European Central Bank

The European Central Bank (ECB) was created in 1998 to serve as the central bank representing the interests of the countries belonging to the European Union. Based in Frankfurt, the ECB General Council replaced the European Monetary Institute (EMI) originally created in 1994 to improve cooperation between the European Union nations. The EMI was dissolved once the European Central Bank was established.

To understand the events leading up to the creation of the European Union, we need to look at the conditions that existed at the end of the First World War as well as some of the early trade and economic agreements in the region. While this timeline summary is by no means complete, it does highlight the most critical developments that ultimately led to the formation of the European Union and the European Central Bank.

History of the European Union

Prior to World War I, there existed several European country alliances that, for the most part, were driven more for political reasons than to achieve economic goals. These political alignments were a major contributor to the conditions that led to both World Wars. However, after World War II and the resulting devastation of the European economies, discussions for inter-state agreements took on a decidedly economic tone. Creating a common market to reduce trade restrictions and share resources and technologies was seen as the most effective means to rebuild the area’s financial system. It was also hoped that forging strong economic and social ties between former enemies could prevent another round of hostilities as was the case after World War I, leading directly to World War II a mere twenty years later. All of Europe was keen to prevent the same thing happening again.

To underscore this desire, several prominent leaders at the time called for a partnership of nations that would replace the old, pre-war alliances. Winston Churchill, in his 1946 speech to the Academic Youth, called for an end to the “frightful nationalistic quarrels” resulting from the collection of “ancient states and nations” that existed in Europe. His solution was to “build a kind of United States of Europe” that shared a common bond and a common goal.^[1]

In this article, we will look at some of the treaties and agreements to see how this union of European nations came about. While this list is not inclusive of all the treaties and agreements over the years, the ones that played the greatest role in defining the thinking that ultimately led to the European Union and the creation of a single, European central bank are described together with the effect they had on the countries involved.

The Council of Europe - 1949

By 1949, the first post-war organization of free European countries – the Council of Europe (COE) – was formed. The COE mandate was to “develop throughout Europe common and democratic principles based on the European Convention on Human Rights”.^[2] Today, the Council of Europe contains forty-seven member countries with five national observer countries including the Holy See, the United States, Canada, Japan, and Mexico. For more information, please see the Council’s website.]

Treaty of Paris - 1951

During the war years (1939-1945), coal and steel – two vital commodities required for heavy manufacturing – had been used almost exclusively for the war effort. In order to share scarce resources and convert manufacturing facilities back to peacetime pursuits, a new binding agreement was drafted to help all the affected national infrastructures recover from the devastation brought on by six years of fighting. ^[3]

In 1951, the Treaty of Paris was signed by six countries; it created the European Coal and Steel Community (ECSC) and was formally adopted on April 18th, 1951. The ECSC was a critical breakthrough and would become the blueprint for recovery for the entire region. It was the first of a series of European Community treaties and the basic premise of this agreement stayed in place until the ECSC was replaced by the European Union in 2002.

The original members of the ECSC were:

• Belgium
• France
• Italy
• Luxembourg
• the Netherlands
• the Federal Republic of Germany

Treaty of Rome – 1957

The Treaty of Rome created the European Economic Community (EEC) which expanded the trade agreement first developed by the Treaty of Paris. Whereas the original plan focused on coal and steel, the EEC included a much wider range of goods and allowed for the free movement of capital and people within the participating states. The treaty also formed the European Atomic Energy Community (EURATOM) which facilitated the sharing of technology and set usage rules for the emerging nuclear energy industry.

The 1957 agreement also created four new institutions designed to provide the administrative tasks required to take on the increasing levels of cooperation between the various communities. These were:

• The European Commission
• The Council of the European Union
• The European Parliament
• The European Court of Justice

The European Commission

The European Commission can propose new laws, but these laws must be ratified by the European Parliament before they become binding for the euro countries. The Commission operates at a supranational level, meaning that decisions are made by international institutions and not by individual countries.

Each member nation of the Commission is represented by a Commissioner who serves a five-year term. In addition to promoting the issues of their native country, Commissioners also take on the oversight of a particular area such as agriculture, finance, and education. ^[4]

The Council of the European Union

More commonly known as the Council of Ministers, this organization consists of government officials from each member state. While it does not have the mandate to propose new laws, any law put forward by the Commission must be ratified by the Council before becoming law.

European Parliament

Members of the European Parliament are the only European Union institution that are elected by the citizens of Europe. However, Parliament does not have the legislative authority of a traditional parliament such the British or Canadian Parliaments and cannot develop and legislate new laws.

