The Evolving Role of Central Banks

12 The Role of an Independent Central Bank in Europe

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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A central bank independent of government influence is essential for a successful monetary policy. This is the rule that one arrives at when looking at the experiences of those countries that perform the role of the central bank in maintaining price stability. There is the rare exception: France appears to be the most obvious example; in recent years, it has achieved relative price stability without its central bank being independent of the government. It is often said that “the exception proves the rule.” And the rule is that countries with an independent central bank show a better record on inflation than those without. Indeed, a fairly close correlation between inflation performance and the degree of independence of the central bank seems evident.

The Case for Central Bank Independence

The issue of central bank independence can be treated as a matter of high principle or of common sense and practical experience. The current British debate provides a lively illustration of the argument over high principle versus actual experience. On one side are those who insist that the elected parliament and government should hold unlimited power over monetary policy, as they do over other policy areas; on the other side are those arguing for an independent central bank on the basis of past and current experience—but also perhaps based on economic reasoning.

In many countries, particularly after World War II, the central banks’ money printing powers were needed to finance the deficit spending policies that gave priority to full employment and high growth. Monetary policy had virtually no role to play, except that money had to be cheap. “Money does not matter,” was part of the accepted economic doctrine, especially in the Anglo-Saxon countries. In any case, monetary policy was not to impede full employment policy.

In the United Kingdom, the “Radcliffe Report,” published in 1959, affirmed the view that the government’s economic policy had to include monetary policy as an integral part of a consistent whole; fiscal and monetary policies could not be allowed to be pulling at different ends. In many other countries, too, monetary policy was fully subjected to the requirements of an activist fiscal policy aimed at full employment and high growth. The victims were usually the balance of payments and price stability. The treatment applied included balance of payments restrictions and exchange rate adjustment, and price controls and incomes policy.

Recourse to restrictions on trade and current payments was made subject to closely monitored rules and international codes of good behavior; the experience of the 1930s had shown that they were undesirable and counterproductive. Restrictions on capital transactions, by contrast, were considered acceptable; the Articles of Agreement of the International Monetary Fund (IMF) gave express permission to use them. Exchange rate adjustments were frequent even though under the IMF’s Articles they were only permitted in case of “fundamental disequilibrium,” a concept that was left somewhat vague and open to interpretation.

Price controls supported by subsidies were widely applied. Incomes policy became popular in the 1960s in some countries as a formula designed to arrive at a more favorable trade-off between inflation and unemployment, or a shift of the Philipps curve to the left. The results were disappointing. Price controls and incomes policy provided no substitute for an anti-inflationary monetary policy. Likewise, trade and payments restrictions or devaluations proved ineffectual for fundamental economic imbalances rooted in wrong policy mixes, with the central bank forced to assist the government’s growth and full employment policies.

The notion of independence for a country’s central bank has to be based on a very different understanding of the role of monetary policy. It has to start from recognition of the fundamental truth that inflation is essentially a monetary phenomenon. Other factors may play a role at times. But as Gottfried Haberler wrote in the 1950s, “… there is no record in the economic history of the whole world, anywhere or at any time, of a serious and prolonged inflation which has not been accompanied and made possible, if not caused, by a large increase in the quantity of money.”1 This holds true even if one makes allowance for changes in the velocity of money circulation, which follow cyclical patterns and react to shocks of various kinds. In fact, as Haberler himself pointed out,

… except in periods of hyperinflation (which could not develop without a sharp and sustained rise in the quantity of money) a rise in velocity by itself has never caused or substantially intensified serious inflationary trouble.2

If, as history tells us (I quote Haberler, page 20, again), “… in every inflation, money is a causal factor, either active or permissive, …” then price stability obviously calls for a monetary policy that will not allow monetary expansion to exceed that needed to accommodate noninflationary economic growth. If experience, furthermore, tells us that monetary policy is a powerful instrument to keep inflation in check, but is much less powerful to stimulate economic growth and employment, then there seems to be a strong argument in favor of monetary policy being committed to pursue price stability as its primary objective. If price stability is, moreover, seen to provide the most solid basis for sustained economic growth and high employment, whereas inflation is recognized to be its worst enemy, if only because it will over time undermine a country’s social fabric, then the case for an independent central bank committed to price stability would seem to become overwhelmingly strong.

