The Bank that rules Europe? The ECB and Central Bank Independence

Mark Baimbridge 
Brian Burkitt 
Philip Whyman 

Contents

• Introduction

• The meaning of independence

• Models of independence

• Issues in central bank independence

• Difficulties of measuring independence

• Empirical analysis of central bank independence

• The ECB and contemporary political reality

• Conclusion

• References

• The Authors

Introduction

The idea that central banks should be independent from political influence has deep historical roots and featured in the discussions leading to the establishment of many 20th century central banks (Toniolo, 1988). The historical desire to impose limits upon the government's ability to fund itself through seignorage merges with the orthodox contemporary argument that politicians manipulate monetary policy to win elections; thus policy tends to exhibit a stop-go nature, reflecting an excessive concentration upon short-term macroeconomic fine tuning (Swinburne and Castello-Branco, 1991). Consequently it is argued that long-term economic efficiency requires the removal of monetary policy from the sphere of democratically accountable politics, and its delegation to an independent central bank with an effectively designed constitution and internal reward system that imposes price stability as the overriding policy objective.

Few institutional reforms recommended by economists have gained such rapid, widespread acceptance as the demand to grant central banks independence from political control. Countries of the North and the South, the post-communist nations of Eastern and Central Europe as well as established capitalist states have all been affected by the debate on the appropriate role and status of the central bank (Posen, 1993). Thus the notion of central bank independence has taken on the character of a panacea, a quick institutional fix, producing desirable macroeconomic results in a wide variety of national contexts. The search for such a beneficial institutional framework has taken shape within the European Union (EU) through the position accorded by the Maastricht Treaty to the European Central Bank (ECB) and the European System of Central Banks (ESCB) at the heart of Economic and Monetary Union (EMU).

There is, however, an interesting division of views between the EU, where an internal integrated monetary order is frequently perceived as a necessary complement, perhaps even a prerequisite, for the successful completion of the single internal market, and the North American Free Trade Area (NAFTA) where there has been no call for, nor consideration of, any agreement on monetary inter-relationships to support free trade. The difference is in objectives; the EU saw the single internal market as a stepping stone to a single currency, and thence to political integration. By contrast, NAFTA is focused solely upon the economic advantages derived from a free trade area.

Of the economic consequences flowing from the single currency, the attainment of the Maastricht convergence criteria and the Stability and Growth Pact have received considerable attention. However, the crucial role to be played by the ECB within the euro zone is becoming increasingly apparent to politicians and citizens alike. Therefore this Occasional Paper examines the EU's preoccupation with establishing a new monetary authority for Euroland.

The Meaning of Independence

The concept of 'independence' is generally perceived to be obvious; it means simply that the government possesses no formal mechanism to influence central bank decisions over monetary policy (Wood, 1993). However, one of the earliest analyses of the various possible dimensions covered by such a concept was made by Friedman (196 2), whose broad definition of independence was that monetary policy is entrusted to some separate organisation which is subject to the head of that agency. In that sense the Bank of England was always independent. Alternatively, on a more rigorous definition, the Bank of England was not independent of the government during the post-war period, except in regard to those functions where the Treasury explicitly or implicitly granted it discretion. Section 4(1) of the Bank of England Act 1946 provided the Treasury with the power to give directions to the Bank on any aspect of policy, whilst the Crown, in effect the Prime Minister, appointed the Governor and the members of the Court. This practice still occurs even under the more 'independent' Bank of England created in May 1997, demonstrating that government retains the desire and ability to influence Bank policy, albeit on a long-term rather than a short-term operational basis.

In practice, however, the Bank traditionally possessed considerable managerial freedom and exercised a degree of discretion in deploying its resources to support the banking system when it comes under threat. Moreover, it has tacitly been allowed considerable scope in the field of banking supervision, which was given statutory form in the Banking Acts of 1979 and 1987 (Hopkin and Wass, 1993). However, whilst the Bank of England always enjoyed substantial freedom of manoeuvre, these links between government and the central bank imposed severe limits on its potential independence. For example, it does not influence the exchange rate for sterling, nor over long-term interest rates, whose levels are affected by fiscal policy and by market expectations as well as by short-term rates. Neither does it control either the liquidity or the maturity of government debt, which significantly influence the degree to which such debt can be monetised by being placed in the banking system. Moreover, the appointment of the Governor and senior members of the Court will presumably remain under any institutional reform, in the hands of the Prime Minister. The power of appointment normally carries with it the power to dismiss. Therefore governors could find their position untenable, if they pursued policies that the government disapproved, even when they enjoyed the statutory freedom to do so.

