Originally published in THE BOSTON GLOBE

Tuesday, December 15, 1998

"European central bank faces task of making euro credible"

The Euro and Price Stability

Martin and Kathleen Feldstein

Eleven countries of Europe will launch a single, common currency, the Euro, on January 1st. With four exceptions, most notably the United Kingdom, the countries of the European Union will also become part of a new Economic and Monetary Union, or EMU. A critical aspect of the new monetary union is that the individual national central banks will no longer set their own monetary policy. Each of the central banks will be represented in the new European Central Bank (the ECB) , but the ECB itself will have sole responsibility for managing monetary policy for the EMU region as a whole.

The architects of EMU were careful to mandate in the Maastricht Treaty, which guides the implementation of the Euro, that the goal of monetary policy is price stability. As a treaty, the Maastricht rules take precedence over ordinary national laws. The Bank's Governing Council (the 11 representatives of the individual countries plus 6 Executive Board members who are approved by all Euro region governments) has reaffirmed that its primary objective is the maintenance of price stability, defined as annual consumer price inflation below 2 percent. The Maastricht rules do not call for attempting to balance economic growth or employment goals against an inflation goal.

Even before the single currency begins, European politicians are challenging the ECB to balance price stability against political goals for economic growth in the Euro region. How the new Bank meets that challenge will have enormous significance for the credibility of the new Euro currency. Perhaps a desire to enhance that credibility explains the German central bank's recent decision to cut interest rates. That move, inevitably followed by the other national central banks, takes pressure off the ECB to cut interest rates early in the new year.

The political background against which the Euro is being introduced has shifted dramatically toward the left in the last year and a half. Left-center coalitions or socialist governments are now in power in France, Italy and Germany. These new governments owe their election, at least in part, to popular dissatisfaction with high unemployment and slow job creation. But although their focus is on job creation, there has been little willingness on the left to confront the underlying causes of high European unemployment: over regulation, overly generous welfare rules, and de facto high minimum wages. Instead, the push is for an easier monetary policy to stimulate demand and , in turn, create more jobs.

The shift toward a more interventionist government is most dramatic in Germany, where its central bank, the Bundesbank, has long been the most independent of central banks and which has had a steady anti inflationary policy. Indeed the Bundesbank was the model used for the European Central Bank.

But the recent election has pushed a left of center Keynesian politician, Oskar La Fontaine, into the key Finance Minister role. He has already created a great controversy by attending a meeting of the Bundesbank and by calling for the ECB to pursue an easier monetary policy aimed at bringing down high unemployment rates and lowering the value of the new currency, the Euro, in order to boost exports from Europe.

The ECB and several national central bank heads have responded that this is in direct contradiction to the conditions agreed on at Maastricht. Furthermore, there is little disagreement among central bankers and economists that an easier monetary policy would not have a sustained effectiveness in lowering European unemployment. But the central bankers are undoubtedly nervous that there will be more pressure in this direction, along with a greater political tolerance for rising inflation.

More generally, French and German politicians are now pushing for a reduction in the independence of the ECB. They want to make it accountable to the European governments. Central bank independence is a relatively new phenomenon in Europe. Although the German Bundesbank has been fully independent since the end of World War II, other European banks have achieved independence from political accountability only recently. And the U.S. Federal Reserve Bank is explicitly accountable to Congress, and more indirectly to the White House.

It is natural to ask, then, how it is that the Federal Reserve has achieved, in practice, an independent monetary policy aimed at low inflation despite its clear political accountability. In fact, such de facto independence and anti-inflationary discipline is relatively recent. White House and Congressional pressure has been placed on the Fed on more than one occasion in earlier decades. And the result of such political pressure was the spiraling inflation that began modestly in the mid sixties but that rose to more than 12 percent by the late 1970's.

Starting with President Reagan in 1981, there has been political and popular support in the United States for a tough anti inflationary policy. But since late 1982 the low inflation policy has been accompanied by an economic expansion, with no significant downturn except that associated with the 1991 Gulf War. Thus, the ability of the Fed to withstand political pressure has not really been tested.

Our system doesn't provide the kind of independence that the Bundesbank enjoyed and that the European Central Bank has hoped to have. Just as the high unemployment in Europe is already threatening to undermine sound monetary policy and to reignite inflation in Europe, there is the risk that political pressure will again some day hang over the Fed. When the next U.S. recession comes, as it surely will, let's hope that our politicians will let the Fed set the right course to maintain price stability.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.