Select Committee on European Union Minutes of Evidence


Examination of Witnesses (Questions 61-79)

TUESDAY 3 JUNE 2003

DR HOLGER SCHMIEDING AND PROFESSOR NIELS THYGESEN

Chairman

  61. I would like to welcome our two witnesses this morning on behalf of the Sub-Committee. They are, in alphabetical order, Dr Schmieding, Chief European Economist at the Bank of America, and Professor Thygesen of Danske Bank—of course known, I think, to members of the Sub-Committee as a member of the Delors Committee—who has been very closely involved in all these matters for a considerable number of years. Welcome to the Sub-Committee. As you know, we are doing a report on the European Central Bank, in particular on the way it has operated, and it is now proposing to change the two pillars, and also on the decisions that have been reached by the bank and the governments as to the post-enlargement institutional provisions. That is the broad outline. You have very kindly given us some useful material on your own reactions to the changes by the ECB and the way it is approaching the two pillars. It is really welcome to us that we have your views on that, because it enables us to move into the question and answer phase pretty promptly, but I wonder if I could ask you before we start if you would be prepared just to give a rather broad-brush analysis from your points of view of how the bank has performed in the four years that it has been so far functioning. What do you feel are its strengths or its weaknesses? I am aware this is on the record and we are not talking about whether or not the bank makes a change in interest rates this week or what-have-you—I mean, that is clearly something on which we are not focusing, it is not our job to—but it would be helpful if you could be as frank as possible in your views because we are trying, among other things, to fit our inquiry into a broader framework, which has to include an analysis of how well the bank has performed in the period it has been in existence. Perhaps I could ask each of you, if you are willing, to give us a reaction to that general point, then the floor will be open and I think we might proceed by first of all discussing the two pillars, then discussing the institutional arrangements, and then perhaps a few words about the issue of how this fits with economic governance.

  (Dr Schmieding) Perhaps I may start with a personal word. By background I am a German euro-sceptic. A few years ago, in late 1998, I clearly was not in favour of abolishing the Bundesbank for the sake of the ECB. But I must say that my euro-scepticism has mellowed a bit over time. One of the reasons is of course that the ECB has definitely not lived up to what were the worst German fears, namely imposing excessive inflation on Germany. That sounds like a strange subject today, but that very fact, I think, is something for which I have to give the ECB credit. Also, we always knew that a multinational institution like the ECB could not avoid some awkward compromises. We see awkward compromises, for instance, in the ECB strategy between the inflation targeting approach and the money-supply target approach. We see apparently another awkward compromise in the proposed voting reform, the compromise between what you could call technocratic efficiency, which would call for a small group of experts taking the interest rate decisions, and what you could call the legitimacy of the multinational institution, which in the extreme would call for the one-country one-vote system. The real question is whether, given the probably inevitable nature of making such awkward compromises, the compromises or trade-offs have gone too far against efficiency or not. In that sense ultimately we can only judge the ECB by results. Looking at their performance in terms of their major goal, price stability, they have delivered inflation roughly around two per cent, not very far from what they said they should be doing. So in that sense I must say the ECB does not score too badly, whatever in detail the criticisms now are. Also I would like to emphasise that probably the nature of the trade-offs that have to be done changes over time. Initially, you may want to be close to the old Bundesbank model to get their credibility; initially, you may want to be close to the one-country one-vote system. But, as the bank acquires credibility on its own over time and legitimacy with the population in the nations at large within the monetary union, then over time probably the balance of arguments could shift more in favour of technocratic efficiency. Thank you.

  62. Thank you very much. Professor Thygesen?
  (Professor Thygesen) Thank you, my Lord Chairman. The European Central Bank has existed for four and a half years. On the whole I think one has to say that it has performed as well or better than those of us who were positive in our assessment expected—and I was never a euro-sceptic like my colleague. It has in particular delivered inflation at around two per cent, which I think is a highly desirable outcome given the disturbances we have seen over the past four and a half years. Inflation has fluctuated somewhat in the euro area between just less than one per cent in 1999 and a bit more than three per cent in the first half of 2001. But inflationary surges which came largely from factors that could not be controlled were subsequently dampened by cautious policy of the ECB, and I think the ECB can rightly take some pride in the strategic review it has recently made in saying that over the medium term—if you interpret that to be the four and a half years that we have now seen—we have delivered inflation at just under two per cent or very near two per cent. I see the strategy review in a sense as confirmation of what has been done so far, a continuation of performance, but some improvement in the formulation of strategy, which does address the concern that many have had in the recent period that two per cent might be a bit low or not having a more explicit lower end to the inflation objective could imply some danger of deflation. I do not think that is highly topical. I think that we should also take some comfort from the fact that on two occasions in the past, in the first six months of the ECB's existence and again in the fall of 2001, the ECB did cut interest rates at times when this was not strictly warranted on the basis of its own criterion, the monetary aggregates. They did so since they were concerned about deflation or low growth in Europe. There was a reference certainly in 1999, which may be the closest analogy to the present time, to sustaining Europe's potential for growth. So I think on the whole the system has worked well. I share many of the academic criticisms that have been made of the ECB and by financial sector economists that their communication strategy has left something to be desired: it has not quite had the transparency and the clarity of the ECB. Some of that is due to the factors mentioned by Dr Schmieding, the complexities of an international institution—and that is the reason why I have not favoured going all the way to transparency in the form of attributing votes and opinions to individual council members—but I think the ECB has now also improved on the transparency side. It has to be accepted by national policy makers that there are special considerations when you have an international institution, that you cannot put all the pressure on individual members of the governing bodies. I share the view of Dr Schmieding on the proposed change in the bank. In my view also there has been insufficient attention to the efficiency consideration, which would certainly have made it desirable to move to a smaller size governing council of the ECB than the 21 that is now envisaged for the medium term future. That is too large a body, I think, to have effective decision making. Thank you.

