMU, with the participation of all EU central banks and before knowing
which member states would be in it. Therefore it would not have been fair to exclude
the central banks of Denmark, Sweden, and the United Kingdom from participation
in its operations. The arrangement was made subject to special conditions that
prevent the intra-day liquidity in euro to banks outside the euro area from spilling
over into overnight credit.

16. While the fees for cross-border TARGET transactions are harmonized, domestic
TARGET payments are priced on the basis of national decisions and differ consid-
erably in terms of both fee structure and fee level. Domestic prices per payment can
be lower than euro 0.20 in some countries and higher than euro 2 in others. The
problem of cost recovery for many RTGS systems in TARGET is illustrated by the
fact that seven out of sixteen TARGET components process each less than 1 percent
of the overall number of TARGET payments. Full-fledged competition between
national RTGS systems would imply that every commercial bank is free to choose
through which national system to enter TARGET. This would in turn imply that
national central banks no longer retain an exclusive business relationship with the
banks of their national jurisdiction, but rather compete to attract any euro area com-
mercial bank. The need to plan for the second generation of TARGET is also based
on the experience of both the United States and the pre-euro German system. In
these two systems, which started with composite systems similar to TARGET, the
various components have converged, over time, toward a single infrastructure.

17. The initiative was taken by the Basel-based Committee on Payment and Settle-
ment Systems (CPSS).

18. This is called “payment-versus-payment,” meaning that settlement in one cur-

rency occurs if, and only if, the other currency also settles.

19. Of course, the emergence of a euro area infrastructure would not conflict with
the development of “international” or “global” infrastructures in the field of secu-
rities settlement, analogous to the Continuous Linked Settlement Bank in the field
of payment systems.

20. CPSS (2001b).

21. Recently some authors (notably King 1999; Friedman 1999; Bengtsson 1999a,
b) have suggested that the further development of e-commerce and associated com-
puterization will attenuate, or even remove altogether, the demand for central bank
money, notably for currency, and that such vanishing demand for monetary base
will in turn limit, or even prevent, the central bank from setting nominal interest
rates in such a system. Others (notably Goodhart 2000; Woodford 2000b; Freedman
2000) suggest that the IT revolution is not going to remove the demand for cur-
rency, and even if it did so (as a theoretical matter), the central bank would still be
able to set the country’s nominal interest rate. They argue that the ability of the
220 Notes to Pages 136–146

central bank ultimately depends on the fact that it is the government’s bank, and
thus has the power to intervene in financial markets without concern for prof-
itability. It can buy or sell the relevant assets in any amount needed to obtain the
desired interest rate—even at a loss—thereby forcing its profit-seeking commercial
confreres, in the last resort, always to dance to its tune yet in a market-friendly way.

Chapter 7

1. The average share of the euro in the international money market issues by non-
residents of the euro area rose from 8 percent for legacy currencies in the period
1994 to 1998 to 21 percent in the period 1999 to 2002.

2. Figures in this paragraph, as well as in the previous ones, are drawn from ECB
(2003).

3. This assessment can be found, inter alia, in Bergsten (1997), although the author
clearly emphasized the uncertainties regarding the precise timing and size of the
projected appreciation of the euro.

4. In 1999 to 2000, GDP growth was 4.0 percent per year on average in the United
States against 3.0 percent in the euro area, and growth forecasts were consistently
more favorable for the United States. This was partly due to the favorable produc-
tivity developments in the United States and the perceived superiority of the country
in terms of labor, product, and financial markets.

5. For the “invisible currency” argument it is hard to find any supporting or con-
trary evidence, and there is no academic analysis of it. The “banknote conversion”
argument appears unconvincing when one looks at the figures. Estimates of the total
stock of illegally held banknotes, and of banknotes circulating outside euroland,
suggest that this stock was too small to influence the exchange rate. Indeed, the
order of magnitude of the estimated total—less than euro 40 bn at the time of
the cash changeover (Padoa-Schioppa 2003b)—corresponds to a small fraction of
the volume transacted in the foreign exchange market of the euro in just one
working day—USD 352 bn on average per day in April 2001 (BIS 2002).

6. Comparisons with pre-January 1999 are made by calculating the value of the euro
in term of the pre-euro currencies, the so-called synthetic euro. True, the exchange
of the euro in January 1999 was below the average level of the synthetic euro over
1994 to 1996. It has to be considered, however, that this was a period of exceptional
weakness of the US dollar. If one looks further back, a period in which the synthetic
euro was significantly lower that the minimum reached in October 2000 is the 1984
to 1985 period. In terms of US dollar, the 0.83 minimum level of October 2000 com-
pares with a minimum of 0.68 in February 1985.

7. The statement was issued at a moment when the euro quoted around 0.95 against
the US dollar and the effective nominal exchange rate was 17 percent below the
Notes to Pages 146–149 221

January 1999 level. The concept of “overshooting” was developed by Dornbusch

(1976). In short, there is overshooting if the short-run change (i.e., depreciation or
appreciation) in the exchange rate of a given currency is larger than its change in
the longer run.

8. Between 1999 and 2001, consumer prices increased on average by 2.0 percent per
year in the euro area against 2.8 percent in the United States.

9. For an overview of models of the real exchange rate based on fundamentals,

see Koen et al. (2001), Maeso-Fernandez, Osbat, and Schnatz (2001), and Meredith
(2001).

10. The “target zone” proposal goes back to 1983, when it was formulated by
Bergsten and Williamson (1983). It has been periodically discussed in policy circles,
but no agreement for implementing it has ever been reached. For an account of the
discussions on Oscar Lafontaine’s proposal, see The Economist (1998).

11. See Williamson (1994) for a collection of essays on the determination of the
equilibrium exchange rate and Alberola et al. (1999) for a review of theoretical and
empirical work on equilibrium exchange rates.

12. The high degree of exchange rate variability in the past twenty-five years is
apparent in the movement of the real effective exchange rates of the major cur-
rencies. The real effective exchange rate of the US dollar (1990 = 100) fell from 143.2
in May 1970 to 95.7 in October 1978, peaked at 146.1 in March 1985, and subse-
quently fell back to 91.9 in May 1995. The real effective exchange rate of the Japa-
nese yen (1990 = 100) soared from 57.0 in August 1970 to 110.6 in October 1978,
dropped to 74.5 in October 1982 before rebounding to 154.4 in April 1995.

13. Such change in the European attitude is led by the strong and unsurprising cor-
relation between a country’s openness and its willingness to let exchange rate con-
siderations influence its policy-making. The more a country is open to international
trade, the more a depreciation of its exchange rate is likely to import inflation over
the medium term without any significant improvement in its competitive position.
As shown in Mussa et al. (2000), individual countries of euroland were very open
to international trade prior to EMU. The degree of openness, as measured by the
average of exports and imports of goods and services as a percentage of GDP, was
around 35 percent on average and exceeded 60 percent in small countries like
Belgium and Ireland. This is one reason why the case for exchange rate stability was
strengthened and, in the end, monetary union was adopted within euroland. Con-
versely, economic relations among members of euroland have now become domes-
tic in nature. As a result euroland is much less vulnerable to external shocks and
influences than its constituent countries prior to the establishment of the EMU.

14. As developed in De Grauwe (1988) and Edison and Melvin (1990), two basic
views have been expounded in the economic debate on the effects of exchange rate
fluctuations. The first one, which can be called a “fundamentalist view,” assumes
222 Notes to Pages 149–151

that fluctuations are, at all times, the outcome of disturbances in the economic fun-
damentals. This implies that fluctuations are not economic “costs” but the proper
corrections that grant stability to other economic variables. As a result any attempt
to stabilize exchange rates will eventually lead to greater fluctuations in other key
variables such as domestic production. The second view is that fluctuations may
turn into “misalignments” owing to factors such as irrationality, “bubbles,” and
extrapolative rules in the determination of exchange rates. In this case economic
agents are not necessarily able to assess correctly how fundamentals affect the
exchange rate, unless the latter diverges “too much” from its equilibrium value. In
view of the author, at least some of the large exchange rate movements for both
advanced countries and emerging markets do not plausibly reflect economic fun-
damentals. This means that the implications of exchange rate fluctuations are not
always a “fair price” to be paid in order to gain greater stability in some key vari-
ables but become a cost for the international community.

15. Even in limiting the observation to the last two decades, we can see that a
number of episodes confirm the close relationship between wide exchange rate
swings and disturbances in the world’s economy. For instance, movements in the
US dollar–Japanese yen rate—which exhibited high variability along a rising trend
from 250 Japanese yen per US dollar in mid-1985 to 85 in mid-1995—triggered
recurrent trade frictions. They are among the contributing factors of the rise and
subsequent bursting of the Japanese asset price bubble in the late 1980s. The appre-
ciation of the yen is also one of the factors behind the protracted loosening of mon-
etary policy in Japan in the second half of the eighties, which in turn contributed
to the Japanese asset bubble.

