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November 15, 1990

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

A European System of Central
Banks: Observations from Abroad
by W. Lee Hoskins

Xhe European Economic Community,
hoping to strengthen the economic benefits of the single-market initiative, seems
headed toward monetary union as outlined in the Delors Commission's report.1
That route would eventually establish a
European System of Central Banks
(ESCB) with powers to conduct a common monetary policy and, presumably,
to issue a single European currency.
Throughout history, nations have devised
many institutions to carry out these same
tasks, often relying primarily on the private sector and market discipline, and giving governments a minimal role. Today,
central banks, functioning as extensions
of governments and issuing fiat currencies, attempt to ensure monetary stability.
However, we have come to call upon central banks to perform many operations
that extend well beyond this traditional
role. The poor record of central banks
with respect to price stability reflects this
diffusion of purpose.

ISSN 0428-1276

movement of goods, services, labor, and
capital. The gains from trade, as resources seek their most efficient use,
will occur with or without the establishment of a common monetary policy or
the existence of a single currency. In the
last century, the various German states
achieved substantial economic gains
from the Zollverein (customs union)
before they achieved political and monetary union. Nevertheless, with appropriate safeguards, a monetary union can
augment the benefits of a single market.

In the context of comments on the
Delors report, I will describe those
institutional attributes that allow central
banks to focus solely on their primary
objective: price stability.

Discussions of monetary union often
emphasize the gains that could result
from eliminating the exchange risks and
currency-conversion costs associated
with intra-European trade. In reality,
however, these costs are relatively small
and unimportant. Any benefits from European monetary union will result most
directly from the ability to strengthen
money as a medium of exchange, as a
temporary store of value, and as a unit
of account. Acting in these capacities,
money reduces the information and
transaction costs associated with commerce, thereby allowing for better decisions, longer-term contracts, and improved productivity.

• Economic Benefits of a
Monetary Union
Benefits of the economic unification of
Europe will accrue primarily from the
removal of artificial restraints on the

As the German people know so well,
the economic efficiencies of money
depend first and foremost on the stability of its purchasing power. Issuers of
money must forge a trust with those

In an effort to enhance the economic
advantages of a single market, the
European Economic Community is
considering monetary union. A
European System of Central Banks
would be structured after the German Bundesbank model and vested
with the power to conduct a single
monetary policy and perhaps issue a
common currency. In a recent speech
to a group of German bankers and
business representatives, Cleveland
Federal Reserve Bank President W.
Lee Hoskins argued that price stability must be the sole objective of a
central bank, and pointed out some
pitfalls that the Community must
avoid if monetary union is to be
successful.

who hold that money or who denominate their wealth in it. When that trust is
eroded, individuals and businesses
devise elaborate and expensive schemes
to minimize their cash holdings and to
protect their wealth. Such unproductive
uses of resources necessarily lessen the
economic benefits afforded from the
use of money. Should the trust between
issuers and holders of money collapse
completely, so too will the functions of
money, and trade will revert to barter.

• The Primary Objective of a
Central Bank: Price Stability
The primary role of a central bank is to
provide an immutable guarantee of the
long-term stability of the purchasing
power of money. In this way, a central
bank maximizes the efficiencies that
money affords and creates an environment conducive to sustained growth in
a nation's standard of living. Countries
with relatively low, stable rates of inflation seem to experience relatively
faster rates of real economic growth.
Price stability not only eliminates the
need to hedge against inflation, but it
removes an important source of uncertainty associated with making longterm contracts and committing to longterm investments. Price stability also
cements the social contract whereby
governments do not impose taxes on
wealth without the consent of their
citizens." The uncertainty and hidden
taxes that inflation generates reduce
long-term investments, which have
proven vital to technological advances
and sustained real economic growth.
The prominence given to price stability
in nearly all proposals for a European
central bank is heartening. The Delors
report recommends that price stability
be the primary objective of the ESCB
and encourages the central bank to support other Community economic policies and exchange-rate stabilization
only when price stability is not compromised.
In recommending this approach, the
Delors Commission is following the
German example of central banking.
The Deutsche Bundesbank Act specifies that the primary function of the
Bundesbank is to "safeguard the currency." The Act also requires the
Bundesbank to support the economic
policies of the federal government, but
only "without prejudicing" its primary
function. Nevertheless, I am concerned
that in some subtle — yet important —
respects, the Bundesbank model is not
strictly appropriate for the ESCB.
Terms such as "safeguarding the currency," "monetary stability," or "price
stability" are ambiguous. In common