The European Parliament’s contribution is to provide an additional review of all new proposals. It can choose to accept new laws as presented or can recommend amendments. It can also reject outright any new laws thus preventing them from becoming law.

From an accountability standpoint, the European Parliament is a critical institution as it is the only legislative body for which citizens can vote directly. Critics of the system note however, that the European Parliament has very little ability to effect new changes. ^[5]

European Court of Justice

The European Court of Justice was established to enforce laws applicable to the entire euro area. It is the highest court in the EU and even out-ranks supreme courts of the member nations. The Court consists of one judge from each member state as well as eight Advocates-General. Members of the court are appointed by their home country and serve six-year terms.

European Union Expansion

With the signing of the Treaty of Rome in 1957, it would seem that Churchill’s vision of forming economic bonds and fostering a greater understanding between European countries was firmly taking root. The original six nations now had three “communities” in which they worked together for a common goal; the European Coal and Steel Community, the European Economic Community, and the European Atomic Energy Community. In 1967, the original treaties were amended under the Treaty of Nice to merge the three communities into one organization called, simply, the European Communities (EC).

Starting in 1973, the European Communities experienced its first expansion since the Treaty of Rome in 1957. Further expansions soon followed and are summarized in the table below:

The Treaty of Maastricht - 1992

The Treaty of Maastricht – also known as the Treaty on European Union – officially replaced the European Communities with a new entity – the European Union, or EU. The EU is the culmination of a series of events forging closer economic and social ties between the members of the European Communities. The Treaty of Maastricht was negotiated to accomplish five specific goals:^[6]

• strengthen the democratic legitimacy of the institutions
• improve the effectiveness of the institutions
• establish economic and monetary union
• develop the Community social dimension
• establish a common foreign and security policy

The Three Pillars

In order to meet these objectives, the EU members put forward the concept of the three pillars as described below:

Pillar 1 – European Community

The concept of the European Community was formalized by this treaty which recognized the need for member states to share their sovereignty with all members of the community of EU nations. From this point forward, laws proposed by the European Commission and adopted and approved by the Council and European Parliament were enforced by a European Court of Justice and applied equally to all EU countries.

Pillar 2 – Common Foreign and Security Policy

The second pillar of the Maastricht Treaty provides for a common foreign and security policy replacing an earlier agreement known as the Single European Act. This pillar provides for a decision-making process that enables the EU to make decisions on behalf of all the member countries as single entity. The Commission and Parliament are involved in this process.

Pillar 3 – Police and Judicial Cooperation

This pillar provides guidance for cooperation with respect to justice and home affairs (JHA). This section of the treaty outlines an approach for ensuring all European citizens receive a high level of protection with respect to freedom, security, and justice, regardless of the country in which they reside.

=== Economic and Monetary Union ===

The fulfillment of the Economic and Monetary Union (EMU) as detailed in the Treaty of Maastricht calls for the implementation of a European Union that shares the same laws and citizenship, as well as a common currency and monetary system. The EMU was designed specifically to implement a single currency with a system of central banks to ensure the stability of the currency on the global markets. ^[7]

In order to do this, the Maastricht Treaty defined a staged approach:

Stage 1 – the liberalization of the movement of capital between the EU countries (Jan 1, 1990)

Stage 2 – convergence of the economic policies of all the member countries (Jan 1, 1994)

Stage 3 – establishment of the euro as the single currency and the creation of the Central European Bank (CEB) to serve as the central bank for the European Union (Jan 1, 1999)

A Common European Union Citizenship

With the movement to create a union of European nations, the next logical step was the creation of a European Union citizenship that is “over and above national citizenship”.^[8] The Treaty of Maastricht created a new citizenship that automatically included every citizen of the EU member states and provides citizens with:

• The right to move and reside freely anywhere within the EU
• The right to vote and stand as a candidate for the European and municipal elections in the state in which they reside
• The right to protection by the diplomatic or consular authorities of any member state without regard for the member state citizenship for that individual
• The right to petition the European Parliament and to submit a complaint to the Ombudsman

The Treaty of Maastricht is important because for the first time, the concept of EU citizenship was clearly documented, permitting European citizens to move freely within all member countries. Most importantly however, the Treaty of Maastricht established a timetable for an even tighter economic and monetary integration as well as guidelines for the entry of more countries into the new European Union.

Several more EU expansions occurred after the Treaty of Maastricht was signed and amendments were approved allowing for the entry of the following countries into the European Union:

Today, the EU has grown to be the world’s largest market as reported by the International Monetary Fund (IMF). In 2006, the IMF pegged the EU’s GDP at more than 14.5 trillion USD.^[9] This tops the number two U.S. economy by more than 1 trillion USD. More countries are set to join the EU with Turkey and Croatia presently working towards meeting the requirements to join.