16. “Peg” is the Bretton Woods jargon, which indicates the linkage of all currencies
to the dollar. It indicates an exchange rate regime in which the monetary author-
ity of a country announces an official par value, or “parity,” of its currency vis-à-vis
another currency or basket of currencies and then seeks to maintain the actual
market exchange rate within a band above and below that value. According to IMF
(2001), three types of pegs are consistent with this definition. First, in “currency
board arrangements” (e.g., Bulgaria) the exchange rate is fixed without any possi-
bility to fluctuate within a band around the parity (the width of the band is there-
fore set to zero). This “hard peg” form implies an explicit legislative commitment
to exchange domestic currency for a specified foreign currency at a fixed exchange
rate, combined with restrictions on the monetary authority to ensure the fulfillment
of its legal obligations. Second, in the “conventional fixed peg arrangement” (e.g.,
China) the country pegs its currency at a fixed rate to a major currency or basket
of currencies, where the exchange rate fluctuates within a narrow margin of at most
±1 percent around the parity. Third, in the case of “pegged exchange rates within
horizontal bands” (e.g., Denmark) the band is wider than ±1 percent. The latter was
the case of the multilateral exchange rate mechanism (ERM) of the European Mon-
etary System (EMS), replaced with ERM II on January 1, 1999. See IMF (2001).
Notes to Pages 152–153 223

17. To be effective, a pegging policy requires a blend of consistent policies, sheer

strength, gaming skill, and persuasion. Economic policies need to be consistent with
the chosen parity, but since full consistency does not exist on earth and markets
are capricious anyway, the policy maker is from time to time confronted with market
sentiments and pressures at odds with the chosen exchange rate. Here is where
“sheer strength” must be available and credible, that is, where the traditional instru-
ments of the Bretton Woods days are called to work.

18. According to IMF (2001), in the “crawling peg” regimes (e.g., Bolivia) the
exchange rate of the currency is adjusted periodically in small amounts at a fixed,
pre-announced rate or in response to changes in selective quantitative indicators.
In the “crawling band” regimes (e.g., Israel) the currency is maintained within
certain fluctuation margins around a central rate that is adjusted periodically accord-
ing to criteria similar to those used for crawling pegs. Finally, in the “managed
floating” regime (e.g., Czech Republic) the monetary authority influences the move-
ments of the exchange rate through active intervention in the foreign exchange rate
market without specifying, or pre-committing to, a pre-announced path for the
exchange rate.

19. Most currency boards in the world are linked either to the euro or to the US
dollar. The euro-based currency boards are in Bosnia and Herzegovina, Bulgaria,
Estonia, and Lithuania, while the currency boards of the East Caribbean Currency
Union, Hong Kong, and Djibouti are based on the US dollar. The Brunei dollar pegs
to the Singapore dollar also under a currency board arrangement. The countries and
other territorial communities that have “euroized”, meaning they have unilaterally
adopted the euro as their currency, are the European micro-states (e.g., Vatican City),
the French territorial communities (e.g., Mayotte), and, in the Balkans, Kosovo, and
Montenegro. Finally, dollarization has taken place in Ecuador, Panama, Puerto Rico,
San Salvador, and a number of micro-states or territorial communities (e.g., Ameri-
can Samoa). A discussion of the arguments on the corner solution theory is pro-
vided by Fischer (2001). The concept of corner solution is found, for the first time,
in Eichengreen (1994), who observed that the middle ground of exchange rate
regimes located between free floating and the full surrendering of monetary control
at country level (e.g., monetary unions, dollarization, and euroization) is being “hol-
lowed out.” This does not mean, however, that Eichengreen is an advocate of the
corner solution view.

20. In the discussion about the prescription of the corner solution theory, the
Eurosystem has taken the view that intermediate regimes, including pegs and
managed floating, may be appropriate, and therefore should remain an option for
a number of countries.

21. The phases of such cycles can be described as follows: sound policies and favor-
able production conditions (e.g., a high saving rate and low wages for skilled labor)
are rewarded by large inflows of capital, which facilitate further investment;
224 Notes to Pages 153–158

however, it can also cause overinvestment and waste as well as strong appreciation
of the currency. The ensuing loss of competitiveness and exports deteriorates the
overall performance, which causes a loss of confidence by markets, hence capital
outflows, depreciation of the exchange rate, and a rise in inflation. After a crisis the
cycle often starts up again. Throughout a cycle those foreign lenders who are quick
enough to pull out their money in time preserve the benefits of high returns enjoyed
during prosperity. Perhaps more numerous, however, are those lenders whose
money is consumed during the crisis.

22. Calvo and Reinhart (2002) developed the idea that many emerging market
economies do not pursue a fully flexible exchange rate regime for fear of the float,
especially when there are currency mismatches in the external financial position of
a country. In such circumstances such countries remain exposed to financial crises
triggered by an excessive depreciation of the exchange rate. Despite a number of
benefits, currency board arrangements (CBAs) leave economies very exposed to
external shocks, and it is not easy to discontinue them once this becomes evident.
In particular, the experience with CBAs shows that the degree of fiscal discipline
and domestic flexibility that a country can afford in a given point in time may
be insufficient to withstand major external shocks. As the Argentine experience
illustrates, this can lead to a substantial overvaluation of the real exchange
rate of the domestic currency, namely the exchange rate adjusted in order to take
inflation into account. This leads to declining growth and difficulty to service
the country’s debt (so-called currency–growth–debt trap). However, when drawing
lessons from this experience for countries currently adopting CBAs, one should pay
attention to some major differences from Argentina. It is a country different from
countries such as Bulgaria, Estonia, and Lithuania, as it is not a small open economy.
It has a substantial share of its foreign trade with countries whose currencies fluc-
tuate vis-à-vis the US dollar. Also Argentine currency was not being anchored in the
relation to a broader process of regional integration. These structural differences help
show both why the CBA experience failed in Argentina and why it has not in the
mentioned countries.

23. Poirson (2001), for instance, examines the exchange rates of ninety-three coun-
tries over the period 1990 to 1998, and finds that significant discrepancies exist
between de jure regimes (especially free floats) and de facto ones.

24. A prominent example of recent progress in regional integration in Asia is the

so-called Chiang Mai initiative (March 2000), which foresees a network of bilateral
swap arrangements among member countries of ASEAN, China, Japan, and Korea.
The swap arrangements are to supplement existing international financing facilities.

25. The distinction between “market-led” and “government-led” international

monetary system was first made in Padoa-Schioppa and Saccomanni (1994).

26. A list of the main recent episodes of financial instability includes, for industrial
countries, the stock market crash in the United States (1987), the banking crises in
Notes to Page 158 225

a number of Scandinavian countries (Norway in 1990–91, Finland and Sweden in

1991–92), the difficulties in the Japanese financial sector throughout a large part of
the 1990s, and the LTCM crisis in the United States (1998). For the Scandinavian
countries and Japan, unlike the United States, the crisis also entailed a considerable
and prolonged slowdown in economic activity. In emerging market economies,
severe financial crises hit Mexico (1994–95), several Asian economies (1997–98),
Russia (1998), Brazil (1999), Argentina (2001–02), and Turkey (2001). Each of these
episodes has its own story. Common to all, however, is the phenomenal develop-
ment of the financial sector over the last twenty-five years.

27. In countries with deficient supervisory institutions or practices, there is a greater

risk that sudden reversals of capital flows will upset the exchange rate, macroeco-
nomic equilibrium, and the ability of local debtors to honor their obligations. As to
contagion, the international transmission of instability may be facilitated by a lack
of transparency as well as by the unprecedented size of capital flows. So-called herd
mentality—namely the propensity of individual market participants to behave like
all others, regardless of whether the others’ assessment of the situation is correct—
tends to exacerbate this risk. This is particularly the case when the amount of public
information available for distinguishing between good and bad borrowers is scarce.

28. The BIS commenced its activities in Basel, Switzerland, on May 17, 1930 and is
thus the world’s oldest international financial organization. It fosters cooperation
among central banks and other agencies in pursuit of monetary and financial sta-
bility. The BIS functions as a forum for international monetary and financial coop-
eration, as a bank for central banks, providing a broad range of financial services
and as a center for monetary and economic research.

29. Cooperation in banking supervision started with the establishment of the Basel
Committee on Banking Supervision in 1974, in the aftermath of the collapse of the
Bankhaus Herstatt in Germany and Franklin National in the United States. The result
was the Basel concordat, whereby the responsibilities for supervising foreign
branches were clearly defined in order to avoid any escaped supervision of an inter-
national bank. In 1983, following the crisis of the Italian group Banco Ambrosiano,
the principle of international consolidated supervision was adopted, extending the
agreement of the 1975 concordat to foreign subsidiaries of banks. The first crisis of
the Latin American debt in the 1980s was an incentive to the adoption of interna-
tionally agreed capital requirements, with the Basel Capital Accord of 1988. Simi-
larly, in the payment system field, the concerns raised by the operational difficulties
experienced by the Bank of New York contributed to the launch of the work on
minimum standards for netting systems described in chapter 6. The G7 and the
IMF became actively involved in regulatory and supervisory issues after the 1994
Mexican crisis. The Financial Stability Forum (FSF) was created in 1999 in response
to the 1997–98 Asian crisis.

30. In one important way the present configuration is incomplete. It lacks a

statutory authority for the liberalization of capital movements. The World Trade
226 Notes to Pages 158–163

Organization, as the institution presiding over the liberalization of cross-border eco-

nomic trade, has limited competence in the field of financial services but none in
the field of financial account transactions. As to the IMF’s Articles of Agreement,
they relate to current transactions but not to the financial account. This gap implies
that unlike in the EU, international regulation and liberalization are not part of a
single process.