It should be noted that some commentators prefer to use alternative expressions to that of 'independence'. Hetzel (1990), for example, adopted a terminology of central bank 'autonomy' or 'autonomy with discretion' because of the risk that 'independence' could be taken to imply a lack of constraints. Similarly Fair (1979) referred to 'independence within government' rather than 'independence from government', even equating this preferred definition to the provision of independent, professional advice by the central bank, possibly combined with the ability to publicise or at least signal a policy disagreement with government. Such a position could be seen as the minimum level of central bank independence.

Models of Independence

Alternative forms of central bank independence are as numerous as the number of 'independent' central banks; the memoranda submitted by nineteen OECD central banks to the Treasury and Civil Service Committee (1993) provide abundant evidence. Consequently, this section concentrates upon a limited number of blueprints. These are the German Bundesbank, the Federal Reserve of the United States of America and the Reserve Bank of New Zealand, which are often cited as models for an independent Bank of England, whilst they influenced the ECB framework outlined in the Maastricht Treaty.

Until recently, most discussion of central bank independence centred on the German Bundesbank, which was widely regarded as being successful in delivering consistently low inflation, with its objectives defined in statutes which insulate it from governmental interference. Moreover, it was not formally accountable, either to the Federal Government or to the Bundestag, for the discharge of its statutory functions (Marsh, 199 2). The Bundesbank Act of 1957 required it to "regulate the quantity of money in circulation and of credit supplied to the economy with the aim of safeguarding the currency" and also to "support the general economic policy of the federal Government, but only insofar as it can do so without prejudice to the performance of its own functions". While it is sometimes argued that these objectives may result in conflict, a hierarchy of goals was established in its statutes where price stability was clearly stated as the priority.

In contrast, the United States of America's Federal Reserve maintains its independence 'within' government, regarding itself as an integral component in the interlocking federal structure. The Federal Reserve's integration into government is secured by its regular accountability, whilst its Chairman and Board are appointees of the President, subject to the consent of the Senate. Furthermore, the objectives of the Federal Reserve are more widely defined than those of the Bundesbank, with no single objective, such as price stability, specifically laid down.

Another model of central bank independence is that instituted by the 1989 Reserve Bank of New Zealand Act. It assigned the Reserve Bank a general responsibility "to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices". A second, unique feature of the Act required the Minister of Finance and the Bank's Governor to establish "precise and agreed policy targets consistent with the Act, and to publish these without delay". Such arrangements have been described as devolving 'operational autonomy', rather than independence to the Reserve Bank, because the government retains the power to authorise a departure from the statutory objective of price stability.

An alternative framework for central bank independence is provided by the Maastricht Treaty. The EU's view on central bank independence is defined by the provisions contained within Article 107 of the Treaty, which states that, "when exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty and the Statute of the ESCB, neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any Government of a Member State or from any other body. The Community institutions and bodies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the ECB and of the national central banks in the performance of their tasks" (European Communities, 1991). However, the legal framework, institutional arrangements and emerging operating practices of the ECB are increasingly coming under closer scrutinisation and criticism (Buiter, 1999).

A central issue arising from these alternative models is the extent to which international experience is applicable to either the UK or the EU. Indeed, Eddie George, the Governor of the Bank of England has conceded the problematical aspect of transposing overseas institutions within a different constitutional context. A fundamental difficulty is that the UK is a unitary state, so that its economy and constitutional traditions differ from those of many foreign countries, such as Germany and the USA, whose federal systems of government reinforce the independence of the central bank and its board members. In contrast, Parliament is the focus of Britain's political structure with all legitimate power derived from it. Given that no Parliament is capable of binding its successors, it follows that every political decision can be reversed, which appears incompatible with the principle of an independent central bank (Busch, 1994).

