KOC UNIVERSITY GRADUATE STUDENT WORKSHOP

A COMPARISON OF FEDERAL RESERVE AND EUROPEAN CENTRAL BANK

GIZEM KUMAS
GRADUATE OF ECONOMICS STUDENT OF INTERNATIONAL RELATIONS AT MASTERS LEVEL

BILKENT UNIVERSITY INSTITUTE OF ECONOMICS AND SOCIAL SCIENCES DEPARTMENT OF INTERNATIONAL RELATIONS MARCH 01ST, 2009

KEY CONCEPTS AND WORDS The European Central Bank (ECB) The Federal Reserve (Fed) Independence Accountability Transparency Bank supervision

ABSTRACT A Comparison of the Federal Reserve and the European Central Bank: Independence, accountability along with transparency and other responsibilities are the concepts that are first considered when a central banks structure and evolution are considered. The European Central Bank (ECB) and the Federal Reserve (Fed) are one of the most important central banks. Because of the district structure of the Fed and the composition of the ECB by several national central banks (NCBs), at first glance both institutions are considered to have similar properties. Although basically these institutions are independent and have a decentralized structure and almost use same monetary tools, they have significant differences. In this context, this paper will compare the Fed and the ECB in terms of their organization, independence, accountability, transparency and their responsibilities in bank supervision.

A COMPARISON OF THE FEDERAL RESERVE AND THE EUROPEAN CENTRAL BANK

The Federal Reserve (Fed) and the European Central Bank (ECB) are one of the central banks which embody significant importance in the world economy and monetary interactions. These central banks belong to the worlds two leading economic areas with the largest GDP shares of the world. Thus they play an important role in the monetary policies. The ECB has 15 countries within itself; on the other hand the Fed is composed of 12 districts. At the first glance, this might yield people to think that these central banks have similarities with each other. It is evident that although in various aspects they seem to have similar characteristics, there are certain differences between them. Thus this paper is going to compare and contrast the Fed and ECB by shedding light to their organization, responsibilities, independence, accountability, transparency and credibility. The first part of this paper will start with the explanation of the ECB. The process throughout its establishment and its evolution along with its structural framework will be discussed. In the second part of the paper, the Fed will be touched upon in order to yield a background for a detailed comparison of these institutions. Its establishment, objectives and structure will be mentioned in this part. The third and analytical part of this essay will compare the ECB and the Fed in terms of independence, accountability, transparency and credibility and finally their responsibilities in bank supervision. In the conclusion part, a summary of the comparison will be touched upon. I. The European Central Bank

Creation of the ECB is an evident example and so to say - evolutionary stage of the economic and monetary integration of Europe. The first attempt to create economically and monetarily integrated Europe was first mentioned in Barres Report of 1969 with an emphasis on greater co-ordination of economic policies and monetary cooperation" (Fratianni, von Hagen & Waller, 1992, 3). Werner Plan of 1970 was the blueprint of economic and monetary union in three stages. Finally Delors Report, in 1989, introduced the plan of economic and monetary union (EMU) in three stages with establishment of new institutions such as European System of Central Banks (ESCB). The first stage of the EMU started in 1990 with aims of abolishment capital controls, improvement of economic cooperation, free use of