31. To overcome the former limit, the Financial Stability Forum (FSF) was created,
as a body comprising, for the G7 countries, representatives of Treasuries, central
banks, financial supervisors, and chairs of the main international institutions
and regulatory bodies. To overcome the second limit, a wider forum (called G20)
was created in 1999, which includes a number of major transition and emerging
economies. Although both the FSF and the G20 are in the process of assessing their
role, the structure of the system of international cooperation described in the text
has not fundamentally changed.

32. A significant example is participation in the meetings of G7 finance ministers

and central bank governors. Up to the launch of stage three of the EMU in 1999,
participation in these meetings was restricted to the respective national authorities
of the G7 countries. With the transfer of the core competencies related to mone-
tary and exchange rate policies from the national to the Community level, adequate
arrangements needed to be made to take into account this new allocation of com-
petencies in euroland. As part of this adaptation of existing practices, it was agreed
that both the ECB president and the Eurogroup presidency are to join in the part
of the meetings that deal with macroeconomic surveillance and exchange rate
issues. While the three central bank governors of the euro area G7 countries (France,
Germany, and Italy) do not participate in this part of the meetings, they take part
when the G7 deals with other issues, for instance, international financial architec-
ture and debt initiative in favor of highly indebted poor countries. As far as mon-
etary policy in the euro area is concerned, the ECB president presents the views of
the Eurosystem. Conversely, the Eurogroup presidency contributes to the discussion
on other economic developments and policies in euroland. Given the shared respon-
sibility of the ECB and the Eurogroup for exchange rate matters, the views presented
at G7 meetings reflect the outcome of prior consultations within the euro area. G7
consultations on exchange rate matters may also lead to foreign exchange market
operations and communication with markets, as exemplified by the concerted inter-
vention in support of the euro carried out on September 22, 2000, and the G7 state-
ment published on the day after the meeting of G7 ministers and governors in
Prague.

33. A telling episode was the discussion among Ministers of Finance and governors
held in spring 2002 about the EU definition of a common European position on
IMF issues. Three possible models were considered: (1) an informal coordination
model whereby EU countries seek to coordinate their positions in the IMF Board
through “common understandings,” (2) a structured coordination model, estab-
Notes to Pages 163–173 227

lishing ex ante both the issues on which common views are requested and the mech-
anism to represent such views at the IMF Board, and (3) the single-chair model,
meaning a single EU or euroland constituency at the IMF. The chosen formula even-
tually was the second one, which is the structured coordination model. It should
be noted that the voting powers of euroland’s countries in the IMF add up to 22.6
percent of the quotas, against 17.2 percent of the United States. It should further
be noted that only three of the twelve countries of euroland are members of the G7
and that these three members are not mandated to speak on behalf of euroland.

Chapter 8

1. In 1994 to 2000, the United States had a growth rate of about 4 percent on
average per year, with GDP growth rate above potential in six out of seven years.

2. As was argued in chapter 2, operating and supervising the payment system refers
to money as a means of payment; ensuring price stability refers to money as a unit
of account and a store of value; pursuing the stability of banks refers to money as
a means of payment and a store of value.

3. Every country and central bank has joined the euro and the Eurosystem with the
full-fledged central banking infrastructure that characterizes the pre-euro situation.
Luxembourg has even gone as far as to newly set up its own full-fledged central
bank (which it did not have on the eve of the euro), as this was a precondition to
be a full member of EMU. National central banks are generally still equipped to
perform all central banking functions as stand-alone institutions (in such fields as
payment services and banknote printing).

4. Article 98 of the Treaty of Paris of 1951 that established the European Coal and
Steel Community (ECSC). A similar accession entitlement is contained in the Treaty
on European Union. Article 49 of the Treaty states that “Any European State which
respects the principles set out in Article 6(1) may apply to become a member of the
Union.” The principles set out in Article 6(1) are liberty, democracy, respect for
human rights and fundamental freedoms, and the rule of law.

5. The four enlargements took place in 1973 (Denmark, Ireland, and the United
Kingdom), 1981 (Greece), 1986 (Spain and Portugal), and 1995 (Austria, Finland,
and Sweden).

6. The Copenhagen European Council also acknowledged in June 1993 the EU’s
capacity to absorb new members with a view to the future accession of central and
eastern European countries. In a protocol attached to the Amsterdam Treaty of 1997,
it was agreed that at least one year before membership of the EU would exceed
twenty, an Intergovernmental Conference should be convened in order to under-
take a comprehensive review of the composition and functioning of the EU insti-
tutions. The Luxembourg European Council in December 1997 emphasized that
the operation of the EU institutions must be strengthened as a prerequisite for
228 Notes to Pages 173–176

enlargement. The Treaty of Nice, signed on February 26, 2001, mainly aims at adapt-
ing the way in which the European institutions operate in order to make it possi-
ble for the European Union to take in new member states. Under the Nice Treaty,
the present configuration of the European Commission (consisting of one or two
commissioners per member state) will be maintained until the European Union has
27 member states. At that point, the Council will have to decide on the number of
commissioners, as well as on a rotation system. Moreover from January 1, 2005, new
provisions will apply with regard to qualified majority decision-making within the
Council. The votes of each member state will be re-weighted and a new threshold
for an act to be adopted will be applied. Additional requirements for an act to be
adopted will also have to be met regarding the number of member states voting in
favor, and the percentage of the population of the EU represented by those member
states. Finally, after the European elections in June 2004, the number of represen-
tatives elected to the European Parliament from each member state was adjusted.
Respecting the relative shares of parliamentarians from each member state, the total
number of members of the European Parliament was maintained as close as possi-
ble to 732. After emerging from the acrimonious and protracted power wrangling
that led to the complex compromise formulas contained in the Nice Treaty, the
heads of state and government declared the European Union ready for enlargement.
At the same time, however, they called for a deeper and wider debate about the
future of the European Union. To this end, at the Laeken European Council in
December 2001, the heads of state and government decided to set up a convention
with the task of elaborating further institutional reform. The convention drew up a
draft Constitution in the form of a Treaty, which was discussed in an Intergovern-
mental Conference opened in Rome in October 2003.

7. The last criterion requires the candidate countries not only to translate into
national legislation the substantive body of EU rules and regulations—what in EU
jargon is dubbed acquis communautaire—but also to ensure their effective imple-
mentation and application.

8. Article 124 of the Treaty.

9. ERM II (the successor of the exchange rate mechanism of the European Mone-
tary System that operated between 1979 and 1998, referred to in chapter 1) pre-
scribes currencies to be kept within a fluctuation band of plus and minus 15 percent
around fixed, central rates. Exchange rate strategies, such as free floats (currently
the policy of Poland) and pegs against anchors other than the euro (e.g., Latvia’s
peg to the SDR) are to be changed before a country can join ERM II and eventually
the euro.

10. Under the rotation system approved by EU leaders (and yet-to-be ratified by
national parliaments), the members of the Board would retain permanent voting
rights, while governors would exercise their voting rights on a rotating basis. Since
the group of governors exercising the voting right should be reasonably represen-
Notes to Pages 176–177 229

tative of the euro area economy as a whole, governors would hold the voting right
with different voting frequencies, with governors from large countries voting more
frequently than those from medium-sized and small countries. Governors would be
placed into three groups, in relation to a country ranking based on the economic
and financial weight of their home countries. In any case the differentiation among
governors on the basis of home countries has only one, purely auxiliary, purpose:
to determine who votes when. For all decisions in the Council, such as on interest
rates, the “one member, one vote” principle would continue to apply to those exer-
cising their voting right. This means that the force of argument will still count in
the deliberations and not a governor’s home country, or whether that country is
large or small.

11. For a full discussion of these three elements, see Padoa-Schioppa (2000b).

12. True, no Group of Three has come into being as yet, nor are there signs that
such a group will emerge in the near future. However, in G7 the deliberations on
macroeconomic policies have already evolved from a round table of many countries
to a focused discussion on the three major economies, their situations, how they
interact, and the implications worldwide.

13. This is shown by the unification of the European trade policy or the increasing
independence of central banks from their Treasuries.

14. The central provisions for the external representation of the Economic and
Monetary Union are laid down in Article 111(4) of the Treaty and Article 6 of the
Statute of the ECB. Building on these provisions, the European Council decided in
1997 and 1998 that two bodies would represent euroland externally, the Eurogroup
and the ECB. On behalf of the former the EU presidency (i.e., one of the twelve
finance ministers of euroland) would speak on a semiannual rotation scheme. On
behalf of the latter the ECB president or his/her nominee would speak, as stated by
the ECB Statute itself (Article 13.2).

15. This explains why both the Eurogroup and the ECB have a somewhat special
position. In the IMF, for example, the ECB was given observer status, to reconcile
the fact that only quota-holders can be members of the IMF Board with the need
to have one of the key policy makers (the central bank of the second largest cur-
rency of the world) at the table. In OECD meetings, the ECB representative is part
of the European Community delegation. At the Bank for International Settlements
(BIS), the ECB is a shareholder and a regular participant in all G10 activities. In the
G7 the president of the ECB attends (like the president of the Eurogroup) the parts
of the meetings that deal with macroeconomic surveillance and exchange rate issues
and speaks on behalf of an area of twelve countries, including nine that are not
members of the G7 itself. In their attempt to reflect the Treasury–central bank
scheme that characterizes all delegations in macroeconomic cooperation, a difficulty
arose in identifying “Who is the Treasury” with the European Union. The difficulty
derives from the multilayered policy structure discussed in chapter 3, but the fierce
230 Notes to Pages 177–181

attempts to keep the Commission out of the action also reflect the persistent
jealousy of member states for the role of Brussels. For a discussion on the adapta-
tion of international organizations after EMU, see Henning and Padoan (2000).