  Chairman: Thank you very much.

Lord Sheldon

  63. What interests me particularly is the body that is ultimately responsible for setting the targets on interest rates. We have of course in Britain the Monetary Policy Committee, as you will know. Should there not be some sort of overarching body that is responsible to look at the range subject to the changes in circumstances? It is all right as long as the circumstances have not changed, one can go ahead, but, if things do change in the economic and financial field, there needs to be some sort of outside body I would have thought that looks at this and makes recommendations. How do you see the possibility of such responsibility being put on an outside body.
  (Dr Schmieding) I think this for the ECB would be a very big revolution which probably would be like two steps ahead of what we may expect in practice to achieve politically. So there are two questions. The first question is whether it would make sense from what I would call the technocratic point of view and the other question is whether we can realistically expect to move the political discussion into that direction in the foreseeable future. As to whether it would make sense, it seems to me that the verdict is a bit open. I have no clear opinion on whether an MPC type committee, with outside members, is preferable to a small committee of insiders, say an enlarged ECB executive board. The outside members do bring outside experience, which is welcome, but I would suggest that we could get roughly the same effect by appointing academics and other outstanding personalities to the executive board in the first place. On that, I think, the evidence is not yet in to see what type of small technocratic committee—a UK style MPC with outside members plus insiders and a mere inside body and a large executive board—is preferable. The other question is whether an MPC-type approach with outside experts is something that could be politically feasible in the foreseeable future. There I think that this approach, taking just, say, a few members of the executive board plus some outsiders is such derogation, of the powers of the present National Central Bank presidents or governors, who are appointed nationally, that I think we will need further other reforms, step by step, curtailing this kind of national influence on the ECB before we can think about proposing such an ultra-integrationist, if, probably technocratically, rather efficient approach.

Chairman

  64. Before you answer, Professor Thygesen, I do not think actually that was the question Lord Sheldon asked.
  (Dr Schmieding) I am sorry.

  Chairman: He was relating his question to the fact that in Britain we have the Chancellor of the Exchequer who tells the Monetary Policy Committee what its broad, basic objective should be.

  Lord Armstrong of Ilminster: For inflation. Not for interest rates.

  Chairman: For inflation. I think his question was, was it not: Does the lack of this, the fact that the ECB sets its own . . . Is that the point?

  Lord Sheldon: That is right.

  Chairman: It is not about whether there are outsiders on the decision-making body about interest rates. I am sorry for interpreting but I think it is important not to have this discussion go in the wrong direction.

Lord Sheldon

  65. Thank you. You are absolutely right, but can I just add something to this. The bank has done very well, as long as inflation was the problem. It is possible that in the future that may not be the only problem and the question is: How would the bank deal with the emergence of a new problem that requires perhaps dealing with deflation. This is the argument for having some other body that can advise on these wider issues.
  (Professor Thygesen) If I may come back to the question again. I think there is some evidence that the ECB is not unconcerned with poor growth performance in the euro area. As I mentioned before, they did cut interest rates in the spring of 1999 by half a percentage point at a time when growth was slowing and the inflation rate had dropped below one per cent. They acted again to stimulate activity, certainly to show solidarity with the US Fed, after September 11, 2001, also at a time when inflation was running well above their target. So I think it is not quite fair to say that the ECB is unconcerned with the underlying performance of the economy. But of course they have a mandate that is in a sense a lexicographic mandate. They have to look first at the inflation rate and then, if there is room for stimulating activity, they would do so. I think we are approaching a situation now where that is certainly one of their concerns. I am not sure it would help that much to have an outside body. Mostly the ECB is not working in isolation: they read the financial press, they have contact with academic economists, I must say, from the viewpoint of academics, and I admire the way of getting ideas and suggestions and having discussions with them. So this works. I should also remind your Lordships that the ECB is somewhat different from the Bank of England. It does not really have operational responsibilities. The six members of the board are largely an analytical group that prepares decisions for the governing council of the bank and in that capacity they are also capable I think of showing some dynamism.

