Throughout history there have been governments without central banks. But until the European Central Bank was set up, there have never been central banks without governments. Central banks are modern inventions: governments are very ancient.
The logical connection between money and power is potentially contradictory. For trade to take place the value of money needs to be guaranteed and this usually requires centralised issue. On the other hand, monopoly of issue gives government the power to manipulate the currency for purposes of policy – traditionally to cover extraordinary war expenditures.
In principle, there is no reason why the first task – of guaranteeing the value of money – should not be farmed out to a central bank: this is what Gordon Brown, the chancellor, did in 1997 when he granted independence to the Bank of England.
However, manipulating the currency is a power that cannot be farmed out in the same way. In modern times it has covered most of what we mean by macroeconomic policy. The distinction between the two functions is recognised in the current British arrangements: the chancellor gives the Bank of England an inflation mandate but retains the right to vary the mandate and is accountable to the electorate for the results. What, then, are we to make of the European Central Bank, created without a state? There are five explanations, with some truth perhaps in each.
To eurosceptics, the ECB is simply a stalking horse for a European state. Monetary union is a political project pursued by economic means. On this reading of European history, institutional innovations are undertaken in order to disclose the necessity for further moves towards statehood.
A second explanation holds that monetary union is the logical counterpart of a single market and has no motive beyond this. Doubtless the same result could be achieved by fixed exchange rates. But, it is argued, such fixing is not credible unless it is irrevocable and fixed rates will not be seen as irrevocable unless individual currencies are abolished.
A third explanation is that the ECB was an attempt to replicate the success of the German Bundesbank, whose price stability mandate is constitutionally enshrined.
A fourth explanation, quite closely related to the third, emphasises the intellectual influence of monetarism, with its associated doctrines, in the constitution of the ECB. Four tenets deserve notice: the assertion that inflation is always a purely monetary phenomenon; that monetary policy influences only monetary, not real, variables; that central bankers have a preference for sound money; and that they should therefore be liberated from political control.
On this view, the lack of a state to monkey around with money is a positive advantage. In fact, it is the condition of the credibility of the ECB. The democratic deficit is not to be deplored but to be celebrated.
The fifth explanation sees monetary union as the quid pro quo for German unification – a means of binding an enlarged German state into a European political system. On this view, Jacques Delors created an independent central bank along monetarist lines for political expediency – which suggests he was a better nationalist than socialist.
The gut issue is whether the lack of a state is a condition of the success of the euro or whether, if not remedied, it will lead to its failure. This is related to the kind of economic model one has in mind. For example, when it is claimed that, in abolishing the pound, the British gov ernment would lose power to regulate the level of unemployment, what is being asserted is a Keynesian theory of macro-policy.
It is one of the ironies of the euro debate in Britain that economists and politicians who repudiate Keynesian policy at home become fervent Keynesians when they contemplate the horrors of British membership of the single currency. However, the question of whether a central bank can succeed without a state is only partly related to economic theory. Even if one accepts the monetarist view that governments should steer clear of economic management, it is still pertinent to ask whether the credibility of the ECB is enhanced or weakened by the absence of a state.
I do not myself believe that it is possible for a central bank to be fully credible in a political vacuum, even on monetarist premises. It can take the easy decisions without political backing – but that is not what credibility is about. Credibility is what causes markets to believe that tough decisions will be persisted with. So I would argue that political legitimacy is a necessary, although not sufficient, condition for Central Bank credibility.
I doubt, for example, whether the Bank of England’s current policy of high interest rates, which has inflicted considerable pain on British manufacturing, could have been sustained without the protection of the British government – which is not to say that the government would have maintained the policy on its own.
So I conclude that a truly independent central bank is bound to be a weak central bank. It is nakedly exposed to political pressure, precisely because all the political incentives are stacked up in favour of criticising it. That, in present circumstances, means a weak euro. This realisation underlies much of the drive for “enhanced co-operation” among the EU’s core members. The French in particular want to create a euro-group within the Ecofin committee of euro-zone finance ministers as a political counterpart to the ECB. It may include agreement by a group of states to contribute to a central fund to be used to offset the effects of a “one size fits all” monetary policy.
For Britain, the implications are tantalising. Voters do not like the idea of joining the euro because they believe – rightly in my view – that it cannot succeed without a state and most Britons oppose joining a European state. Our opposition to a European state in turn blocks the steps to further political unification that might make the single currency experiment work. This is an untenable position. Given the British stance, what the UK ought to be doing is making the case, as strongly as it can, for the stabilisation of the euro/dollar exchange rate. This would let sterling off the hook. Those EU members who wanted to would be free to create their state. And the continent would live happily ever afterwards.
Robert Skidelsky 