16. NAFTA and MERCOSUR in the Western Hemisphere and ASEAN + 3 in Asia are
noteworthy experiences. However, with the establishment of the single market and
of the single currency, Europe has gone much beyond any other regional arrange-
ment. The relevant economic literature has mainly focused on trade and monetary
aspects of regional integration. See, for instance, Frankel and Wei (1993), Bayoumi
and Eichengreen (1993), Frankel and Rose (1998), Eichengreen (1998), Alesina and
Barro (2002), and Wyplosz (2001).

17. The 1998 edition of the New Oxford Dictionary defines policy as “a course or
principle of action adopted or proposed by a government, party, business, or indi-
vidual”; politics as “the activities associated with the governance of a country or
area, especially the debate or conflict between individuals or parties having
or hoping to achieve power”; and polity as “a form or process of civil government
or constitution, an organized society, a state as a political entity.”

18. As Goethe puts it: “A master shows his powers in limitation, and freedom
follows only law’s direction.”

19. As the case of Switzerland and the Swiss franc shows, a strong polity is not
necessarily the same thing as a strong world power. A stable and well-established
political system, long-lasting independence, and reliable institutions may well be
sufficient to produce a strong polity.
Bibliography

Further Readings

This section provides a short selection of references that is intended to serve as a

suggestion for further reading on topics covered in this book. These references are
mainly of a general character, in order to be useful also for nonspecialized readers.
More specialized references, such as research articles published in academic jour-
nals, are referred to in the text and included in the main part of the Bibliography.
A number of books have been published on the process of European integration
leading up to the Maastricht Treaty. Dyson and Featherstone (1999) provide the most
comprehensive effort to analyze the process toward EMU, with particular focus on
the political aspects of the Maastricht treaty negotiations. An earlier reference, Padoa-
Schioppa (1987), contains a report on the economic system of the EEC that was
requested by the Commission of the European Communities, and that was prepared
by a group of distinguished economists and political scientists. The report focuses
on the economic consequences of a number of political decisions taken by the EEC
in 1985, including the decisions to create a market without internal barriers.
There are a number of good references on the economic policies of the European
Union. One example is the report “One Market, One Money,” by Emerson et al.
(1992), which provides an early, but thorough, economic appraisal of the costs and
benefits of a European monetary union, prepared by the Commission’s staff. A more
academic treatment of the subject is provided by De Grauwe (2003), who examines
the costs and benefits of monetary unions in general, and also focuses on the spe-
cific case of EMU and its economic policies. Another source of information on Euro-
pean economic policies is given by Pelkmans (2001), who focuses on economic
integration in Europe and how to design regulatory and policy frameworks to
promote integration.
On the subject of monetary policy, Walsh (2003) provides an excellent overview
of recent theoretical and policy-related developments in monetary economics and
monetary policy. The book presents and discusses not only theoretical economic
models but also quantitative evaluations of these models and recent empirical evi-
dence. Issing et al. (2001) discuss monetary policy in the euro area from the view-
232 Bibliography

point of the ECB. They provide a comprehensive treatment of the monetary policy
strategy of the ECB, and also describe the operational procedures and institutional
features of the Eurosystem.
Useful reading on the financial system in the euro area includes Goodhart et al.
(1998), who focus on different aspects of financial regulation, including the needs
for regulation, various forms and incentive structures for financial regulation, and
prospects for financial regulation in the future. A recent conference volume edited
by Gaspar et al. (2003) includes a number of papers that investigate the ongoing
transformation of the European financial system. On the topic of the euro area
payment system, ECB (2001) provides an overview (alongside detailed information
on national payment systems). The more specific description of TARGET, the new
European payment system that was designed in preparation for the introduction of
the euro in 1999 is given in ECB (1999).
On the international environment and exchange rate relationships, Corden
(2002) presents a systematic overview of different exchange rate regimes, and how
the regime choice is related to economic policies in general. Corden presents both
theoretical arguments and actual experiences from different countries when dis-
cussing various types of exchange rate regimes. Related to this issue is the topic of
financial crises. Eichengreen (2002) looks at the international financial architecture
and explains what underlying factors may have been behind recent crises in finan-
cial markets. Moreover he goes on to propose various policies aimed at avoiding the
dangers of crises, and to discuss how to manage them better in case they do occur.
In addition to the references mentioned above, a vast amount of useful informa-
tion can be found on official Web sites. For example, the ECB site (www.ecb.int)
contains official publications relating to monetary policy, payment systems, finan-
cial stability, and other issues of relevance for the ECB. It also contains links to
working papers and occasional papers, as well as speeches, press releases, legal doc-
uments, and euro area statistical data series. Publications related to the general area
of payment systems are also available on the Web site of the Bank for International
Settlements (www.bis.org). More general information on the European Union and
its institutions can be found by accessing the Europa Web site (europa.eu.int). This
site provides coverage of EU affairs, European integration, as well as legislation cur-
rently in force or under discussion. It also provides links to the Web sites of each of
the EU institutions, where more information is available about the policies admin-
istered by the European Union.

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Index

Abbreviations, list of, 183–84 institution of supervision in, 112

Accession Treaty, 3 Automatic stabilizers, 55, 201n.27
Accountability, 32, 33–34
and communication, 95 Baffi, Paolo, xv–xvi
vs. transparency, 96 Bagehot, Walter, 216n.31
Action Committee for the United Banca d’Italia, 17, 85, 87. See also Italy
States of Europe, 185n.1 independence of, 32, 94
Adenauer, Konrad, 3, 6, 186n.2, 187n.7 Banco Ambrosiano, 225n.29
Allocation Bank-assurance, 99, 101
fiscal policy for, 11 Bank of England. See also United
as national function, 57, 58 Kingdom
Amendments to EU treaties, 5, 196n.28 euro market activities of, 105
Amsterdam Treaty (1997), 2, 9, 36, independence granted to, 32
227n.6 and inflation forecast, 93
Anchor of currency, 151, 152, 153 new responsibilities of, 206n.8
dollar as, 12, 190n.27 (see also Bretton and “one voice versus many voices”
Woods system) issue, 94
euro as, 12, 154–57 operating procedures of, 86
and exchange-rate agreement, 148 Banking Supervision Committee,
gold as, viii, ix, 15–16, 17, 19, 180, 215n.27
190n.27 Bank for International Settlements
state (political power) as, 15, 16, 180 (BIS), 158, 225n.28, 229n.15
Andreotti, Giulio, 6, 189n.18 Bank of Japan, independence granted
Argentina, 152, 153, 224n.22, 225n.26 to, 32
ASEAN group, 198n.7 “Banknote conversion” argument for
ASEAN + 3 group, 230n.16 weakening of euro, 146, 220n.5
Asset management, market integration Banknotes, 22, 120, 123
in, 105 and central bank, 22
Austria and commercial bank money, viii
euro introduced for, 2 for euro, 127–30
and European Union, 2, 227n.5 and gold, 15, 16
244 Index

Bank reserves, 84, 208n.26 Bundesbank Act (1957), and Maastricht

Banks. See also Financial system Treaty, 21
publicly owned, 99, 101, 212n.4
range of functions of, 100 Canada, division of economic
Banque de France, 17 responsibilities in, 56
dependence of, 94 CAP (Common Agricultural Policy), 5,
and overnight interest rate, 209n.31 11, 39
Basel Capital accord (1988), 225n.29 Capital market activity, market
Basel Committee on Banking integration in, 104–105
Supervision (BCBS), 160–61, 225n.29 Capital mobility, 12, 13, 14, 15, 148,
Basel concordat, 225n.29 191n.32. See also Four freedoms
Belgium. See also Benelux countries Cash changeover, 127–29
and bank-assurance links, 101 Central arbiter, 107
euro introduced for, 2 Central bank money, 121–23, 126,
in European Coal and Steel 129–30, 137, 209n.32, 210n.36
Community, 3 Anglo-American tradition, 136
institution of supervision in, 112 availability of, 123, 217n.8
policy transmission in, 87 solution to crisis, 117–18
and “snake” agreement, 2 Central banks and banking, viii, x,
Benelux countries, and Treaty of Rome xiii–xiv. See also European Central
implementation, 4 Bank; Eurosystem
Berlin wall, fall of, 7 as archipelago of monopolists,
BIS (Bank for International 170–71
Settlements) 158, 225n.28, 229n.15 and banking supervision, 116
Brazil, financial crisis in, 152, 154, centralized vs. federal structure of,
225n.26 23–24
Bretton Woods system, 11, 12, 150, changes in, ix, x
190n.27 and changes in monetary systems,
collapse of, 2, 17, 71, 150, 157, 176, 22
190n.29 credibility of, 89, 210n.38
and exchange rates, 145, 148 as crisis defense, x, 115
and pegging, 152 and European integration, xii
policy conflicts undermining, 14–15 and exchange rate, 52
vs. present global system, 157, 158 history of, 15–19
Britain. See United Kingdom independence in, 28
Broad Economic Policy Guidelines, as paradigm for Europe, xiv
202n.31 and payment-system problems, 122
Brouwer I report, 109 perfection of, 168
Brussels, 4, 186–87n.6 policy profile of, 81
Budgetary policy, 54, 200n.21 and political power, ix, x, xii
Bulgaria, 173, 222n.16, 223n.19, three activities of, viii, x, 22–23,
224n.22 168–69
Bundesbank. See Deutsche Bundesbank three-stage evolution of, viii
Index 245