Acceptance of the central bank’s independence by parliament will be tantamount to political recognition of the need for safeguards against the misuse of the potentially unlimited financing powers of the government through resort to the printing press. Individuals are warned strongly against resort to illicit issuing of money, for very obvious reasons; the state has clearly reserved that power for itself. Those like Professor Hayek favoring monetary arrangements based on currency competition between private issuers would reverse that situation, by depriving the state of its money printing monopoly and allowing private citizens to issue bank notes instead. There are strong arguments against that concept, and it would hardly be practicable.

Limiting the state’s recourse to the printing press by entrusting responsibility for monetary policy to an independent central bank with clearly defined powers and objectives can be shown to be in the public interest. It may even be in the interest of the government itself, because the temptation to use the powers of the printing press will always be present; the consequences of yielding to such temptation are not always self-evident and, all too often, are left to succeeding governments to deal with.

For all these reasons, independence from the government would seem to be a necessary constitutional element for a central bank if it is to achieve its primary objective, price stability. This view has not always been accepted generally. But it has gained acceptance in the years of high inflation in the 1970s and after.

The success of the Deutsche Bundesbank with the independence bestowed upon it by the Bundesbank Act (which was adopted in 1957) has helped to make this viewpoint more generally attractive to many other countries as recent examples of new central bank legislation show.

The Independence of the Bundesbank

The Bundesbank is committed by law to the task “of safeguarding the currency.”3 In pursuing this objective, it is often regarded as the central bank with “a relative maximum of independence.” As the expression indicates, the Bundesbank’s independence is not total, but it is relatively high in relation to the government and compared with that of other central banks. When discussing central bank independence, different aspects should be distinguished, of which the institutional, functional, and personal independence aspects are probably the most important.

Institutional Independence

In exercising its powers, the Bundesbank as an institution is independent of instructions from the government, the parliament, or any other government institution. Needless to say, it is also free from interference by other bodies. Most important, the exertion of direct influence on the conduct of monetary policy by the Government is thereby ruled out. In its policy, the Bundesbank is guided by the mandate given to it under the law. But institutional independence alone is not sufficient.

To be assured of full control over monetary policy the central bank also needs to be functionally independent. The Bundesbank has the sole and unrestricted authority to use the traditional instruments of monetary policy, namely, rediscount policy, minimum reserve policy, and open market policy in order to pursue its functions. It disposes of the full array of monetary policy instruments and is not inhibited from using them by interest rate ceilings or other limitations. Public authorities have no recourse to borrowing from the Bundesbank, except within very limited short-term overdraft credit lines. With fully functioning money markets such access has of course become less relevant to the financial operations of public entities, though most of them still make regular use of the overdrafts for convenience. Recourse to them was particularly attractive so long as access was at below-market interest rates; only recently has this been changed.

The functional independence of the Bundesbank is not complete. The Federal Government has the right to decide on the exchange rate regime and to determine the parities, or central rates for the deutsche mark, in a system of fixed exchange rates. It is generally recognized that obligations to intervene in the foreign exchange market to defend a particular parity may conflict with monetary policy, even though the central bank may be able to offset all or part of the immediate liquidity effects on the banks through other operations. At times this proved difficult or impossible, and serious conflicts arose between the Bundesbank and the Federal Government over external monetary policy, especially under the old fixed parity regime with the U.S. dollar at its center. To avoid such conflicts as much as possible in the future, it was agreed between the Federal Government and the Bundesbank in 1978, prior to the creation of the European Monetary System, that should a fundamental conflict arise for monetary policy as a consequence of the obligation to defend a particular exchange rate the Bundesbank would have the option to suspend its intervention obligation in the exchange rate mechanism (“opting out”).

The Bundesbank’s functional independence is also somewhat limited in other ways. Members of the Government may attend and propose motions at meetings of the Central Bank Council. They even have the right to ask Council decisions to be delayed for up to two weeks. But this has, so far, never led to any serious problem regarding the conduct of monetary policy. The “veto right” has actually never been used to date. And, as said, it can only be used to delay action by the Central Bank Council, not to block it.