Lord Taverne

  66. Is there any point in keeping the monetary pillar? Very sensibly, the bank has disregarded the signs, the direction in which that was pointing in the past. You yourself gave the example of cutting interest rates at a time when the growth of money supply suggested it should not. Is there any point in keeping it? I know for the sake of saving face it still pays lip service to it but in practice does it not ignore it?
  (Professor Thygesen) I think the ECB has taken some steps to downgrading the monetary pillar with the recent strategic review. They have scrapped the so-called reference value, which led to a lot of speculation in the markets: why should they now try to raise it, because the demand for money was really higher than was justified by the reference value, and, if they did not change it, why not. It led to a lot of rather destructive discussions. Taking that away, I think, is an important step, as they are now doing. They are not reverting to fixing a reference value each year. They have also stressed that the monetary pillar is on a somewhat different footing from the more inflation oriented second pillar. It has a longer time horizon. It is now called not a monetary pillar. We have the monetary analysis which looks further ahead than the horizon of one and a half, maybe to two years. The ECB, as a third step, are beginning to look more at what are the causes of the growth of the stock of money, reviewing credit to the private sector in particular. That variable I think has some justification as a supplementary longer term indicator, along with asset prices, for houses in particular. So I think it is too much to say that the monetary pillar has been scrapped, but it has been modified in a way that seems reasonable and could open up, in a sense, for an intelligent longer term framework for monetary policy.
  (Dr Schmieding) On the role of monetary aggregates in this old first pillar, there are two basic issues. First of all, whether there should be a separate pillar for the monetary and credit numbers, and the second issue is of course whether money matters. On the second issue most economists would say that money indeed matters for the long-run inflation trend. Also, credit especially matters often for judging whether asset markets, the equity markets, the housing markets, may be approaching a bubble. As such, bubbles typically go along with an excessive rate of growth in credit. So money very much matters. But it matters more on the longer term horizon; it matters less for the near-term business cycle outlook and thus for the immediate inflationary pressures which may be facing the Central Bank four quarters down the road. In that sense I think the ECB has done a step in the right direction by emphasising that money is now a long-term concern and money is used to cross-check the information from the other pillar rather than something which is a pillar on its own. So I think the ECB has gone in the right direction but I think it would be better if the ECB were to go further. The ECB should leave the old Bundesbank model, the time-honoured Bundesbank model, further behind and come to what one could call a unified assessment of future inflation prospects in one rather than two pillars. As to the importance of money, one may need to add that of course the ECB has, as you said, ignored the information from money supply to some extent and has overshot the reference value for a long, long time. The old Bundesbank used to miss its money supply target on average every other year. So we are getting to where the technocratic efficiency arguments are leading us, we are getting there step by step at the ECB. Could I briefly come back to what the first question was, Lord Sheldon, whether there should be a non-ECB body to set the inflation objective. First of all, in a historical context we have to understand—and I see that very much in the Bundesbank tradition—that the concern was to safeguard price stability in a system where no longer the Bundesbank was in charge. That explains why so much emphasis was put in the treaty on price stability being the objective and something which could not be changed as an objective very easily; that is, without going through the ratification process of amending the treaty. Now whether this historic concern makes sense going forward, is a separate matter. I would very much agree that it will be preferable ultimately for the legitimacy of the project if there were a high body that gave the ECB what the definition of price stability is; for instance, around two per cent would still be defined as price stability. But in order to counter concerns that politicians or, in the case of the UK, pretty much one person could then change such a definition at will, any future changes to such a definition of price stability, or called an imposed inflation target on the ECB, would need a highly qualified majority in an appropriate political body.

Lord Lamont of Lerwick

  67. I would like to follow up on what Lord Sheldon has said about inflation, whether the ECB is well suited in its set-up to counter inflation. Because it seems to me that countering inflation is not just a question of loosening an inflation target; countering inflation, and deflation if it actually happens, goes wider. It seems to me that there is a certain amount of denial in the rhetoric of officials, although recently the denial has begun to be ended and people are now talking about a high probability of deflation in Germany whereas a year ago there was no prospect of it. We have now had two months of falling retail prices in Germany. Mr Duisenberg has said, "When I was governor of the Central Bank of the Netherlands we had a certain amount of deflation but it remained moderate and it will remain moderate." Just quite how someone knows it will remain moderate, I am not so sure. Germany is a very indebted country: household debt is quite high, so the danger of deflation is obviously a serious one. Mr Issing has, I think, encapsulated it very well by saying there is no danger of deflation in the euro zone but possibly only in parts of the euro zone—and of course Germany is just a part, which is the problem: you cannot have an interest rate set for Germany, you cannot have a policy just for Germany. This is my question: Is not the real problem that if you did get into a deflationary situation in Germany which would affect Austria, which would affect Belgium, what you require is close coordination between the fiscal authority and the monetary authority, and the monetization of debt, perhaps the creation of money, and you have got such an extreme version of independence in the ECB—much more independent than the Fed, much more independent than the Bank of England—and you have 12 governments to coordinate. It seems to me that the whole set up of the ECB is brilliant from the point of view you were describing, from the inflationary threat. Were deflation actually to come, I am not sure it is at all set up or equipped to deal with this.
  (Professor Thygesen) I will leave the German scene, I think, to my colleague.
  (Dr Schmieding) Fine. If I may start with some thoughts on that. First of all, you rightly point out that we have to discriminate between the possible deflation risk for the euro zone and the possible deflation risk for parts of the euro zone—which is where Germany nowadays is at risk. For the euro zone, as a statement of fact I still think the risk remains fairly low, with core inflation of about two per cent. We are likely to see a significant fall in inflation there, probably to below one per cent by early next year—helped hopefully by lower oil prices. But, to deal with any risk that this may develop into deflation, the ECB from its present interest rate levels, I think, has adequate tools left. They can cut interest rates aggressively and I gather from them that they would be ready to do it if need be. Of course, they would do it in their own way, which is on average one month later than most outside commentators would recommend to do that, as a reflection of their internal consensus approach. On the euro-zone-wide issue I am not very concerned for the time being. Now coming to some of the specific German issues. First of all, there is quite a significant likelihood that headline inflation early next year could turn negative in Germany largely due to lower oil prices on top of the very strong euro and on top of the general weakness of domestic demand. Whether that risks a deflationary spiral or whether that is just largely a welcome gift thanks to OPEC for delivering low oil prices, which is actually good rather than bad for growth, is a separate question. A negative deflationary spiral fortunately seems at least significantly less likely than it was probably, in retrospect, in Japan say five, six, seven, eight years ago. Germany is tightly integrated into the euro zone and the EU economy. If the ECB were to meet its objective of keeping aggregate inflation, say, close to two per cent for the average, and you were still to get German deflation, say, minus 0.5 per cent for Germany, then to get an average of two per cent for the euro zone, the difference between Germany, minus 0.5, and the rest of the euro zone would have to be almost 3.5 percentage points. This is not impossible—the difference at the moment is roughly 1.5 percentage points. But such a difference would imply such a significant gain in competitiveness of German exports in a tightly integrated region that the deflationary downward spiral from fading domestic demand in Germany would after a short period of time be offset, to a noticeable extent by rising foreign demand from within the euro zone. There is a similar mechanism at work as to the second aspect of deflation which is virulent in Japan, namely the problem of the financial sector. The German financial sector is so tightly integrated now, not into the euro zone but into the EU legal framework, that the risks for the financial sector as a whole are limited. If German banks were to fail—and, please, this is definitely not a forecast of mine, this is just what were to happen if—if German banks were for some reason to encounter problems on the scale of the Japanese banks and thus were to restrict credit to the domestic economy severely, as has happened in Japan, then it would be much, much easier for UK banks, for instance, or for French banks to enter the German market in an established legal framework and offer the credits to the consumers or to the businesses that should be offered on viable commercial terms. A longer term artificial restriction of credit supply as a reflection of the banking system being weak is much less likely to develop in Germany than in Japan. Having said that, Germany faces severe problems, structural problems. There may be periods of negative inflation, there may be some signs of deflation—the worse case scenario evolving—but I think these problems will be significantly more manageable than they were in Japan. Returning to the euro aggregate level, I think, if the problems were to affect the euro averages, the ECB would take action. Of course, ultimately, you are right, any fiscal monetary coordination, if it really were needed—I think we are far away from the point where it might be needed, but if it really were needed—would be more difficult than in a nation state. On the other hand, Germany as one nation state gains the benefits of this tight integration which I have outlined before as a safeguard against deflation.

