The ECB’s key characteristics are as follows:
■ Instruments and goals:
● Instrument: Interbank lending rate
● Goals:
* Primary: “Maintain price stability”
* Secondary: “Support the general economic policies in the Community
with a view to contributing the achievement of the objectives of the
Community”
● These goals are similar to those of other central banks. However, the ECB’s
focus on inflation is more intense than most other central banks.
■ Forbidden activities:
● The ECB may not finance member states’ fiscal deficits.
● The ECB may not provide bailouts to member governments or national public
bodies.
■ Governance and decision making:
● Decisions are made at the Governing Council, with the following
membership:
* The central bank governors of the Eurozone national central banks
* The ECB executive board
● Decisions are made by consensus rather than majority vote.
● Meetings occur twice each month.
● Note to instructor: The system is not dissimilar to the design of the Federal
■ Accountability and independence:
● The ECB is responsible for all monetary policy for the system.
● The ECB has complete autonomy from all other EU bodies.
● The ECB is not required to release minutes from meetings, and has
independence over decisions about the instrument (interest rate).
● The ECB is among the most independent central banks in the world.
Criticism of the ECB
■ The goal of price stability:
● The primary objective of the ECB is to maintain price stability through
maintaining an inflation rate of no more than but “close to” 2%.
● The target is asymmetrical because there is no lower bound to the inflation
target. Such a lower bound would help guard against deflation. This was
important during the Great Recession of 2008–2009.
● In practice, the ECB has ignored its secondary goal, placing little weight on
economic activity.
● This stands in contrast to the Federal Reserve System and the Bank of
■ Inconsistent nominal anchors:
● The ECB relies on the “first pillar,” expected price inflation, and the “second
pillar,” money supply growth.
● In general, fixed money growth is not consistent with interest rate policy.
■ The ECB is not a lender of last resort.
● During banking crises, most central banks are expected to extend domestic
■ Decision-making process and consensus:
● Requiring consensus often means that policy making will lag because it takes
time to reach a general agreement.
● This will become a bigger problem as the Eurozone expands to include more
countries.
● While the consensus requirement will become more of a problem as the
Eurozone adds countries, changing it will be very difficult. The structure of
the Council was established as part of the Maastricht Treaty.
■ Lack of accountability:
● Without political oversight, the ECB is independent from criticism and
popular opinion.
The German Model Supporters of the ECB say that independence and freedom from
political interference are necessary to allow the young institution to establish credibility.
The ECB was modeled on the Bundesbank. German preferences and Germany’s
economic performance gave German central bankers the upper hand in negotiations. And
Germany’s aversion to inflation can be traced directly to the hyperinflation the country
experienced between the two World Wars.
Monetary Union with Inflation Bias All countries have a problem with inflation bias if
monetary policy is discretionary. A politically controlled central bank is always tempted
to surprise the country with an unexpected increase in the growth rate of the money
supply. That eventually leads to inflation. As the public builds inflation expectations into
The Rules of the Club
The Maastricht Treaty established five rules for admission to the Eurozone. A country
applying for membership had to meet all of these convergence criteria. The rules can be
divided into two groups: convergence in nominal measures closely related to inflation
and rules covering fiscal discipline.
Nominal Convergence
■ Exchange rate: Two consecutive years inside the ERM band with no change in
central parity (no devaluation of the target exchange rate).
Fiscal Discipline
■ Government deficit: No more than 3% of GDP in previous year.
■ Government debt: No more than 60% of GDP in previous year.
Criticisms of the Convergence Criteria There are several:
■ Rules involve asymmetric adjustments that may take a long time.
● During the 1980s and 1990s, German preferences dominated monetary policy,
■ The fiscal rules are inflexible and arbitrary.
● There is little or no justification for the specific numerical targets chosen.
● Fiscal rules make no allowance for the business cycle, even though there is
general consensus among economists that fiscal rules should account for
economic fluctuations.
* A country in recession may experience a temporary reduction in its tax
● Although there may be good results from imposing strict convergence criteria,
countries may “cheat” once they are admitted, eliminating these potential
gains.
• Countries not able to meet strict convergence criteria have an incentive to cheat in
Sticking to the Rules
If the convergence criteria are painful for countries seeking membership, then they might
fail to meet these criteria once admitted, especially if fiscal policy remains independent.
In terms of monetary policy, the euro area has enjoyed success in achieving low
The Stability and Growth Pact (SGP) was adopted by the EU in 1997. It was designed
to address growing concerns about fiscal discipline, but failed to do so in an effective
way.
The SGP created a “budgetary surveillance” process by requiring member states to
submit economic data and policy statements for periodic review.
■ An “early warning mechanism” would notify countries of “slippage.”