Personal Independence

With regard to the aspect of personal independence, the members of the Central Bank Council are appointed upon nomination by the Federal and the Länder (state) Governments. Their terms are for a relatively long period (maximum eight years), during which they cannot be removed from office. They are not subject to any specific mandate other than that enscribed in the Bundesbank Act. In particular, the Länder central bank presidents are not expected to pursue any special interests of their Länder or to receive instructions from them. The Länder central banks are integral parts of the Bundesbank; they are not shareholders of the system, nor are the Länder. The Federal Government holds the capital of the Bundesbank and receives any profits, but it too does not derive any further rights from this fact. The Bundesbank’s financial structure thus does not impair its autonomous status.

One other factor of independence may be worth mentioning and that is the geographical distance between the site of the Federal Government (Bonn) and the site of the Bundesbank (Frankfurt). This, too, may have helped to prevent too strong informal channels of influence being established. The Federal Parliament has just passed legislation providing for the Bundesbank’s seat to remain in Frankfurt even if the government should move to Berlin. Here again, the independence of the central bank is duly recognized. The Bundesbank Act contains a provision which stipulates that “[w]ithout prejudice to the performance of its functions, the Deutsche Bundesbank is required to support the general economic policy of the Federal Government.”4 This is understood to mean that in case of conflict, where supporting the Government’s policies would impair the Bundesbank’s ability to pursue its primary objective, the commitment to price stability would carry the day.

The recent debate about the Bundesbank’s role in regard to German economic and monetary union and to European economic and monetary union prompts me to add the following: the Bundesbank is required by law to give advice to the Federal Government on matters that are relevant to monetary policy. The Government can seek the Bundesbank’s advice, or the Bundesbank can offer it. But the Government is also free to accept it, or not to accept it. In any case, the Government may have to accept the consequences, if the Bundesbank sees a need to act in the pursuit of price stability.

As far as German economic and monetary union is concerned, the Bundesbank’s well-publicized advice was clearly based on economic and monetary considerations, not political considerations. The Bundesbank initially saw merit in a step-by-step approach, like most economic experts; this was based on the assumption of two German states remaining in separate existence. The rapid train of events made full economic and monetary union imperative, giving political considerations precedence over economic and monetary concerns. The Bundesbank’s advice of a 2:1 conversion rate both for stock and flow variables (i.e., savings accounts, outstanding liabilities of companies, wages and salaries, etc.) was not followed “to the letter,” but the Government’s decision on this issue came out close enough to that of the Bundesbank, if translated into a weighted average, to invalidate the existence of major disagreement. Above all, the Bundesbank’s advice on organizational matters relating to its own involvement in the transition to economic, monetary, and social union was fully accepted, and this has contributed substantially to the successful conclusion of the union of Germany.

On European economic and monetary union (EMU), there can be no question of the political nature of the decision if and when to enter into EMU, or into its various stages. This is not a matter for the Bundesbank to decide. But the Bundesbank has been closely involved at every stage of the debate and has made its views known to the Government and to the public. In a recent statement on the issues involved, it set out the conditions that in its view need to be met if further steps are to be taken, and it reaffirmed the basic requirements of a future European central bank system. Needless to say, the institutional requirements and safeguards, including the political independence of a future European central bank, will not by themselves guarantee success of the EMU. Other conditions have to be met for full success. I shall come back to these questions in a moment.

The reasons for the success of German monetary policy in defending price stability are in part historical. The experience gained twice with hyperinflation in the first half of this century has helped to develop a special sensitivity to inflation and has caused the wider public to believe in the critical importance of monetary stability in Germany. For this reason, the strong position of the Bundesbank is widely accepted by the general public—questioning its independence even seems to be a national taboo. This social consensus has yielded strong support for the policy of the Bundesbank. I have already mentioned that no government has ever used its right to “veto” a decision of the Central Bank Council. No government has ever seriously considered modifying the Bundesbank Act as a means to deal with cases of conflict, although it could have done so with a simple majority of the Parliament.

