American Economic Association

The European Central Bank, the Euro, and Global Financial Markets
Author(s): Kathryn M. E. Dominguez
Reviewed work(s):
Source: The Journal of Economic Perspectives, Vol. 20, No. 4 (Fall, 2006), pp. 67-88
Published by: American Economic Association
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20, Number4-Fall 2006-Pages 67-88

Perspectives-Volume
JournalofEconomic

The European CentralBank, the Euro,

and Global FinancialMarkets
KathrynM. E. Dominguez

European monetary union, thought by many to be a pipe dream when first

proposed in 1969, became a realityin 1999. Afterdecades of debate over

Europeanwhethera singlecurrencywas feasibleforEurope, scholarsare now focus-

ing on the more immediatequestionofwhethermonetaryunion has made Europe

betteror worseoff.The euro was launched as an electroniccurrencyand accounting unit in January1999, and has been in circulationsince January1, 2002, in
Germany,Austria,Belgium,Spain, France,Finland,Greece, Ireland,Italy,Luxembourg, the Netherlands,and Portugal. Three European Union member countries-Denmark, the United Kingdom, and Sweden-have not introduced the
euro. The population of the euro zone is slightlylarger than thatof the United
States,while U.S. GDP per capita is about 12 timesthatof the euro zone.
The euro zone is likelyto be expanded eventuallyto 22 countriesby the
additionof the ten new memberstatesthatjoined the European Union on May 1,
2004: Cyprus,the Czech Republic, Estonia, Hungary,Latvia, Lithuania, Malta,
Poland, Slovakia,and Slovenia. These countriescurrently
participatein a (probationary)exchange-ratemechanismknownas European MonetarySystemII. Bultermed"acceding countries"and are expected to
garia and Romania are currently
join the European Union in 2007, while possible countriesfor futureaccession
include Turkey,Macedonia, Croatia, Albania, Bosnia and Herzegovina,Serbia,
Montenegro,and Kosovo.
The euro has had some successes. The European Central Bank (ECB) has
managed monetarypolicyin a waythathas treateda 2 percentrate of inflationas

in theGeraldR
ofPublicPolicyand Economics
SKathrynM. E. Dominguezis Professor
FordSchoolofPublicPolicyand theDepartment
ofEconomics,
ofMichigan,Ann
University
NationalBureau ofEconomicResearch,CamArbor,Michigan,and ResearchAssociate,
Massachusetts.
Her e-mailaddressis (kathrynd@umich.edu).
bridge,

68 JournalofEconomic
Perspectives

a targetlevel,and inflationhas exceeded thisrate onlyslightly.

European interest
ratesare probablylowerthan theywould have been had the GermanBundesbank
remainedthe predominantcentralbank in Europe. The euro is second onlyto the
U.S. dollar in use and importancein internationalmoney and capital markets,
fora currencywhichhas onlybeen in circulationfor
whichis an impressivestatistic
fouryears.
But a strongcase can be made that European monetaryunion has thus far
provento be no more than the sum of itsparts.' The euro is less widelyused than
the combinationof European currencies-the Germanmark,Frenchfranc,Italian
lira, Dutch guilder,and so on-that it replaced. Some countrieshave benefited
fromthe euro, mostvisiblythosewithlowercostsofissuinggovernmentdebt,while
othershave sufferedunder policies designed forthe European Union as a whole
ratherthan theirown economic circumstances.
The fundamentalissue is that European economic integrationis built on a
group of countrieseach of whichwantsto staylargelyas it was beforeintegration.
Although monetaryunion is now a reality,many citizens in Europe are still
grapplingwiththe questionof how trulyunifiedtheycare to be-as exemplifiedby
the French and Dutch votes thatblocked ratificationof the proposed European
Union constitutionin summer 2005. European institutionslike the European
CentralBank are more like additionsto the originalmembercountryinstitutions,
take on European economic policy
ratherthan new constructionsthatefficiently
making.The European CentralBank is subjectto the same tensionthatexistsfor
a desireformore integrationcombinedwithreluctance
all European institutions,
to cede national political control.Europe's economy has been littleaffectedby
monetaryunion because the distributionof power among those in charge of
European monetarypolicy decision making,and the implementationof those
decisions,remainstoo highlydecentralizedto takeadvantageof the possiblegains.
It should come as no surprise,therefore,that the performanceof the European
withintegrationand thatthe global role
economies has not changed dramatically
of the euro is not much differentthan the combinationof currenciesthatit has
replaced. Althoughthe euro has not matteredmuch so far,it also hasn't been
under severepoliticalor financialstressyet,and thereare reasonsforconcern as
to how well it will functionwhen severe macroeconomic or financial shocks
eventuallyoccur.

ofEuropean economic and monetaryunion withdiscussions

There is a vastliteratureon theprehistory
of whatwas likelyto happen; forexamples,see Flam (1992) and Bean (1992) in thisjournal, or Kenen
(1995). A related literatureconsidered whethermonetaryunion was likelyto be a good idea; for
examples,see Wyplosz(1997) and Feldstein(1997) in thisjournal.

M. E. Dominguez 69
Kathryn

The European CentralBank as an Institution

History
The conceptionof an economicallyunifiedEurope is an astonishingdevelopment from a historicalperspective.Afterall, France and Germanyand other
European nationswent to war witheach other three timesin the 75-yearperiod
from1870 to 1945. European leadersbecame convincedthatthe onlywayto secure
a lastingpeace was to unite economicallyand politically.The firststep in this
directionwas theintegrationof coal and steelindustriesin the early1950s.In 1957,
withthe signingof the Treatyof Rome, the European Economic Communityand
the European AtomicEnergyCommunitywere established.Twelveyearslater in
December 1969, the European Economic Communitydecided to make economic
and monetaryunion an officialgoal of European integration.2
A group chairedby
PierreWerner-at the timethe PrimeMinisterofLuxembourg-was giventhe task
of drawingup a reporton how this goal mightbe reached by 1980. The group
submitteditsfinalreport,an ambitiousplan thatwould resultin fullliberalization
of capitalwithinEurope and a new single currencyin October 1970. Indeed, this
plan envisionedfiscalas well as monetaryunion. The firststage of the plan, which
involved a narrowing of intra-European currency fluctuation margins, was
launched just as the BrettonWoods exchange rate systemcollapsed and world
currencymarketswentintoturmoil.The timingcould not have been worseand the
fledglingmonetaryunion projectwas broughtto an abrupthalt.3
At the instigationof France and Germany,effortsto coordinate monetary
policyand stabilizeexchange rateswere renewedin March 1979,withthe creation
of the European MonetarySystem,based on the concept of fixedbut adjustable
exchange rates.The currenciesof all the memberstates,except the United Kingdom, participatedin the exchange rate mechanism.The principlewas that exchange rateswerebased on comparisonswiththe European CurrencyUnitor ECU,
a European unit of account, which was a weightedaverage of the participating
currencies.A gridofbilateralrateswas calculatedon thebasis of exchange ratesfor
national currenciesexpressedin termsof ECUs, and currencyfluctuationshad to
be containedwithina marginof 2.25 percenteitherside of the bilateralrates(with
the exceptionof the Italian lira,whichwas allowed a marginof 6 percent).
Afterten fairlysuccessfulyearsof the exchange rate mechanism,a new push
was made to achieve monetaryunion. This effortculminatedwitha reportand the
2 Dyson and Featherstone (1999) provide a comprehensiveanalysisof the political and economic
process thatled to European economic and monetaryunion.
2SIn March 1972, the Europeans attemptedto restartmonetaryunion by creatingthe "snake in the
tunnel":a mechanismforthe managed floatingof currencies(the "snake") withinnarrowmarginsof
fluctuationagainstthe dollar (the "tunnel").But the snake of managed exchange rateswas thrownoff
course bythe oil crises,theweaknessof the U.S. dollar,and the differences
in nationaleconomic policy.
It lost mostof itsmembersin less than twoyearsand was finallyreduced to a "mark"area comprising
Germany,Belgium, Netherlands,Luxembourg, and Denmark. See Gros and Thygesen (1992) for
furtherdiscussion.