Mandate of the European Central Bank

The mandate for what would become the formal European Central Bank (ECB) was first identified in the 1957 Treaty of Rome. This agreement established the European Economic Community (EEC) and identified the maintenance and protection of price stability as the single-most important goal of the central banks for each of the member countries. This same mandate became the goal of the new European Central Bank when it assumed responsibility for the Eurozone on January 1, 1999. ^[10]

In addition to implementing monetary policy decisions to maintain price stability, the ECB is also responsible for the following:

• Banknotes – the ECB has the exclusive right to authorize the issuance of banknotes within the euro area
• Statistics – in cooperating with the National Central Banks (NCBs), the ECB collects economic details used for planning monetary policy
• Financial Stability and Supervision – the Eurosystem contributes to the smooth conduct of policies pursued by the authorities in charge related to the prudential supervision of credit institutions and the stability of the financial system
• International and European cooperation – the ECB maintains working relations with relevant institutions, bodies and forums both within the EU and internationally with respect to tasks entrusted to the Eurosystem.

European Central Bank and the European System of Central Banks

The Treaty of Nice (1967) amended the 1957 Treaty of Rome and included a proposal to merge the existing European Communities (Coal and Steel, European Economic Community, and the Atomic Energy community into a single entity known simply as the “European Communities” (EC).

This treaty also established a three-stage plan to create a single currency and monetary policy for the euro area by creating the European System of Central Banks (ESCB). The ESCB consists of the European Central Bank (ECB) as well as the national central banks (NCBs) for each of the member nations. The ESCB officially became law for the countries participating in the ESCB on January 1, 1999 – this date also saw the introduction of the Euro as the official currency for the euro area, replacing the native currencies of each country.

Not all countries comprising the European Union signed on to be part of the ESCB however, with the U.K. being the most prominent country not to join. In order to distinguish between the EU countries and the European System of Central Banks participants, the term Eurosystem is used when referring to the ESCB countries. Note that the premise is that eventually all EU members will adopt the euro at which point the term “Eurosystem” will be replaced by “European System of Central Banks”.

The Governing Council

The Governing Council is responsible for providing direction for the ECB and makes final decisions with regards to policy. It consists of the six members of the Executive Board as well as the governors of each of the national central banks for each of the countries in the Eurosystem – as of the date of this article, there were thirteen euro area countries in the Eurosystem.

Governing Council Responsibilities

The responsibilities of the Governing Council can be summarized as:

• Working within the ECB guidelines, make the appropriate decisions to ensure the Eurosystem and ESCB functions as intended
• Analyzing current conditions, formulate monetary policy that ensures the euro area meets monetary objectives.
• Determine and implement best practices with regards to interest rates and the supply of reserve funds within the Eurosystem.

The Governing Council meets twice a month at the ECB headquarters located in the Eurotower in Frankfurt am Main, Germany. The first meeting of each month is given to the assessment of current economic conditions and the preparation of an action plan based on the assessment. While the minutes of these meetings are not made public, the ECB President and Vice-President hold a press conference shortly after the meeting and announce any monetary policy decisions.

Executive Board

The Executive Board is the senior policy setting organization and consists of the President of the ECB, the Vice-President, and four other members from the Governing Council. All members of the Executive Board are appointed by common agreement by the Heads of State of the Eurozone countries. The terms are for eight years and are non-renewable.

The General Council

The General Council was established to serve as a transitional body replacing the European Monetary Institute (EMI) created in 1994 as part of the European Union agreement. However, because not all EU member states have joined the Economic and Monetary Union (EMU) – which is the third stage of the Treaty of Maastricht – a forum was still required to represent the interests of all EU countries in financial matters; this role is fulfilled by the General Counsel.

The General Council is made up of the President and Vice-President of the ECB as well as the Governors of each member state’s central banks. While only thirteen EU countries have formally joined the EMU at this time, all twenty-seven members of the European Union have a seat on the General Council.

The General Council performs the following functions:

• Prepares the ECB annual reports
• Collects macroeconomic statistical information
• Provides expert advise to various sub-committees at the ECB
• Determines the approach for standardizing accounting and reporting of ECB operations
• Establishes the irrevocable exchange rate of EU member states against the euro

ECB Accountability

The ECB is required to provide a report at least once every two years that evaluates the progress made by the member states with regards to meeting and upholding the goals of the EMU.