■ A “political commitment” was designed to impose “peer pressure” on member
■ Surveillance failed because countries concealed their true fiscal situation by using
accounting tricks or by simply falsifying records. (A common deficit figure was
2.9%, probably not a coincidence. And Greece produced fake deficit figures to
gain admission to the Eurozone, only admitting its ruse after the country was
using the euro. )
■ Punishment has been weak and peer pressure has been ineffective. With so many
governments breaking the pact, there is little will to enforce it or to impose
punishment.
■ The deficit limit rules do away with the automatic stabilizer associated with fiscal
4 The Eurozone in Crisis, 2008–13
Until 2008, Eurozone policymaking had two targets:
■ The ECB’s credibility and inflation target (success).
European countries. In Europe, the lenders were the core Northern European countries,
while the borrowers were fast–growing peripheral countries: Portugal, Italy, Ireland,
All bubbles burst eventually. The 2007 housing bubble was no exception. Housing
prices collapsed, with the aforementioned boom areas suffering the largest price declines.
The banks were in crisis, but the Eurozone had no lender of last resort. Governments
tried to guarantee private banks to prevent bank runs, but this merely socialized private
losses, moving the black hole from the banks’ balance sheets to the government’s. The
The ECB did not want to see any country default. The official policy was to make
loans to member states’ banks if they used “eligible” government bonds as collateral. In
The euro depreciated sharply against the dollar and other major currencies.
The EU decided to bail out everyone, making sure that no bank or government
creditor was hurt. That contravened almost every rule in the Maastricht Treaty. On May
Peripheral countries now have large euro-denominated debt. They desperately need
economic growth so they can pay the debt service. But their economies have continued to
shrink. They cannot depreciate their currency (naturally), leaving them with large wage
and cost reductions as the only way to become competitive again. The cost declines are
being speeded along by high unemployment. The concomitant deflation will, of course,
make the real cost of the external debt even higher.
And the risks are high. If a country defaults, its citizens will have made enormous
5 Conclusions: Assessing the Euro
We applied the OCA criteria to the case of Europe and found that the EU does not satisfy
these criteria. The euro area’s success may depend on non-OCA criteria.
Euro–Optimists The arguments in favor of the euro zone are as follows:
■ The euro has functioned adequately for several years.
■ There is a general desire among countries to join the monetary union in Europe.
■ The ECB will prove to be a strong, credible, independent central bank that can
resist political interference.
● Structurally, the ECB is more independent than most of the world’s central
banks.
● Even if the costs of joining the currency union are high in the short run, the
long-run benefits will outweigh them in the form of lower inflation rates.
■ Forming a currency union in Europe will strengthen political unity.
Euro–Pessimists The arguments against the euro zone are as follows:
■ Market integration will not dramatically change—the marginal contribution from
currency union is small.
■ Cultural and linguistic barriers will continue to limit labor mobility.
■ There is wide divergence in economic growth and inflation rates across the
Eurozone. This will lead to divergence in preferences for tight versus loose
monetary policy.
■ The rules indicate governments cannot pressure the ECB to lower rates to reduce
their debt burdens, but historically governmental preferences can trump central
bank preferences when times are tough.
Summary The political dimension of the Eurozone is likely to ensure its success in the
long run. There is still mixed evidence on the OCA criteria—they may turn out better
than previously thought. In the immediate term, the Eurozone will continue to operate as
an economically costly currency union.
EU enlargement undercuts the OCA criteria and makes resolution of conflicts more
cumbersome. Only 50% to 60% of citizens within the Eurozone believe the euro has been
beneficial. British citizens have rejected it and in 2016 voted to leave the EU entirely.
TEACHING TIPS
Teaching Tip 1: The history of the European Union covers 65 years. West European
Teaching Tip 2: The European Economic Union (http://europa.eu/index_en.htm) is not
identical to the Eurozone (http://www.ecb.int/home/html/index.en.html). An interactive
map available at the European Economic Union website shows how the Eurozone has
expanded since 1999. If your classroom has an Internet connection and a projector, walk
through the history. Then point out that some major economies (Sweden, Norway, the
U.K., Denmark, and Switzerland) do not use the euro. Two of them—Norway and
Switzerland—also do not belong to the European Economic Union.
IN–CLASS PROBLEMS
1. Describe how labor market mobility affects the cost-benefit OCA analysis for joining
a currency union. How does labor market integration in the EU compare with that of
the United States? Explain why labor market mobility is different in these two
regions.
Answer: Labor mobility means that labor is free to move across national borders in
2. Consider three countries that are considering joining a currency union called the CU:
Country A, Country B, and Country C. Country A and Country B have similar trade
volumes with other countries in the CU, and both are higher than Country C’s trade
volumes with the CU. Country B and Country C have the same degree of symmetry
in their shocks with the CU and both are lower than Country A’s symmetry of shocks
with the CU.
a. Plot Country A, Country B, and Country C on a symmetry‒integration diagram.
Answer: See the following diagram. Countries A and B have the same degree of