Central bank track to financial Constitution for Europe,

stability, 115–16 Intergovernmental Conference for, 3,
China, 142, 151, 222n.16 36, 196n.33, 228n.6
Coal and Steel Community, European, Consultative forum, 47, 48, 56, 62
2, 3, 4 Continental European model, 99–102,
Cohesion Fund, 11, 58, 190n.28 137, 212n.6
Cohesiveness Continuous linked settlement (CLS)
and euroland economy, 90 system, 133, 219n.19
and transmission of monetary policy, Convention on the Future of Europe,
86–87 3, 9, 39, 190n.24
Commercial bank money, viii, 22, 121, Coordination of policies. See Policy
123, 129, 130 coordination
Committee on Payment and Copenhagen European Council, 173,
Settlement Systems (CPSS), 135, 227n.6
160–61 Corner solution theory, 15, 152,
“Committee of Wise Men,” 110, 191–92n.34, 223nn.19, 20. See also
214n.18 Two-corner solution theory
Common Agricultural Policy (CAP), 5, Corporatism, 59, 202–203n.34
11, 39 Corrigan, Gerald, 119
Common market, 187n.9 Council of Ministers, 35, 38, 199n.1.
implementation of, 4–5 See also ECOFIN
as “single market,” 8 (see also Single and draft constitution, 39
market) and establishment of monetary policy,
Common regional development fund, 67
5 Court of auditors, 188n.12
Common rule mode of policy CPSS (Committee on Payment and
coordination, 48 Settlement Systems), 135, 160–61
Communication, of monetary policy, Credibility, of central bank, 89,
92–96, 211n.41 210n.38
Competition, among NCBs, 171. See Credit rationing, 87
also Policy competition Crises in banking and finance, 97
Competitive mode of price-setting central banks as defense in, x, 115–16
decisions, 88, 90 and cooperative effort, 158, 159,
Complementarity, in payment system, 225n.29
123–24 and Eurosystem, 116, 118
Condition of indifference, 125–26, 127, and exchange rate agreement,
129 150
Confidence, and money, 22, 169 and exchange rate strategy, 154
Congress of The Hague, 2 of 1930s, 212n.3
Consolidation, and payment system, solutions to, 116–18
136 Cross-border mergers, 102–103
Constitutional structures of member Cross-border payment services, 129,
states, 197–98n.4 218n.13
246 Index

Currency, 6. See also Money; Single De Gasperi, Alcide, 3, 6, 186n.2

currency de Gaulle, Charles, 4, 5, 187n.8
and central banking, ix–x Delors, Jacques, 2, 6, 188n.15
commodity vs. paper, 22 Delors Committee and Report, 2, 7,
and confidence, 22, 169 179, 188–89n.15
and economic/political/social and Treaty of Maastricht, 7
strength, 36 Denmark
international use of, 139–40 EEC joined by, 2, 5, 227n.5
paper, viii, 16, 22, 120 (see also and European System of Central
Banknotes) Banks, 21
social factors in soundness of, 181 “opt-out” clause for, 174, 189n.20,
Currency board arrangements (CBAs), 194n.1
224n.22 and pegging of currency, 222n.16
Currency segmentation, 98, 105 and Single European Act conference, 9
euro as end of, 102 TARGET used in, 131, 219n.15
Customs union, 4, 187n.9 and Treaty of Maastricht, 7
Cyprus, accession of, 3, 173 Deposit insurance, ix
Czech Republic Deutsche Bundesbank, 67, 72
accession of, 3, 173 decentralization of policy execution
and “managed floating” regime, in, 85
223n.18 and ECB, 81
and EMI, 196n.23
Decentralization, 24–25, 26, 31 and euro as anchor, 156
of mechanics, 85 Eurosystem compared to, 21
of policy execution, 85 independence of, 94
Decision(s), 25, 26 and interbank interest rates, 87
interest-based vs. wisdom-based, and liquidity transfer, 131
29–30 Deutsche mark, 36
and strategy, 77 as European standard of value, 145
Decision-making, 27–31 and exchange rate yardstick, 147
by majority vote, 5, 28–29, 36, international role of, 142–43
195n.20, 196n.20 (see also Majority outside Germany, 128
voting) and reunification of Germany, 14
and noncompetitive mode of price- as standard for euro, 67, 143
setting, 88–89, 90, 91 Deutsche mark (DM) regime, 13
unanimity requirement in, 5, 29, 45, Discount rate, 209n.32
188n.10, 195n.20, 196n.32 Dollarization, 152, 153, 156, 223n.19.
Defense policy, 45 See also US dollar
Deficit reduction, 61 Duisenberg, Willem, 78, 146
Deficit spending, 17, 200n.21
three percent limit on, 54 East Asia, 152, 153
Deflation, 80, 167. See also Stability, East Caribbean Currency Union,
price 223n.19
Index 247

ECB. See European Central Bank interplay of, 45–47

ECB Board, 26, 27–28 market policy, 42–43, 43, 48, 51–52
and establishment of monetary policy, monetary policy, 52, 67, 68–92 (see
67 also Monetary policy)
and implementation of policy, 25, 26 and Treaty of Rome, 11
and new members, 228–29n.10 Economic and Social Committee, EU,
ECB Council, 25–26, 27, 27–31 59, 203n.35
and bank crisis, 118 EDC (European Defence Community),
and change in strategy, 80, 82 2, 3
decision-making under enlargement EEC. See European Economic
of, 175–76 Community
deliberation style of, 77 Efficiency, 44, 53, 123, 217n.8
growth and employment neglected EIB (European Investment Bank), 11,
by, 53 190n.28
as melting pot, 172 Einaudi, Luigi, 1, 185n.1, 211n.41
and TARGET, 133 EMI (European Monetary Institute), 2,
weighted voting in, 195n.21 8, 195–96n.23
ECB two-pillar strategy, 68, 69, 80, 82, e-money, 130, 136, 213n.7, 218n.14
205n.2 Employment policy, 42, 43, 59–61,
ECOFIN Council, 56, 198–99n.11 203n.38
Economic constitution, EU, 42, 44, 45, “Empty chair crisis,” 188n.11
61, 213n.15 EMS. See European Monetary System
and market policy, 52 EMU (Economic and Monetary Union),
and policy coordination, 46 6, 60, 111, 130, 139, 176, 178, 179,
Economic and Financial Committee, 202n.32
56, 198–99n.11 “E pluribus unum,” xii, xiv
Economic and Monetary Union (EMU), Equity
6, 60, 111, 130, 139, 176, 178, 179, and euro area responsibilities, 44,
202n.32 53
Economic performance, 41 as national or regional concern,
and economic policy, 61 57–58
improvement possible in, 166 and Treaty of Rome, 11
and interplay of decisions, 45–46 Erhard, Ludwig, 187n.7
in United States, 204n.45 ERM (exchange rate mechanism),
Economic policy(ies), 41 188n.13, 222n.16
assessment of, 61–62 ERM II, 228n.9
assignment of, 42–45 ESCB (European System of Central
coordination of, 11, 46–51, 56, 177 Banks), 21
employment policy, 42, 43, 59–61, Estonia
203n.38 accession of, 3, 173
exchange rate policy, 42, 43, 52–53 and currency board arrangements,
fiscal policy, 11, 42, 43, 44, 45, 53–59 224n.22
goals of, 11, 43–44 euro-based currency board in, 223n.19
248 Index

EU. See European Union establishment of, 2

EU Council of Ministers. See Council of and European Monetary Institute, 8
Ministers and European Parliament, 37
Euro. See also Single currency and Eurosystem, xiv
and business outside euro area, 98 exchange rate intervention by, 146
chronology of development of, 2–3 and exchange rate policy, 53
creation of, 1 as head of system, 24
as “currency without a state,” 35 and inflation rate, 79
Deutsche mark as standard for, 67, as lacking track record, 81
143 minutes of meetings of, 196n.25
economic road in development of, and monetary policy, 71–72, 72–74,
11–15 78 (see also Monetary policy)
and financial system, 102–107, 111 NCBs’ future relationship to, 171–72
(see also Financial system) and new countries, 175
first day of, 119 and participation in international
and history of central banks, 18–19 organizations, 229n.15
as international currency, 139–47 (see and September 11 aftermath, 118
also International role of euro) European Central Bank, future of. See
name decided on, 8, 127 Future of euro and Eurosystem
notes and coins for introduced, 3, 8 European Coal and Steel Community,
political determination of, 180 2, 3, 4
political road in development of, 1, European Commission, 35, 37
3–11 Community regulatory framework
synthetic, 220n.6 proposed by, 130
Euro, future of. See Future of euro and and competition, 171
Eurosystem and cross-border payments, 129
“Euro area,” 197n.1 downgrading of role of, 177
Euro-dollar market, 98 and draft constitution, 39
Eurogroup, 52, 198n.11, 229n.15 and economic policy, 56
Euroization, 152, 153, 223n.19 and market integration, 107
Euroland, ix, 197n.1 and new members, 228n.6
as fragmented area, 85 and state aid in banking crisis, 117
in key triad, 154, 177 European Community, and
European Central Bank (ECB). See also redistribution, 11
Central banks and banking; ECB European Convention (June 2003), 36
Board; ECB Council; Eurosystem European Council, 2, 5, 38
and central bank paradigm, viii–ix and ECOFIN, 199n.11
communication practices of, 92–93, and “euro” as name, 127
96 and exchange rate, 53
and cross-border payment services, and labor force participation rate, 61
129 European Court of Justice, 35, 38
and e-money, 130, 213n.7 (see also European Defence Community (EDC),
e-money) 2, 3
Index 249