70 JournalofEconomic
Perspectives

so-calledDelors proposalin 1989,whichincluded the creationofa new,completely

independent institution,the European Central Bank or ECB, which would be
responsiblefor the common monetarypolicy.The Delors approach to monetary
union (whichwas codifiedin the Treatyof Europe) included a precise timetable
whichwas (to the surpriseof many) largelyfollowed.The firststage of the plan
mainly involved the elimination of all restrictionson within-Europeancapital
movements,as wellas the creationof greaterseparationbetweencentralbanksand
governments.Specifically,centralbanks were prohibitedfromofferingoverdraft
facilitiesto public authoritiesand public undertakings,
and public authoritieswere
access
to
other
financial
institutions.
prohibitedprivileged
In stage twoof the plan, whichtook place on January1, 1994, memberstates
wereto make significant
progresstowardseconomic convergencein bothmonetary
and fiscalpolicies. A European MonetaryInstitute,whose taskwas to strengthen
cooperation between the national central banks and to carryout the necessary
was also established.Stage
preparationsfortheintroductionof thesinglecurrency,
three was to be European monetaryunion for all but Denmark and the United
Kingdom,who obtainedopt-outclausesallowingthemthechoice to remainoutside
the euro zone.
In a strikingexample of deja vu,European currencymarketswentintocrisisin
1992,just as theyhad in the early 1970s during the firstpush towardmonetary
union. Marketsdid not believe that the quasi-fixedEuropean MonetarySystem
exchange rates were sustainablegiven the disparate economic situationsacross
European countries;forexample, France was in recession,while Germanywas in
the midstof unifying.The British(who had onlyjoined the European Monetary
Systemin 1990) and the Italianswere the firstto be forcedto break awayfromthe
agreed-uponexchange rate zones and to allow theircurrenciesto depreciate in
September1992. The Irishpunt,thePortugueseescudo, and the Spanishpeseta all
soon were allowed to depreciate as well. During summer1993, the French franc
also came under strongpressure,and European Union governments
respondedby
changing the rules to allow exchange rates in the futureto fluctuateby up to
15 percenton eitherside of theircentralrates,in place of the 2.25 percentband
that had previouslyprevailed. Doubt was once again cast on the feasibilityof
European monetaryunion.
the
In a displayof amazing (or some mightsayreckless)resolve,aftersurviving
currencyturbulencein 1992 and 1993, European leaders stayedthe course toward
monetaryunion. The European CentralBank was establishedin 1998 and the new
launched on January1, 1999.
European currency,the euro, was officially
InternalStructureand Mandate of the European CentralBank
The constitution
of theEuropean CentralBank is containedin an annex to the
MaastrichtTreatyof 1993. The European Central Bank is part of the European
Systemof CentralBanks,along withthe nationalcentralbanksof all memberstates
of the European Union. Governorsfrom national banks inside the euro zone
(meaningthatBritain,Denmark,and Sweden are not included,since theyhave not

TheEuropeanCentralBank, theEuro,and GlobalFinancialMarkets 71

adopted the euro) take part and are responsiblefor euro-zone monetarypolicy
decisions. The headquarters of the European Central Bank is in Frankfurt,
Germany.
Accordingto itsfoundinglaw,the primaryobjectiveof the European Central
Bank is unequivocallystatedas price stability,
witheconomic growthas a (decidArticle105 of the MaastrichtTreatydefines
edly) secondaryobjective.Specifically,
that"theprimaryobjectiveof the ECB shall be to maintainprice stability"
and that
"withoutprejudice to the objective of price stability,the ECB shall support the
general economic policies in the Community."This mandate is in contrastto the
U.S. Federal Reserve,whichhas a multiplemandate of price stability,
fullemployment,and moderatelong-terminterestrates.4The European CentralBank has the
exclusiverightto authorizethe issue of banknotesand coins; however,the national
centralbankshandle the technicalaspectsof euro issuance.The European Central
Bank's other tasksinclude conductingforeignexchange operations,the holding
and managementof officialforeignreserves,the promotionof the smoothoperation of paymentsystems,
and the collectionof statistical
informationnecessaryfor
its tasks.Importantly,
no provisionwas included in the MaastrichtTreaty
fulfilling
for the European Central Bank to act as a lender of last resortin the case of
financialcrisis,nor does the European CentralBank have supervisory
powersover
European banks-both of theserolesare stillheld bythe nationalcentralbanksor
othernational authorities.
The main decision-making
bodyof the European CentralBank is the Governing Council,whichincludesthe twelvegovernorsof the nationalcentralbanksand
six membersof whatis called the ExecutiveBoard. The ExecutiveBoard includes
the presidentand vice-president
of the ECB, and fourmembersthatare appointed
"on the basis of professionalmeritand monetary/banking
experience."The heads
of stateof the membercountriesappoint membersto the ExecutiveBoard, though
the processis a secretiveone. Viewedfromthe outside,the appointmentsseem to
be based on implicitquotas, so thatthreeor fourmembersof the ExecutiveBoard
are fromthe four large countries (Germany,France, Italy,and Spain) with the
small countriesfightingover the remainingslots. The procedure does seem to
select people set in a common mold. Accordingto Giavazziand Wyplosz(2004),
"[T]hey all currentlycome fromsuccessfulcareers in theirown national central
banks.Theysharea penchantforcautionand secrecy,a distancefromthe markets'
logic and fromthe latestacademic thinking."
The ExecutiveBoard is responsiblefor day-to-day
managementand the implementationof GoverningCouncil policydecisions.The MaastrichtTreatystates
that GoverningCouncil policy decisions, in turn,be made by simple majority,
meaning thatthe preferencesof the twelvenational centralbank governors,who
are appointed by their respectivenational governments,dominate the decision
4This U.S. Federal Reservemandate is in section2A of the Federal ReserveAct (dispersedthroughout
12 USC; ch. 6, 38 Stat. 251, December 23, 1913). See (http://www.federalreserve.gov/generalinfo/
fract/sect02a.htm).

