The European Central Bank (ECB) is the central bank for the euro area. It opened its doors in June 1998 in Frankfurt, Germany. Together, the ECB and the national central banks that are members of European Monetary Union (EMU) form the European System of Central Banks (ESCB), also known as the eurosystem.
Before the ECB began to take responsibility for the conduct of monetary policy in the euro area, the member countries created the European Monetary Institute (EMI) in 1994 to facilitate the work toward transition to the era of the single currency. Its primary task was to address the technical needs for the switch to the euro. The EMI was responsible for reporting to the European Union (EU) on the progress toward convergence by individual member states, as prescribed by the Maastricht Treaty. The conduct of monetary policy remained under the responsibility of the individual member states. By the end of 1995, member governments approved a plan for change that focused on the need for rigorous acceptance of the convergence requirements. A legal basis for the single currency was necessary so that all who used the euro could be confident that it would be an accepted means of payment.
The primary objective of the ECB and, by implication, the ESCB, is to maintain price stability, a goal set but not defined by the Maastricht Treaty. The ECB defines price stability as an inflation rate close to 2 percent in a Europewide index of consumer prices called the Harmonized Index of Consumer Prices over the “medium term. ”What is the medium term? The ECB does not provide a precise definition. It notes that monetary policy acts with long and variable lags, an idea made famous by Milton Friedman. Experience, however, suggests that inflation can be controlled within the objectives set out by the ECB within a two-year horizon. To achieve this objective, the ECB decided to give prominence to money growth as well as to a wide range of indicators such as the exchange rate, the yield curve, and various fiscal indicators. More precisely, the ECB’s strategy involves a so-called two-pillars approach. This means that, in setting interest rates for the euro area, the ECB considers developments both on the real side of the economy, which are of a shorter-term nature, as well as on the monetary side, which captures the longer-run influences on monetary policy. Since current interest rate decisions have an impact on future decisions by individuals and firms, the ECB also receives guidance from forecasts of inflation and real economic activity for the euro area as a whole.
The ECB is headed by a president who serves a nonrenewable eight-year term. The first president of the ECB, Wim Duisenberg from the Netherlands, did not serve his full term, which would have ended in 2006; instead, Jean Trichet of France was appointed as the president of the ECB in 2003. Since the president and other senior officials of the ECB are appointed by “common accord” by the heads of state or governments of EU members, national political imperatives play an important role in such appointments. Therefore, it is unlikely that a country could have more than one representative on the executive board.
The principal decision-making body of the ECB is the governing council made up of the governors of the thirteen euro-area national central banks and the executive board. The executive board, which consists of six members chosen from the governing council, is responsible for the implementation of monetary policy and carrying out the day-to-day affairs of the ECB. The governing council of the ECB consists of members of the executive board and all the heads of the national central banks that belong to the euro area. The governing council is mainly responsible for formulating monetary policy. The general council, largely an advisory body, includes members from both euro-area and non-euro-area countries that are members of the EU.
Both the executive board and the governing council meet twice a month, generally in Frankfurt. During the first monthly meeting the governing council announces the monetary policy decision made by the executive board. The second monthly meeting is reserved for making decisions related to the other tasks of the euro system. The schedule of meetings is published in advance so financial markets can prepare for the announcement of the interest rate decision. Additionally, in an emergency or crisis the governing council can meet in an extraordinary session, as happened, for example, following the terrorist attack on the United States in September 2001. The president of the ECB announces the interest rate decision immediately after the meeting and holds a press conference, but the ECB does not release minutes of the meeting.
In addition to its responsibility for defining and implementing monetary policy in the euro area, the ECB conducts foreign exchange operations, holds and manages member states’ foreign exchange reserves, and helps promote the Europewide payments system. This payment system is called TARGET (Trans-European Automated Real-Time Gross Settlement Transfer System). Finally, the ECB, together with the individual national central banks, collects and disseminates a large variety of financial and economic statistics.
The primary monetary policy instruments consist of open market operations followed by a marginal lending facility that permits select financial market participants to borrow overnight from national central banks against eligible assets. Finally, banks in the EMU are required to hold reserves against short-term deposits.
In 2004, a historic enlargement took place. Ten new member states joined the EU on May 1: the Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovakia, and Slovenia. In 2007, Romania and Bulgaria joined the EU. All of these countries must fulfill the Maastricht Treaty convergence requirements. The enlargement of the EU in 2004 introduced a potential organizational problem for the ECB’s governing council. With 15 national central banks and six executive board members, the main decision-making body of the ECB originally consisted of 21 members. Following enlargement, membership would rise to a total of 31 members and, potentially, a still larger number once other countries are admitted into the EU. Therefore, in 2002, the ECB recommended a voting system that would limit the number of voting national central bank members to a maximum of 15. This means that there would be a rotation system among members of the eurosystem. The rotation system is designed to ensure that the national central bank governors with the right to vote are from member states that, taken together, are representative of the euro-area economy as a whole.
In spite of the growing pains experienced by the ECB, it remains a grand experiment that shows every sign of success, durability, and future expansion. The euro, which is the most visible expression of the ECB’s existence, is a currency that may someday rival the U.S. dollar as a reserve currency. Finally, the economic size of the euro area is now larger than that of the U.S. economy, and it is likely that economic performance in Europe will have repercussions worldwide.
See also common currency; euro; European Monetary Union; Federal Reserve Board; Maastricht Treaty; optimum currency area (OCA) theory
Related Credo Articles
The organization responsible for conducting monetary policy in the eurozone at the supra-national level ( European Monetary Union (EMU) ). It...
What Are Central Banks? The central bank is a nation's monetary authority. Central banks can also be called reserve banks or monetary...
This chapter addresses the issues relating to the past, present, and future of the European Monetary Union (EMU), focusing on the way in which...