European Economic Community (EEC), adoption of name, 8

2, 3–5 decision-making of, 195n.20, 196n.32
revenue sources for, 5, 188n.12 (see also Decision-making)
and United Kingdom, 9 evolution of, xi–xii
European fixed exchange rate system, 7 finances of, 39
European integration, xi–xii, 58 and fiscal policy, 53
and central banking, xii incompleteness of, 35–36, 50, 106,
European Investment Bank (EIB), 11, 179, 180
190n.28 institutional architecture of, 179–80
European Monetary Institute (EMI), 2, institutions of, 36–39 (see also specific
8, 195–96n.23 institutions)
European Monetary System (EMS) and international organization vs.
and anchor role, 148 federal state, 45
beginning of, 2, 5 legislation of, 197n.2
and DM regime, 13 Maastricht Treaty creates, 1, 2
in exchange rate crisis (1992–93), 7 and market policy, 51, 52
and exchange rate mechanism, and monetary power, 19
188n.13, 222n.16 and policy coordination, 50
and fixed exchange rates, 145 preconditions for membership in, 173
and inconsistent quartet, 14 and responsibility for main public
and monetary policy, 70 goods, 44–45
paths leading to, xii three pillars of, 8–9
and United Kingdom, 9 and Treaty of Nice, 3
European Parliament, 5, 35, 37–38 Euro-scepticism, 7, 10
and draft constitution, 39 Eurosystem, xii–xiii, 21–23. See also
ECB president appears before, 93 European Central Bank
Eurosystem accountable to, 34 and accession of new countries,
first elections for, 2 173–76
members’ representation in, 228n.6 as archipelago of monopolists, xiii–xiv
and mix of monetary and fiscal as catalyst, 163
policies, 56 center and periphery in, 23–27, 31,
perception of, 95 176
seat of in Strasbourg, 186n.6 decision-making in, 27–31, 195n.20
European public opinion, slow (see also Decision-making)
emergence of, 95 and “e pluribus unum,” xiv
European Regional Development Fund, and European Union, 35–36
190n.28 and execution of policy, 25–26
European Social Fund, 190n.28 and financial stability, 115–18, 163
European System of Central Banks (see also Stability, financial)
(ESCB), 21 fiscal and political counterpart in,
European Union (EU), 1, 35–36 57
accession of new countries into, independence and accountability in,
173–76, 227nn.4, 5, 227–28n.6 32–34
250 Index

Eurosystem (cont.) Faust (Goethe), and paper notes, 16,

international role of, 139 (see also 192n.36
International role of euro) Federal Reserve Act (1913), and
and national bank systems, xiii, 163, Maastricht Treaty, 21
170 (see also National central banks) Federal Reserve System, US. See US
and national price setters, 90 Federal Reserve
as perfect central bank, xiv, 168–72 Fiduciary money (currency), viii, 19
as unified “system,” 98–99 and Germany, 67
Eurosystem, future of. See Future of Finality, 123, 217n.8
euro and Eurosystem Financial Holding Companies Act
Eurosystem Statute, reform of, 176 (1999), 100
Excessive Deficit Procedure, 202n.31. Financial intermediation, 99
See also Stability and Growth Pact Financial sector, 64
Exchange rate(s), 12–13 Financial Services Authority, 111
and corner solutions, 15 Financial Stability Forum (FSF),
and ECB, 53 226n.31
and economic constitution, 53 Financial system, 97. See also Banks
and European Monetary System, 5 Continental European model of,
factors in strategy for, 154 99–102, 212n.6
floating of, 147–51 and euro, 102–107, 111
fundamentalist view on, 221–22n.14 and financial stability, 115–18 (see also
and incoming members, 174 Stability, financial)
and international role of euro, regulation and supervision of, 107–16
143–47 restructuring of, 98
key variables for, 167 and single currency, 99
“misalignments” view on, 222n.14 under single market, 98
as monetary-policy variable, 69–70 wholesale activity, market integration
and 1992–93 EMS crisis, 7 in, 103–104
and pegging, 151–54, 222n.16, Finland
223n.17 banking crisis in, 225n.26
and single currency, 145, 147, euro introduced for, 2
203n.36 and European Union, 2, 227n.5
and Treaty of Rome, 11, 13 institution of supervision in, 112
Exchange rate mechanism (ERM), and interest rates, 87
188n.13, 222n.16. See also ERM II Finnish central bank, 85
Exchange rate policies, 42, 43, 52–53 Fiscal policy(ies), 43, 53–59
Exchange rate regimes assignment of, 42, 45
with euro link, 154–56 in interaction with monetary policy,
fully flexible, 224n.22 56–57
Exchange rate targeting, as monetary three goals of, 11, 43, 44
policy, 69–70 Flexibility
Externalities, 178 fiscal, 55
External sector, 64 in labor market, 60
Index 251

Forecasts, economic Geographical mobility of workers, 12,

by Bank of England, 93 60
publication of, 95–96 German Bundesbank, 17, 18
Foreign exchange transactions, Germany
settlement of, 133 in European Coal and Steel
Foreign and security policy, 45 Community, 3
Four freedoms, 179, 186n.3, 189n.17 communication style in, 94
hindrances to, 48 deficit limit exceeded by, 54–55
laws passed to implement, 6 division of economic responsibilities
and single currency, 15 in, 56
support for (1980s), 14 economic output from, 64
and theory of optimum currency and EMS policy conflict, 15
areas, 12 euro introduced for, 2
France hyperinflation in (1923), 16, 18
and bank-assurance links, 101 inflation rate in (1949–1998), 67
central bank independence in, 32 institution of supervision in, 112
in European Coal and Steel Länderfinanzausgleich (Regional
Community, 3 Financial Compensation) in, 59,
deficit limit exceeded by, 54–55 202n.33
de Gaulle as leader in, 4, 5, 187n.8 Landesbanken in, 213–14n.16
economic output from, 64 and monetary policy, 70
euro introduced for, 2 reunification of, 2, 7, 14, 174–75
and European Defence Community, 3 and “snake” agreement, 2, 13, 145,
franc supported, 7 192n.35
inflation in, 67 and Treaty of Rome implementation,
institution of supervision in, 112 4
and interest rate structure, 87 Global financial system, 162
and monetary policy rates, 88 Globalization, as payment-system
and “snake” agreement, 2 challenge, 136
Friedman, Milton, 18, 193n.40 Goals of economic policy, 11, 43,
Fungibility, preservation of, 129–30 44
Future of euro and Eurosystem, 165 Goethe, Johann Wolfgang von,
and global cooperation, 176–79 192n.36
and incoming countries, 173–76 and paper notes, 16, 192n.36
and lack of political union, 179–81 quoted, 230n.18
and perfect central bank, 168–69 Gold, first monetary use of, 216n.1
and price stability with growth, Gold anchor, viii, ix, 15–16, 17, 19,
165–68 180, 190n.27
Gonzalez Marquez, Felipe, 6, 189n.18
Galí, Jordi, 74 Government sector, 64, 204n.42
Game theory paradigm, 89–90 Great Britain. See United Kingdom
General equilibrium paradigm, 89, Great Depression, 168, 212n.3
210n.39 Great Inflation of the 1970s, 75, 76
252 Index

Greece Independence, 32–33, 34

euro adopted by, 3 India, and number of key currencies,
and European Communities, 2, 151
227n.5 Indifference condition, 125–26, 127,
relative poverty of, 174, 204n.43 129
and Single European Act conference, 9 Inflation, 67, 78. See also Stability, price
Greenspan, Alan, 211n.42, 212n.6 distribution of rates of, 81–82
Growth, as future challenge, 165–68 and future support for Eurosystem,
G7 (Group of Seven), 150, 184, 168
204n.44 German hyperinflation, 16, 18
in cooperative framework, 158 and government’s overcreation of
and decision-making, 163 money, 16
and euroland, 226n.33 Great Inflation of the 1970s, 18, 75,
foreign-exchange intervention by, 76
146, 147 growth of, 79
as loose-coordination example, 49 key variables for, 167
meetings of restricted to national long-term expectations for, 81
authorities, 226n.32 and monetary-policy re-evaluation,
shortcomings of, 151, 159, 162 79–80
three major economies as focus of, and money, 193n.41
229n.12 and 1970s United States, 207n.18
G20 forum, 184, 226n.31 and “real money gap,” 207n.20
reduction of, 61
Hands-on approach to regulation and rules for, 75, 207n.19
supervision, 99, 102 and separation of supervision,
Harmonized Index of Consumer Prices 111–13
(HICP), 68, 79, 80 and unemployment (Phillips curve),
Herd mentality, 225n.27 17, 18, 193n.39, 207nn.16, 17
Herstatt risk, 133, 225n.29 Inflation bias problem, 210n.38
Hicks, John, 17, 206n.16 Inflation forecasts, by Bank of England,
HICP (Harmonized Index of Consumer 93
Prices), 68, 79, 80 Inflation targeting, in monetary policy,
Hume, David, 69 69–70, 71, 73
Hungary, accession of, 3, 173 Information and communication
technology (ICT), for payment
IAIS (International Association of system, 122
Insurance Supervisors), 160–61 Instability, financial, 224–25n.26
IASB (International Accounting Instruments of monetary policy, 84
Standards Board), 160–61 Interest rate, 208nn.28, 29
IMF. See International Monetary Fund and bank reserves, 208n.26
“Inconsistent quartet,” 12–13, 14, 148, and central bank rates, 87
191n.32 changes in, 78
and corner solution theory, 152 natural equilibrium of, 75, 76
Index 253

