When the Economic and Monetary Union (EMU) was set up, a lot of work went into specifying the governance and objectives of the European Central Bank (ECB). The target inflation rate for the ECB was set at 2 per cent, similar to the objective of the Bundesbank before EMU, and it was a major concern for Germany that it should be enshrined as the ECB's target.
Recent experience would suggest that this target rate was too low. The chief economist of the IMF, Olivier Blanchard, has suggested that it would be better set at 4 per cent. By contrast, the Institute for World Economics in Germany has celebrated its century in existence by suggesting that the target inflation rate for the ECB should be reduced, possibly to zero. Whatever the right answer, and I would favour the higher number, any change today could damage the ECB's credibility, a credibility that has been hard won and which has proved beneficial to Europe in the current crisis.
While the ECB’s decisions on interest rates have not always been wise, especially the decision to raise interest rates in 2011, since EMU began the inflation rate has averaged 1.9 per cent a year; the ECB has met its objective.
In recent months, because of the low inflation rate, the ECB has bought government bonds, aiming to move inflation back to the target rate. So far this policy has had a substantial impact on the exchange rate of the euro, one of the important mechanisms for raising the rate of inflation. It now looks likely that the policy will succeed in restoring a more normal inflation rate by 2017.
The second major task of the ECB has been to ensure the integrity of the euro area financial system. When there were major concerns about the survival of the euro in 2012, the president of the ECB, Mario Draghi, stated that the ECB would do "whatever it takes" to ensure the survival of the euro. In that case his statement alone was enough to reassure the markets that the euro system would survive. The ECB did not actually have to intervene because Draghi's statement had credibility.
With the benefit of hindsight, in both cases of ECB action it would have been better if the interventions had taken place at an earlier date. However, this is to ignore the political problems that the ECB faced and it also, unreasonably, absolves the governments of the euro area of their failure to act to head off the problems that the ECB ultimately had to deal with.
If the governments of the euro area had put in place a big enough European Stability Mechanism (ESM) at an early stage in the crisis it might never have been necessary for Draghi to promise to do “whatever it takes”. The ESM would have needed to have been large enough to deal with any potential problems faced by Ireland, Spain, Portugal and Italy. However, because of the delays in establishing the ESM, and the problems in decision-making about the allocation of its funds, it did not persuade financial markets that it was sufficient for the task. As a result, it was left to the ECB to do the job, which it would have preferred to leave to euro area governments.
Having already cut interest rates to zero, and with output stagnant or falling in the EU, it was always going to be difficult for the ECB to meet its inflation target. However, as was apparent at the time, there was a strong deflationary bias to euro area fiscal policy between 2011 and 2014. This deflationary bias was aggravated, rather than moderated, by the changes in fiscal rules introduced at the height of the crisis. Thus, as fiscal policy remained contractionary, it left the ECB with little choice but to act.
One of the major political problems faced by the ECB in this crisis was that German interests are very underrepresented in the governance of the ECB. There are only two German members of the ECB’s governing council of 21, and some months only one of them has a vote. Under more normal circumstances this probably would not matter too much. However, when decisions are being taken which are very strongly opposed by Germany, their underrepresentation raises concerns about democratic legitimacy. As a result, the governing council appears to have been slow to outvote the German members. This has meant that the ECB fire brigade was late arriving to do “whatever it takes” in 2012 and, again, to take action to move the rate of inflation back towards its target of 2 per cent. Nonetheless, the ECB did take action.
EU decision-making is often criticised for moving at a snail’s pace. However, as a result of the crisis, “banking union” has been established and, by the standards of the EU, it was implemented very rapidly. The development of banking union is very important for Ireland as it provides much greater certainty that the recent financial crisis will not be repeated and also, if such a financial crisis were to occur again, that it would be dealt with in a manner that did not saddle Irish taxpayers, or taxpayers from other countries, with an unacceptable burden. In the next few years it should also contribute towards enhanced competition in the banking sector, something which would be of significant benefit to the Irish economy.
While there are definitely aspects of the ECB’s handling of the crisis which we in Ireland would deplore, overall it has done its job at a difficult time.