72 JournalofEconomic
Perspectives

making.Neitherthe European Parliamentnor the ExecutiveBoard have a say in

(or veto power over) appointmentsof national centralbank governors.
In December 2002, the GoverningCouncil decided to limitthe number of
votingrightsof theGovernorsof theEuropean CentralBank to 15, throughtheuse
of a tieredrotationsystem,
whichwould take into account the likelyproblemsthat
would arise with euro-zone enlargement.Under the new system,governorswill
continue to participatein all meetingsof the GoverningCouncil, regardlessof
whethertheyhold a votingright.The rotationsystemwas designed to ensure that
the governorswiththe rightto votewould be frommembercountrieswhich,taken
of theeuro zone's economyas a whole.In practice,this
together,are representative
willmean thatthe governorsof thelargercountries(whichformthe firsttierof the
rotationsystem)willvote more frequentlythan governorsof smallercountries.Of
course, expanding the representationof the governorsfromitscurrenttwelveup
to 15 dilutes the power of the Executive Board further.In contrast,the Open
MarketCommitteeof the Federal Reservehas twelvevotes,of whicha majorityof
seven are the centrallyappointed members of the Federal Reserve Board of
Governorsand a rotatinggroup of fiveare presidentsof the regional Federal
Reservebanks.
The normal frequencyof GoverningCouncil meetingsis everytwoweeks;in
contrast,the Federal Reserve'sOpen MarketCommitteehas onlyeightscheduled
meetingsper year. The firstmeetingof the monthfor the GoverningCouncil is
typicallydevoted to evaluatingwhetherinterestratesneed to be adjusted and the
second meeting is left open for discussion of other tasks of the Eurosystem,
includingportfoliomanagementof officialforeignreservesand oversightof the
operation of the paymentsystem.
A fewdayspriorto the GoverningCouncil meetings,membersreceivea copy
of the "Orangebook" (named forthe color of itscover) preparedbythe European
CentralBank's chiefeconomist,whichprovidesan analysisof euro-zoneeconomic
a policy recommendation.The Govand monetaryconditionsand, importantly,
erning Council self-describesits monetarypolicy decisions as being made by
consensus (whichmayor maynotbe thesame as thesimplemajorityrulesuggested
bytheTreaty),so thatthereis no "formal"votingrecord.For comparison,theFed's
Open MarketCommitteeon the Thursdayprecedinga Tuesday meetingreceives
the "Greenbook,"which contains the staffsanalysisand forecastsof economic
conditions,and just beforethe meetingcommitteemembersreceivea "Bluebook,"
which updates economic conditionsand listspolicy options,but never provides
policyrecommendations(Pollard, 2003).
The European Central Bank was establishedas an independent institution,
presumablyin part because of the vast academic literaturearguingthatpolitical
is to make sound policydecisions.
independence is essentialifa monetaryauthority
Article107 of the MaastrichtTreatyestablishesthe politicalindependence of the
European CentralBank. Executivesof the European CentralBank are not to seek
fromany otherinstitutionor governmentbody,European or
or take instructions
national,and the European governmentsare not to seek to influencethe decision-

M. E. Dominguez 73
Kathryn

making bodies of the European Central Bank. Lengthynonrenewabletermsin

officeare anotherwayto encourage independence. The termsof officeforcentral
bank membersare foreightyearsand are nonrenewable.Membersof Germany's
Bundesbank Directorate,which servea similarrole as the ECB ExecutiveBoard,
also have eight-yearnonrenewableterms.Members of the U.S. Federal Reserve
Board of Governorsare appointed formuch longer,14-yearnonrenewableterms;
also, newmemberscan be appointed to servetheremainderofa termifa Governor
resignsearly,and then can be appointed fora full 14-yeartermof theirown.
Given that the European Central Bank was designed
to be independent,it is
ironicthatmuch of the criticismleveledat the ECB revolvesaround the perception
thatit is excessivelyindependentand undemocratic.The ECB does not publishor
invitecommentson itsproposed decisions.It providesimmediateinformation(via
a press conference) about its policy decisions, though it does not provide the
rationaleforitsdecisions.In contrast,the analogous U.S. policy-making
body,the
Federal ReserveOpen MarketCommittee,providesin its press releases a descriptionofanypolicychange,thevote,thenames ofanydissenters,and theirpreferred
policyaction. Everyyear the European Parliamenthas passed a resolutioncalling
on the ECB to publishminutesof the GoverningCouncil meetings.The Governing
Council has alwaysdeclined to do, althoughtheyhave indicatedthatminutesmay
eventuallybe released aftera 20-year(!) lag. The European Parliamentgivesadvice
on appointmentsto theExecutiveBoard of theEuropean CentralBank,but has no
veto power over appointments,no authorityover the governorsof the national
centralbanks,fewpowersof persuasion (as highlightedbydebate over the releasing of the minutes),and no powerto change the lawsgoverningEuropean Central
Bank. Indeed, the charterof the ECB can only be changed withthe unanimous
consentof the signatoriesto the MaastrichtTreatyand ratification
of the changes
the
national
by
parliaments.
But the failureto publishminutesmaybe a symptomof a deeper issue; Buiter
(2004) suggeststhatthe currentpracticeof not releasingthe votingrecord of the
GoverningCouncil may provide members cover for nationalisticvotingpreferences. The officialrationalefornot publishingthisinformationis that confidentialitywill protectindividualsfrompressureto vote in line withnarrownational
can cut in otherdirectionsas well. Meade and Sheets
interests,but confidentiality
(2002) argue that the monetarypolicy decisions of the European Central Bank
from1999 to 2001 are consistentwithnationalcentralbank governorsvotingin line
withtheirnational interests.(Interestingly,
thispatternalso holds trueforpolicy
decisions of the Federal Open MarketCommittee,whichare found to be in line
withgovernors'regionalinterests.)
European Central Bank independence must be viewed in the contextof an
institutionwhere a large majorityof the membersof the GoverningCouncil are
appointed in a highlydecentralizedfashion.The structureof the European System
of CentralBanks most resemblesthe German Bundesbank,whichin turn,resembles the U.S. Federal ReserveSystem.The ECB was modeled on the Bundesbank,
both because Germanyhad a large influenceon its design, and because of the