usage, for example, price stability has
at least three interpretations. To some,
it implies that prices can rise, but not to
such an extent that inflation affects private decisions. Others interpret price
stability as an expected zero-inflation
rate, but see no need to offset actual
jumps in the price index. Accordingly,
the price index can drift up or down.
A third interpretation of price stability
requires the central bank to offset any
deviations in the price level from its
baseline value.
The Bundesbank views its principal
directive, "safeguarding the currency,"
as a mandate for price stability in the
sense of not allowing inflation to affect
private decisionmaking. More important, the Bundesbank interprets this
directive very narrowly in its operations,
exhibiting a general distaste for inflation
exceeding 2 or 2.5 percent per year. Consistent with its legal mandate, the
Bundesbank does at times pursue other
policy objectives, notably, exchange-rate
stabilization. Yet, it has maintained its
credibility in pursuing price stability.
Credibility is important because it
reduces the real economic costs of maintaining price stability in the face of random economic shocks or policy errors
that periodically buffet price indexes.
As the Delors Commission undoubtedly realizes, the Deutsche Bundesbank Act provides the German central
bank with a foundation for its credibility. But more important, through years
of steadfastly interpreting its primary
directive narrowly, the Bundesbank has
built a strong reputation for consistently pursuing low inflation. This
reputation has strengthened a rather
vaguely stated official objective. No
other central bank enjoys a similar
level of credibility for price stability.
The ESCB, initially, will lack such a
reputation. Because good reputations are
slow to build and quick to vanish, many
economists recommend that central
banks adopt rules for price stability that
are verifiable, unambiguous, and
enforceable. I have long advocated such
a rule for the Federal Reserve System,
and I would encourage the European

Community to adopt a similar pricestability directive.
I have suggested that the Federal
Reserve System adopt a stable price
level as the sole target for monetary policy. When prices deviate from the baseline level, the System must act to bring
prices back in line.5 I also support Congressional legislation to underscore the
importance of price-level targeting. Such
a system would be simple to monitor,
and the legislature could easily hold the
central bank accountable for attaining
the goals of the directive.
• An Institutional Structure to
Achieve the Price-Stability Objective
To secure a goal of price stability for
the ESCB, the European Community
must craft an institutional structure
capable of carrying out that task. The
structure must offer no leeway for political maneuvering, which ultimately
would undermine the central bank's
pledge to maintain price stability.
A perennial issue in the debates about
central banking — one that is especially germane to the establishment of
the ESCB — is how to balance central
bank independence from political pressures with central bank accountability
to the public. The Delors Commission,
wisely choosing the Bundesbank as a
model, recommended that the ESCB be
independent of European fiscal authorities, but nevertheless noted the need to
make the central bank accountable to
the "democratic process."
Independence: Countries that afford
their central banks a high degree of independence typically have experienced
lower rates of inflation.6 The basic
requirements to ensure central bank independence are that the central bank have
no obligation to purchase the debt of any
fiscal authority, and that the respective
finance ministers be excluded from voting on monetary policy. Nevertheless,
concern remains because most European
central banks presently assist in financing their governments' fiscal budgets.
Many, for example, prefinance their
governments' budgets by buying and
reselling the debt. Even the Bundesbank

can grant temporary short-term credit to
the government. The ESCB must remain
free of all hints of fiscal assistance if it
hopes to establish credibility for price
stability.
Although buying government debt is
the most direct and obvious linkage
between central banks and fiscal authorities, indirect channels of influence also
exist. The structure of the Federal
Reserve System attempts to minimize
these indirect connections between the
power to create money and the ability to
spend public funds. For example, the
System is self-financing: It generates its
own revenues, pays its own bills, and
remits its profits to the U.S. Treasury.
The Federal Reserve is not subject to
the appropriations process of the U.S.
Congress, since this could prove to be
a conduit for political pressures.
The governance structure of a central
bank can also affect its susceptibility to
political influence. Within the Federal
Reserve System, the Federal Open
Market Committee (FOMC) decides
monetary policy by a majority vote of
the seven governors and the five voting
District Bank presidents. The President of the United States appoints the
seven governors of the Federal Reserve
Board, subject to Senate confirmation.
To minimize the potential for political
influence, the Federal Reserve Act
stipulates that governors serve a single
14-year term. Each District Bank's
board of directors, with the approval of
the Board of Governors, appoints a
president of that regional Reserve Bank.
The District Bank directors represent
banking and other public interests in
each district. Commercial banks elect
most of the directors, and the Board of
Governors chooses the remainder.
This dispersion of power among different individuals who have come to
the central bank through different
paths, and with different allegiances,
helps to reduce the concentration of
political interests and to lessen the
impact of external political influences
on the central bank.
An analysis of the voting record of Federal Reserve Bank presidents and gover-

