Unconventional Monetary Policies of the Economic and Monetary Union - Essay Example

Unconventional Monetary Policies of the Economic and Monetary Union Introduction The Economic and Monetary Union is a set of policies, agreed upon by seventeen countries of Europe, that stipulates some economic and monetary measures for the member countries as decided upon by a Governing Council and implemented by the European Central Bank. The main area of working of the Union is the formulation of the larger monetary objectives of the Eurozone, especially for the member countries, however deliberation over and influencing of financial proceedings is also part of the portfolio of the Union. The main body presiding over the decisions of the Union is the Eurosystem which consists of the governors of the European Central Bank (ECB) and National Central Banks (NCBs) of the seventeen member countries (European Central Bank, 2004). While the ECB has only a major share in deciding the policies of the EMU, it bears the whole of the responsibility of implementation of the EMU’s policies. The Governing Council of the EMU comprises the people voting over the prospective policies of the EMU. Each person has one vote of the common weight. Members of the council include the President, Vice-President and the four directors of the ECB, and the governors of the NCBs of each of the seventeen member countries thereby rendering the total number of Governing Council members twenty three. Primary Objective The main objective of the EMU as described in article 105 of the Maastricht Treaty (Jenkins & Economist Intelligence Unit, 1992, p. 466) is the maintenance of price stability. The article goes on to state that “Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of the Community”. The reasoning for the selection of this objective can be traced to the incentive for formation of the ECB, which was the fear of rise in inflation due to the dominance of the Germans over the European economic landscape. Hence the EMU has a stated primary objective of keeping the average growth, over the Union countries, of the Harmonised Index of Consumer Prices below two percent (Buti & Sapir, 2002). Monetary Policy In order to pursue this objective the EMU has to choose between the two main macroeconomic approaches. It can either concentrate on an Inflation Targeting approach where a clearly defined objective of numerical indicators of levels of inflation is to be pursued or it can adopt a monetary targeting framework where it expends its resources on influencing the monetary aggregate. So far the strategies adopted by the EMU have been described by economists as inclusive of certain aspects of both types of approach; a two-pillar approach. The first pillar in this approach is the money stock manipulation while the second pillar comprises the inflation control strategies. It has been evident for at least a decade that the monetary aggregate indicators do not correspond to the inflation rates which the monetary control purportedly affects (Bofinger, Reischle, & Schächter, 2001). The basis for this approach is the economic relation of the money stock to price stability represented by the Quantity Theory Equation (Mayer, 1990, p. 132): Δm = Δp + Δy – Δv Where Δ: Change from one year to the next m: Money stock p : Price level y : Real GDP v : Velocity of stock However the equation and the corresponding monetary theory assume that the monetary base represents the M3 aggregate. This assumption has turned out to be incorrect from the experience of the Euro area economies in the past decade. The theory misses out on considering two important facets of the M3 aggregate: it is affected by changes in the financial portfolios, a factor not incorporated in calculation of the monetary base; and structural changes may influence the relationship of the monetary base with the inflation rate, an aspect unaccounted for in this approach. The failure of the monetary aggregate to predict or even follow the inflation trend is evident in the following figure which shows how the inflation rate remained close to the EMU target over the years while the M3 growth was completely off the mark and unrepresentative of the growth of prices. Figure 1 Inflation and money growth (M3) in the Eurozone. Source: European Central Bank, monthly bulletin. The main culprit over the years of the discrepancy in measurement of growth of the monetary base has been the monetary velocity which continuously declined over the whole period by three percent on average. Two-Pillar Strategy Thus it is remarkable that despite a critically flawed approach to controlling the rate of inflation over the Eurozone, the ECB was able to keep the growth of prices under check and close to the targeted value. Another issue with this approach was an incompatibility between the target of monetary growth control and the larger objective of keeping inflation under two percent. This is because for low rates of inflation the portfolio effects are very large as the low inflation provides room for financial liquidity of markets and financial innovation comes to the foreground of economic activity giving rise to accumulation of assets and the formation of economic bubbles (De Grauwe, 2003). Therefore the short-term effects of the aforementioned phenomena dominate the growth signal of the monetary indicator and hence the medium-term stable financial activity is lost in the more dominant noise. Hence the monetary growth model is particularly ill-suited to the strategic makeup of EMU’s functionality, a fact illustrated