74 JournalofEconomic
Perspectives

perceptionthatthe Bundesbankrepresented"bestpractice"among the European

centralbanks. One importantdifferencebetweenthe ECB (and the Bundesbank)
and the Fed, however,is that power at the GoverningCouncil resides with the
nationalbanks,whereaspowerat the Fed resideswiththe Governors(and not the
regionalFederal Reservebanks). The current,highlycentralized,powerstructure
of theFed Open MarketCommittee,on whichonlyfiveof theFederal Reservebank
presidentsvote at any one time,was not created until 1933-20 years afterthe
establishmentof the Federal Reserve.It was not untilthe 1935 Amendmentto the
Federal ReserveAct thatthe regionalFederal Reservebankswere prohibitedfrom
conductingindependent open marketoperations (Wynne,1999). Friedmanand
Schwartz(1963) make the case thatthe decentralizeddistributionof powerin the
earlydecades of theFederal Reserveled to inappropriateand overlycontractionary
monetarypolicy decisions, which in turn may have precipitated,and certainly
prolonged, the Great Depression. The ECB should take this experience as a
cautionarytale.
The greaterdecentralizationof the European CentralBank is also reflectedin
at the ECB, comparedwithover20,000
itsrelatively
smallstaff;around 700 staffers
forthe Bundesbankand 16,000 forthe Bank of France. Althoughthe numberof
national centralbank staffhas fallen since 2000, the euro zone stillpacks 16.1
centralbankersforevery100,000of thepopulation,comparedwith6.8 per 100,000
in the United States and 3.1 per 100,000 in the United Kingdom (CentralBank
2006, 2005).
Directory
The decentralizeddistributionof power at the ECB does not make it inherentlyinefficient.Indeed, a case can be made that because the national central
banks have local knowledgeand accountability,
theymaybe in a betterpositionto
A case
manage and implementmonetarypolicythana more centralizedinstitution.
could even be made thata more decentralizedorganizationwillfostercompetition
betweenregionsforbest practice.There is littleevidence to date thatdecentralization has led to bad policyoutcomesforeuro-zonecountries.There is also little
evidence of competitionamong national centralbanks (or nationalgovernments)
in euro-zonepolicymaking.It is worthrememberingthat
leading to improvements
not the national centralbanks,are the ones thatpushed
European governments,
formonetaryunion. In thiscontext,it is remarkablethatthereis not more friction
between the national centralbanks and the ECB. A reluctanceto confrontthis
frictionmaywellexplainwhytheECB has not made more stridesto centralize.The
concern is whetherthisapproach willcontinueto be appropriatewhen European
capital marketsand banking systemsbecome more integrated(a process that
monetaryunion will presumablyfoster). Centralized financialsurveillanceand
crisismanagementwillbe needed once pan-Europeanfinancialmarketsdevelop,
has no
yetthe institutionthatseems most suited for thistask,the ECB, currently
jurisdictionto do so.
The role of the European Central Bank as the representativeof European
monetaryinterestsis stillevolvingand is at timesawkward.For example, the ECB
representsEurope at some parts of the G-7 meetingsof finance ministersand

TheEuropeanCentralBank, theEuro,and GlobalFinancialMarkets 75

centralbank governors(fromthe United States,Canada, Japan,France,Germany,

the United Kingdom, and Italy); at other parts of these meetings,the national
centralbanksofFrance,Germany,and Italyjointheproceedingsand the president
of the ECB leaves (Truman, 2005). There is no European representativeof the
European fiscal authoritiesbecause there is no euro-zone fiscal authority.The
United KingdomattendsEuropean economics and financeministermeetingsbut
is not a participantin the euro zone; however,itis a full-fledged
memberof theG-7.
The euro zone also has a president,known as Mr. Euro, who representsthe
interestsof the euro zone at certaininternationalmeetings.
The European CentralBank does not formally
answerto anyone institutional
body (or perhaps answersto too many). Thus, the presidentof the ECB presents
the annual monetaryreportto four differentgroups: the European Parliament;
European economics and financeministers;the European Commission(the executivebranchof theEuropean Union); and theEuropean Council (European heads
of state).
The MaastrichtTreaty
Widespreadviolationsof the Growthand StabilityPact in the aftermathof the
MaastrichtTreatyvividlyillustratethatEurope's national governmentsare willing
to pursue theirdesiresto run unfetterednationalmacroeconomicpolicies. (In the
contextof the rejectionof the European Constitutionin 2005, it is worthremembering that the MaastrichtTreatyitselfbarely came into effect:it was initially
rejectedbyDanish voters(the Danes laterapproveda modifiedversionof thetreaty
whichexemptedthemfrom,among otherthings,joining the euro zone) and only
just squeaked throughwitha "yes"vote of 50.5 percentin France in 1992.)
The MaastrichtTreaty laid out four criteriathat countries must meet to
become eligible to join the euro zone. First,a country'sinflationrate was not to
exceed the averageinflationrate (measuredwiththeconsumerprice index) of the
threebest-performing
memberstatesbymore than 1.5 percent.Second, long term
interestrates(measuredusinglong-term
governmentbonds) werenot to exceed by
more than 2 percentagepoints the average of the threebest-performing
member
states.Third,the exchange rateof a country'scurrencymusthave stayedwithinthe
normal marginsprovided for by the exchange rate mechanism,for at least two
years,withoutdevaluingagainstthe currencyof anyothermemberstate.Fourth,a
ratiomustnot exceed 3 percentand itsratio
country'sgovernment-deficit-to-GDP
of governmentdebt to GDP mustnot exceed 60 percent.The officialwordingof
the fiscalprudence criteriaallows for some flexibility.
It allows a breach of the
referencevalue forthe budgetdeficitifthe figurehas declined substantially
and is
the
reference
or
if
circumstances
are
such
that
value,
approaching
divergenceis
thought to be "exceptional and temporary."The public-debtcriterioncan be
exceeded ifthe ratiois fallingand approachingthe referencevalue steadily.After
countriesjoin the euro zone, theyare supposed to continueto adhere to the fiscal
prudence criteriathroughthe provisionsof the 1997 Stabilityand GrowthPact.

76 JournalofEconomic
Perspectives

thatviolatethe 3 percentdeficitrule
Indeed, under thepact,nationalgovernments
of
GDP.
fined
to
one-half
were to be
percent
up
However,violationsof the Stabilityand GrowthPact have been widespread.In
2000, one yearafterthe euro was launched,fiveof the eleven countriesin the euro
zone (Greece joined the euro zone in 2001) were in violationof the public debt
of the pact is clearlynot being imposed; in 2005, the
rule. A strictinterpretation
three largest euro-zone economies-France, Germany,and Italy-were out of
compliance with both the budget deficitand public debt rules. No fineswere
imposed as a consequence of these violations.Instead, the Stabilityand Growth
for countriesin the midst of
Pact was revisedin 2005 to allow more flexibility
structuralreformsor businesscycledownturns.
For the European Central Bank, the failure of countries to abide by the
Stabilityand GrowthPact illustratesthateven afterEuropean countrieshad agreed
to certainelementsof a common macroeconomicpolicy,the countriesfollowed
theirperceivednational interestsnonetheless.The failureto followagreed-upon
rules for fiscalpolicy suggeststhat the decisionmakersin the member countries
look firstat whatpolicysuitstheirown country,and onlysecond at whatpolicysuits
Europe as a whole. This breakdownof fiscalcoordinationwithinthe euro zone
makes the ECB's job of settingeuro-zone-widemonetarypolicy all the more
complicated.In apparentresponseto the lack of enforcementof the Stabilityand
GrowthPact,in November2005 the ECB statedthatit would onlyaccept member
governmentsecuritieswitha ratingof A- or above as collateralin its refinancing
operations (describedin detail in the next section).