  68. Is it really likely, with Germany taking 36 per cent of GDP—something like that—that you could get the average of inflation up to the level required to strike an average of two per cent throughout the euro zone? If prices had fallen minus 0.6 per cent, say, in Germany, it seems mathematically difficult.
  (Dr Schmieding) For roughly a two per cent euro area aggregate average you need almost three per cent inflation outside Germany and then minus 0.5 within Germany—or minus a little bit, roughly—to get to the two per cent average for the euro zone as a whole. And this gap in inflation is what would increase the competitiveness of German producers and thus help to stimulate foreign demand. May I make another comment which I did not make in my first reply. You talked about the danger of excessive debt, high indebtedness, at a time of deflation. This is very much correct, but I think it is not genuinely a problem of deflation. It is a problem in general of unanticipated falls in inflation rates; that is, the value of your debt is not eroded by inflation as much as you thought, as the borrower, when you made the contract. Then we have to see whether the scale of unanticipated falls in inflation rates now may be worse than in the past. I think past disinflationary periods, such as after some of the oil price shocks and the case of Germany after the episode of unification, were at least as bad in terms of inflations surprising to the downside than they are now and than they would be even if German inflation were to dip into mildly negative territory. So I think this is a problem. But it is almost a normal problem of the business cycle rather than a specific feature facing the German economy now and not before.
  (Professor Thygesen) The question raises a number of issues. I share broadly Dr Schmieding's view that the way the German economy is attached to the rest of the euro zone really in itself imparts a stability that has not been available to Japan. What has made the Japanese situation particularly vicious, I think, is the interaction of falling prices at home and a tendency for the yen to appreciate still. It was the shock of major appreciation of the nineties that made it particularly difficult for Japan. Probably there, I think, the implicit advice that was in the question was that if only there could have been a better coordination of monetary and fiscal policy then Japan could have gotten out of its problems. I think we have to keep in mind the starting point and the fiscal position in Germany now, and for that matter in Japan at the time, was not really conducive to counting on a fiscal stimulus to redeem the problems of deflation because the deficit was already too large. I think the German public would be alarmed if there were now efforts at coordination under the heading of let us do a bit more on the fiscal side to stimulate activity. I think the question about coordination is not quite as urgent in Europe as it was in Japan and the solution to it might not be desirable. I also have difficulty in seeing how you could get two per cent inflation if Germany really had negative inflation, but inflation is no doubt coming down towards one per cent in the euro zone as a whole. The target or, the way you call it, the aim of keeping the medium term inflation rate at two per cent will imply that there will be from time to time one per cent inflation in the euro zone, as we have seen in the past, and that may be compatible with slightly falling prices in Germany. What has also made inflation vicious in Japan—and of course even more so in the deflation of the thirties—was that the fall in prices was larger, much faster than the very modest decline that may now be happening in Germany next year—it was in the order in the thirties of about four per cent per year. In Japan it is probably correctly measured quite a bit more than the one to one and a half per cent that we see in the price statistics. So I think there is too much analogy made with the Japanese situation for various reasons. The main reason for deflation, in my view, is of course attached to the exchange rate, because if we believe some of the models we are looking at as economists a rise of 10 per cent of the euro in effective rate terms, would depress the price level by something like one per cent over a period of a couple of years, and that is of course something that will temporarily reduce inflation quite sharply. I am sure the ECB is watching that. Although they do not like any suggestion that they have any responsibility for the euro exchange rate—and I think that is basically a correct attitude—they are obviously concerned and well aware that this will require some offsetting monetary action if the situation continues.