nors highlights the importance of a
decentralized structure for a central
bank. Over the past 25 years, as the
U.S. price index rose nearly fourfold,
presidents were twice as likely as governors to dissent from the FOMC's
majority in favor of a tighter monetary
policy, while governors were five times
as likely as presidents to dissent from
the majority in favor of an easier
monetary policy.
Although Germany has a central bank
with a similar decentralized structure,
nearly all other European nations seem
to favor a more centralized arrangement.
As the European Community considers
the governance structure of the ESCB,
it should be careful not to adopt a structure that could compromise the pricestability objective.

ability — is ambiguous and subject to
change. Priorities will shift as political
and economic circumstances alter the
implicit weights that elected officials
assign to specific objectives. Being ultimately responsible to Congress, the Federal Reserve System has an incentive to
alter the weights that it gives to various
goals. This provides monetary policy
decisions with a myopic focus. Fashioned in this manner, accountability
becomes the antithesis of independence.

Accountability: While supporting the
independence of the ESCB, the Delors
report stresses a need to make the central bank accountable to the "democratic
process." Central banks are products of
governments and as such are naturally
accountable to the governmental entities that create them. This accountability can provide a useful support for central banks, or it can become a serious
impediment to their proper functioning.
The outcome depends on how a nation
or a group of nations frames central
bank accountability.

When, instead, legislatures measure accountability in terms of an operationally
unambiguous and technically achievable
goal, accountability effectively complements central bank independence by
giving the central bank a single longterm focus. Self-imposed monetary
rules can lack force and credibility with
the public because a believable enforcement mechanism does not exist. Has a
central bank policy committee ever dismissed itself for generating inflation, or
for consistently missing a monetary target? When a superior legislative body
that is responsive to the public imposes
the rules on a central bank, those rules
are more likely to be enforced and are
more credible. For this reason, I, along
with a number of other Federal Reserve
officials, have supported Congressional
legislation that would mandate price
stability as the Federal Reserve's
primary goal.

When a nation does not assess central
bank performance in terms of an unambiguous, verifiable goal, such as price
stability, accountability is a detriment to
the bank's smooth functioning and
becomes an avenue for political influence. The Federal Reserve System offers
an example. The U.S. Congress created
the System and retains the power to alter
its form and function. Congress requires
the Federal Reserve "...to promote effectively the goals of maximum employment, price stability, and moderate
long-term interest rates." However, Congress allows the System discretion in
how best to pursue these goals.

• Pitfalls to Avoid
Although most legislatures acknowledge the importance of preventing
inflation, none specify price stability as
the sole business of central banks, and
few even accord it top priority. The
Delors report envisions the ESCB
undertaking other economic functions,
notably, exchange-rate stability. I
object to such contingency plans on
two counts: First, they create doubts
about a central bank's willingness and
ability to pursue its primary objective.
Second, these contingencies are often
technically infeasible and of dubious
economic merit.