European

Central Bank Policy

The European Central Bank came into being during a particularlyvolatile

period for global financialmarketsand has succeeded in creatinga stable eurozone money market.Criticismsof the European Central Bank come fromboth
directions:both that it has run an overlyloose monetarypolicy and allowed
inflationto exceed the bank's statedtargets,and also thatit has run an overlytight
attentionto unemploymentratesand economic
monetarypolicywithoutsufficient
the
on
both
But
sides,
complaintsare only mild ones. Overall, the ECB
growth.
deservesgood marksforits performanceto date.
European MonetaryPolicy
The most controversialelement of the monetarypolicystrategyof the European Central Bank is the role assigned to the growthof monetaryaggregates,
specificallya referencevalue of 4.5 percentforannual M3 growth.Of course,the
money supplyis usefulas a policy targetonly if a stable link existsbetween the
money supplyand inflation.In the U.S. economy,the relationshipbetween the
moneysupplyand rateof inflationwas fairlystableduringthe 1960s and 1970s,but
then the relationshipbecame volatile and uncertainduring the 1980s, at which

M. E. Dominguez 77
Kathryn

Figure1
Euro-ZoneMoney (M3) GrowthRate
1210-

6
4-

M3 referencerate (4.5%)

2
0
c

c
c

c c
c

c c

c c

c c

timethe Federal Reserveswitchedawayfromtargetingmonetaryaggregates.Howfolloweda monetarytargetingregime

ever,the German Bundesbanksuccessfully
and Germanywas presumablykeen forthe ECB to continue its tradition.
The money growthrule (originallydescribed as the "firstpillar") is nearly
impossible to implement,as Cecchetti and O'Sullivan (2003) point out. The
European CentralBank definesM3 to include onlycurrencydepositsand marketable financialinstruments
heldbyeuro-zone
whichrequirestheECB to know
residents,
theidentityof theultimateownersof the relevantinstruments,
a non-trivial
task.In
and
to
its
there
is
little
evidence
that
the
in
ECB
case,
credit,
has,
fact,
any
put much
weighton monetaryaggregatesin itsmonetarypolicydecisions.Figure1 showsthat
the euro-zone M3 growthrate (year-to-year
percentage changes) exceeded its
referencevalue of 4.5 percent continuouslysince 2001. Euro-area M3 growth
averaged 6.4 percentfrom1999 though 2005.
The second (and curiouslyless controversial)pillar of the ECB's monetary
policyinvolvesmonitoringa range of indicators,such as wages,price indices,and
businessconfidence.The twopillarsare used to maintainan inflationtargetforthe
euro zone of less than2 percentper year.Figure2 showsthe euro-zonemeasureof
inflationover the period 1996 through2005. Inflationgenerallyexceeded the 2
percenttargetafter2000. In practice,the ECB has behaved as if2 percentwerethe
to measure
midpointof itsinflationrange,not the ceiling.It is notoriouslydifficult
inflation,and because the index trackedby the ECB (the harmonized index of
consumerprices,whichattemptsto measureinflationin a common wayacrossthe
euro-zonecountries)excludes the housingcostsof owner-occupiers,
theindex may

78 JournalofEconomic
Perspectives

Figure2
Euro-ZoneInflation
indexofconsumer
(basedon theharmonized
prices)
3.5
3.
2.5
be

2-

ECB HICP target(2%)

be

1.5

1be

0.5
0
c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6 c6
Source:ECB MonthlyBulletin.

well understatethe truerisein the cost of living.Calculationsbythe OECD suggest

thatif owner-occupiedhousing costswere added in, averageinflationin the euro
zone in 2004 would have been 2.7 percent,ratherthan the published2.1 percent.
An alternateview,based on the conjecturethatEuropean statistical
agenciesdo not
fullytake into account qualityimprovementsin goods and servicesin theircalculationsof cost of living,is thateuro-zoneinflationis overstated.
The main waythe European CentralBank providesliquidityto the marketis
throughopen marketoperations,known as "refinancingoperations,"which are
conductedaccordingto a pre-arrangedschedule on a weeklyand monthlybasis.In
practice the ECB (through the national central banks) gives banks reservesin
exchange forsecurities,and then reversesthe transaction.The ECB also provides
overnightloans to banks at the "marginallendingrate."5One of the main motivatheirminimumreservelevels,
tionsforbanks to borrowfromthe ECB is to satisfy
whichrequirebanks to hold a level of depositsat theirnationalcentralbank equal
to 2 percentof theiroutstandingloans. These reserverequirementsare said to have
5 Technically,the GoverningCouncil determinesthe "spread"betweenthe marginallending rate and
the targetrefinancingrate.In practice,the marginallendingratehas been set at 100 basispointsabove
the refinancingminimumbid rate (European CentralBank, 2004). Bywayof comparison,the federal
fundsrate in the United Statesplaysa role similarto the refinancingrate,and the U.S. discountrate
(which is set at 100 basis points above the federalfundsrate target)is largelyequivalentto the ECB
marginallending rate.

TheEuropeanCentralBank, theEuro,and GlobalFinancialMarkets 79

been imposedat the GermanBundesbank'sinsistence,but unlikethe Bundesbank,

the national central banks pay intereston these bank deposits (as well as on
depositsof overnightfundsbeyond those required to meet the minimumreserve
requirements).
The GoverningCouncil makesthe day-to-day
and longer-term
monetarypolicy
decisions,but the national centralbanks actuallyundertakethe monetaryoperations.Indeed, refinancingoperationsare done simultaneouslyby all the national
central banks in the euro systemin combination with over 500 counterparty
institutions,
using a wide range of governmentsecurities(the list of acceptable
collateraldiffersby country).The case formore efficientliquidityprovision,via a
more centralizedprocess,is easyto makewhenone considersthe complexityof the
simultaneousoperationsthatcurrently
takeplace. Presumablythe rationaleforthe
currentarrangementis based on the European principleof subsidiarity,
whichsays
decisions should be made at the lowestpossible level of political authority.The
currentdecentralizedsystemfor open-marketoperations in the euro zone can
certainlybe explained by politics,but not by economic efficiency.6
Quite apart fromthe logisticsof European monetarypolicy,some criticsfeel
thatthe objectivesgivento the European CentralBank are inappropriate.The ECB
setsinterestrateswitha primaryobjectiveof controllinginflation,withno explicit
objectiveforemployment,growth,or exchange rate stability.However,empirical
evidencesuggeststhattheEuropean CentralBank has been more concernedabout
employmentthanmightbe expected givenitsmandates.One gauge of the relative
weightsa central bank places on price stabilityversus economic growthis to
calculate a "Taylor rule" regression (Taylor, 1993). In such a regression,the
dependent variableis the targetinterestrate i', the twoexplanatoryvariablesare
the n-period-aheadannual expected inflationrate rg
t+, and the expected output
gap (Yt - y) (the differencebetweenexpected outputand potentialoutput,with
a positivegap implyingoutputabove potential),and thereis also a constantterm.
Thus, the Taylor-ruleinterestrate satisfiesthe equation:
Y)In this regression,the parameterp3on the expected inflationrate measures the
centralbank's preferenceforlowerinflation;thatis, ifbeta is greaterthanone, an
increase in inflationcauses the real interestrate to rise. The coefficienty is the
weightput on adjustingto cyclicalvariationin the economy.The Taylorrule does
not prescribespecificweightsfor inflationand economic growth;instead,it provides a frameworkfor measuringhow the policypreferencesof a certaincentral
bank respond to inflationand outputgaps.
A numberof studieshave found thatFederal Reservepolicygivesweightboth
to inflationand outputin recentyears.In comparison,the European CentralBank
6 Alesina and Perotti(2004) discuss the difficulties
forEuropean Union centralizationmore broadly,
whichare typically
viewedas encroachmentsupon national competencies.