Lord Lea of Crondall

  69. I would like to explore what I think is an explicit assumption that the growth versus inflation trade off is a fixed trade off and there is no way of improving the growth and inflation trade off—because of course over the last 30 years there have been changes in the growth inflation trade off. The reason I would like to explore that question is that both in his paper and in this morning's comments Mr Thygesen has talked about an interest rate cut "to stimulate activity", as though it is axiomatic that we are in the business of, in some cases, stimulating activity. That to me sounds as if quite reasonably there is an implicit output growth target, an output growth idea of an optimum in economic policy which is partly the responsibility of the European Central Bank, albeit couched in terms of an inflation target; in other words, that an inflation target is really in part a proxy for an optimum economic growth target as well. Would he comment on that? Likewise, Mr Schmieding, in the last sentence of his paper says, "The decision to delay a rate cut can hardly qualify as a second-best let alone a first-best solution to the immediate needs of the euro zone to stimulate domestic demand." There again we have the question: Is it part of the remit of the European Central Bank to have such a policy to stimulate domestic demand in some circumstances? If so, why, unlike the Fed in Washington, is that not made explicit as part of its remit and what is the efficacy of such a policy?
  (Professor Thygesen) If I may start, since there was reference in your Lordship's question to my note. We have great difficulties in measuring what the output gap is in our economy, how closely our economies are to working at capacity limits, and there is some dispute, I think, between governments and the European Central Bank as to where that balance currently lies. The European Central Bank has a pessimistic but I am afraid reasonably realistic view that most of the problems of slow growth in Europe have been of a structural nature and that there is not really that much room left for stimulus. The unemployment rate in Germany, for example, is largely structural. There is not much significant slack in the German economy. It is now developing, clearly. In some other countries also that slack is less than it would have seemed some time ago. In fact the growth rate of the economy has slowed—productivity has been particularly slow. In these circumstances, of course, the Central Bank is fairly powerless to stimulate very much because the room for that is not very great. I also note that still in Germany wages are going up at quite a remarkable pace, given the situation that we find in the unemployment figures, which also suggests that we are not so far from the limits of capacity. The aim of the policy of maintaining a stable inflation rate, let us say, of two per cent on the average over longer periods, is of course also in that process to ensure that the economy grows in the long term approximately at its natural rate but that natural rate can be influenced by other policies. Governments are working on those other policies which are of a structural kind. We are finally seeing efforts in European countries, on the Continent, to step up a rate at which their economies can grow. They are proceeding slowly, but there are now some reforms on the way in Germany and France which would make it possible that the rate of growth could be a bit faster in the next few years than it is today. Then it is, I think, the natural obligation which will come out of the Central Bank's mandate to maintain a stable inflation rate, and once it tries to maintain two per cent inflation in that climate it has some space for cutting interest rates.
  (Dr Schmieding) If I may briefly add to that. Of course in an explicit inflation objective there is always an implicit objective for the real economy, in the sense that the real economy should, over a medium to long term, be kept at its growth rate which we would call potential. Otherwise, if the Central Bank were to overstimulate the economy, inflation would rise; if it were to deliver insufficient stimulus, inflation would fall. So in an explicit inflation objective, there is an implicit assumption on the need or the objective for the Central Bank to try to keep the real economy close to its natural rate. Whether growth should be made not just an implicit but an explicit part of the remit is what I would call either a question which does not really arise, if we agree on what I said first, or a question which could politically be dangerous. It might nourish a popular illusion that indeed the Central Bank can do more than influence the short-term fluctuations of the growth rate but that the Central Bank may be responsible for the longer term trend rate of growth. Coming from this angle, that it might be politically dangerous to nourish such an illusion, I would come out clearly on the side of those saying there should not be an explicit growth objective in the remit of the Central Bank.

  70. Could I ask a supplementary on that. Although it may be politically misconceived to try to make the productive potential explicitly one of the parts of the remit, it is an unfortunate consequence of not having it as part of the remit, would you not agree, that we are left in the position that the European Central Bank is seen to believe or to operate on the precept that the inflation rate is uniquely able to act as a proxy for all these matters of productive potential and we are left in the position—we are in denial in this sense—of saying anything about the fact that it is a part of their job to try to make sure that Europe grows accordingly to its productive potential, as long as the overriding first priority of inflation, no more than about two per cent, is adhered to. So the question still remains, whether or not it is part of the remit, does it not?—and the danger of popular illusion, that all you have to do is put your foot on the accelerator. Nevertheless, for many of the people that I used to represent as a trade union official, for example, it looked very strange that there was no explicit acknowledgement that productive potential of the economy does not need to be looked into at the same time as we have this overriding two per cent inflation target.
  (Professor Thygesen) I am not sure that it would be productive to have any such explicit obligation for the European Central Bank. I share the view of my German colleague and I still point out that the Central Bank has acted in ways and times and has tried to exploit what was seen as a faltering exploitation of the actual growth potential. Raising the growth potential really requires very different means of economic policy—the kind of structural reforms that are now finally under discussion in Germany, France and Italy: labour market reforms, pension reforms. They may only be fully effective if there is then some policy that follows it up on the demand side, but we have to see the structural policies be put in place first before I think there can be any discussion of stimulating demand. In that context I think it is particularly valuable that the European Central Bank does have this clear explicit mandate of maintaining price stability. This in itself should not be overlooked. It is a contribution to growth in the long term by dampening fluctuations around the economy's potential.
  (Dr Schmieding) I think that almost all central banks, including the European Central Bank, understand it as part of their remit to avoid excessive fluctuations in economic growth and, you could add, hopefully avoid excessive fluctuations in asset markets. If we are not talking about growth, which ultimately is a matter of the structural policies you referred to, if we are talking about fluctuations, then we are leaving a bit the dangerous territory but we are also coming to something which for the central banks is very obvious. So I do not think that there is a major need to make it as a part of their explicit remit secondary to the overriding objective of price stability, and I would probably consider it technically not easy to find the wording which points in the right direction without giving rise to any hopes that this might in the end compromise the attachment to price stability.