Although the apparent success of the New Zealand model made it a candidate for imitation by Britain, reflected in New Labour's changed relationship to the Bank of England, a number of reasons exist for doubting its relevance. First, the New Zealand reforms were introduced in response to an inflationary crisis, second, its economy is much smaller than the UK and less prone to currency speculation, and third, the reformed arrangements have operated primarily in a period of recession; so that it is too early to evaluate their lasting effectiveness (Evans, et al., 1996).

Moreover, the UK is almost unique amongst developed economies in the importance attached to variable short-term interest rates, because of its method of financing house purchases and small business operations (Miles,1994). Additionally, the British economy is vulnerable to international developments and to associated changes in the external value of sterling (Taylor, 1995). These factors demonstrate that overseas models of central bank independence are less than wholly appropriate to the UK.

Issues in Central Bank Independence

The conceptual case for central bank independence is primarily based on the view that arrangements which raise the credibility of monetary policy will increase its effectiveness in pursuit of price stability. Although this view has long been held, only in recent years has the concept of policy credibility been defined and analysed rigorously (Cukierman, 1986; Blackburn and Christensen, 1989).

The establishment of an independent central bank with strong anti-inflationary preferences is seen as a way for the state to bind its hands against the electoral temptation of inducing unanticipated increases in the price level. As commitment increases credibility, orthodox theory predicts that divergences between the central bank's policies and people's expectations will be smaller. Therefore lower costs and fewer delays are incurred when adjusting to monetary policy shifts. It is from this theoretical perspective of monetarism and rational expectations that the ECB was launched. However, just months after its inception, the ECB faces intense pressure from European politicians to cut interest rates. Given the levels of inflation and unemployment, the case is strong, but the ECB fears the danger of being seen as open to persuasion. It argues that an independent central bank must guard its credibility. If the financial markets suspect that the bank is susceptible to political influence, long-run inflation and the cost of controlling it would be higher.

This argument has recently been challenged. If central bank independence increases credibility, it should be associated with greater rigidity in the setting of nominal prices and money wages, reflecting the fact that the bank's promise to keep inflation low is believed. However, a study of OECD countries by Posen (1993 & 1998) indicated that neither effect occurs. Indeed independence, not merely fails to reduce the cost of dis-inflation, but rather seems to increase it. Getting inflation down takes as long and calls for a larger short-term sacrifice of output and jobs, on average, in countries with relatively independent central banks.

Most of the contemporary support for central bank independence stems from a partial and frequently historically naive view of West German experience. Any one item that helped to promote rapid post-war German growth, such as the independent Bundesbank, was part of a structural totality defining its role. Accordingly it is unlikely to be effective if transferred by itself to other countries or onto the broader EU stage (Dowd, 1989 & 1994). It may be more appropriate to reverse the fashionable view; the structural conditions that produced the strength of the German economy, allowing it to grow while maintaining a low inflation rate also enabled it to afford the luxury of an independent central bank concentrating on monetary stability. For example, the wage negotiations system in Germany has generally produced a less inflationary outcome than in many other countries over the post-war period, thus not requiring intervention from the Bundesbank. Therefore it must be open to question whether the creation of a more independent central bank is significant in containing inflation, or whether the existence of an independent bank merely reflects a political economy in which price stability is a widely-shared objective and where governments, as well as the central bank, regard low inflation as an over-riding objective (Mitchell, 1993). Consequently, the possibility of 'reverse causality' is accepted by economists as a significant constraint when interpreting the experience of countries with independent central banks.

The theoretical case for independence is based on two analytical assumptions that have become generally accepted by economists over the last decade: (a) the 'no-trade off' vertical long-term Phillips curve, which implies that price stability can be achieved at no long-term cost of unemployment; (b) the political business cycle. However, both rest on insecure foundations. First, the vertical Phillips curve analysis rests upon the concept of a natural rate of unemployment, about whose frequently changing determinants economists remain largely ignorant (Davidson, 1998; Karanassou and Snower, 1998; Madsen, 1998; Nickell, 1998; Phelps and Zoega, 1998). Second, repeated studies indicate that relatively little evidence exists for the occurrence of any systematic political business cycle (Kalecki, 1943; Breton, 1974; Nordhaus, 1975; MacRae, 1977; Wagner, 1977; Frey, 1978; Alesina, 1989).

