By Frances Coppola
In the history of international monetary policy, the ECB is a relative newcomer to the ranks of central banks. By the time it was founded in 1998, inflation control was accepted worldwide as the principal task of most central banks, although the tools used to control inflation varied.3 Consequently, price stability was paramount from the ECB’s creation.
The Treaty on the Functioning of the European Union allows the ECB to manage the euro’s exchange rate, but this must be consistent with its primary objective of price stability. So far, the ECB has never used the provisions within the Treaty that allow it to set an exchange rate policy for the euro.4 However, it nonetheless guides euro exchange rates indirectly. The ECB’s interest rate policy and – in recent years – quantitative easing (QE) indirectly influence the exchange rate of the euro, since keeping inflation low and stable exchange rate volatility of exchange rate volatility.
The concept of European monetary union dates back to the Werner report of 1970, which insisted that “considerations of a psychological and political nature militate in favor of the adoption of sole currency which would confirm the irreversibility of the venture. For such a union only the global balance of payments of the Community vis-a-vis the outside world is of any importance.”5 But this idea was put on the back burner after the failure of the Bretton Woods system of fixed exchange rates in 1971, though most European countries made repeated attempts to control exchange rates throughout the 1970s and 80s.6
But from 1986 onwards, as European countries pursued their goal of establishing a single market for trade in goods and services, the idea of monetary union re-emerged. The existence of national currencies was widely seen as an obstacle to creating a genuinely free market, since it forced businesses to accept exchange rate risk.7 In 1980, the Delors Report recommended that the European Community (as it was then known) move towards eventually adopting a single currency, and outlined three stages by which that would be achieved.8
The Maastricht Treaty of 1992 established the “European Union” and created the framework for eventual unification of the members of the European Community as a single integrated whole.9 As part of this, most member states committed to adopting a single currency, which eliminated exchange rate risk among member states. The exceptions were Denmark and the U.K., both of which negotiated the right to retain their own currencies indefinitely and do so to this day. Of note, Switzerland is not a member of the EU or of the single currency.
The Maastricht Treaty provided for the introduction of a common monetary policy, implemented by a single and independent central bank with price stability as its primary objective. Attached to the Treaty was the draft Statute for the European System of Central Banks (ESCB), and its new central hub, the ECB.10
The ECB is the core of the ESCB, which is made up of the central banks of all European Union member states whether or not they are members of the single currency. Thus, the Bank of England is part of the ESCB, even though the U.K. issues its own currency, the pound sterling, which has a floating exchange rate to the euro. When the U.K. leaves the European Union, currently scheduled for 29 March 2019, the Bank of England will cease to be part of the ESCB.11
In 1994, the European Monetary Institute was created to oversee fiscal convergence of EU countries as a prelude to introducing a single currency. And in December 1995, in a summit in Madrid, Spain, the EU Heads of State confirmed the date at which the single currency would become functional. The new “euro” was adopted by all participating countries on 1 January 1999. Notes and coins were introduced a year or two later, and all national currencies ceased to be legal tender shortly after that.12
The introduction of the euro created a smaller grouping within the ESCB, known as the “Eurosystem.” This is made up of the national central banks (NCBs) of the countries that are members of the single currency. The ECB is their hub, and bears overall responsibility for Eurozone monetary policy. Because they don’t issue their own currencies, these NCBs have much less responsibility or influence over monetary policy than, for example, the Bank of England or the Riksbank (Sweden’s central bank), both of which are members of the ESCB but not the Eurosystem, or the Swiss National Bank, which is not a member of the ESCB (since Switzerland is not in the EU).
As primary issuer of the euro, the ECB is ultimately responsible for determining the quantity of euros in circulation.13 The ECB sets interest rates for the whole Eurozone and determines the quantity of notes and coins that each NCB can issue. Generally, the ECB uses interest rate policy to control the money supply, since commercial banks create money when they lend, and adjusting interest rates influences the amount of lending that banks will do. However, because Eurozone banks are currently not lending enough to keep inflation near the ECB’s target of 2 percent, and ECB interest rates are already at or below zero, the ECB is doing quantitative easing – buying financial assets from banks in return for newly-created euros – to increase the money in circulation directly and thus raise inflation and support growth.14
The ECB is also responsible for settling euro payments. Its real-time gross settlement system, Target2, is a crucial part of the single-market infrastructure, facilitating trade by ensuring that euros can flow fast and freely across borders. In June 2017, the ECB announced plans to introduce instantaneous euro payments via Target2 by November 2018.15
The ECB’s single mandate aims to ensure that within the countries that use it, the euro’s purchasing power is fixed and stable. But internationally, the euro’s exchange rate floats freely. For businesses, this means that exchange rate barriers to trade are eliminated within the Eurozone. But beyond the Eurozone’s borders, the euro’s exchange rate fluctuates against other international currencies, creating FX risk that businesses may wish to hedge.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“Article 127,” The Lisbon Treaty; http://www.lisbon-treaty.org/wcm/the-lisbon-treaty/treaty-on-the-functioning-of-the-european-union-and-comments/part-3-union-policies-and-internal-actions/title-viii-economic-and-monetary-policy/chapter-2-monetary-policy/395-article-127.html
2.“ECB’s Single Mandate is a Handcuff,” Wall Street Journal; https://blogs.wsj.com/marketbeat/2011/10/12/ecbs-single-mandate-is-a-handcuff/?mg=prod/accounts-wsj
3.“Objective of Monetary Policy,” European Central Bank; https://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html
4.“Foreign Exchange Operations,” European Central Bank; https://www.ecb.europa.eu/ecb/tasks/forex/html/index.en.html
5.“Economic and Monetary Union,” Werner Report; http://aei.pitt.edu/1002/1/monetary_werner_final.pdf
6.The Road to Economic and Monetary Union, European Central Bank; https://www.ecb.europa.eu/pub/pdf/other/escb_en.pdf
8.“Report on Economic and Monetary Union in the Economic Community,” Delors Report; http://ec.europa.eu/archives/emu_history/documentation/chapter13/19890412en235repeconommetary_a.pdf
9.Maastricht Treaty, European Union; https://europa.eu/european-union/sites/europaeu/files/docs/body/treaty_on_european_union_en.pdf
10.“Protocol on the Statute of the European System of Central Banks and of the European Central Bank,” European Union; https://www.ecb.europa.eu/ecb/legal/pdf/en_statute_2.pdf
11.“Europe’s Odd Man Out,” London Institute of Bankers; http://www.libf.ac.uk/docs/default-source/financial-world/10-11-paul-wallace.pdf?sfvrsn=0
12.Press release, Madrid Summit 1995, European Commission; http://europa.eu/rapid/press-release_DOC-95-9_en.htm
13.The Road to Economic and Monetary Union, European Central Bank; https://www.ecb.europa.eu/pub/pdf/other/escb_en.pdf
14.“How quantitative easing works,” European Central Bank; https://www.ecb.europa.eu/explainers/show-me/html/app_infographic.en.html
15.“ECB to develop a service for the settlement of instant payments,” European Central Bank; https://www.ecb.europa.eu/press/pr/date/2017/html/ecb.pr170622.en.html