Lord Marlesford

  71. If one accepts that some of the overall objectives of economic management are not to have inflation, to have optimum growth, and, perhaps most importantly, not to have recession or deflation, would you agree that the ECB is designed really with the first of those in mind, the inflation, and that indeed was its remit, and it has performed, as you have suggested, pretty well in its first four years? But we are now moving into a different world and there is a sort of discontinuity between having an ECB which is able to fulfil a role that it is given in the first world and the role in the second world, where the role of the Central Bank on its own is much more limited. I was rather struck with I think it was your paper, Professor Thygesen, where you said "the weekly unrecorded breakfast meeting between the Chairman of the Fed and the Treasury Secretary". There is, it seems to me, a lack of overall responsibility for the euro land EU area economic management. We have the Commission trying to impose the stability pact, which has been shown to be pretty inappropriate for changing circumstances, I believe, and we have the individual governments striving to manage their own economics, and yet we have an ECB trying to perform an overall role, we have a single currency with all the implications of that, and somehow it seems to me, and I do not know if you agree, that there is a danger of what I would describe as internal contradictions emerging over the coming period.
  (Professor Thygesen) If I may start this challenging question. Certainly at the time when the rules in the Maastricht Treaty were written, the concern was inflation, excess demand, very possibly lack of control of budgetary expenditures, too large deficits. These problems have not completely disappeared. From a long-term point of view there are some problems about fiscal policy. In the long term perspective one can certainly question whether the public finances of several of the major European countries are sustainable. They show such growth in underlying deficits that there are major challenges to the policy makers. I think it would be more appropriate if they had attached considerable weight to these problems instead of looking as much as they seem to do at the short term. One should not underestimate that the present machinery does offer a number of opportunities for monetary policy makers to meet national policy officials and, indeed, for the presidency and members of the Euro group there are similar possibilities of contact. There are constant exchanges about what is the appropriate policy mix. I do not think the system is quite as far from the US system as your question implies, although there is no weekly breakfast meeting. The persons there may have even closer personal contacts, I would not deny that, but I do not think the world is all that different from what the rules of the treaty, including the stability pact, were set up to do. I think some of the reticence of the ECB also to enter into any further strengthening of that mechanism is due to these underlying imbalances and the continuing concern, maybe, by national policy makers with shorter term issues.
  (Dr Schmieding) Yes, you are right, the ECB statutes were devised in a different situation. We may or may not be moving to a different world—at least the subject of deflation is much more frequently mentioned than before. It is of course among the reasons why I would prefer an explicit symmetric inflation target for the ECB, say around two per cent. The symmetry already signals that both risks to the upside and to the downside are to be taken into account with equal weight if they were to arise. In practice, of course, the ECB has kept inflation pretty close to two per cent, most of the time actually slightly above two per cent, so I am not sure whether the move to what I would call a clearer rhetoric, namely a two per cent symmetric target, would for practical policy make a significant difference. On the second aspect, the coordination of the monetary and fiscal coordination, I find some of the arguments for such coordination theoretically rather compelling for an optimal steering of, say, the economy short term. My experience, which largely is grounded in a few countries admittedly of central Europe, is that politicians find it very, very difficult actually to commit to that and to keep their side of the bargain. It is very easy for the Central Bank the next week to act on interest rates. It is much more difficult for fiscal policy to actually push the laws through Parliament. Largely for practical reasons I think we should not expect much, if anything, out of monetary-fiscal coordination. In a European Union context one general problem of fiscal monetary policy coordination would be exacerbated. Fiscal policy tends to run on its own election dictated cycle with any tightening, if possible, coming after the election and any loosening ahead of the next election. That may or may not by accident meet the requirements of the business cycle, but it does not lend itself easily to coordination with the Central Bank even on a national level. Trying to achieve such coordination with 12 or even more governments who uppermost in their minds, and rightly so, have their own legitimacy and their prospects of re-election, is not a very easy proposition. Thus for practical purposes I would stick with the approach and possibly improve on it: keep each other informed as much as possible about what fiscal policy may be up to and what monetary policy may be up to; but do not try to rely on any explicit coordination.

  Chairman: After Lord Armstrong, I think we will switch to the structural problems of decision-making and also the questions of transparency and public presentation policy.

Lord Armstrong of Ilminster

  72. I think Dr Schmieding has probably answered the question I was going to ask, whether our witnesses would like to see the inflation target for the ECB expressed as a range? I think Dr Schmieding was saying he would like to see a symmetry. If that view was accepted, what should that range be? We are told by Professor Issing and Mr Papademos that the aim would be inflation close to two per cent from below. That suggests that the range might be from one to two per cent or possibly 1.5-2.5 per cent. Could you comment on that?
  (Professor Thygesen) I do not think there is all that much difference between the past practice of the ECB and following such a rule. The actual policy of the ECB could be described by the policy of keeping inflation within a one to three per cent range, as has happened in the first four years. So the two per cent on average in the medium term already gives flexibility to the ECB management. The range I think may give an undue element of precision to the idea of a target. As soon as you are somewhat away from just below two per cent you begin to react more and more as you are driven away from it. There is no particular range. I do not see any great harm in that. It does not necessarily increase accountability. I know this is a new area in this country. The Bank of England has 2.5 per cent minus one per cent. The ECB might move to that in the longer term—I am not sure. I do not think it would make much difference.
  (Dr Schmieding) I would very much agree with that. I think an explicit symmetric inflation target is preferable, but I would call it preferable on grounds of rhetoric—preferable in terms of making it easier to communicate with the public. I share the view that it would not have made any difference to the actual decisions by the ECB which, judging by results, have indeed been to keep inflation at roughly two per cent, rather than trying to do everything to either get inflation below two per cent or actually to get money supply growth closer to the 4.5 per cent reference level.

  Chairman: I suggest we look at the subject matters of structure and the new decision-making arrangements for an enlarged European Union, and presumably at some stage an enlarged euro zone, and also at the issues of transparency and public presentation of policy, which go together.