These theoretical difficulties are compounded by the empirical evidence concerning central bank independence and lower-than-average inflation which again draw heavily upon the German Bundesbank, although counter-examples exist. For instance, the USA with an independent central bank has not enjoyed such a phenomenon. Moreover, German experience since reunification demonstrates that an independent central bank is unable to guarantee low inflation, whilst the Bank of Japan, no more independent than the Bank of England, frequently presided over falling rates of price increase.

The dominance of monetarism led to the widespread conviction that low inflation is an essential, or at least a very important, condition for high, sustained growth, so that its achievement should be the priority for government economic policy. The importance attached to low inflation as the prerequisite for high employment and rapid growth is central to the case for an independent central bank, which pursues price stability as its major, or sole, objective. However, the belief that low or zero inflation produces sustained growth is not supported by the available evidence, with many studies indicating that no significant relationship exists between low inflation and higher rates of growth, until double-digit rates of price increase occur, which do retard economic development (Thirlwall and Barton, 1971; Brown, 1985; Stanners, 1993). Thus, the consensus of research fails to support the advantages of low inflation, so that a key element in the case for an independent central bank remains unsubstantiated.

Until the 1980s the corner-stone of British economic policy was the pursuit of four policy objectives, namely high levels of employment, stable prices, balance of payments equilibrium and an expanding economy. However, if responsibility for the second objective rests solely with an independent central bank, while the other three remain with the government, economic management potentially becomes more difficult due to the separation of monetary and fiscal policy (Blake and Weale, 1998). Hence, an advantage of a non-independent central bank is that budgetary and monetary measures can complement each other, forging a co-ordinated strategy of economic management. A failure of policy co-ordination was demonstrated by Germany's problems in the aftermath of reunification, when the failure of the Kohl administration to raise taxes for financing reunification generated a historically large budget deficit, which in turn triggered the Bundesbank into setting high interest rates. Such policy inconsistency highlights the ambiguous nature of 'independence' itself. The Bundesbank could not be seen to succumb to political pressure, which may damage its credibility, but was unable to avoid a political role; for instance, it regularly lowered interest rates before G7 meetings to avoid criticism from its trading partners. Analysis of the role of a central bank confirms that, in a world of external shocks, the case for delegating monetary policy is weak and that a co-ordinated approach is more likely to achieve the electorate's objectives (Rogoff, 1985a&b).

Furthermore, if eliminating inflation is all-important and elected politicians cannot be trusted to give it priority, the logical conclusion is that all economic instruments, including fiscal policy, should be taken out of their hands. The assertion often made is that monetary policy is different, because it is a technical operation with a single objective and well-understood, reliable techniques. Such a belief is questionable, since monetary policy impacts upon employment and living standards, as vitally as does fiscal policy. Moreover, periods of high inflation have not occurred wholly, or even mainly, due to lax monetary expansion, whilst there is greater international evidence of fiscal, rather than monetary, policy being manipulated for electoral ends (Alesina, 1989). Despite this, few economists advocate placing fiscal policy in the hands of independent functionaries, because such a course of action would be obviously undemocratic.

Difficulties of Measuring Independence

When assessing the impact of central bank independence upon price stability economists have mostly utilised imputed 'degrees of independence' to evaluate the heterogeneous character of central banks. These are based upon factors, ranging from the level of political control exerted upon the bank to its operational role with the economy. A large body of literature focusing upon single or multi-country time-series studies has accumulated, with an additional series of studies attempting to rank independence for a cross-section of countries. The majority of this research draws attention to the inherent difficulty of defining, let alone measuring, the concept of independence (Mangano, 1998).

The initial method of imputing degrees of independence, based solely on legislature arrangements, found no relationship between inflation performance and independence (Bodart, 1990). The index was refined by subsequent studies, which constructed a measure of central bank independence that reflected both 'political independence' and 'economic independence' (Alesina and Grilli, 1991 and Grilli et al., 1991). The former relates to the ability of the monetary authorities to choose the goals of policy, whilst economic independence is defined by their capacity to choose the instruments with which to pursue policy objectives. The main conclusion from such analyses is that the average rate of inflation, and occasionally its variability, is significantly lower in countries that possess independent central banks. However, the value of such evidence is problematic, as the authors usually acknowledge, because measurement of 'degrees of independence' possesses serious weaknesses, which cast doubt upon the validity of any purported association between central bank independence and the attainment of price stability. The main failings are:

• A limited spread of rankings inevitably restricts sensitivity across a wide number of inherently different countries, which raises difficulties concerning the index's analytical usefulness.
• Many of the studies cover overlapping time periods, opening up the possibility that they have found a result unique to that particular set of data. Therefore it becomes crucial to test a hypothesis on data sets other than those which suggested the hypothesis (Friedman and Schwartz, 1991).
• The time periods covered by some studies increase concern over the reliability of their findings; for instance, the participation of countries within the EMS could be viewed as a potentially important determinant of inflation rates. Consequently, if all countries in a pegged exchange rate system are compelled to possess the same rate of inflation over the long-run, whatever the various influences are on that rate, the status of national central banks cannot be amongst them.
• Disregard for non-economic factors that shape fiscal and monetary policy choices is a consistent feature of these studies, illustrated by their assumption that electorates always prefer low inflation to the possible trade-off of higher economic growth and employment (Muscatelli, 1998). However, even casual observation of Swedish public opinion refutes this perspective; it has consistently favoured full employment over low inflation as the central objective for economic strategy.
• Even after analysing the role of political factors, other potential sources of differences in inflation rates are often neglected. For instance, even if EU countries were subject to the same exogenous shocks in the post-war period, structural differences-labour relations systems, wage indexation mechanisms, vulnerability to raw material price changes, varying preferences for inflation versus unemployment - between them may explain their different reactions.
• The position of the government in the political spectrum and various proxies of social consensus offer some explanation of inflation rates in different countries (Hansson, 1987). Likewise, the size of the public sector appears to be another significant factor (Alesina, 1988). Moreover, lower inflation in Germany and Switzerland could result from the presence of 'guest' workers during periods of economic growth, who absorb part of the unemployment costs of disinflationary policies by having to return to their country of origin when the work is no longer available (Burdekin and Willett, 1990).
• In an attempt to compare monetary regimes, many studies focus exclusively on institutional characteristics disregarding behavioural indicators, such as the average rate of growth of the money supply or the level and variability of interest rates.
• New research rarely possesses at first the reliable database it requires. Therefore greater attention should be devoted to improving databases and to recording any national specificity that may exist or has occurred.
• These studies suffer from the omission of indicators not identified as potential explanatory factors, so that influences other than central bank independence may be important, but as yet unidentified, determinants.

Empirical Analysis of Central Bank Independence

In this section we examine the issue of central bank independence within those EU members states (excluding Luxembourg which at the time did not possess its own central bank), who were original signatories to the 1991 Maastricht Treaty. Although this reduces the number of countries in comparison to several of the previous studies, it offers a logical basis for the subsequent analysis. Little analytical precision is gained, when examining the likely impact of the ECB, by including those countries which will never enter EMU (for example, Australia, Canada, Japan, New Zealand and the USA). Moreover, few previous studies offer a rationale for the countries they include, for instance, whilst focusing upon industrialised economies, they all fail to incorporate every member of such a representative grouping as the OECD.

A further aspect that differentiates this analysis is that it disaggregates central bank independence into its constituent features of political and economic independence. The approach is further developed by dividing these principal features into sixteen individual components. Such a procedure enables a detailed examination of the separate elements that comprise a central bank's independence, alongside an evaluation of the aggregate level analysis pursued in previous research. Finally, in addition to the now traditional comparison of central bank independence and inflation, an additional GDP growth variable is introduced to evaluate the proposition that independence carries no detrimental consequences for output (Eijffinger et al., 1996).

Table 1 shows the correlation results between the series of measures of central bank independence and both the rate of inflation and growth. An association between a particular indicator of independence and either macro-economic variable is demonstrated by the use of an asterisk to represent alternative significance levels of one (††), five (†) and ten (*) per cent.

Table 1: Correlation between central bank independence and macroeconomic variables for EU member states

With regard to the relationship between central bank independence and inflation, Table 1 indicates that only the factors of the 'board appointed for > 5 years' and 'no government approval of monetary policy formulation is required' are significant from the series of political features, whilst 'direct credit facility at market interest rate' and 'central bank does not participate in the primary market for public debt' are the sole significant economic characteristics. Hence only four of a possible sixteen features of central bank independence contribute to lowering inflation. Such results hardly support the contention that an independent central bank is an effective anti-inflationary mechanism.