Historical experience in Germany testifies to the success of the concept of an independent central bank. Inflation rates have remained far below the average rates of most other industrial countries. Stable prices have contributed to a fairly stable social climate, which is felt to have favored growth of the German economy; this has strengthened its role in the world economy. The German currency, the deutsche mark, has become a major reserve currency in the world and the “anchor currency” in the European Monetary System, and it enjoys a high standing. The former British Chancellor of the Exchequer, John Major, said in his address to the Annual Meetings of the IMF and World Bank in October 1990 in Washington with reference to the ERM: “Increasingly it has functioned like a modern day gold standard with the deutsche mark as the anchor.”5

In the light of the success of the Bundesbank, it is only natural that the German public will expect any successor, which could take its place at the European level, should be at least as well equipped as the Bundesbank to defend price stability. The Governor of the Bank of England, Robin Leigh-Pemberton, said only a week ago in Berlin that

[t]he Bundesbank has acquired its reputation as an inflation fighter after a long period of skillful monetary management, and it is this that gives the Bundesbank its credibility and legitimacy. A new institution would begin with no such inherent credibility or legitimacy.6

Independence of a European Central Bank System

Progress in economic and political integration induced the Heads of State and Government of the EC member states to decide on the early establishment of a European economic and monetary union (EMU). An Intergovernmental Conference has been convened in Rome to discuss and work out the contractual basis for this union. How much time this conference will take to arrive at full agreement, which according to treaty rules calls for unanimity, is difficult to say. A monetary union rests on the irrevocable fixing of exchange rates between the currencies concerned, with the possible—or likely—introduction of a single currency. This implies, at the same time, the need to relinquish sovereignty over national domestic and external monetary policies, and to transfer the responsibility for such policies to a Community institution that could be named the European Central Bank System (ECBS).

The construction of an ECBS is a step on virgin soil. European national authorities will, for the first time, have to give up their powers in an important field of public policy, namely monetary policy. A monetary union will be an irrevocably sworn fraternity, in which the participating economies will be linked inextricably. At the present state of the discussions, there is a wide measure of agreement on certain basic characteristics of a future European central bank system.

First of all, an ECBS must be committed to price stability as its primary objective. This must be its special area of responsibility and its “token of success.” For this purpose, it is essential that its position within the constitutional order of the Community, its internal organizational structure, and its instruments enable it to pursue this objective. The ECBS will be expected to support the general economic policy of the Community, but only to the extent that this does not interfere with its prime objective of price stability.

Second, it is indispensable that the ECBS be independent in institutional, functional, and personal terms. Not only has the German experience shown that monetary stability can best be realized in a system that is independent of political interference, but the European environment may also add a further dimension to the issue. It cannot be excluded that in the EC there will be a tendency for compromises to be sought to deal with arising difficulties; this could be at the expense of price stability. It is therefore crucial for the ECBS that, in the performance of their duties, the members of its governing bodies are not subject to instructions from other national or Community authorities.

Third, the ECBS can only be successful, if it retains full control over the instruments that are necessary for conducting monetary policy. These include instruments not only for domestic monetary policy, but also for external monetary policy. Hence, the ECBS must also be given sole responsibility for exchange market intervention against currencies outside the system. Decisions on the exchange rate regime, including the fixing of parities or central rates and their change, will have to remain in the hands of the political authorities. In all other decisions affecting external monetary policy, especially in the event of exchange rate policy decisions, the ECBS should be involved in good time and on a basis of co-responsibility.

Fourth, and as a matter of course, the ECBS should not be allowed to extend credit to public authorities in the Community or in member states.

Fifth, too many tasks assigned to the European central bank could complicate the conduct of monetary policy. The ECBS should be free, therefore, from responsibilities other than those for monetary policy. In particular, banking supervision should not be assigned to the ECBS but left with national authorities, if only to prevent the ECBS from being forced into a “lender of last resort” function that would not be compatible with its task of safeguarding the currency. There are different views on this issue, but it seems clear to me from our own experience and that of some other countries that a successful monetary policy does not require that the central bank itself be given full control over the banking system and thus for banking supervision; indeed, this could even reduce the effectiveness of monetary policy. Experience also shows that central banks that are not charged with such additional responsibilities enjoy a higher degree of de facto independence.

