European Central Bank Fraught with Turbulence in Early Years

May 06, 2005

As public opinion in France appears to be mobilizing to reject the European Union constitution just two months after the EU's stability and growth pact was watered down, the EU itself continues to be an entity subject to significant change and challenge.


A research paper written by Michael Melvin, professor of economics at W. P. Carey School of Business and co-authored by Manuel Gomez of the University of Guanajuato, offers some insight into the turbulence the European Central Bank (ECB) faced in its early years. The research zeros in on the potential causes for euro depreciation, especially amid economists' high hopes for the new currency.


The launch of the euro on Jan. 1, 1999 was easily considered one of the most important international financial events since the end of the Second World War. Acceptance of the new currency was expected immediately, and some predicted that it would vie for supremacy against the U.S. dollar. The nations that comprise the European Monetary Union make an economic unit at least as large as the United States, and the EU's GDP exceeds U.S. GDP. As well, EU population exceeds U.S. population and EU exports surpass U.S. exports. Even outstanding claims in total EU capital markets (bank assets, bonds and equities) are larger than those in the United States.


"All these indicators would lead us to think that the new currency would challenge the supremacy of the dollar as the most important currency in the world," Melvin wrote. Although the euro has faced considerable obstacles -- and in the beginning, did not perform as well as expected to by some economists -- he considers the currency a success.


But the powerful interests of member nations made the euro's infancy difficult, Melvin added. Individual representatives at the ECB may have more allegiance to home countries than the concept of European unity. As a result, monetary policy could have been compromised by home country concerns that outweigh European goals.


With sample sizes just becoming large enough now to permit reasonable empirical analyses, the paper analyzes a related possible cause of euro depreciation -- policy uncertainty on the part of the ECB. Because policymakers at the ECB represent member countries, observers might expect them to weigh decisions based on individual national interests.


"The governors of each of the 12 central banks sit on the monetary policy committee and each country has its own unique issues and problems. That said, I think that the euro has been a surprising success so far," Melvin said. "We need to wait until a really significant negative shock impacts one or a few countries and not the others, to see how things will play out under stress. That will be the ultimate test."


In the paper Melvin wrote that "it may be that the representatives of the member countries have a dual allegiance that results in information leakage."


"This is not to say that leaks come from the ECB staff, but rather the representatives of the national governments who are linked to the Governing Council. There would be great incentive to protect the home market from any harm done by ECB policies. In this case, tipping off a home bank or home government officials to a forthcoming policy change would allow home-market positioning so that no losses are incurred by the ECB policy action."


Researchers compared records of ECB meetings to the earlier meetings of the Deutsche Bundesbank and the current meetings of the Federal Reserve. Established in 1957 on the Federal Reserve model, the Bundesbank is the central bank of Germany and was in charge of the German Mark until the euro was issued. The paper acknowledges that hard evidence is essentially impossible to find, but "wide spreads on the euro would be consistent with market makers protecting against the adverse selection probabilities of quoting to an informed trader. In addition, on the day the ECB first changes interest rates, there is a flurry of exchange rate volatility more than an hour prior to the public revelation of the news of the policy action. This is consistent with leakage of the news..."


Although this potential for policy announcement leaks has been daunting for the euro's stability, Melvin said the currency, in some ways, looks good compared to the U.S. dollar as long as trends continue. "The longer-term trend of (U.S.) dollar depreciation is likely to continue as long as the U.S. continues to have a large current account deficit," he notes.


And the euro has appreciated a great deal against the dollar in the last four years.

"Even though economic growth is higher in the U.S. than in Europe, the dollar has been pulled down by the huge U.S. current account deficit," he explained. "The U.S. has borrowed massive amounts of money to finance this deficit and until U.S. savings rise and spending falls, relative to U.S. output, this is unlikely to turn around."


However, Melvin says the largely negative news that regularly comes from Europe about the EU and the euro specifically does seem to lead to temporary euro depreciation against the dollar.


For instance, France's voters head for the polls May 29 to vote on the EU's constitution, which aims to harmonize and streamline decision-making in the expanded 25-member EU. It must be ratified by all member states, which means a rejection in France would kill the treaty. While French politicians have been working hard to change public opinion, poll after poll shows French voters intend to reject the constitution.


The initial drop in the euro value that was so puzzling to people in the first years after issue is more understandable when viewed as the effect of the market learning what to expect from the officials who manage monetary policy. Because the ECB was new, the market had no prior record of its behavior upon which to base its responses, Melvin explained. That uncertainty led to volatility for the euro. In fact, Melvin pointed out, evidence suggests that "euro volatility on the first ECB policy action days was much greater than earlier mark volatility on Bundesbank policy action days."


The paper suggests that "beyond the impact of the immediate change in interest rates announced by the ECB after two meetings in 1999, the policy actions convey important information to the market on how the ECB will conduct policy."


"One may view the Bundesbank as making policy to achieve national goals with any international goals strictly secondary in importance. So, in a sense, policymakers at the Bundesbank were all "team players" working to achieve a common goal. So if there was any significant leakage of information, it may have been associated with the startup of the policy process rather than an ongoing phenomenon," according to Melvin.


One of the success stories of the ECB is convincing the public of its strong commitment to keeping inflation low, according to the professor. "We suggest that the market was learning about the ECB ability to maintain low inflation in Europe," he writes.


As well, Melvin says that, overall, the ECB "has done a very good job of convincing the public that it has a credible commitment to low inflation."


"They have made inflation targeting the number one goal," says Melvin, noting no one has seen "a serious test of this commitment," such as if one or more of the countries undergoes a serious contraction of their economy.