Although these findings partially support the conclusions of previous studies (Alesina, 1989; Grilli et al., 1991; Alesina and Summers, 1993), there are several important caveats. First, the analysis of the individual features of political and economic independence indicates that only a limited number are statistically significant, raising difficulties concerning the necessity for all such characteristics to be present simultaneously within the ECB. Second, the index of political independence is insignificant, indicating that such criteria proved historically inconsequential to EU member states' inflation rates. Third, although the indices of economic and combined independence are inversely related to inflation, only 66% of the variation of inflation is 'explained'. This surely is insufficient evidence from which to launch such a fundamental institutional reform, or to expect it persist over the medium- to long-term, particularly if negative externalities are associated with greater independence.

The relationship between central bank independence and output is also examined to evaluate the orthodox hypothesis that the former constitutes "a free lunch" (Grilli et al., 1991:375), because it carries no detrimental consequences for GDP growth. The final column of Table 1 shows the correlation results for the individual features and the three indices of independence in relation to growth. With respect to political independence, neither the individual factors nor the index are statistically significant, whilst three of the economic independence criteria are significant: 'direct credit facility not automatic', 'direct credit facility at market interest rate' and 'central bank does not participate in the primary market for public debt'. Of particular interest, however, is the negative association between these features and GDP growth, which contradicts the previously established proposition that central bank independence has no "costs in terms of macroeconomic performance" (Grilli et al., 1991:375). The probability therefore is that independent central banks exert a negative impact on the rise in their citizens' standards of living. Such a research finding constitutes an ominous background to the actual operation of the ECB.

The ECB and Contemporary Political Reality

The ECB, which started running the monetary policy of the eleven countries adopting the euro on January 1st 1999, is a creation of the Maastricht Treaty, which designed it to be the most independent monetary authority in the world. The Maastricht Treaty established the ECB as the only institution possessing the right to issue the single currency. Its sole aim is to pursue price stability. Article ³A makes the latter goal legally explicit, and therefore binding, whilst stating that other objectives may be pursued only 'without prejudice' to price stability. Furthermore, the ECB is forbidden by its founding charter to balance the goal of price stability against other aims such as growth and job creation.

The ECB's architects at Maastricht sought to insulate it completely from political pressures, both at the national government and at the EMU-zone level. By contrast, the US Federal Reserve, for instance, is required to take into account output and employment objectives alongside inflation targets, whilst being subject to fierce, regular scrutiny by Congressional committees with wide powers of investigation and review.

The position of the ECB under the Maastricht Treaty permits no clear accountability to any national nor EMU institution. It stipulates that the ECB Council's deliberations remain confidential, although Wim Duisenberg, the ECB's President, suggested that minutes of Council meetings could be made public after a time lag of sixteen years! The only method of questioning the ECB's policies is through periodic reports to the ineffective European Parliament. Consequently, in an EU structure of decision-making widely acknowledged to be suffering from a 'democratic deficit', the powers handed to an unaccountable ECB will exacerbate the shortcoming. Charles Dumas of Lombard Street Bank recently argued, "the ECB's 'excessive' independence was the price paid for persuading German voters to give up the mark" (The Times, 3rd March 1999).

In Britain, the USA, Canada, Australia and a growing number of smaller countries, monetary policy is used to control both inflation and unemployment by managing aggregate demand. For example, the UK government and the Bank of England's Monetary Policy Committee have recognised (as was implicit in the Chancellor's specific 2.5% inflation target) that moderate inflation may generate growth and a greater number of jobs. By contrast, within Euroland any suggestion that monetary policy could be used to increase living standards and reduce unemployment is a heresy not to be contemplated. The ECB's legal responsibility is to maintain price stability, but that target has not been attained in France and Germany for the past five years. However, the ECB consistently ignores the success of the UK and the USA in achieving low inflation, whilst simultaneously deploying monetary policy to reduce unemployment. The explanation of this conundrum lies in the ECB's origins and the macroeconomic theory it has adopted.