Lord Geddes

  73. Thank you, my Lord Chairman. I would like to concentrate on the former at the moment and let some of my colleagues concentrate on the latter. We have, as you know, had evidence from other witnesses. I would particularly like to hear both our witnesses this morning give their opinion on the optimal solution as far as the Governing Council is concerned when enlargement comes through. Could we also hear your opinions, in the plural, of the relative size of the roles of the Executive Board relative to their Governing Council?
  (Professor Thygesen) The optimal size, I am afraid, is by now a somewhat moot question, because we have a recommendation from the ECB Governing Council which has been endorsed by the European Council and I do not see any prospect of changing that. I regret there was not more discussion of it in public and not in your country or in my own which is also outside the euro area. Obviously it was a very difficult compromise to try to reconcile the basic idea of democratic legitimacy with efficiency. The issue was one man one vote and efficiency in decision-making. Initially I thought they had gone too far in satisfying the former and without gaining too much in efficiency because the size of the Governing Council could still go up to 21 members—15 plus six, and I come back to the question of the size of the Executive Board—which is even larger than the one today of 18. I think this does raise serious questions of concern. It will make it more difficult for the Council to function in the way it has done so far, largely by gradual consensus-building. There have been very few instances of any votes in the Governing Council. With a very large membership there is always a danger that coalitions could build up. This has not been obviated by this particular proposal; that would still be possible although slightly less likely of course than if every country remained with one vote. It is mainly a question of the efficiency. In a way it is also a problem that all national central bank governors, whether they currently vote or not, will be participating in a discussion which will take a form more suited to a parliamentary debate than to a decision-making forum on interest rates. It is more difficult for the Executive Board to maintain its coalescing role in such a large party. I am concerned about that. My own idea would be to move towards a much leaner structure and give more decision-making authority to the Executive Board itself with the Governing Council in full composition having a quarterly role as an assembly that gives general guidelines for monetary policy but does not month by month sit down in Frankfurt to take votes on interest rates. I do not think that is particularly desirable. I understand why this compromise has been entered into and I know it was difficult to arrive at it. In that light one can always discuss whether it is reasonable to redress this imbalance and increase the Executive Board somewhat to offset its relative decline in the total Governing Council. I do not think so because the Executive Board does not have all that much to do. They have a few operational tasks and six is quite adequate for the functions they handle at the Board. I would have preferred to go the other way. That is, I am afraid, not very feasible in the short-run.
  (Dr Schmieding) This is, indeed, a very, interesting and difficult question. Let me first start out as an academic, not looking at the political context. As an academic I would come out on the side of those saying it should be a small committee of up to nine members to serve for a fairly long time. You could say possibly an enlarged Executive Board of the ECB that takes all the decisions month on month on interest rates. This might be guided by a larger body meeting occasionally. That is the academic optimum, I would say. The next question is the political question. I would like to emphasise that this touches on core issues of the perceived legitimacy of such an arrangement. It is easy to imagine a situation where by accident, say, all European Nobel Prize winners in economics were to be from France. If one were to pick the best experts to serve on the ECB Executive Board, one may have to say there should at least be three Frenchmen or Frenchwomen on there in such a case. We are getting into very tricky terrain here the closer we get to the academic optimal of picking a small number of the best suited experts for the task. Especially in the initial stages, we have to ensure that the legitimacy which national central banks enjoy, hopefully, in their own country is transferred to a supranational body. We should think very hard whether for the sake of preserving such legitimacy for quite a while, until the ECB has gained legitimacy by its track record rather than by consensus, we should accept deviations from what I would call "technocratic efficiencies". I can understand in this context how the debate has evolved, and how the ECB has come up once again with what I would call an "awkward compromise". The next question—agreed that it is an awkward compromise on which as an academic (or with a bit of an academic record) I would find it easy to improve on—whether this is indeed harmful, leads to a very different debate. I think that interest rate decisions especially are rather clear-cut yes or no decisions. You either cut or you do not cut next Thursday by 25 or 50 bases points. After a long arduous debate, the matter can easily be settled by a vote; and can almost be as easily settled by a vote among 21 members or 25 members rather than nine, 15 or 18 members. What the awkward compromise entails is more an internal problem for the ECB, namely that the actual debates, with so many people having the right to speak and many of them in the future retaining the right to vote, complicates and prolongs the debate. I am not sure that it will have a significant impact on the outcome of the debate. One could actually argue that enlargement, regardless of how precisely it happens, in adding to the number of people who are entitled to speak on interest rate decisions, may even speed up such decisions. The present practice of the ECB is to try to form a consensus, which is very understandable once again for historic reasons—the ECB does not want its decisions to be seen in terms of one country outvoting the other. But with ever more members being entitled to speak and vote than in the past, it is quite easy to imagine that the larger group may agree to vote on interest rate decisions one month before the smaller group would have found consensus. It is an important issue. But for practical policy decisions, as opposed to how difficult it is for the ECB and the internal debate to actually get there, I do not think that the proposed enlargement of the ECB council will make a crucial difference. Thus I have some sympathy for those who say, "If it does not make a crucial difference on the actual policy, we should for the time being preserve some element of national legitimacy".

  Chairman: Could I ask that in the next exchange you should include within it perhaps some comment on the public presentation policy, transparency and so on.

  Lord Taverne: I think my question has been answered pretty comprehensively. I hope that Dr Schmieding's more optimistic version prevails. If it does not and discussions are interminable and decisions are compromised, that sufficient pressures can be generated to come to a more workable conclusion and to allow the technocratic element to play a bigger role. However, I think the question has been pretty well answered. I favour moving on to the transparency aspect.