European Currency Unit (ECU), and increased cooperation between central banks (European Central Bank, [n.d.]). In the second stage of EMU which started in 1994, the forerunner of the ECB was established under the name of European Monetary Institute (EMI). The EMI did not have any responsibility to conduct monetary policy for the European Union (EU) (which is the basic difference between the EMI and ECB), but had the objectives to strengthen central bank cooperation and monetary policy co-ordination, and to make necessary preparations for the establishment of the ESCB and the ECB (European Central Bank, [n.d.]). In accordance with Article 123 (ex Article 109l) of the Treaty establishing the European Community, the EMI went into liquidation on the establishment of the ECB in 1998. All the preparatory work entrusted to the EMI was concluded in good time and the rest of 1998 was devoted by the ECB to the final testing of systems and procedures. (European Central Bank, [n.d.]). In 1999, the third stage of the EMU started. Irrevocably fixed exchange rates and the conduct of the single currency, Euro, which composed the backbone of the third and final stage of the EMU, were under the control of the ECB. The design of the ECB in the Treaty of Maastricht was proposed to be according to two models of central banking, the Anglo - French Model and the German Model, which evolved in the post-war period. These models have different characteristics in terms of institutional design and objectives of the central bank. Grauwe (2005), on page 164, classifies the differences of these models as follows; In the Anglo French Model, the central bank pursues several objectives, such as price stability, stabilization of the business cycle, the maintenance of high employment, financial stability. On the other hand, in German Model, the main and primary objective is to achieve price stability; as the central bank has the incentive to pursue other objectives (such as financial stability and financial integration), these objectives should not affect the process of stabilization of the prices. When the institutional design is taken into consideration, these models significantly propose different positions for the central banks. The Anglo French model is characterized by the political dependence of the central bank, for instance the monetary policy decisions are subject to the governments (the minister of finances) approval. Thus in this model the decision to raise or lower the interest rate is taken by the minister of finance. (Grauwe, 2005, 164). The German Model, on the contrary, supports political independence and takes its decisions on the monetary policies without the interference of political authorities. According to these explanations, why was the ECB designed according to the German Model? In 1950s and 1960s, Keynesian policies were very popular. High growth in the

economy along with low levels of unemployment was the main objective of the monetary and fiscal authorities. However especially by the early 1970s, it has been proved that the Keynesian model holds in the short-run (Dornbusch, Fischer, Startz, 2004, 105). Besides, because of especially short-term electoral aims of the politicians, the expansionary fiscal policies increase the influence of the political authorities. On the other hand, central bank independence from the government is not only necessary to achieve lasting price stability; empirical evidence suggests also that long run inflation rates are lower in countries with independent central banks (Fratianni, von Hagen, Waller, 1992, 28) (Independence of a central bank and the inflation rates are inversely proportional. As independence of a central bank increases, the inflation rate decreases). Therefore the Deutsche Bundesbank constituted a precedent with its monetary independence. Thus it is not surprising that the Delors Committee described the future of the ECB simply as independent. (Fratianni, von Hagen, Waller, 1992, 28). The other reason for independent design of the ECB was the strong role of Germany. German authorities faced the risk of having to accept higher inflation when they entered monetary union. In order to reduce the risk, they insisted on creating a central bank that would be even more hard - nosed about inflation than they were themselves. (Grauwe, 2005, 168). The Eurosystem (or in other words, the ESCB), which is headed by the ECB, is charged of the monetary policy of the Euroland (The geographical region which uses the single currency, Euro). The Eurosystem consists of the ECB and the national central banks (NCBs) of the Euroland. One of the governing bodies of the Eurosystem is the Executive Board which is composed of the president (Mr. Jean Claude Trichet), the vice president, and four directors of the ECB (European Central Bank, [n.d.]) (elected for 7 year term). The Executive Board implements the monetary policy decisions, gives instructions to the NCBs and sets the agenda for the governing council meetings (Grauwe, 2005, 182). The Governing Council, which is the superior body of the Eurosystem, involves Executive Board and governors of 15 NCBs. It is the main decision making body of the Eurosystem. It formulates monetary policy, decides on interest rates, reserve requirements and provisions of liquidity in the system (Grauwe, 2005, 182). The members of the Governing Council do not use qualified majority voting; instead each member has one vote, since the aim of ECB is to give importance to interests of the Euroland, instead of interests of national states. Grauwe (2005) mentions that unity of decision making in the Governing Council makes the ECB decentralized in the structure. The governors of the

