How the ECB Really Works

The European Central Bank is probably the most misunderstood central bank in the world. It is often portrayed as doing too little, too late and doing it the wrong way. There is a kernel of truth in the assertion.

So far, the ECB has indeed been far more reluctant to bail out governments and calm markets by buying bonds. Since the start of the Lehman crisis, America’s central bank, the Federal Reserve, has purchased Treasuries and mortgage bonds worth 18% of US GDP. In Britain, asset purchases by the Bank of England are approaching 25% of GDP.

But the reluctance of the ECB is not accidental. The ECB holds back until it sees enough economic reforms to justify a stronger central bank intervention. Now that it is seeing enough progress on reforms in Spain and Italy, the ECB is finally planning to intervene more forcefully.

The most startling difference between the eurozone on the one hand and the United States and the UK on the other is not their respective fiscal situations. In fact, public debt in the eurozone amounts to 87% of its GDP, well below the 98% in the United States.

Instead, the major difference between the eurozone and other regions of the Western world lies in the reaction function of the central bank to financial turmoil and economic problems. Whereas the Federal Reserve and the Bank of England have been extremely active, the European Central Bank has intervened far less.

Why does the ECB not react to financial turmoil and recession risks like other central banks? Superficially, the ECB differs from the Federal Reserve in that it has the sole mandate of safeguarding price stability — as opposed to the Fed’s dual mandates of ensuring price stability and full employment.

In practice, however, the precise nature of the mandate does not matter all that much. In its discussions of future risks to price stability, the ECB — like the Fed — takes full account of labor markets trends and output gaps.

Instead, the characteristic that really sets the ECB apart is that it is the most independent central bank in the world. There are three closely related reasons for this:

1. The ECB does not face just one finance minister. Instead, it interacts with a disparate group of 17 national finance ministers who rarely agree.

The ECB can pretty much afford to ignore any of them. In the eurozone, the central bank president cannot meet the finance minister for U.S.-style cozy breakfasts because there is no such finance minister for the eurozone as a whole.

2. In the United States, it would take one act of Congress to change the mandate or setup of the central bank. In the eurozone, no politician who disagrees with the course of monetary policy can credibly threaten to change the mandate of the central bank or the process in which board members are selected.

Any change to the ECB mandate would have to be ratified by all 27 European Union member states, in some cases with referendums. That is close to impossible, about as difficult as inserting, say, a binding balanced-budget amendment into the U.S. Constitution. Now imagine if this amendment also had to be ratified by all, and not just three-fourths, of the 50 U.S. states.

3. The ECB largely sees itself as the heir to “best practice” monetary policy in Europe — that is, to the traditionally hard-nosed approach of Germany’s Bundesbank.

Not only is the eurozone’s central bank a much more independent and hard-nosed creature than national central banks elsewhere by design. The unique institutional set-up of the multi-nation eurozone also systematically favors a tough-love approach to internal problems.

The eurozone is neither one nation nor a bunch of separate nations who care little about each other. The eurozone is kept together by strong political glue — by the lessons Germany, France and other nations have drawn from two disastrous world wars.

Helped also by a protective U.S. military umbrella, the political and economic integration that began with the European Coal and Steel Community in 1951 helped deliver the longest period of peace and prosperity that the continent has enjoyed in almost 2,000 years.

The eurozone is best understood as a family of separate individuals kept together by strong, long-term bonds. The bonds are not unbreakable — but they can withstand quite a lot.

The eurozone’s structure means that transfers are largely horizontal (from nation to nation) rather than vertical (from a strong center to subordinate parts of a nation). Donor nations can and do set the terms at which they grant support to the recipients.

Put simply, Germany (as a donor) can be much tougher on Spain (as a recipient) because Spaniards do not vote in the national elections that matter for the government setting the conditions (German elections).

In the United States, the Sunbelt states of the Southwest (as a donor) could never be as tough on the Rustbelt states as Germany can be on Greece or Spain. Within nation-states such as the United States and the UK, the recipients do vote in the relevant national elections. Within the eurozone, they do not.

As a result, the support which eurozone countries grant each other mostly takes the form of highly conditional credits rather than unconditional, nonrefundable transfers. For this reason, there is much less risk of moral hazard in the mutual support system between eurozone countries than in the usual transfer systems within nation-states.

Many observers argue that the lack of major automatic and unconditional transfers within member countries counts against the eurozone. It makes it more difficult to smooth over internal problems.

But on the more important criterion as to whether the institutional setting of the eurozone promotes reforms, this counts as an advantage. Those countries that need support can get it only if they accept conditions for fiscal repair and for supply-side reforms that will make their economies more dynamic — and hence less likely to require aid in the future.