80 JournalofEconomic
Perspectives

has actuallymaintainedinterestrates at lower levels than would have been prescribedby a Taylorrule weightedtowardlow inflation.One wayto see thisis to
compare ECB interest-rate
policy with the interestrates that the Bundesbank
stance) would have set, had it taken
(whichwas reveredfor its inflation-fighting
over monetarypolicyforEurope. Figure 3 shows the fitted(targetinterestrate)
values froma "Taylorrule" regressionfor the period since 1999 based on the
weightson inflationand growthmaintainedby the GermanBundesbankover the
euro-zoneinterest
period 1985-98. The figurealso includes the actual short-term,
rate that has been in place over the period 1999-2005.7 The fittedBundesbank
exceeds the actual euroTaylor-ruleinterestrate shown in Figure 3 consistently
zone interestrate,suggestingthatthe ECB has eitherfocusedless on inflation(or
focused more on the outputgap) than the Bundesbankwould have done.
The European CentralBank mustimplementpoliciesforthe entireeuro area,
sensitivities
among countriesin preferredpoliciesand differing
despitedifferences
to policychanges.In themid-1990s,beforetheeuro became established,short-term
across the euro-zonecountries;after1999, shortinterestratesvariedsubstantially
the
identical.Unsurprisingly,
terminterestratesin thesecountriesbecame virtually
unusuallylow interestrates set by the ECB in the earlyyearswere criticizedas
inappropriateforregionsof Europe withpossiblebubbles in theirpropertyvalues,
and the relativelyhigh recent interestrates have been criticizedas hampering
economic growthforsome of the largercountries.But some complaintsof thissort
are inevitablewhen a common monetarypolicy is imposed on a large zone
regional economies. Further,afteronlya fewyearsof the
comprisedof different
across euroeuro, it requires heroic assumptionsto attributegrowthdifferentials
zone countriesdirectlyto ECB policies.
Althoughthe existenceof the euro means that nominal exchange rates are
fixedwithinEurope, differencesin inflationacross countriescan stillaffectreal
exchange rates. For example, Germany'slow domestic inflationhas made the
country'sexports relativelycheap, while higher rates of domestic inflationin
Greece and Spain make theirexportsrelativelyexpensive.Lane (thisissue) documentsthe dispersionand persistenceofinflationdifferentials
among theeuro-zone
countries.Labor marketrigiditiesin Europe aggravatereal divergencesbyfailingto
allow wages to adjust to local circumstances.Duval and Elmeskov(2005) provide
evidence that European structuralreformsof labor and product marketshave

parametervalues forP and y are fromFaust,Rogers,and Wright(2001) who estimate/ = 1.31,

interestratesdepend
y = 0.18, and an interestratesmoothingparameter(reflectingthatcurrent-period
on the interestrate in the previousperiod and the targetinterestrate) of .91 forthe Bundesbankover
the period 1985-98. The data used in the regressionthatunderliesFigure 3 are fromthe European
Central Bank, Datastream,and Eurostat.The interestrate is the Frankfurtcall money "day to day"
interestrate, inflationis the yearlygrowthrate of the harmonizedindex of European Union (EU)
consumer prices, and the output gap is measured by the percent deviation of log EU industrial
production froma quadratic trend.An alternativeapproach, taken in Gerdesmeier,Mongelli, and
Roffia(2005), is to directlyestimatetheTaylor-rule
parametersforthe ECB. Theyfindevidencethatthe
ECB places weighton both inflationand economic growth.
7 The

M. E. Dominguez 81
Kathryn

Figure3
Comparisonof Fitted"Taylor Rule" InterestRates (Based on Bundesbank
Preferences)and ActualEuro-ZoneInterestRates
8.5

7.5
FittedBundesbank-Taylor-rule
interestrate
6.5

5.5

4.5

3.5

Actualeuro-zone
short-term
interestrate

2.5

1.5
1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
Source:Authorcalculations,Datastream,Eurostat,and ECB.
Notes:"FittedBundesbank-Taylor-rule
interestrate" is the interestrate thatwould have existedif the
ECB had followedthe Bundesbank's monetarypolicy regime (1985-98). Fittedvalues are based on
regressionestimatesusingBundesbankweightson inflationand growthfromFaust,Rogers,and Wright
interestrate is the Frankfurt
call money"day-to-day"
interestrate,which
(2001). The actual short-term
is virtually
identicalto other euro-zoneshort-term
interestrates.

slowedratherthanincreasedin recentyears.The fiscalprudence criteriadiscussed

earlier,ifadhered to, make thingsworsebylimitingthe abilityof governmentsto
use national fiscalpolicy to counteractrecessionsthat affectone member state
more than the others.
European Exchange Rate Policy
The main economic rationalefora single European currencywas to deepen
economic integrationamong its membersby reducing the costs of cross-border
incommerce,encouragingcross-bordermergers,improvingprice transparency,
creasingcompetition,and eliminatingexchange rate risk.Beforemonetaryunion,
the focuswas on the ratesat which the pre-existing
national currencieswould be
turnedinto euros. AfterJanuary
1, 1999, the focusquicklychanged to the value of
the euro relativeto other non-Europeancurrencies,especiallythe U.S. dollar.
Figure4 showsthe bilateraleuro nominalratesrelativeto the U.S. dollar,the
Britishpound, and theJapanese yen over the period 1999 through2005. On the

82 JournalofEconomic
Perspectives

Figure4
Euro againstMajor Currencies
1.4

160

1.3

1.2

1.1

0.5 0.5 0.5

0.5
0.5
0.5
0.5
0.5 0.5

0.5
0.5
0.5

150
140
130

110

0.8

pj

0.6

90

0.5

80

pj pj pj pj

100

0.7

120

0.9

e
e e
e

0
0

pj

pj

pj pj

pj

pj

pj pj

pj

pj

pj pj

pj

pj

pj

pj

pj

pj

pj pj

pj

pj pj pj

Source:Datastream.