NCBs have a clear majority in the Governing Council (15 out of 21). This shows that there is a strong influence of the NCBs on decisions taken by the Governing Council (especially large countries have much more important influence on the decisions since they highly affect the aggregate). However in one of Grauwes previous studies on interest rates, it was shown that Eurolands aggregates on interest rates are close to the median. (Grauwe, 2005, 185-187). Thus almost every states interest meet on a common ground. In bank supervision and financial stability, the ECB shares the responsibilities with NCBs. In this context, the ECB is responsible for the monetary policies and the NCBs are responsible for the bank supervision and financial stability. Grauwe (2005) divides the responsibilities of the NCBS among the host and home countries. According to this, supervision is under the control of the home country. Meanwhile host countries are responsible for financial stability. Grauwe (2005) states that this separation of responsibilities between home and host countries does not cause a problem as long as NCB system remains segmented (which simply means domestic banks dominate in the domestic market). However Grauwe (2005) also, on page 191, mentions that the banking system in Euroland becomes increasingly integrated, rather than becoming segmented. Thus this distribution of responsibilities for financial stability in Euroland might become increasingly problematic, as the integration of NCBs increases. This would yield a need of centralization of supervisory and regulatory responsibilities. Thus ECB should take the lender of last resort function. (Grauwe, 2005, 191). II. Federal Reserve

The Federal Reserve System was created by the Federal Reserve Act, passed by the Congress in 1913 in order to provide for a safer and more flexible banking and monetary system. (The Federal Reserve System, 1984, 1). Its objectives have been changing throughout the history of the Fed according to the changing needs of the system. At first, its original purposes were to give the country an elastic currency, provide facilities for discounting commercial credits, and improve the supervision of the banking system under a decentralized bank. (The Federal Reserve System, 1984, 1). Before establishment of the Fed, the supply of bank credit and money was inelastic. This resulted in an irregular flow of credit and money and contributed to unstable economic development. (The Federal Reserve System, 1961, 2). These objectives were aspects of national monetary and economic policies. However, in time, stability and growth of the economy, a high level of employment, stability in the purchasing power of the dollar, and reasonable balance in transactions with foreign

currencies have become to be recognized as primary objectives of the governmental economic policy. (The Federal Reserve System, 1984, 1). The Fed is an independent central bank. Its decisions are not ratified by the president or any other government institutions. However the Fed has to report to the Congress. The book of the Federal Reserve System (1984, 2) uses the term of independent within the government, since the Fed has to work within the framework of the objectives of economic and financial policy established by the government. Unlike the ECB, the Fed is composed of 3 main bodies. The Board of Governors of the Fed is the decision making body of the Fed. The Board is an agency of the federal government. It consists of seven members appointed by the President and confirmed by the Senate for 14 year - terms. Basically it sets reserve requirements and approves discount rates as part of monetary policy, supervises and regulates member banks and bank holding companies, establishes and administers protective regulations in consumer finance, and finally oversees Federal Reserve Banks. (The Federal Reserve System, 1984, 5-6). The other body of the Fed is the Federal Open Market Committee (FOMC). Open market operations are the necessary tool for a central bank to implement its monetary policy with controls on money supply by buying and selling government securities or bonds. Therefore the FOMC becomes a very important body, which is responsible for determining what transactions the Fed will conduct in open markets. These operations affect the amount of the Fed balances available to depository institutions, thereby influencing overall monetary and credit conditions. (The Federal Reserve System, 2005, 11). The FOMC is composed of seven members of the Board of Governors and five of the twelve Reserve Bank presidents. The Federal Reserve Bank of New York is the permanent member; on the other hand the others serve on a rotating basis. The Federal Reserve Banks is the other and the largest body of the Federal Reserve System. It is like a network binding all central banks together. There are 12 central banks in the system located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco (The Federal Reserve System, 1984, 7). Each central bank has 3 classes named as A, B and C in order to serve for different interest groups such as commercial, agricultural, banking, industrial and public interests. Class A represents member banks (Member banks involves commercial banks, which satisfy the requirements established by the Board of the Governors in order to become a member of the System, and national banks, which are required by law to be member of the system), class