From its monetarist background, the ECB argues that the majority of Euroland's historically high unemployment (currently around seventeen million) originates from structural deficiencies on the supply side of its member states economies. Consequently it denies responsibility for increasing aggregate demand to lower unemployment, believing that there is no further room for expansion in the Euro-11 economies. In support of this thesis, another impeccably orthodox economic institution, the OECD, has published estimates for the natural rate of unemployment, below which inflation is believed to accelerate, for all industrialised economies. The estimated weighted average for Euroland is 11%, where the actual average was 10.6% in January 1999. On this reasoning, no scope exists to reduce unemployment without accelerating inflation. Such a view emphasises the grip that the natural rate of unemployment hypothesis exerts over ECB policy makers.

Contemporary EMU monetary policy is dominated by the view that inflation inevitably increases once unemployment falls below a critical level (the non-accelerating rate of unemployment). Therefore the focus of monetary policy becomes to ensure, in practise, that unemployment is sufficiently high to reduce price and wage increases. This theory is the clue to ECB strategy. However, if the sole objective of policy is to maintain a constant rate of inflation, wide variations in output and employment may be required. In so far as a potential conflict exists between steady inflation and full employment, the latter should enjoy priority, because the consequences of fluctuation in employment are more serious than those in the rate of inflation. Apart from the human costs of lower income, job insecurity, loss of skills, poorer mental and physical health, and higher crime rates, the industrial cost is enormous, since lost capacity cannot subsequently be made good when demand recovers.

These problems do not deflect Europe's establishment from its objectives. As Strauss-Kahn, the French Finance Minister, said in a speech to the Centre for Economic Policy Research on 9th November 1998: "We have made the choice of having an independent central bank. Its autonomy vis-"-vis national governments and the EU institutions, which results from an international treaty, is more soundly guaranteed than anywhere else in the world...We have clearly enshrined in our treaty a fiscal policy that emphasises the need for fiscal responsibility and we have drafted secondary legislation that will make sure that member states will deliver on this commitment". On the change from an international economy dominated by the fear of inflation, when the Maastricht Treaty was signed in 1991, to today's deflationary climate, Strauss-Kahn remarked: "Our task is to make this system work in a context which is clearly different from the one the architects of Maastricht had in mind when they drafted the Treaty". The more effective alternative of changing the policy decision-making framework as circumstances change is self-evidently not on the agenda.

Strauss-Kahn does, however, accept the "need for institutions that can deliver effective co-ordination between the eleven governments of the euro-zone, and between them and the independent ECB", because "in the absence of effective co-ordination, doubts about the other players might well lead the euro-zone to adopt a less than optimal policy-mix". However, difficulties arise when Strauss-Kahn claims that "the efforts made since the late 1980s have created conditions for a long EU cycle of growth". Such a claim flies in the face of all the evidence; the EU was a low growth area over the last decade, when these 'efforts' were undertaken, expanding at 1.7% per annum between 1991 and 1997 compared to 3.5% for the rest of the world. Consequently unemployment in the EU was 5 million in 1979, 14 million in 199 2 and is now nearly 19 million. Similar increases have not occurred in other OECD countries.

Nonetheless the ECB's monthly bulletin of February 1999 asserted that monetary and fiscal conditions "are favourable for sustained output and employment growth in the euro-zone in line with price-stability" (ECB, 1999). The ECB has consistently said that it would have to see clear signs of deflation before reducing interest rates. However, Robin Aspinall, chief European economist at National Australia Bank, argued on 16th February 1999 that, "the ECB will have to cut rates eventually because there is no sign of any inflationary danger. However, the ECB is resisting a cut because it distrusts the fiscal discipline of Europe's politicians. The ECB deliberately keeps its inflation target vague, at simply below 2%, so that it would not be beholden to the bidding of politicians once it meets its objective. The ECB also that interest rate cuts will not have much effect on unemployment. It favours structural reform to reduce unemployment" (The Times, 17th February 1999). However, the attainment of a 2% inflation target has not been achieved by any major economy in recent times; the USA figure over the last decade was 3.3% and that of Germany 2.8%. Therefore an unaccountable institution has assigned itself an exacting inflationary goal, with ramifications for other dimensions of economic policy. Furthermore, the ECB argues that Germany's current troubles are structural not cyclical, but even if correct, embarking upon structural change and realising its results, is a lengthy process. However, distancing itself from democratic demands to emphasise its independence is a crucial tactic for building ECB credibility.