Intergovernmental Conference (IGC), IS-LM model, 191n.32, 192n.37,

3, 36, 196n.33, 228n.6 206n.16
International Accounting Standards IS-LM-plus-Phillips curve model, 74–75,
Board (IASB), 160–61 206–207n.16
International Association of Insurance Italy
Supervisors (IAIS), 160–61 Banca d’Italia, 17, 85, 87
International Monetary Fund (IMF), 30, central bank independence in, 32, 94
198n.7 in European Coal and Steel
Articles of Agreement of, 49, 226n.30 Community, 3
and Bretton Woods conference, and economic differences vs. political
190n.27 divisions, 30–31
common European position on, economic output from, 64
226–27n.33 euro introduced for, 2
and cooperation for financial stability, institution of supervision in, 112
159, 163 and interest rate structure, 87
and ECB, 229n.15 policy transmission in, 87
euroland weight in, 227n.33 and “snake” agreement, 2
exchange-rate regime of, 190n.29 and Treaty of Rome implementation,
and exchange rate rules, 150 4
exclusion of, 151
inflation targeting recommended by, Japan
71 bank functions in, 100–101
voting power on, 195n.22 banking crisis in, 225n.26
International Organization of Securities central bank role in, 53
Commissions (IOSCO), 135, 160–61 and equity holdings, 141
International role of euro, 139–43 in key triad, 154, 177
and cooperation for financial stability, liquidity trap of, 79
157–63 as model, 166
and euro as anchor, 154–57 Japanese yen
and exchange rate, 143–47 proposed fixing of exchange rates for,
and floating of dollar/yen/euro, 147–48
147–51 as reference currency, 156
in future, 176–79 and US dollar, 222n.15
and pegging of currencies, 151–54,
222n.16, 223n.17 Keynes, John Maynard, 17
“Invisible currency” argument for Keynesian IS-LM model, 192n.37,
weakening of euro, 145–46, 220n.5 206n.16
Ireland Keynesian IS-LM-plus-Phillips curve
EEC joined by, 2, 5, 227n.5 model, 74–75, 206–207n.16
euro introduced for, 2 Kohl, Helmut, 6, 7, 188n.14, 189n.19
income of, 204n.43
institution of supervision in, 112 Laeken European Council, 228n.6
and Schengen agreement, 189n.17 Lafontaine, Oscar, 147
254 Index

Lamfalussy, Alexandre, 214n.18 and monetary policy, 68

Lamfalussy report, 110, 214n.18 and payment systems, 218n.10
“Last resort clause,” 116 on policy-making steps, 25–26
Latvia and political union, 36
accession of, 3, 173 ratification of, 7, 189n.23
currency peg of, 228n.9 and supervisory institutions, 111–14
Law of one price, 103 and Treaty of Rome, 9, 15
Lending-of-last-resort solution to crisis, Majority voting, 36, 196n.32
116–17, 216nn.30, 31 and de Gaulle veto, 5
Lithuania in ECB Council, 28, 29
accession of, 3, 173 qualified majority, 5, 188n.10,
and currency board arrangements, 195n.20
224n.22 and Single European Act, 6
euro-based currency board in, 223n.19 Malta, 3, 173
Lucas, Robert E., 18, 69, 193n.40 “Managed floating” regime, 152,
Luxembourg. See also Benelux countries 223n.18
in European Coal and Steel Maritain, Jacques, 1, 185n.1
Community, 3 Mark, German. See Deutsche mark
economic output from, 64 Market integration, 103–106
euro introduced for, 2 impediments to, 106–107
income of, 204n.43 Market policy(ies), 42–43, 43, 48,
institution of supervision in, 112 51–52
Luxembourg compromise, 188n.10 Market system, 178–79
Luxembourg European Council, 227n.6 Mechanics of policy implementation
Luxembourg process, 203n.38 and execution, 83, 84–85
MERCOSUR, 198n.7, 230n.16
Maastricht criteria, 7, 8 Mergers, cross-border, 102–103
Maastricht Treaty, 1, 2, 7, 19 Mergers and acquisitions (M&A)
budget rule from, 54 services, 103, 213n.11
on central-bank independence, 32 Messina conference (1955), 10
from central banking point of view, Mexico, financial crisis in, 152,
23 225n.26
collegial decision making of, 77 Mitterrand, François, 6, 188n.14
and decision-making principle, 29 Mobility of capital, 12, 13, 14, 15, 148,
ECB Council and Board derived from, 191n.32. See also Four freedoms
27 Mobility of workers, geographical, 12,
and economic policy, 48 60
and EU economic constitution, 61 Modigliani, Franco, xv, 17, 192n.37
“European Union” term adopted Moltke, Helmuth James Graf von, 1
through, 8 Monetary policy. See also European
foundations of single European Monetary System
currency from, 19 assignment of, 42, 43
and history of central banking, 15 and central bank development, 22
Index 255

and central-bank perfection, 169 Money stock, viii

and creation of money, 17 as monetary-policy variable, 69–70
de-politicization of, 18–19 Money targeting, as monetary policy,
Deutsche mark as standard in, 67 69–70, 71
as European-level responsibility, 52, 53 Monnet, Jean, 1, 3, 185n.1
and Eurosystem, 23 Montesquieu, Baron de (Charles de
and exchange rate policy, 53 Secondat), 4, 186n.4
in interaction with fiscal policy, 56 Moral hazard, ix, 111, 215n.21
mandate for, 68 M3, 69, 78–79, 83, 205nn.4, 5
and natural rate of unemployment, 18 Multi-currency system, management
and neutrality of money, 18, 193n.41 of, 151
operations in, 83–86 Multilateral netting system, 121,
and other central banking functions, 216n.3
91 Mundell, Robert, 12
and payment system, 119 Mundell-Fleming analyses or model,
price stability as priority for, 53 13, 191n.32
in recent past, ix–x Musgrave, Richard, 11
and separation of supervision, 111–13 Mutual recognition of national
single policy adopted, 8 regulations, 51, 199n.14
strategy for, 68–72
strategy debates in, 72–78 NAFTA, 198n.7, 230n.16
strategy practice and evaluation in, National Bank of Belgium, 17
78–83 National central banks (NCBs), xiii, 24,
transmission of, 86–92, 92, 157, 25, 26, 194n.7
205n.3 and central bank operations, 83, 84,
transparency and communication of, 85
92–96 competition among, 171
two pillars of, 68, 69, 80, 82, 205n.2 and national constituency vs.
Monetary system, viii, 121. See also Eurosystem, 163
European Monetary System as national entities, 172
Money, 120. See also Currency stand-alone features of, 169–70
creation of by state, 16–17 National price setters, and Eurosystem,
e-money, 130, 136, 213n.7, 218n.14 90
fiduciary, viii, 19 National public budgets, 200n.21
functions of, viii NCBs. See National central banks
and inflation, 193n.41 Netherlands. See also Benelux
and monetary-policy re-evaluation, countries
79, 80 and bank-assurance links, 101
neutrality or nonneutrality of, 17, 18, in European Coal and Steel
68, 192n.38 Community, 3
and prices, 69 euro introduced for, 2
silence of, 211n.41 institution of supervision in, 112
and social contract, 180 and “snake” agreement, 2
256 Index

Netting system, 121, 122, 131, 216n.3 innovations in, 22

Neutrality of central bank, 123, 217n.8 large-value payments in, 124, 130–33
Neutrality of money (question of), 17, in recent past, ix
18, 68, 192n.38 retail payments in, 124, 127–30
New Zealand, 71, 206n.13 securities settlements in, 124, 133–35,
Nice, Treaty of, 3, 9, 36, 39, 227–28n.6 217–18n.9
“No-bail-out-clause,” 54 and single currency, 124–27, 129
Noncompetitive mode of price-setting Pegging of national currencies, 151–54,
decisions, 88–89, 90, 91 222n.16, 223n.17
Nondisclosure method, for monetary Pension systems, 92, 100, 211n.1
policy, 72 Phillips, Alban W. H., 193n.39
Nonmonetary actors, 91 Phillips curve, 17, 18, 193n.39,
Nonmonetary policy matters, 31 207nn.16, 17
Norway, 225n.26 Poland, 3, 156, 173, 228n.9
Policy, economic. See Economic
OCA (optimum currency areas), theory policy(ies)
of, 12, 13, 190–91nn.30, 31 Policy competition, 47, 48, 49–50
OECD (Organization for Economic vs. protectionism, 107
Cooperation and Development), 30, and supervision, 114
229n.15 Policy coordination, 46–51, 56–57
One Market, One Money report, 191n.31 and introduction of euro, 177
One-to-one correspondence model, under Treaty of Rome, 11
170–71 Policy-making, 76
One price, law of, 103 and monetary policy, 76–77
Open market operations, 84 Political union, lack of, 36, 44, 50,
Operational target, 83, 84 179–81
Optimum currency areas (OCA), theory Portugal
of, 12, 13, 190–91nn.30, 31 deficit limit exceeded by, 54
“Opt-out” clauses, 7, 174, 189n.20, devaluation of escudo, 7
194n.1 economic output from, 64
Organization for Economic euro introduced for, 2
Cooperation and Development and European Communities, 2,
(OECD), 30, 229n.15 227n.5
Overnight rate, 84 institution of supervision in, 112
“Overshooting,” 146, 221n.7 monetary policy instruments of,
209n.31
Paris, Treaty of (1951), 2, 173, 227n.4 Price setters, national, and Eurosystem,
Patinkin, Don, 193n.40 90
Payment system, x, 119, 122–24 Price stability. See Stability, price
challenges to, 130, 135–37 Price stabilization, primacy of, 33
cross-border transfers, 129, 218n.13 Private money solution to crisis, 117
currency specificity of, 121 Privatization, and payment system,
historical background of, 119–22 135–36
Index 257