Required Reporting

The ECB is required to publish the following documents:

• Monthly Bulletin

The Monthly Bulletin explains all monetary policy decisions made during the reporting period. The Monthly Bulletin also includes a detailed analysis of the current economic situation and outlines future risks and concerns to price stability. It is an important document for market watchers as it explains any concerns the ECB may have with the economy and may help predict future ECB policy moves.

• Quarterly Report

Produced in the same format as the Monthly Bulletin but data range is for the most recently ended quarter.

• Annual Report

The Annual Report covers the entire European System of Central Banks and provides information on the monetary policy for the past year. Some of the sections in this report include:

• Economic developments and monetary policy
• Central bank operations and activities
• Financial stability and integration
• European and international issues
• Accountability

• Weekly consolidated Financial Statement

The ECB also produces a series of reports and documents for specific areas of interest. These materials include:

• Statistics Pocket Book

This is a small, portable publication that is published every month together with the Monthly Bulletin. It is intended to be a “quick guide” version of the Monthly Report and contains selected macroeconomic data for individual member states of the European Union.

• Convergence Reports

The ECB is required to produce a report at least once every two years that evaluates the progress made by member states with regards to their obligations towards the achievement of a complete economic and monetary union.

• Economic Research Papers

The ECB publishes monetary and economic research documents in its Working Paper Series. These materials are intended for policy-makers, academics, the media, and the general public and are intended to make the ECB as transparent as possible. In addition, non-economic papers but with topics that are still relevant to EU citizens are published under the Occasional Paper Series.

Internal Controls

Internal auditing of the European Central Bank is conducted by the Directorate Internal Audit which reports directly to the Executive Board. The internal control structure is aligned by function with each organizational unit being responsible for its own control and efficiency.

One of the controls that must be carefully managed is the prevention of insider information from areas responsible for monetary policy reaching divisions responsible for managing the ECB’s foreign reserves and its own funds portfolio. Allowing the funds management division to profit on the basis of knowing in advance moves by the ECB would give them an unfair advantage over market counterparties. This would simply be unacceptable in a true free market, and in order to prevent this, the ECB employs a set of rules and procedures known euphemistically as a Chinese wall.

External Controls

Independent audit firms provide an external review of the ECB’s annual accounts as well as the operational efficiency of the management of the ECB. These audit reports are made public and are published as part of the ECB Annual Report.

European Central Bank Monetary Policy

Like most other central banks the European Central Bank (ECB) relies on open market operations to influence short-term interest rates in order to manage the Eurosystem’s money supply. The ECB also uses public messages and press releases to indicate its position with respect to monetary policy.

European Central Bank Policy Objectives

The ECB monetary policy centres on the maintenance of price stability as a way to encourage low inflation and high employment. To make it possible to measure results, the ECB has adopted the following benchmarks:

• The ECB’s Governing Council defines price stability as “a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%”.
• In addition, the ECB has adopted the measuring of inflation as a reference as well by stating that “in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term”.

While the ECB does not use inflation targets as its primary monetary goal like Canada or the United Kingdom for instance, it does seek to keep inflation within the range noted above. Inflation is a critical measurement of the euro’s purchasing power which translates directly to prices and price stability.

How Monetary Policy is Implemented

The European Central Bank relies on a policy of open market operations to implement monetary policy for the countries participating in the Eurosystem. By influencing the interest rates charged by the system’s financial institutions and controlling the supply of funds available for lending, the ECB attempts to create the conditions that maintain prices and keeps inflation within the targeted range.

Open Market Operations

There are three main categories of open market operations that can be employed depending on the desired outcome:

1. Main Refinancing Operations

This is the most commonly-used means of providing liquidity to the euro area financial system. Main Refinancing Operations are repurchase (repo) transactions with a frequency and duration of one week and are tendered on a pre-determined schedule.

By setting the interest rate or by allowing financial institutions (also referred to as counterparties) to compete directly by offering variable rate tenders, the ECBS can influence the interest rate financial institutions charge their customers. Depending on the direction that the ECBS wants to guide interest rates, the ECBS can increase the available money supply, usually resulting in a decrease in interest rates once supply exceeds demand.

Should the ECBS wish to increase interest rates, simply decreasing the amounts tendered will cause increased competition for funds. This forces institutions to bids in order to secure enough cash to meet their liquidity needs. Naturally, the increased costs incurred by the counterparties are passed on to their clients in the form of higher interest rates.

2. Longer-Term Refinancing Operations

In addition to Main Refinancing Operations, the ECBS also employs Longer-Term Refinancing Operations. These are used much less frequently than the Main Refinancing Operations but still serve the same purpose and the basic procedure is the same except that Longer-Term Refinancing Operations are tendered on a monthly basis, and typically have a three-month maturity. Longer-Term Refinancing Operations are offered almost exclusively at a variable rate to encourage competition for the bidding process but under exceptional circumstances, Longer-Term Refinancing Operations may be offered at a fixed rate.