B represents public and is elected by the each Federal Reserve District, and finally class C represents public, but its members are appointed by the Board of the Governors. (The Federal Reserve System, 2005, 10). Federal Reserve Banks propose discount rates, hold reserve balances for depository institutions and lend to them at the discount window, furnish currency, collect and clear checks and transfer funds for depository institutions, and handle US government debt and cash balances. (The Federal Reserve System, 1984, 5). III. Comparison of the Fed and the ECB

The Fed and the ECB, both, have common characteristics. Basically they are both independent institutions with a decentralized structure and using basic monetary tools such as reserve requirements, and open market operations (Guttmann, n.d., 2). However these two central banks are characterized by significant differences in various fields. Even their common characteristics (as simply mentioned above) differ to some extent. First of all, the ECB and the Fed have different objectives and different methods to achieve these objectives. As mentioned before, the primary objective of the ECB is to achieve price stability; on the other hand the Fed has chosen several goals to achieve; basically safe, flexible and stable monetary stability and financial system. For monetary policy of the Euroland, there are two pillars which serve as intermediary targets. The first pillar, which plays a prominent role for the assessment of price stability is the development of the monetary aggregate M3 (basically the broadest explanation of the money circulation), and the second pillar is a broadly based assessment of the outlook for future price developments, which basically amounts to inflation forecast. On the other hand, the Fed does not have explicit intermediary targets. (Heron, 2005, 15). Independence of a central bank is an issue which has evident importance in the functioning and implementation of monetary and economic policies. According to Gkbudak (1996), there are two types of independence; political and economic independence. Political independence is defined as the ability of the central bank to determine its policy objectives free from the government influence. On the other hand, economic independence is the ability of the central bank in determining and implementing its policies freely to achieve its objectives. (Gkbudak, 1996, 4). In virtue of these definitions, the first element for measuring the independence must be the way of appointment of the members of the central banks body. As mentioned above, the members of the Board of the Fed are all appointed by the President of USA and approved by the Senate. On the other hand, unlike in the US, the

nomination process does not comprise a confirmation procedure; the European Parliament has no power to enforce its decision or legally to prevent a nomination. (Plath &Schioppa, 2000, 13). Thus no power can change the statues of ECB, because these changes can only be done by changing the Maastricht Treaty which requires unanimity of all EU member states (Grauwe, 2005). In addition to these, strong pressures on inflation and employment by financial institutions upon central banks create political dependence. Central bank governors mainly try to fight against inflation; however politicians want to have low unemployment and pay the debts. This conflict within the economic policies limits the independence. Besides, according to Gkbudak (1996), the central bank cannot be truly independent if the government controls the exchange rate. In Euroland, exchange rate policy is not a national policy. On the contrary the Fed, as touched upon earlier, works within the framework of the policies decided upon by the government. There are several indicators of independence such as who sets the targets?, who formulates the policy?, what are the limitations on lending to governments?, and what is the length of the terms of office?(Grauwe, 2005, 177). With these indicators, the study concludes that the ECB is the most independent central bank, followed by the Bundesbank and the Fed. (Grauwe, 2005, 177). The optimal relation between independence and accountability is directly proportional (Grauwe, 2005, 177), and in addition to independence, accountability is another element that differs from the ECB to the Fed. First of all, in the Treaty of Maastricht, the ECB was designed as independent without any superior power upon itself to control and mandate its policies. On the other hand, the governors of the Fed are appointed by the president of the US and approved by the Senate. Thus the Fed is responsible to Congress which has the power to affect the internal circumstance of the Fed. By simple majority voting and through interventions by laws the structure and the functions of the Fed can change. The US legislation makes the Fed responsible for all movements in employment. (Grauwe, 2005, 179). Conversely, as mentioned, absence of strong political institutions in Europe capable of exerting control over the performance of the ECB is one of the weaknesses of accountability of the ECB. (Grauwe, 2005, 179). In addition, although the main objective of the ECB is to maintain price stability which is to fight against inflation, in the Treaty of Maastricht, the objectives (apart from price stability) and the ways how to achieve these objectives are not precisely defined (Plath & Schioppa,