Protectionism, 106–107 Russia

Prudential controls, 108 financial crisis in, 15, 225n.26
Public goods, 44–45, 57, 58 and number of key currencies, 151
international, 178
Public interest Safety, 123, 217n.8
interpretation of, 28 Schengen agreement, 10, 189n.17
as national interests, 172 Schuman, Robert, 3, 6, 185–86n.2,
Public opinion in Europe, slow 186n.5
emergence of, 95 Schuman declaration, 186n.5
Public ownership of banks, 99, 101, Securities markets, 100
212n.4 Securities settlement systems, 124,
Purchasing power parities (PPP), 133–35, 217–18n.9
204n.40 Security
as EU objective, 45
Qualified majority, 5, 188n.10, EU’s failure to provide, 35, 180
195n.20 Shocks, price, 79, 208n.24
Single-agency approach, 111,
Rational expectations school, 18, 214nn.19, 20
193n.42 Single currency, 6–8. See also Euro
Real-time gross-settlement (RTGS) challenge in adoption of, 90–91
systems, 123, 130–31, 134, 172, and exchange rate, 145, 147, 203n.36
219n.16. See also TARGET as matching American dollars, 142
Redistribution and OCA theory, 12, 13, 191n.31
on Europe-wide basis, 11, 58, and payments system, 124–27, 129
190n.28 political determination of, 180
as national function, 57–58 road toward, 14, 15
Redundancy, 170 and single market, 48, 97–98, 199n.12
Regional development, aid for, 5, 39 substitutability of, 123
Regionalism, 179 and system of banking and finance,
Regulation, 108 99
of financial system, 108–10 with unachieved polity, 181
Reputation, of central bank, 210n.38 Single European Act, 2, 6, 8–9, 189n.16
Reserve requirement, 84 and United Kingdom, 9
Retail activity, market integration in, Single institution mode of policy
105–106 coordination, 46, 47–48
Risk, systemic, 122, 217n.4 Single market, 2, 98
Rivlin, Alice, 218n.11 beginning of, 6, 8
Romania, 173 and public ownership of banks, 101
Rome, Treaty of. See Treaty of Rome regulatory/supervisory framework for,
RTGS (real-time gross-settlement) 109
systems, 123, 130–31, 134, 172, and single currency, 48, 97–98.
219n.16. See also TARGET 199n.12
Rueff, Jacques, 211n.41 Single Market Program, 12, 52
258 Index

Slovakia, accession of, 3, 173 Stabilization

Slovenia, accession of, 3, 173 fiscal policy for, 11
Smithsonian Agreement, 190n.29 as national function, 57
“Snake” exchange rate agreement, 2, shift from monetary to fiscal, 55
13, 145, 192n.35 Stabilizers, automatic, 55, 201n.27
Social Charter, and United Kingdom, Standing facilities, 84
9–10 Structural funds, 11, 58, 190n.28
“Sound money-sound finances” Structured coordination model, for IMF
principle, 55 representation, 226–27n.33
Spain Subsidiarity, 24, 25, 45, 57, 115, 194n.9
central bank independence in, 32 Substitutability, in payment system,
devaluation of peseta, 7 123
economic output from, 64 Supervision of banks, 22, 23, 108
euro introduced for, 2 of financial system, 108–16
and European Communities, 2, Supranationalism, 178
227n.5 Svensson, Lars, 73, 74
institution of supervision in, 112 Sweden
Spinelli, Altiero, 1, 185n.1 banking crisis in, 225n.26
Stability, financial, 108, 115–18 and European System of Central
and central banks, x Banks, 21
international cooperation for, and European Union, 2, 227n.5
157–63 TARGET used in, 131, 219n.15
and payment systems oversight, 123 Switzerland, 230n.19
Stability, macroeconomic, 44, 53, 61 Synthetic euro, 220n.6
Stability, price. See also Inflation Systemic risk, 122, 217n.4
as central bank mission, x
through cooperation between central TARGET (Trans-European Automated
bank and price setters, 90 Real-time Gross settlement Express
and euro as anchor, 156 Transfer) system, 125–26, 131–33,
exchange rate contrasted with, 148 172, 219nn.15, 16
as future challenge, 165–68 Target zones, 53, 147–148, 199n.17
and HICP, 80 Taxation, 201n.25
and M3 growth, 69 Taxpayers’ money solution to crisis,
and new members, 175 117
as priority, 19, 53, 68, 167 Taylor rule, 207n.19
quantitative definition of, 68, 73, 79 Tietmeyer, Hans, 30, 196n.24
and supply shock, 79 Transparency, 32
Stability and Growth Pact (SGP), 48, vs. accountability, 95–96
55, 200n.20, 201–202n.28 and communication, 95
budget rule from, 54, 200n.23 of monetary policy, 92
fiscal rule in, 58 “Treaty, the” 8–9
and national governments, 91 Treaty of Amsterdam (1997), 2, 9, 36,
Stability programs, 200n.23 227n.6
Index 259

Treaty on European Union monetary policy in, 18, 70, 206n.8

accession entitlement in, 227n.4 “opt-out” clause for, 174, 189n.20,
and Treaty of Nice, 3 194n.1
Treaty of Maastricht. See Maastricht and pound sterling, 7, 140, 142
Treaty and Schengen agreement, 189n.17
Treaty of Nice, 3, 9, 36, 39, 227–28n.6 TARGET used in, 131, 219n.15
Treaty of Paris (1951), 2, 173, 227n.4 Thatcher revolution in, 18, 193n.44
Treaty of Rome, xi, xiv, 2, 3–4, 19 and Treaty of Maastricht, 7
and economic policies, 11–13, 48 United Nations, 198n.7
and EU economic constitution, 61 United States. See also at US
and Maastricht Treaty, 9, 15 bank activities in, 100
and Single European Act, 6 banking supervision in, 113–14
and United Kingdom, 9 central bank role in, 53
Turkey, financial crisis in, 152, 225n.26 cross-borders mergers in, 103
Two-corner solution theory, 13. See also division of economic responsibilities
Corner solution theory in, 56
Two-pillar strategy, 68, 69, 80, 82, in economic comparison with
205n.2 Euroland, 62–65, 204n.45
and equity holdings, 141
Unanimity requirement in decision and exchange rates, 145
making, 5, 29, 45, 188n.10, 195n.20, financial system as single entity in, 99
196n.32 government sector in, 64, 204n.42
Unemployment, 167 growth rate of, 227n.1
challenge of, 41 “hands-off” approach in, 102, 212n.5
factors in reduction of, 62 inflation in, 67
and future support for Eurosystem, in key triad, 154, 177
168 market-based finance in, 100
and inflation (Phillips curve), 17, 18, as model, 166
193n.39, 207nn.16, 17 monetary policy in, 18
and wage bargaining for single wage and response to Great Depression,
rate, 60 212n.3
Unemployment policy, 59–61 and retail payments, 218n.11
Unit of account, and euro, 128, 141 value of transactions in, 132
United Kingdom, 9–11. See also Bank of Universal banking, 99, 100–101
England US Constitution, interstate commerce
division of economic responsibilities clause of, 62
in, 56 US Constitutional Convention
EEC joined by, 2, 5, 227n.5 Convention on Future of Europe
and European System of Central compared to, 9
Banks, 21 as single founding act, 42
European Union joined by, 227n.5 US dollar
inflation in, 67 as anchor, 12, 190n.27 (see also
market-based finance in, 100 Bretton Woods system)
260 Index

US dollar (cont.)
and euro, 145
other currencies pegged to, 151
power of, 141–42, 142
proposed fixing of exchange rates for,
147–48
and regional clustering, 156
and Vietnam War, 14
US Federal Reserve, 17
and e-money, 218n.14
Eurosystem compared with, xiii, 21
federal structure of, 26–27
and Fedwire, 123, 131, 132, 217n.6
and financial structure, 86, 210n.36
and independence, 34
inflation tamed by, 18
and liquidity transfer, 131
and monetary policy, 70, 71
and 1987 stock market crash, 118
and “one voice versus many voices”
issue, 94
operating procedures of, 86
and publication of forecasts, 93
rediscount operations of, 209n.32
and September 11 aftermath, 118
and target-interest-rate
announcement, 92
track record of, 81

VAT, minimum standard rate for,

201n.25
“Vital interest,” veto based on, 5
Volcker, Paul, 18, 193n.43
Voting. See Decision-making; Majority
voting

Wage equalization, 60
Wage setting, 89
Walras, Léon, 89
World Bank, 159, 190n.27, 198n.7
World Trade Organization, 198n.7