Sixth, the national central banks must be integral parts of the European central bank. A uniform monetary policy cannot result from decisions of separate independent institutions. Monetary policy by its nature is indivisible. Coherence of monetary policy requires central decision making and uniform rules for the implementation of monetary policy decisions. National central banks will still have a role in the implementation of the decisions of the ECBS. But this will only be possible if they have previously been given the same degree of independence within their states as the ECBS enjoys at Community level, and if monetary policy instruments have been duly harmonized among the member countries. At present, the central banks of a number of member countries are in some respects only executors of instructions from their respective governments. Especially in some of our major partner countries, France, Italy, Britain, and Spain, monetary policy is still under government control. It will probably be necessary to give national central banks a sufficient amount of time to practice their new autonomy before the ECBS is implemented.

To guarantee the uniformity of monetary policy, on the one hand, and to take account of the federate structure of the Community, on the other, the ECBS should have a management structure comprising two governing bodies: a Council and an Executive Board. While the Council should be responsible for the setting of monetary policy targets and for certain other key policy decisions, the Executive Board should be empowered to control their implementation. For this purpose, the Executive Board will need some discretionary latitude to respond flexibly to developments in the markets.

The Council should be composed of the governors of the national central banks and the members of the Executive Board. A sufficiently long term of office without possibility of dismissal (except for serious cause) and an effectively independent status must be guaranteed to all members of the Council. It is of the highest importance that its members do not regard themselves as representatives of national interest. For that reason, it is necessary that all national central banks be made independent from their governments before the foundation of the ECBS.

The Executive Board members would be appointed by the European Council by virtue of their experience and ability. As the ECBS has to act in line with its goals and not in the pursuit of national interest, all members of the Council should have equal voting rights. Weighted voting would give undue emphasis to regional or national interests in decision making, which would be in conflict with the need for a single monetary policy geared to price stability in the Community as a whole.

The Committee of Governors of the EC central banks submitted a draft ECBS statute to the Intergovernmental Conference, which largely meets the criteria listed above. The final discussions in the Governors’ Committee will take place in the coming weeks.

There can be no doubt that the creation of a successful European Monetary Union will promote economic integration. It will eliminate uncertainty regarding exchange rates between the member countries and hence reduce transaction costs for international business. For these and other reasons, some of them of a more emotional nature, the concept of European economic and monetary union with a European central bank system as its center has widespread appeal. But the economic good expected of EMU has to be weighed against the risks associated with the setting up of the EMU. These risks are likely to be seen differently from the standpoint of the various countries. As stated in a recent Commission study entitled “One Market, One Money,”7 a major risk lies in the elimination of the exchange rate as an adjustment tool. If exchange rate changes are ruled out, authorities lose an important instrument to deal with regional imbalances within the Community. These imbalances still exist in Europe, and it is not clear that they will be eliminated in the near future. Lack of exchange rate flexibility will also deprive countries with greater price stability of a means to reduce the risk of imported inflation.

At present, economic, fiscal, and monetary policies and performance in the EC are still marked by great differences between some of the member states. It is true that some member states have made substantial progress toward greater convergence in the field of anti-inflation policy, owing in part to the European Monetary System. Throughout the whole EC, however, deep-seated divergences still remain, and in some areas are actually widening again. These divergences are reflected, in particular, in inflationary cost and price trends, excessive budget deficits in some countries, and large external imbalances. These “convergence deficits” are especially pronounced in Greece and Portugal—neither are yet participating in the ERM; in the United Kingdom, which has joined the mechanism just recently, and, in Italy and Spain, they are unmistakable. They are in some cases not only transitory but are rooted in considerable differences in institutional structures, economic fundamentals, and the attitudes of management and labor.

It is not clear that convergence has already proceeded far enough to allow the EMS to dispense with exchange rate correction as a means to facilitate external adjustment inside the Community. In any case, it may be wise to retain the possibility of exchange rate adjustment as an “ultima ratio” for as long as there may be a need for it. The fact that realignments in the ERM have been rare in recent years should not mislead us into believing that there will be no need for exchange rate adjustment in the future.

In monetary union, unsustainable fiscal policies or excessive wage demands would have serious consequences for the respective regions and for the Community as a whole. That is why in an economic and monetary union binding rules for limiting fiscal deficits and their financing are likely to be necessary; market discipline is not likely to be sufficient. A framework providing for advance consultations, surveillance of budget outcomes, and possibly also sanctions would seem to be the minimum required before the ECBS can start to take up responsibility for monetary policy. From the viewpoint of a stability minded public in Germany an early irrevocable fixing of exchange rates and the transfer of monetary policy powers to a Community institution would involve considerable risks to monetary stability, given these prospects and the actual economic and economic policy situation in the Community. Further progress toward stability in various partner countries is clearly needed before one should think of implementing monetary union.

