Is German Dominance of the ECB Responsible for sub-optimal Monetary Policy in the Eurozone?

The UACES Network |

By Sarah Fuchs

German dominance over the European Central Bank (ECB) is nowhere more apparent than in the price stability goal of inflation at or below 2% enshrined in the Maastricht Treaty. A notable success in postwar Germany was the excellent record of the Bundesbank on maintaining price stability, which represented an important break with the hyperinflation that had characterised the Weimar Republic prior to WWII. For the German public to give up the Deutschmark, another potent symbol of post-war success, there had to be some guarantee that the single currency would be equally strong and stable. One answer to this was the price stability mandate of the ECB, a crucial element of Germany’s willingness to sign up to monetary union and a goal still deemed paramount in the execution of ECB monetary policy; both to German policy makers and the general public. However, just as this focus on price stability has been criticised in the past as being to the detriment of growth and jobs in Europe, it is the subject of much debate now, resulting from divergence in inflation trends between the core and periphery of the Eurozone . While the core, and in particular Germany, is experiencing strong growth and the risk of inflation increases, peripheral economies, such as Greece and Ireland have yet to resume growth since the onset of recession in late 2008.

Nonetheless, the ECB raised its key interest rates by 25 basis points to 1.25% following its April meeting, which prompted widespread criticism from economists who saw the move as damaging to the Eurozone’s periphery or too timid to address rising inflation in the core, depending on perspective. Thus, as I have argued previously, it seems safe to say that the ‘one-size-fits-all’ monetary policy of the ECB is more nearly ‘one-size-fits-none’ at this point.

But how does this relate to German dominance?

German insistence on enshrining the price stability goal of inflation at or below 2% in the Maastricht Treaty is a tenuous argument for German dominance over the ECB today, yet the impact of that strict target is apparent in the current situation. As argued by Wolfgang Munchau in the Financial Times, the risks of inflation in the core were not necessarily so profound as to justify the harm of increased interest rates for peripheral economies, yet the ECB is sticking doggedly to the 2% target. While the ECB is hardly the only Central Bank that uses a strict inflation target to signal the credibility of monetary policy, the ECB has at times been exceptional in its strict observance of this goal, over the course of the financial and debt crises. Specifically, the ECB was slower than the US Federal Reserve, the Bank of England and the Swedish National Bank to lower interest rates in response to the onset of financial crisis in 2008, and, as already mentioned, has moved faster to increase rates in response to the modest recovery underway. While the Bank of England has overshot its inflation target of 2% in 34 of the past 40 months, the majority of members on the Bank’s Monetary Policy Committee continue to vote against a rate rise for fear of damaging the already weak recovery. It is true that recovery in the Eurozone’s core, and Germany in particular, has been stronger than that in the British economy, but certainly the situation in the periphery of the Eurozone is far more tenuous than that in Britain. Thus, the difficulty of identifying a ‘one-size-fits-all’ monetary policy to accommodate the diverse economies of the Eurozone is compounded by the singular focus on a strictly defined target for price stability, a mandate that can surely be traced back to German dominance over the ECB.

To provide one further example, since the possibility was mooted that Mario Draghi, governor of the Italian Central Bank, could takeover from Jean-Claude Trichet as ECB President, there has been talk of the need for this candidate from the south to demonstrate his anti-inflationary credentials to win German support. Draghi is already familiar with the workings of the ECB and the twists and turns of this crisis, having sat on the ECB Governing Council in his capacity as Italian Central Bank governor, while it unfolded. Further to that, Draghi was heading the Italian Treasury during that country’s own debt crisis in the 1990s which, crucially, did not end in default. In addition to these qualifications, Draghi has enthusiastically promoted his anti-inflationary credentials and his intention to withdraw emergency support for Eurozone banks at the earliest possible opportunity. Eventually declared by German newspaper Bild Zeitung as “the most German of the remaining candidates,” he appears to have convinced those who needed convincing. It is important to note, though, that Draghi only became the frontrunner to replace Trichet following the surprise resignation of Axel Weber from his position as Bundesbank President. The rumor is that Weber no longer wanted that post, nor the post of ECB President, because he disapproved of the enhanced role of the ECB to combat the current Eurozone debt crisis, as well as German Chancellor Angela Merkel’s handling of negotiations over future crisis measures . I’m not sure which would be more frightening to those highly indebted economies on the Eurozone’s periphery – a German ECB President seeking to right the wrongs of the help given them by the ECB so far, or an Italian President aiming to prove that he can be just as hawkish on inflation as the Germans.

It does seem, then, that one way or another German dominance of the ECB can be linked to a monetary policy that is suboptimal for the majority of the Eurozone, though the question remains as to whether this leads to a ‘one-size-fits-one’ or in fact a ‘one-size-fits-none’ monetary policy. Neither I nor any other sane person would suggest that it is a simple task to identify a ‘one-size-fits-all’ monetary policy for the Eurozone at the best of times, not least in the midst of the current debt crisis. However, it is still worth asking whether a more meaningful debate over the appropriate direction for ECB policy could take place in the absence of German dominance. For example, should the ECB focus less on discrete price changes and more on inflation inertia? Should the average inflation be weighted differently than it currently is? Should the bank have a dual-mandate (price stability and full-employment)? These are all questions worth asking in the current climate where dramatic policy changes, beyond the scope of monetary policy alone, are surely necessary to correct glaring imbalances between Eurozone economies.

Susan Fuchs is a PhD Candidate in the School of Public Policy at University College London. Her Doctoral Research looks at International Negotiations, with a focus on negotiations between EU Member States over the Stability and Growth Pact. With the support of the UCL European Institute and in collaboration with another PhD student in the Department of Public Policy, she is currently carrying out a research project on Economic Governance in the Eurozone in the face of the debt crisis.