When financial market liquidity dried up in August, it was the European Central Bank that led the charge in making funds available to member banks. This was a notable step for a central bank that has yet to celebrate its tenth anniversary. Internationally it has gradually earned its spurs while within the European Union it frequently has been under attack, especially from national leaders frustrated by their lack of control over an integral part of economic policy.

The ECB was organized to be independent of political influence. This is clearly delineated in both the Maastricht Treaty and in its statute. Neither the ECB, the national central banks nor any decision-making body members are allowed to seek or take instructions from European Community institutions, from any EU Member State government or from any other body. Monetary policy’s mandated goal is to control inflation. But this focus raises questions about whether a one-size-fits-all monetary policy really works given the disparate economies and growth levels among the 13 EMU Member States. This almost myopic focus on inflation has raised the ire of some politicians who would like to see other targets for the central bank such as growth and employment. Some would like to have some influence on decision making as well.

One of the key elements to the European Union’s economic policy is the sharp division between fiscal and monetary policy. While fiscal policy remains in the hands of the national governments, monetary policy rests with the multinational ECB. This leaves little coordination between the two. The EU’s attempt at controlling fiscal policy has been honored in the breach, even within the guidelines of the revised Stability and Growth Pact that have loosened fiscal controls and give most countries a way around fiscal discipline. But just as deficits ballooned early in this decade when economic growth languished, now most deficits have declined as a percent of gross domestic product as economic growth became vibrant.

The European Central Bank (ECB) is the guardian of price stability. Founded in June 1998 as the successor to the European Monetary Institute, its structure is loosely based on America’s Federal Reserve (though the ECB is far more decentralized). Monetary policy is formulated by the ECB’s Governing Council, on which sit the six-member Executive Board, including the Bank’s president, Jean Claude Trichet, and the central bank governors of the 13 euro-area countries.

Since its inception, the ECB has been trying to build its credibility. It is extremely conscious of its independence and protects it with zeal. Any attempt at political intervention in its affairs only seems to solidify its position in the opposite direction. The ECB’s independence is conducive to maintaining price stability above all other considerations. The ECB has been steadfast in rebuffing verbal assaults. But this independence has been and continues to be under attack by political leaders most recently by the new president of France, Nicolas Sarkozy. The ECB has been blamed for virtually all of France’s economic ills but the war of words has been ironically between two Frenchmen — President Sarkozy and ECB President Jean Claude Trichet (he was previously the President of the Bank of France).

Financial markets prefer a monetary authority that is free from political interference and the ECB had been organized with that in mind. While the EMU languished in anemic growth during the first several years of the new century, politicians called on the ECB to lower interest rates from 2 percent. The Bank steadfastly refused sticking to their focus on the 2 percent inflation target. Ultimately growth improved without lowering rates as did growth elsewhere. The ECB then began to increase interest rates at a measured pace and were expected to continue to do so before the onset of the liquidity crunch and market turmoil in August.

The ECB is unique in that it is a central bank for many nations and its committees are composed of the heads of the member country central banks including the once powerful German Bundesbank. The Bank’s design and focus were very much influenced by the Bundesbank and follow many of its ways of doing business. However, there are similarities with the U.S. Federal Reserve System as well. The Fed is split somewhat arbitrarily into 12 regional banks, while the ECB has 13 national banks which originally were the central banks of the Member States. This number will increase as more EU countries become members of the European Monetary Union. But while all national banks have a vote at the monthly governing council meetings, the Fed’s 12 regional banks rotate with four voting each year. The exception is the New York Fed which has its own FOMC seat in perpetuity because it is the only bank that conducts market operations. In contrast, eurozone national banks still conduct many of the operations they did when they were independent central banks. They conduct market operations, are more active in bank supervision and have two-thirds of the votes at each ECB rate decision. But when more of the European Union's 27 members join the single currency, this system could become unworkable.

One of the organizational issues that the ill-fated EU constitution addressed was this potential roadblock of too many governing council members (not only at the ECB but at other EU institutions as well). When France and the Netherlands voted to reject the new EU constitution in May and June 2005, a restructuring of the ECB decision-making process also came to a halt along with many other proposals to streamline EU operations. Essentially the governing council would adopt an arrangement similar to that of the FOMC where there would be permanent members with others revolving like the regional Federal Reserve Banks. German chancellor Angela Merkel, EU president for the first six months of 2007, tried to revive the moribund constitution without success. The constitution remains at sea, with many members balking at ratification despite changes in the text. Smaller countries are balking because they feel that the EU is evolving into a two-tier organization where they would have diminished power. But Germany is especially keen to stick to most of the present text, if only because the new voting system in the council would substantially increase its weight.

The ECB decides monetary policy, and member national central banks (NCBs) implement it. Together these banks form the European System of Central Banks (ESCB). The member banks of the ECB include Nationale Bank van België/Banque Nationale de Belgique, Deutsche Bundesbank, Banque de France, Banco de España, Banca d’Italia, Banco de Portugal, Bank of Greece, Banque centrale du Luxembourg, De Nederlandsche Bank, Central Bank and Financial Services Authority of Ireland, Oesterreichische Nationalbank, Suomen Pankki–Finlands Bank and The Bank of Slovenia. The three non-ECB members are the Bank of England, Danmarks Nationalbank and Sveriges Riksbank.

Bottom line

In 2002, the ECB oversaw the successful conversion of national currencies (deutschmark, franc, lira, drachma, etc.) to the euro for all transactions. This has been one of the ECB’s major successes. The currency is accepted as a primary currency of the industrial world only superseded by the U.S. dollar.

The ECB focuses on inflation regardless of the circumstance. Even in this recent upheaval in the financial markets, ECB president Trichet made a distinction between its monetary policy activities and those that ensure the proper functioning of money markets. He said that the institution's actions to provide liquidity were not part of its monetary policy responsibilities because it was not linked to its broader inflation-fighting responsibilities. Some analysts will argue about that.