2000, 8). This causes vagueness in the objectives of the ECB. As the primary objective of the ECB is to maintain price stability, at the same time, the Treaty mandates the ECB to support the general economic policies of the Community, provided this does not interfere with price stability (Grauwe, 2005, 178). Vagueness in the objectives of the ECB limits its accountability. Actually the reason of this vagueness might be long-term and slow interactions between states (Grauwe, 2005, 179). Political bureaucracy might slow down and also affect the accountability of the ECB. This is another reason for the ECB to be less accountable. Accountability brings also transparency issue into consideration to be discussed. Transparency is defined as one of the ways to achieve informal accountability of a central bank in Grauwes book (2005, 187). Transparency means that the central bank provides the general public and the markets with all relevant information on its strategy, assessments and policy decisions as well as its procedures in an open, clear and timely manner. (Begg, n.d., 3). According to Mariscal (2003, 19), an increase in monetary policy transparency should reduce the degree of policy surprise at the short end of the yield curve. This points out that if a central bank is transparent in its policy implementations financial institutions can have better and clear expectations about the markets, and can eliminate uncertainties especially on exchange rates. Besides, analysis of transcripts of the FOMC shows that increased transparency can have the effect of reducing the freedom of committee members to express discordant views, (Begg, n.d., 11) and also the Fed believes that the volatility of financial markets can be retrained by a transparent decision making process. (Plath & Schioppa, 2000, 16). Through gazing this information, it can be concluded as; the president of central bank should explain central banks decisions and its reasons to press. Since transparency is directly related with accountability, it can be stated that the ECB is less transparent than the Fed. Although the ECB is open to external monitoring on the part of the Commission and Ecofin Council principally (Stolfi, 1999, 9), minutes of the Governing Council of the ECB are not published, because the Treaty prevents such an announcement with an aim of precluding emergence of national-interests in the monetary policies. The main logic is that since the ECB takes its decisions without considering national-interests, these minutes should not be announced in order to be able to implement whole Euroland based policies. On the contrary, as the Board of Governors of the Fed is required to submit a number of reports to the Congress, including annual report on its operations and special reports twice each year on the state of the economy and the systems objectives for the growth of money and credit, it also makes available detailed statistics and other information about the systems activities

through a variety of publications such as the monthly Federal Reserve Bulletin. (The Federal Reserve System, 1984, 6). In order to become more accountable, the ECB should become more transparent. Besides, increasing the accountability of a central bank can also be achieved by inflation targeting method. This is another element for informal accountability (Grauwe, 2005, 179). By announcing a certain inflation target, future expectations will be much clearer. This will also enable the central banks to increase their credibility along with the effective price stability when independence is granted from the short term political influences. Recognizing the importance of a sound banking system to the health of the economy and financial markets, The Fed shares the responsibility with other federal banking agencies to establish a more effective supervision of banking. (The Federal Reserve System, 1984, 87). The Feds responsibilities include; supervision and regulation of state charted banks, of US activities of foreign banking organizations, regulation of the US commercial banking and of foreign activities of all US commercial banking organization within the Federal Reserve System. (The Federal Reserve System, 2005, 67). On the other hand, in Euroland, the responsibility of banking supervision is in the hands of nation states. There is a separation between the controls and the responsibilities; home country control and host country responsibility. As host countries are mainly responsible for financial stability within their country, the home countries control and supervise the banking system. IV. Conclusion:

The Fed and the ECB are one of the worlds important central banks. Despite the fact that there are some similar properties of these central banks, there are significant differences between these institutions. First of all, objectives and the methods used to achieve these objectives differ from each other. Besides, independence of these two central banks is different. Due to reasons mentioned above it can be concluded that the ECB is more independent than the Fed. On the contrary vagueness in defining the aims of the ECB and political bureaucracy negatively affect the accountability of the ECB, conversely the governors of the Fed are elected by the President and approved by the Senate; the Fed has responsibility toward the Senate in its decisions and in the methods it implements to achieve these decisions. Besides the Fed publishes all its steps it takes in monetary policy in monthly reports to the Senate, consequently to the public. Thus it can be said that the Fed is more accountable than the ECB.