Unlike the Main Refinancing Operations, it is generally accepted that the ECB does not use Longer-Term Refinancing Operations as a way to send interest rate direction signals to the market. This type of open market operation is simply to provide stable liquidity to financial institutions for terms exceeding one week.

3. Fine-Tuning Operations

The ECBS may also conduct what are referred to as Fine-Tuning Operations to counter unexpected market shocks and liquidity fluctuations that require immediate actions targeted towards a specific institution or industry. For this reason Fine-Tuning Operations are highly flexible and may take the form of outright transactions, foreign exchange swaps, and various fixed-term deposits. Fine-Tuning Operations are not offered on a regular schedule like Main Refinancing Operations and they do not have standard maturity terms.

Fine-tuning operations are usually performed by individual national central banks by way of “quick” tenders for immediate completion. These operations may even be offered to only a specific counterparty or restricted to a group of counterparties invited to participate in the tender.

Cost of Reverse Transactions

The difference in the purchase price and the repurchase agreement price equals the cost associated with the refinancing operation. This is the direct cost incurred by the counterparty that the institution seeks to recover when setting interest rates for the firm’s commercial lenders.

Counterparty Eligibility Requirements

Counterparties wishing to participate in the Eurosystem monetary open market operations must meet certain eligibility requirements. These criteria are in place to ensure that counterparties meet basic operational and solvency requirements:

• Only institutions that meet the Eurosystem’s minimum reserve requirements are eligible to be counterparties.
• Counterparties must be financially sound as verified by at least one form of a harmonized audit sanctioned by European Union / European Economic Area authorities.
• Counterparties must meet any operational criteria specified in contractual or regulatory arrangements applied by the applicable national central bank or the ECB itself

Note that these requirements are consistent throughout the euro area and institutions that meet these conditions may then:

• Participate in Eurosystem open market operations, and
• Access the Eurosystem’s standing facilities

Standing Facilities

Whereas the Open Market Operations facilities are used to provide liquidity on a weekly or longer basis, Standing Facilities are used to manage overnight liquidity. Qualifying counterparties can use the Standing Facilities to increase the amount of cash they have available for overnight settlements using the Marginal Lending facility. Conversely, excess funds can be deposited within the ECBS and earn interest using the Deposit facility.

Counterparties must have collateral for the funds they receive from the Marginal Lending facility and will be charged the overnight rate set by the ECBS. Excess capital can be deposited with the Deposit facility and they will earn interest at the rate offered by the ECBS. The rates for these two facilities signal the central bank system’s outlook for commercial interest rats and sets the upper and lower limit for interest rates on the overnight market.

Minimum Reserves

All financial institutions in the euro area are required to maintain minimum reserve levels based on their reported liabilities. By ensuring a minimum amount of reserve funds are maintained by each financial institution, wild fluctuations in daily liquidity needs are reduced thus providing more stability within the entire financial system. Reserves are held at the national central bank for the institution and these reserves can be used as collateral for Standing Facilities transactions.

Monetary Policy Independence

The ECB was set up in a way to ensure no direct political interference on the part of the EU government in the day-to-day operation of the central bank. While monetary policies goals are set and endorsed by the Governing Council, the ECB’s Executive Board has the authority to set interest rate targets and control the availability of the money supply as required to meet the policy goals.

Interestingly, while the separation of state and the implementation of monetary policy is common in countries like Canada and the United States and more recently in the United Kingdom, not all members of the Eurosystem are accustomed to this approach. For example, France as part of it’s rebuilding efforts after World War I had established a program of dirigisme, implemented mostly by a succession of socialist governments that increased state involvement in areas including industry, energy, and the financial system.

Update - Single Euro Payments Area (SEPA)

On January 28, 2008, the Single Euro Payments Area (SEPA) project came into effect. SEPA is intended to make it easier tio transfer funds between Euro-member financial institutions.

Related Links

ECB Governing Council Meeting Dates

ECB President Jean-Claude Trichet

Nicolas Sarkozy Commenting on Central Bank Independance

References

1. ↑ Winston Churchill - Speech to the Zurich Youth, 1946
2. ↑ Council of Europe website
3. ↑ European Parliament website
4. ↑ European Parliament website
5. ↑ BBC News
6. ↑ European Commission website
7. ↑ European Commission website
8. ↑ European Commission website
9. ↑ International Monetary Fund website
10. ↑ European Central Bank website