With multiple goals and no overall ranking of System objectives, the criterion
for success — the measure of account-

Foreign-Exchange Intervention: The
Delors report, for example, would
instruct the ESCB to smooth European

Currency Unit exchange-rate movements. Research indicates that central
banks cannot conduct intervention
separate from monetary policy. Focusing monetary policy on an exchange
rate is, at times, consistent with price
stability, such as when a central bank
acts to prevent an inflation-induced
depreciation of its currency. Just as easily, however, intervention can be inconsistent with price stability, such as when
real economic factors alter exchange
rates. Then, intervention raises doubts
about the central bank's commitment to
pursue a stable price level. If traders
expect policy to switch between price
and exchange-rate objectives, they will
continue to hedge against inflation and
exchange risk, creating uncertainty and
costs. Intervention then reduces the
efficiency of money.
Inflation-Unemployment Trade-off:
Similarly, many legislators on both
sides of the Atlantic believe that central
banks should attempt to exploit possible
short-term trade-offs between inflation
and unemployment in an effort to stabilize the business cycle. I disagree.
Besides jeopardizing credibility, such
attempts are not systematically feasible.
Money-stock changes can temporarily
alter employment and output only if
these changes cause confusion about
the nature of price movements or if market frictions prevent individuals from
adjusting prices quickly. In either case,
there is no stable trade-off between real
economic activity and inflation. As markets anticipate the resulting inflation,
more and more inflation is built into the
economy, quite independent of the phase
of the business cycle. U.S. inflation
immediately after the last recession was
roughly as high as it was at the businesscycle peak in the late 1960s.
Financing Debt: The ESCB could face
a unique challenge to price stability
because of the ability of national governments in the European Community
to issue debt. Because the borrowings
of many European nations are large
relative to credit markets, monetary
union could allow the debt of some
individual nations to raise interest rates
throughout the Community. Pressures

on the central bank to avoid high
interest rates could result in the ESCB
inadvertently financing borrowing by
individual member countries. Some
European countries have fiscal policies
that seem unsustainable. Others support various inefficient industries. With
the power to create money no longer
vested at the national level, some
nations could experience difficulties in
placing debt. This further highlights
the need for a price-level target.
Financial Panic: Questions also arise
concerning the role of the ESCB
should a government or a state-run
enterprise default on its obligations.
Major defaults, stock market crashes,
and other shocks occasionally buffet
the economy, producing financial
panics.' A financial panic can slow
money growth dramatically and place
strong downward pressure on prices. In
such cases, an increase in the monetary
base is consistent with an objective of
price stability.
Financial panics are especially precarious because, in confronting them, a
central bank must stabilize the price
level without providing bailouts to
specific institutions or groups of institutions. Should it fail, the public will
come to view the central bank as a
political institution and will question
its commitment to price stability.
To avoid the perception of political
expedience, the central bank must
approach the task in a manner that
emphasizes its macroeconomic aspects,
rather than its lender-of-last-resort character. The general objective is to provide a temporary injection of liquidity
without attempting to prop up insolvent
firms or even giving such a perception.
Supplying liquidity exclusively through
open-market operations not only avoids
loans to specific institutions, but is also
more efficient. Offering loans to individual banks, especially institutions that
are approaching insolvency, creates a
moral hazard problem that, in the long
run, can increase the frequency of financial crises. Lending, and the associated
moral hazard problems, requires the central bank to spend substantial resources

on the supervision and regulation of the
financial community.
Implicit in a macroeconomic approach
to financial crisis is a willingness to
allow individual institutions, even large
ones, to fail. Discount-window lending,
particularly at or below market rates, can
easily become a subsidy to firms that do
not meet the market test. If the European Economic Community is unable to
allow certain firms to fail, it should
remove the bailout function from the
central bank and vest that responsibility
in an independent agency that is directly
responsible to the European Council
and European Parliament. The European Parliament should fund the bailouts
through specific budgetary appropriations. Such an arrangement would
ensure direct political accountability for
the bailouts while preserving the monetary integrity of the central bank.
• Conclusion: Monopoly or
Competition?
The Delors Commission seeks to grant
the ESCB a European monopoly for
the issuance of fiat money. I have suggested four general criteria to ensure
that this institution produces an efficient product: First, unambiguously
establish price stability as the sole
objective of the central bank; second,
make any government-sponsored central bank completely independent from
fiscal authorities; third, hold the central
bank accountable to a legislative body
(the European Parliament) solely for
attainment of a stable-price rule; and
fourth, address any financial crisis that
threatens price stability only through
open-market operations.
The Delors report, using the Deutsche
Bundesbank as a model, endorses most
of these recommendations. However,
beyond Germany, few European nations
appreciate the dangers of mingling the
power to spend with the power to issue
fiat currency. I find it difficult to accept
the argument that governments, which
individually resort to the inflation tax,
will collectively choose to avoid that
revenue source, particularly in an
arrangement that lessens the dominance
of the Bundesbank. Today, Germany's