The other point that must be mentioned is transparency when accountability is taken into consideration. Due to reasons mentioned above and since the Fed is more accountable, it is evident to say that the Fed is more transparent than the ECB. Also points to make the ECB earn informal accountability have been discussed. Besides, their responsibilities and tasks in banking supervision of these two central banks have shown that they differ from each other. The monetary system in which the Fed is involved is more segmented. On the other hand, the Euroland banking system is not segmented because of enlargement, instead it is integrated.

REFERENCES Begg, I. (n.d.). Economic policy and institutional transparency: the ECB. Retrieved November 20, 2008, from www.qub.ac.uk/polproj/reneg/contested_meanings/Begg_transparency _draft %20aug05.doc Dornbusch, R, Fisher, S. & Startz, R. (2004). Macroeconomics. (9th Edition). McGraw Hill, Singapore. Fratianni, M., von Hagen J. & Waller, C. (1992). The Maastricht way to EMU. Princeton University Press, Princeton, New Jersey. Grauwe, P.D. (2005). Economics of Monetary Union. Oxford University Press, New York. Gkbudak, N. (1996). Central bank independence, the Bundesbank experience and the central bank of the Republic of Turkey. Retrieved: November 17, 2008 from http://www.tcmb.gov.tr/yeni/evds/teblig/96/9610.pdf Guttmann, R. (n.d.). Central banking in a debt-deflation crisis: a comparison of the FED and ECB. Retrieved November 20, 2008, from http://www.univparis13.fr/CEPN/texte_guttmann_210308.pdf Heron, E.L. (2005). The new governance in monetary policy: a critical appraisal of the Fed and the ECB. Macroeconomics and Macroeconomic Policies. Retrieved November 20, 2008 from http://www.boeckler.de/pdf/v_2005_10_28_leheron.pdf Mariscal, I.B. & Howells, P. (2003). Transparency and uncertainty: A comparison between the Bank of England and the Bundesbank/ECB. Retrieved: November 17, 2008 from ideas.repec.org/p/uwe/wpaper/0508.html Plath, C.R. & Schioppa, T.P. (2000). The European Central Bank: independence and accountability. Zentrum fr Europische Integrationsforschung, Berlin. Retrieved November 20, 2008, from http://www.zei.de/download/zei_wp/B00-16.pdf Ruckriegel, K. & Seitz, F. (2002). The Euro system and the Federal Reserve system compared: facts and challenges. Zentrum fr Europische Integrationsforschund, Berlin. Retrieved November 20, 2008, from http://www.uni-mannheim.de/edz/pdf/zei/b02-02.pdf

The European Central Bank (n.d.). History of the European Central Bank. Retrieved November 20, 2008, from http://www.ecb.int/ecb/history/emu/html/index.en.html The Federal Reserve System; Purposes and functions (1961). Board of Governors of the Federal Reserve System, Washington D.C. The Federal Reserve System; Purposes and functions (1984). Board of Governors of the Federal Reserve System, Washington D.C. The Federal Reserve System; Purposes and functions (2005). Board of Governors of the Federal Reserve System, Washington D.C. Retrieved November 20, 2008, from http://www.federalreserve.gov/pf/pdf/pf_complete.pdf Stolfi, F. (1999). The accountability of the European Central Bank: sketching a comparative perspective. Retrieved November 20, 2008, from http://aei.pitt.edu/2398/