One other point deserves attention. Even if it were possible to agree on a system that fulfills the necessary legal conditions for an independent stability-oriented monetary policy, the factual success of that system would also depend on other circumstances. The Governor of the Bank of England, Robin Leigh-Pemberton, alluded to this recently when he said:

However independent a central bank is in principle, it cannot be impervious to the pressures of public opinion or indifferent to public support. It must rely for its legitimacy on the public’s aversion to inflation and to the public’s trust that potentially unpopular short-term measures of restraint will be justified by longer-term benefits.8

To sum up, the essential steps to be undertaken before the establishment of the ECBS seem to be the following. First, the single-market program should have been implemented in full. After all, economic union comprising a common economic area without internal borders is the basis for monetary union. At present, there are still some major deficiencies in decision making and implementation. Unless they are overcome, the elimination of border controls, which is envisaged for 1992, will jeopardized. This applies particularly to the harmonization of indirect taxes, which is regarded as an essential precondition for lifting border controls. Without the full implementation of the single market, a monetary union lacks the necessary counterpart in the real sphere.

Second, adequate economic convergence must be achieved. This means that price differences have been virtually stamped out and that inflation has been largely eliminated. Furthermore, budget deficits in the participating countries will have to be reduced to a manageable level in terms of anti-inflation policy. And the durability of this convergence must be reflected in the markets’ verdict, that is, in virtual harmonization of capital market interest rates. To satisfy these conditions, all countries willing to join the ECBS should previously have been full members of the EMS for a sufficiently long period. Experience in the 1980s has shown that full membership in the EMS has contributed significantly to price stability in the participating countries.

Third, significant convergence in the statutes of the central banks of the Community toward independence is indispensable. Otherwise, these central banks cannot be expected to be integral parts of the ECBS. As I argued before, such harmonization also includes an adequate harmonization of monetary policy instruments.

Finally, there have to be guarantees that the stability-oriented policy of the union cannot be counteracted by unsustainable budget policies. For that reason, contractual arrangements for ensuring budgetary discipline must be adopted at Community level. I hope that the Intergovernmental Conference will arrive at full agreement on these points without delay. The heads of state and government agreed at the end of October 1990 to an ambitious timetable. Whether it can be adhered to or not will depend decisively on the ability to find a consensus among the participating governments and on the determination of member states to adapt their policies quickly to the requirements of EMU. The coming years will demonstrate whether they are able and willing to do so.


The author is a member of the Executive Board of the Deutsche Bundesbank.


Gottfried Haberler, “Internal Factors Causing and Propagating Inflation,” Chapter 2 in Inflation, proceedings of a conference held by the International Economic Association in 1959, ed. by D.C. Hague (London: Macmillan and Co., 1962), page 19.


Ibid., page 20.


Article 3 of Deutsche Bundesbank Act (Gesetz über die Deutsche Bundesbank) of 1957, according to an unofficial English translation. See Deutsche Bundesbank, The Deutsche Bundesbank: Its Monetary Policy Instruments and Functions, Special Series No. 7 (Frankfurt, 3rd ed., 1989), pp. 110–35.


Article 12 of Bundesbank Act, according to an unofficial English translation. See Deutsche Bundesbank, The Deutsche Bundesbank: Its Monetary Policy Instruments, and Functions, Special Series No. 7 (Frankfurt, 3rd ed., 1989), pages 110–35.


International Monetary Fund, Summary Proceedings (Washington, 1990), page 85.


Robin Leigh-Pemberton, “Approaches to Monetary Integration in Europe,” Auszüge aus Presseartikeln, No. 83, Deutsche Bundesbank, (Frankfurt, 1990), page 3.


European Economy, No. 44 (October 1990), pp. 3–347.


Robin Leigh-Pemberton, “Approaches to Monetary Integration in Europe,” in Auszüge aus Presseartikeln, No. 83, Deutsche Bundesbank (Frankfurt, 1990), page 3.

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