Chairman

  74. May I suggest that one solution is to do what the United Nations Security Council often does, which is to take the decision before you have the debate! Perhaps you could say a little bit about the question of public presentation of the ECB's policy, its track record in doing that and possible ways of improving it—whether that is by publication of minutes, publication of votes. You know the menu is rather well known and has been devoured by the many experts, academics and others, but it would be interesting for the Sub-Committee to hear your views on those points, even though I think we all recognise that they are second order points and not ones we should assume actually make a huge difference between a successful ECB and an unsuccessful one.
  (Professor Thygesen) My Lord Chairman, we are talking about a moving practice on the part of the ECB. Communication is improving. It has rightly been criticised over a few years on several occasions. It is true the ECB has always published a lot of material and some of that has been out in the public domain earlier than those central banks that are proud of publishing the minutes and records through the press conference of the ECB President. Of course, that kind of practice does not give the full flavour of the debate. It is not a full substitute for it and may tend to become too defensive, with the decision taken not giving sufficient weight to the whole discussion that was behind it. That is a matter of the actual skill of the President and his colleagues in presenting that. On the whole the markets seem to have better anticipated and understood the ECB's action over the past year. They may have been unhappy that action was not taken earlier on a couple of occasions but, on the whole, they have understood and been sympathetic to the explanations given by the ECB. The problem has improved over the past year or so. Could it be improved further? Yes, certainly. Explanations at press conferences could become better. The monthly bulletin could be further enlarged, although it is already quite rich. The use of the work of the staff, the staff forecasts, might be a bit better integrated into the presentations and more emphasis could be given to that part of the Bank's work. On the whole, I think it is a process which is improving and is recognised as such by the people to whom it is most important, namely those who are in the financial markets.
  (Dr Schmieding) I think that the more the institution, the ECB, acquires its own gravitas and track record over time the easier it will find it to become more open to publish the minutes, to publish the votes. I have sympathy for the initial natural inclination to say, "We are a new body. We have to find our own rules how we, representing 12 nations now, come to a conclusion, and we do not want every journalist and politician to peer over how exactly we do this". That is a valid argument not forever but only for the initial stage of establishing the internal culture. In the longer run there is indeed a risk that the internal culture evolves too far from what the public would like to see. Over time the arguments for more transparency will become more forceful. Ultimately the ECB should be told that eventually, possibly in a process in stages, it should start to publish votes, if there are votes, and start to publish minutes, and then start to publish who actually said things—that is, attributed minutes—and, in the end, attributed votes. This I think is something which is and should remain step-by-step on the agenda. It is a legitimate demand of the public that that should eventually happen. One further small side comment on the Council reforms. My optimum action at the moment, as the Intergovernmental Conference will take up the issue of the ECB Council reform anyway in the coming years, would be to insert a new clause saying that three years after 15 countries are in the monetary union, so that the new procedures are starting to bite, the ECB is instructed to come up with an unanimous proposal on how to reduce the number of people actually talking and voting on interest rate decisions. But one should not to impose that at the moment.

Lord Lamont of Lerwick

  75. One of the things which has not been commented on very much is the way in which the larger countries hitherto have carved up the Executive Board and you have a rotating position for the Finns or the smaller countries, but in effect the French, the Germans (and I think the Italians) have managed to get two members. Do you think that is right, given that we are not meant to be having national representatives? Why should Germany have two representatives on the board?
  (Professor Thygesen) They do not have two representatives on the board.

  76. They did when you count the Executive Board?
  (Professor Thygesen) With the Board member and the Bundesbank President they have two.

  77. They effectively have two votes.
  (Professor Thygesen) So have Finland and the Netherlands. They have also had two votes in the past four and a half years.

  78. That is because Mr Duisenberg was the President. What if Mr Duisenberg had been replaced by Mr Trichet?
  (Professor Thygesen) In the meantime we have exceptionally had three nationals of smaller and three from larger countries. But normally, a 2:4 balance between the smaller and the larger countries has been rather reasonable in terms of the economies within the euro area. There is no written rule. We have seen in particular circumstances France has currently had no member on the Executive Board, in the hope it would have the presidency. There is no fixed rule and I think it has to be left flexible, and has been left flexible — also with a view to seeing if the UK were to join and what it would then be like.

  Lord Lamont of Lerwick: It is a carve-up with France and Germany, and they did not have a vice president because they expected Mr Trichet halfway to step in. The theory is that France and Germany have two votes.

  Chairman: I am not sure it is the votes that is interesting, it is the appearance. There is one other structural aspect which Lord Geddes would like to address which I think relates to the decision of appointing the President or Chairman of the Bank, not a very happy occasion—the only occasion on which it has happened. Is there any way you can think of (and I choose my words carefully) so a future "botched job" can be avoided? It certainly does not seem to me it is at all desirable that the European Union should slip into a period of divided mandates and things like that, which is better known in the UN Security Council and has not produced very good results there either?

Lord Geddes

  79. You have virtually asked my question, my Lord Chairman. I will just add a little flesh to it. You have got the Commission, the European Council, the European Parliament and national parliaments. What should be the role of each of those, if any, in appointing a President and other members of the Executive Board?
  (Professor Thygesen) I think that the current procedure is not really that bad. What happened in the appointment of the first President was possibly that the central banking caucus took the matter too far and had reached an opinion without having sufficient input from the political side. It has to be recognised there has to be a strong political interest in this nomination. The European Central Bank is such an independent creature that the nomination of its president is a political prerogative and must be preserved in political hands. Maybe there was too much consensus among the central bankers before it reached a political level and then some reservations arose. It would certainly be desirable to avoid similar situations in the future. I think there should be no obvious role of the national parliaments in looking at this particular nomination. The European Parliament has and will retain this European role in having very elaborate hearings with candidates for the whole Executive Board, in particular with the president. That, I think is a reassuring practice. The European Council nomination, no doubt discussed carefully first in Ecofin or the euro group and consultation with the ECB, has to have a collegiate element in it also. That would be my view.


 
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