ECB 101: A guide for beginners

As most of you will be easily able to deduct from this article, I am very interested in monetary policy, but I often feel like outside the ‘economics world’ only a few people actually have knowledge about the functioning of the European Central Bank (ECB). This article aims at filling these gaps in a very concise way, outlining only the most relevant aspects of this complex machine.

1. What is the ECB?

The history of this institution officially starts in 1992 with the Treaty of Maastricht, which formalized the intention to create the European Monetary Union (EMU). Today the EMU comprises the European System of Central Banks (ESCB), composed of the ECB and the national central banks (NCBs) of the 28 member countries of the EU, and the Eurosystem, composed of the ECB and the NCBs of the 19 European countries that have adopted the euro.

On the 1st of January 1999 the ECB, located in Frankfurt, Germany, assumed responsibility for monetary policy in the euro area (by definition, the 19 out of the 28 countries that have adopted the euro), and finally on the 1st of January 2002, the euro started to replace national currencies.

2. How is the ECB governed?

In the Eurosystem, there are three decision making bodies that we have to consider: the Governing Council, the Executive Board and the General Council.

The Governing Council is composed of six members of the Executive Board, including the President of the ECB, and the 19 governors of the NCBs . This body meets twice a month, even though press conferences to inform the public about its decisions are held only every six weeks. In the first meeting of the month, the Council formulates decisions regarding the conduct of monetary policy in the euro area by setting the key interest rates, while in the second meeting they establish guidelines regarding the practical implementation of these goals. Decisions are always taken by consensus (without the need for a formal vote) and the members of the Council are assumed not to act as national representatives but in an independent manner with the aim to safeguard the euro. However, theory and practice sometimes differ considerably: in fact, multiple times we have experienced situations in which members voted to promote the interests of their own countries, as in the case of the debate about the banking union. This is one of the most important criticism of the ECB raised by Eurosceptics parties.

The Executive Board is composed of the President and the Vice-President of the ECB and four other members appointed by unanimous agreement of the Heads of State or Government of the EU countries. This body is in charge of running the ECB, for example preparing the meetings of the Governing Council.

The General Council is composed of the President and the Vice President of the ECB and the governors of the NCBs of the 28 EU member states. This body is not involved in the design of monetary policy but is responsible for the coordination of goals and objectives of the different countries and for preparing countries for the transition from their national currency to the euro.

3. What is monetary policy?

Now it is time to explain what the statement “central banks are responsible for the conduct of monetary policy” actually means. Stripping this statement to the bones, we can say that conducting monetary policy means setting three key interest rates, which in Europe are called: marginal lending facility, deposit facility and main refinancing operations. These three rates are related to the exchange market for reserves, where reserves is additional money commercial banks have and which is in that particular moment not necessary for their operations.

In this market above described, banks can either borrow or lend reserves from and to other banks as they like and based on their needs. However, they can also decide to deposit this money at the ECB and earn the deposit facility rate or to borrow from the ECB paying the marginal lending rate. But commercial banks will only want to borrow (deposit) money from (at) the ECB if other commercial banks are lending (borrowing) their reserves at higher (lower) rates than the ECB. Therefore, these two options will occur only in extreme circumstances in which the markets are not self-sufficient, constructing a corridor within which the actual rate fluctuates. By fixing the lower and the upper bound rates, the ECB conducts monetary policy. These are also the rates the newspaper refer to when they cover the decisions communicated during the ECB press conferences.

4. How independent is the ECB?

One of the hottest topics debated in the economic literature is the independence of central banks. Here is a list of the most important arguments made both in favor and against it:

The critics of central bank independence state that, since monetary and fiscal policy affect citizens in the same way (broadly speaking), the former needs to be subject to the same accountability process as the latter. In particular, it is not considered fair that citizens have the possibility to elect politicians (who decide about government spending) while they cannot elect central bankers and governors.

The supporters of central bank independence will argue, instead, that political interference in the conduct of monetary policy will lead to political business cycles (meaning, expansionary policy before and contractionary policy after elections). Moreover, independence may cause a shift of focus: politicians, if given control of the central bank, are more likely to focus on achieving short run objectives simply to show some concrete results of their actions, such as lower unemployment or higher economic growth, at the expense of long run objectives like price stability. Empirical evidence shows that a negative correlation exists between central bank independence and inflationary pressures.

Let’s now move to the most important questions: how independent is the ECB? There exist two different types of independence when considering the central banks: goal independence and instrument independence.

The founding treaties established that the ECB is independent of political decisions of the member states and its deliberations are to be considered irreversible; this provides evidence in support of the instrument independence.

Price stability is one of the goals of the ECB mandate (along with achieving a low level of unemployment and facilitating economic growth with low inflation), but since the ECB can freely choose how to interpret these objectives in terms of a in terms of the rate of inflation it targets, we can prove also goal independence.

Further elements supporting the independence of the ECB are the fact that it has its own budget and subscribed capital, as well as the long non-renewable term of office of the members of the Governing Council (eight years for the Executive Board members and at least a five-year term for the governors of the NCBs).

5. Where can I learn more about the ECB?

Based on the calendar available on the website, the next press conference following the meeting of the Governing Council will be held on the 12th of December, so if I have been able to stimulate at least a bit your curiosity, I highly suggest you to watch it.

Disclaimer: All the images above portray the institutional bodies as they were in the eight years of Mario Draghi's presidency; therefore, they might be subject to change with the inauguration of the new legislature.