day it was launched, the euro was worth$1.17. The value of the euro thensteadily
declined over the firstyear,and by late January2000 the euro fell below dollar
thresholdin termsofeconomics,but one thatevokedstrong
parity,an insignificant
reactionsfromEuropean politicians.This general pattern-a weakeningof the
exchange-ratevalue of the euro after1999 followedby a strengthening-holds
even if we use a more rigorousmethod for calculatingthe real exchange rate,
comparingthe euro to a trade-weighted
average of currenciesof the euro area's
main tradingpartnersand deflatingthe currenciesby the consumeror producer
cheaper right
priceindex. Thus, exportsto outsidethe euro zone became relatively
after1999, but have become relativelymore expensivesince then.
As the exchange rate value of the euro declined after1999, therewas much
speculationin the financialpressoverwhetherthe European CentralBank would
intervene.Althoughthe European CentralBank is whollyin charge of monetary
policy,the MaastrichtTreatyputsnationalfinanceministersin chargeof exchange
rate policy for the euro. In Article111 finance ministersare given authorityto
"formulategeneral orientationsand formalagreementsfor the Euro" as long as
mandate. Intervention
such arrangementsdo not impede the ECB's price stability
operations,which involvepurchases or sales of euros in the foreignexchange
marketwith the goal of influencingits relativevalue, are also addressed under
"ExternalOperations"in Article23 of the MaastrichtTreatyforthe ECB and the
nationalcentralbanks.The United Stateshas a similarjurisdictionalsplit,withthe
U.S. Treasuryhavinglegal authorityto decide dollar exchange rate intervention
policy,though in practice the Federal Reserve is generallyan equal partnerin

TheEuropeanCentralBank,theEuro,and GlobalFinancialMarkets 83

intervention
decisions.Euro interventions
maybe carriedout eitherdirectlybythe
ECB or by the national centralbanks actingon behalfof the ECB.s
Eventually,the European CentralBank did intervenein the currencymarket
on September 22 and on November 3, 6, and 9, 2000, to strengthenthe euro
againstthe dollar. The firstECB operationwas coordinatedwiththe U.S. Federal
Reserveand the Bank ofJapan,along withother centralbanks. While the dollar
magnitudeswerereleasedbyall theothercentralbanks,themagnitudesoftheECB
operationshave neverbeen made publiclyavailable.The ECB operationscame as
the euro was at itsweakestagainstthe dollar,and the operationscoincided witha
substantial(although relativelyshort-lived)strengtheningof the euro. Afterthe
initialobsessionwithdollar parityand an "undervalued"euro in the earlyyears,the
more currentconcernis thattheeuro is "overvalued,"hamperingeconomicgrowth
forexport-oriented
European countries.
The evidence on whetherthe introductionof the euro increased intra-EuroBaldwin(2006) reviewstheliteratureand findsthatthe
pean tradeis controversial.
consensus estimate is that the euro boosted intra-euro-zonetrade by 5 to 10
percent.While trade withinthe euro zone as a percentageof total trade for the
euro-zonecountrieshas remainedrelatively
stableatjust above 50 percentsince the
mid-1990s,intra-euro-zonetrade as a percentage of GDP rose steadilyfrom
25 percentin the mid-1990stojust over40 percentby2004. However,countriesin
the European Union but outside the euro zone (like Britain,Denmark, and
Sweden) also experienced significantincreases in euro-zone trade after 1999.
Moreover,trade withinthe euro zone is likelyto have been influencedby the
dismantlingof tradebarrierswithinEurope and the initialweakeningof the euro
afterits introduction,makingit difficult
to pin down how the move to the single
contributedto trade patterns.
currency,specifically,
The Global Role of the Euro
In the early,headydaysafterthe signingof the MaastrichtTreaty,therewere
suggestionsthatonce monetaryunion was solidlyin place, the euro mightrivalor
even surpassthedollar as theworld'sinternationalreservecurrency.To date, there
is littleevidencethatthe global role of thedollar has been usurped.The popularity
of the dollar in worldmarketssupposedlyled CharlesDe Gaulle to lament"America's exorbitantprivilege"allowingit to livebeyonditsmeans unconstrainedbythe
nations must endure.
periodic shortagesof foreignexchange thatless-privileged
Anotherbenefitthe U.S. economyreceivesfromthe global popularityof the dollar
is seignorage,whicharisesfromthe differencebetweenthefacevalue of U.S. notes
8 Interventionsmay also take place among the non-euro-zonecountrieswithinthe frameworkof the
Exchange Rate Mechanism. Currentlyseven European countriesparticipatein the Exchange Rate
Mechanism (known as ERM II): Denmark (since January4, 1999); Estonia, Lithuania,and Slovenia
(since June 28, 2004); and Cyprus,Latvia,and Malta (since May 2, 2005). The other countriesthat
enteredthe European Union on May 1, 2004, are expected tojoin ERM II as a preconditiontojoining
the euro-zone.New countriescannot formally
opt out of the euro. If theypass the Maastrichttests,they
are supposed tojoin the euro-zone-though Sweden has stayedout withouta treaty-sanctioned
opt-out.

84 JournalofEconomic
Perspectives

and the cost of producing and distributingthem. Rogoff(1998) estimatesthat

duringthe firsthalfof the 1990s,U.S. seignorageaveraged0.41 percentof GDP, or
more than $30 billion per year.Althoughthe European Union has neverformally
statedany global goals forthe euro, Wyplosz(1997, p. 15) suggeststhisis one of
"understatedmotivationsof EMU."
The role of the euro as a reserve currencyin central bank and private
portfoliosis stillevolving.A numberof Asian centralbanks as well as the Russian
centralbank have suggestedthattheywill diversify
out of dollars and into euros,
though there is littleevidence that this has yet occurred. Data on the currency
compositionof officialforeignexchange reserves(COFER) is available fromthe
IMF at (http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf).
The share of
the euro in officialforeignexchange reserveswent from 14.7 percent of total
reservesin 2001 (compared to 76.3 percentforthe U.S. dollar) to 16.2 percentin
2005-and even thissmall change was mainlydue to the appreciationof the euro
relativeto the dollar. The dollar remainsthe dominantintervention
currencyfor
non-U.S. central banks, though the euro is increasinglybeing used in Europe's
neighboringcountries.
Foreign exchange tradingin euros as a percentageof global trade has not
increasedcomparedto theshareof thecombinedEuropean currenciesthatexisted
currenciesin the foreignexchange marketare
priorto the euro. Data on different
available from the Bank of InternationalSettlements'sTriennial Central Bank
Survey of Foreign Exchange and DerivativesMarket Activityat (http://www.
In 1998,theU.S. dollarwas present43.7 percentof the time
bis.org/triennial.htm).
at one end of a transactionin the foreignexchange marketwhile the European
currencieswere present26.3 percentof the time.In 2004, the share of the dollar
was largelyunchanged at 44.4 percent,while the share of the euro was lower at
18.6 percent.Table 1 showsthe breakdownof currencyusage forthe U.S. dollar,
the euro, theJapaneseyen,and the U.K. pound in foreignexchange marketsfrom
1989 through2004. (The "euro" data priorto 2001 is derivedfromsummingthe
entries for the euro-zone legacy currencies.) There was a marked increase in
European currencyusage in the run-upto monetaryunion, but once the euro was
launched, usage actuallyfell by almost 10 percent and has remained virtually
unchanged since 2001. The initial fall in usage afterthe euro launch can be
and portfolio
currencytransactions
explained bythe eliminationofintra-euro-zone
rebalancingbytheeuro-zonecentralbanks (who no longerneeded to hold reserves
in the legacycurrencies),but the factremainsthateuro usage has not increased
since its introduction.
The greatestincreasein theuse of euros has come in thestockofinternational
debt denominatedin euros-for example,debt issued in euros bycountriesnot in
the euro zone-which rose frombelow 20 percentat the end of 1998 tojust above
30 percentat thebeginningof 2003. Mostof the non-euro-zonecountriesthatissue
euro-denominatedbonds,lend in euros,and createeuro depositsare neighborsof
the euro zone; forexample, U.K. residentsown almost40 percentof all nonresident euro-denominateddeposits.Lenders and borrowersin Asia, Latin America,