low-inflation monetary policy provides
a price anchor to countries participating in the European exchange-rate
mechanism. An ESCB structure that
dilutes Germany's influence without
establishing a clear, mandatory pricelevel target will almost certainly make
Germany worse off.
If the European Economic Community
cannot adopt a legal commitment to
price stability along the lines that I have
suggested here, Germany might not
wish to grant the Community a monopoly in this area. Instead, your country
might foster a monetary-policy competition by strengthening sanctions
against countries that attempt to reimpose barriers to the free movement of
capital and real resources.
The resource movements associated
with the single-market initiative will
confer great benefits on the European
Economic Community. They will create natural competition for sound
government policies, and the movements of resources across borders will
effectively register votes on policy.
Governments that institute excessive
rates of taxation, through inflation or
more explicit means, will see their tax
bases shrink. This competition will
foster—indeed encourage—coordination of monetary and fiscal policies
even without the establishment of a
single European central bank. This
competition either will produce an
evolutionary convergence of inflationary preferences among the European
states, thereby completing the groundwork for monetary union, or it will
graphically illustrate the impossibility
of forcing monetary union on countries
that have different inflation preferences.

• Footnotes
1. The European drive toward economic
union consists of two parts. The singlemarket initiative refers to the goal of
eliminating all artificial barriers restricting
movements of economic resources in the
European Economic Community by 1992.
Monetary union refers to the goal of eventually establishing a single monetary policy
throughout the Community. The Delors Commission was charged with preparing an initial
recommendation for monetary union.
2. For a discussion and references to evidence, see William T. Gavin, "In Defense of
Zero Inflation," Working Paper 9005, Federal Reserve Bank of Cleveland, June 1990.
3. See David Altig and Charles T. Carlstrom,
"Inflation and the Personal Tax Code: Assessing Indexation," Working Paper 9006 , Federal Reserve Bank of Cleveland, July 1990.
4. This English translation of the Deutsche
Bundesbank Act is found in The Deutsche
Bundesbank, Its Monetary Policy Instruments and Functions, Deutsche Bundesbank
Special Series No. 7, October 1982.
5. A 2 percent band around the target level
would be acceptable provided that the target
is an unchanging price level.
6. For a discussion and references to evidence, see "Central Bank Independence,"
Federal Reserve Bank of Cleveland's 1989
Annual Report.
7. All 12 District Bank presidents attend the
FOMC meetings and participate in deliberations, but only five vote at any particular time.
8. Some appointments, however, fill vacancies left in existing terms.
9. See "Central Bank Independence,"
Federal Reserve Bank of Cleveland's 1989
Annual Report, footnote 3, p. 18.
10. A price-level target could eliminate a historic source of such shocks: abrupt shifts in
monetary policy.

W. Lee Hoskins is president of the Federal
Reserve Bank of Cleveland. The material in
this Economic Commentary is based on a
speech presented to a group of German
bankers and business representatives in
Munich on September 4, 1990.

Economic Commentary is a semimonthly periodical published by the Federal Reserve Bank of Cleveland. Copies of the titles listed
below are available through the Public Affairs and Bank Relations Department, 216/579-2157.
Does the Fed Cause Christmas?
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to Sound Monetary Policy?
W. Lee Hoskins
February 1, 1990
How Are Wages Determined?
Erica L. Groshen
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The Economic Outlook: Growth
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John J. Erceg and Paul J. Nickels
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The Case for Price Stability
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A Monetary Policy for the 1990s
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May 1, 1990
A Critique of Monetary
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Owen F. Humpage
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Making Sense of the Moynihan
Gambit: A Perspective on the Social
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Current Outlook: Sustained Growth,
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Minority-Owned Banks: History
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The High-Yield Debt Market:
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or Opportunity?
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Standardizing World Securities
Clearance Systems
Ramon P. DeGennaro and
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April 15, 1990

Payment System Risk and Financial
Reform
W. Lee Hoskins
August 1, 1990

Federal Reserve Bank of Cleveland
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Inflation and Growth: Working
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Michael F. Bryan
August 15, 1990
Underlying Causes of Commercial
Bank Failures in the 1980s
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James B. Thomson
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Can State Employment Declines
Foretell National Business Cycles?
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