in the figure below. Figure 2 Effect of low inflation on money growth. Source: De Grauwe and Polan (2005) Because of the effects of the two-pillar strategy, the EMU in 2003 implemented a few policy changes that signalled a desertion from the money growth targeting strategy and a move towards the inflation targeting (IT) strategy. One of the main benefits of an inflation targeting strategy is the transparency it naturally brings to the working of the ECB as controlling inflation is more a matter of implementation than policy-formation according to set numerical objectives and inputs as in the monetary aggregate strategy. The transparency brings what is known as ‘informal accountability’ into the performance of the ECB, a measure it desperately requires to maintain the trust of the authorities of the member states as well as that of the European public in the absence of any input legitimacy, which is legitimacy acquired through accountability towards the elected representatives. It is clear that no elected body has enough stature to serve as the regulator for the ECB penalizing personnel for bad performance and implementing the body’s recommendations (Bean, 1998). But while the failure of the ECB in instituting a self-accountability mechanism in the absence of possibility of foreign oversight remains ethically a bone of contention, the ECB has managed to muster output legitimacy, a product of its consistent fulfilling its commitment to the Governing Council of achieving its main objective. Financial Measures The other major ethical talking point regarding working of the ECB that has picked up steam recently because of the global financial crunch is that of interference in individual countries’ financial systems. It is alleged that through better monitoring of Central Banks’ crediting systems the ECB could have pre-empted the recent financial crisis in Europe. In this regard a minimum reserve limit for banks could have been set up, a suggestion that is still under consideration. The crediting bubbles would have been easier to identify by observing asset accumulation if the EMU had adopted a policy of Inflation-Targeting with a secondary objective of monitoring of the money growth indicators rather than utilization them as policy tools. However the ECB did play a vital role after the initial demand and supply shocks of stimulating the Euro-based economies, however the inflation had fallen to critically low levels by the time. Inflation rate is inversely proportional to the nominal and, by consequence, effective interest rates (Grauwe, 2009). Hence when it gets close to or below zero it is impossible to lower the nominal interest rates much to induce activity in the consumer markets. Therefore the ECB had to resort to unconventional measures of stimulating the economy because of not being able to influence the real interest rates. These measures mainly pertained to reviving the liquidity of the consumer markets. In this regard the EMU must further employ the two main unconventional approaches for stimulating the economy which are: Bringing into the ECB the reserves of the NCBs in order to grant access to a wider range of clients and broader investment landscape; and buying up the public assets in order to directly influence selected markets that have satisfactorily high liquidities. Conclusion Hence as the EMU looks to expand its membership in order to mainstream the European monetary system it must look to address the deficiencies in dealing with demand and supply shocks and accommodating for the increase in heterogeneity of policy transmission channels. The Union is still aspiring for the holistic system it requires for effective pursuit of its secondary objectives like targeting GDP growth rate and unemployment levels. And thanks to its current target-conservative nature, it is reluctant to delve into financial stability mechanisms which are required to deal with sovereign debt crises such as the recent one in Greece. However the institution boasts an impressive record of achievement of its primary objectives and hence is on a strong footing to promote homogeneity of the European monetary system and make it more incorporative of smaller states as well as some of the larger countries. References Bean, C. (1998). Monetary policy under EMU. Oxford Review of Economic Policy. 14, 41-53. Bofinger, P., Reischle, J., & Schächter, A. (2001). Monetary policy: goals, institutions, strategies, and instruments. Oxford, Oxford University Press. Top of FormTop of Form Buti, M., & Sapir, A. (2002). EMU and economic policy in Europe: The challenge of the early years. Cheltenham, UK: Edward Elgar Pub. De Grauwe, P. (2003). Challenges for Monetary Policy in Euroland. Integration in an Expanding European Union : Reassessing the Fundamentals. 203-228.Bottom of Form De Grauwe, P. (2009). Economics of monetary union. Oxford, Oxford University Press. De Grauwe, P., & Polan, M. (2005). Is Inflation Always and Everywhere a Monetary Phenomenon? The Scandinavian Journal of Economics. 107, 239-259. European Central Bank. (2004). The monetary policy of the ECB, 2004. Frankfurt am Main, European Central Bank. Top of Form European Central Bank. (2009). Monthly bulletin. Frankfurt am Main, European Central Bank. Jenkins, C., & Economist Intelligence Unit (Great Britain). (1992). The Maastricht treaty. London, U.K: Economist Intelligence Unit. 466.Bottom of FormTop of Form Top of Form Top of Form Mayer, T. (1990). Monetary theory. Aldershot, Hants, England, E. Elgar. 132. Top of Form Top of Form Top of Form Read More