M. E. Dominguez 85
Kathryn

Table1
CurrencyDistributionof ForeignExchange MarketTurnover
showthepercentage
shareofaveragedailyturnover
in Apriloftherelevant
year)
(entries
Year

U.S. dollar

Euro"

Japaneseyen

British
pound

Pre-euro

1989
1992
1995
1998

45.0
41.0
41.7
43.7

16.5
27.6
29.9
26.3

13.5
11.7
12.1
10.1

7.5
6.8
4.7
5.5

Post-euro

2001
2004

45.2
44.4

18.8
18.6

11.4
10.2

6.6
8.5

Source:BIS TriennialCentralBank Survey,2004.

aThe launch of theeuro was in 1999 so the "euro"data priorto 2001 is derivedfromsummingtheentries
forthe euro-zonelegacycurrencies.

and theMiddle East continueprimarily

to use theU.S. dollarand theshareofeuros
in cross-borderlending and deposit activityconducted outside the euro zone is
small,around 5 to 6 percent (European CentralBank, 2005).
One of the main rationalesforthe Stabilityand GrowthPact discussedearlier
was that because financial marketswould not differentiate
between countries'
debts
once
were
all
denominated
in
rules
were required to
euros,
public
they
preventcountriesfromtakingon excessivefiscaldeficits(Feldstein,2005). Yields
on long-termgovernmentbonds issued by euro-zone governmentsdid indeed
withthe establishmentof European monetaryunion. Interconvergedramatically
estinglyhowever,even thoughtherehave been widespreadviolationsof the Stabilityand GrowthPact, thereis littleevidence thatcountriesare being penalized by
financialmarkets(or, forthatmatter,bythe European Union). Only Portugalhas
been formally
warnedregardingitsfiscalprudenceviolations,and thatwarningwas
followedby a compromisewhichallowed Portugalmore time to reduce its deficit
beforea sanctionsprocedurewould be put in place.
The most recent enlargementof the European Union, with its promise of
additionaleuro-zonemembersin the future,maybode well forthe global role of
the euro. In a recentstudy,Chinn and Frankel(2005) providetwoscenariosunder
which the euro could become more dominant. The firstscenario occurs if the
United Kingdomand enough otherEuropean countriesjoin the euro zone so that
it becomes largerthan the U.S. economy.However,thereis littlereason to believe
thatcurrencyusage necessarilyrisesin proportionto GDP. Afterall, the GDP of the
United Statesand the United Kingdomwere about the same in 1870, but it took
another80 yearsor so beforethe U.S. dollar displaced the Britishpound sterling
as the dominantinternationalcurrency.A case can also be made thatthe global
prominenceof the euro could decline withthe additionof the accession countries,
mostofwhichare significantly
poorer thanthe currentmembersof the euro zone.
The second scenario arises if confidencein the value of the U.S. dollar falls,and
thereis a flightto the euro as an alternative.

86 JournalofEconomic
Perspectives

A finalfactorthat is hinderingan increased global role for the euro is the

continued hesitationon the part of euro-zone countriesthemselvesto embrace
theirnewlycreated currency.Leaders of a numberof euro-zonecountriesincluding Germany,France, and Italyhave at one time or another hinted that an exit
strategymightbe needed under certaineconomic conditions.(In the case of an
exitbyItaly,it is not clearwhetherthiswould increaseor decrease the prominence
of the euro.) Even if these murmuringsare intended only for internalpolitical
consumption,theyleave the restof the worldwitha naggingsense of doubt about
the longevityof Euroland.

The Test is Yet to Come

The introductionof the euro and the establishmentof the European Central
Bank as the monetaryauthorityof Europe have gone smoothly.But doubts about
the wisdomof economic and monetaryintegrationpersistacrossEurope. The slim
marginsby which the MaastrichtTreatypassed in 1993, and the wide marginby
which the proposed European Constitutionfailed in 2005, are remindersthat
This warinessalso
Europeans remainwaryof givingup theirnational sovereignty.
influencesthe abilityof the European CentralBank to take over monetarypolicy
and limitsthe abilityof the euro to become a truerivalof the dollar in
efficiently
global financialmarkets.
The concept of economic and monetaryunion was sold to Europeans as the
means by which theycould achieve political and economic stability.There are a
number of potentialchallenges to thisvision of stabilitywhich Europe (and the
European Central Bank) may soon face. Germanyand France spearheaded the
march to union, but theyare now the euro-zone laggardsin termsof economic
growth,oftendescribedin the pressas "thesickmen of Europe." At the same time,
countrieslike Ireland (the Celtic Tiger), Spain, and Greece continue to sustain
relativelyhigh ratesof economic growth.If Germanyor France go into recession
and badly need monetarystimulus,how will the European CentralBank balance
theirneeds againstthe restof the euro zone? What if the dollar sinksunder the
weightof the U.S. currentaccount deficit,causing the euro to rise?How will the
European CentralBank reactto theinevitabledemandsforexpansionarymonetary
policythatwillcome fromEuropean exportersin thisscenario?If Europeans are
alreadyevidencingwarinessabout the monetaryunion duringa timewhen economic stabilityhas largelybeen maintained,how will theyreact to instability?
The truetestof the influenceof the European CentralBank and the longevity
of the euro has yetto come. The U.S. Federal Reservehas proveditselfable to calm
financialmarketsand keep the U.S. economyon trackeven in theface of dramatic
financialmarketturbulence:the 1987 stock marketcrash,the collapse of LongTerm Capital Managementin 1998, and the aftermathof the terroristattacksof
September11, 2001. It is less clearwhatrole theEuropean CentralBankwould play
if a European bank were to suffera major collapse, or if one countryor region

TheEuropeanCentralBank,theEuro,and GlobalFinancialMarkets 87

withinEurope were to go into financialcrisis.At least rightnow,it seems likelythat

individual countrygovernmentswould want to take center stage, leaving the
on the sidelines.
European CentralBank and otherEuropean institutions
toJamesHines,LarsJonung,
EllenMeade,AndreiShleifer,
Timothy
Taylor,
SI amgrateful
Linda Tesar,MichaelWaldman,and Mark Wynne
and toRon Alquistfor
forcomments
excellent
research
assistance.

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