Following the Second World War, British economic policy was directed to the simultaneous attainment of four policy objectives; high levels of employment, stable prices, balance of payments equilibrium and an expanding economy. Within Euroland, responsibility for the second lies solely with the ECB, whilst the other three remain with national governments. An obvious danger is that economic management will become more difficult through the separation of budgetary and monetary policy. It was demonstrated by the shortcomings of the Reagan-Volcker era in the USA and Germany's problems following reunification; in both cases lax fiscal policy resulted in high interest rates. By contrast, with a non-independent central bank, budgetary and monetary management can complement each other, forging a co-ordinated strategy of economic management.

Since the EU Heads of Government met at Maastricht in 1991 to finalise the blueprint for EMU, their political complexion has changed beyond recognition. The centre-left now controls or shares power in thirteen of the fifteen EU governments, Ireland and Spain being the exceptions. The majority won elections by promising job creation. Therefore a new European consensus is emerging which prioritises the need to reduce unemployment.

Consequently the theoretical possibility of a division between the conduct of budgetary and monetary policy has become a reality within months of the launch of the euro, far more rapidly than even sceptics anticipated. A crevasse has opened up between centre-left governments focusing upon unemployment and the ECB operating from a monetarist, natural rate of unemployment perspective. Moreover, the bankers insisted in advance, via the Stability and Growth Pact, that governments should be deprived of the ability to spend their way out of recessions. The battle between the ECB and European politicians was thrown into sharp focus by the resignation of Oscar Lafontaine. However, the underlying structural conflicts within Euroland lie deeper then the career of any individual, so that the danger of divisions between fiscal and monetary policies remains. Moreover, the gloomy economic prospects for the EMU-zone ensure that such pressures will intensify; for instance, the German economy contracted by 0.5% in the last three months of 1998, whilst in France industrial output declined by 1.6% in December 1998.

The euro-11 countries, even without the UK, do not constitute an optimum currency area (see Baimbridge et al., 1998). Consequently for many years to come, persistent national divergences in growth and unemployment are likely to recur. This nightmare scenario has not taken long to unfold; Wim Duisenberg felt obliged to concede on 4th March 1999 that the economies so painfully corseted together by meeting the convergence criteria are already diverging (The Times, 6th March 1999). While Ireland appears likely to overheat due to large reductions in interest rates at a time of unprecedented high growth, Germany appears to be drifting ineluctably into recession. Whatever happens in the future, it is plain that one key argument of the eurosceptics is correct; no single interest rate is suitable for the euro-zone. Therefore any action of the ECB will cause trouble for some parts of Euroland, whose economies are destined to diverge over the foreseeable future. Thus, in the last quarter of 1998, Germany's GDP fell by 0.5%, yet Spain's rose by 0.8%, whilst Ireland's increased by 8.0% over the whole year. Such sharp divergences in economic performance will make the ECB's stewardship a difficult task.

Conclusion

The weight of theoretical and empirical evidence surveyed in this paper suggests that, the creation of an independent central bank in an established national economy, is an enterprise with certain costs and with only dubious prospects of the anti-inflationary benefits so frequently claimed. To transpose such a hazardous undertaking to a supranational framework such as the EU, whose constituent national economies experience varying economic cycles and possess divergent economic structures, is fraught with difficulties.

The decisions taken by the ECB are amongst the most sensitive actions deployed in a modern economy. Determining interest rates influences the growth of living standards, the level of unemployment and the amount that people pay for their credit and their mortgages. However, nobody votes for the ECB, which is unaccountable for its actions. It does not publish its forecasts nor the minutes of its deliberations. ECB members cannot be removed from office by the European Parliament, by the Council of Ministers nor even by the European Court. Therefore the move to ECB control reduces the amount of democracy, increasing disillusionment and grievance with democratic institutions.

The ECB's problems arise from its lack of democratic accountability, its arbitrary objectives, its outdated economic philosophy, and its potential for intermittent conflict with the national governments whose destinies it possesses considerable influence over. Therefore the ECB as currently constituted is an anti-democratic, economically inept institution. Its lack of accountability, transparency and democratic legitimacy makes clear that no British government concerned for the efficiency of the UK economy and capacity for self-governance could submit to the ECB's monetary authority. Therefore it is crucial that the British people, if and when consulted, steer clear of this ill-defined, bureaucratic nightmare.

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