European System of Central Banks (ESCB) and European Central Bank (ECB) - dummies

European System of Central Banks (ESCB) and European Central Bank (ECB)

By Ayse Evrensel

In 1998, the European Central Bank (ECB) was established under the European System of Central Banks (ESCB). The ESCB includes the ECB and the national central banks (NCB) of all EU member states, independent of their adoption of the euro. The Eurosystem, on the other hand, consists of the ECB and the NCBs of the EU member states whose currency is the euro.

Because some EU member states still have their national currency, making a distinction between the Eurosystem and the ESCB is important.

Euro-zone combines 11 member states

When the euro was introduced as an accounting unit in January 1999, the Frankfurt-based ECB took over the responsibility of monetary policy for the Euro-zone from the central banks of 11 member states. Introducing the common European currency requires putting a central bank in charge of conducting monetary policy in the Euro-zone.

Therefore, a country in the Euro-zone has no autonomy to respond to economic shocks using its own monetary policy. Individual central banks cannot take steps to stabilize their economies. The idea is that countries in the Euro-zone use fiscal policies and structural changes to manage their economy.

The aims of the ECB are similar to the aims of any modern central bank. The ECB’s primary objective is to maintain price stability. Quantitatively, it aims to maintain a medium-term inflation rate below but close to 2 percent. The ECB’s primary goal is also consistent with the EU’s goals.

The Treaty on European Union lists price stability, economic growth, a highly competitive social market economy, full employment, and social progress among its goals. Therefore, the ECB’s primary objective of price stability is helpful in achieving economic growth and full employment.

When conducting monetary policy, as in the case of other central banks, the ECB adjusts its key interest rate instead of exchange rates. Modern central banks are aware of the impossibility of maintaining interest rate and exchange rate targets simultaneously, unless they implement capital controls. Therefore, the ECB has chosen the monetary autonomy, and the euro floats against other currencies.

Additionally, as any other modern central bank, the ECB issues currency within the Euro-zone, collects data about the ESCB and the Eurosystem, and provides supervision (whether rules are followed), regulation (which rules to follow to reduce risk), and monitoring (identifying weaknesses and vulnerabilities) of the financial system.

The makeup of the ECB

The Governing Council is the main decision-making body of the ECB. It consists of the six members of the Executive Board, plus the governors of the national central banks of the 17 Euro-zone countries. The Governing Council usually meets twice a month in Frankfurt.

At its first meeting each month, the Governing Council assesses economic and monetary developments and makes its monthly monetary policy decision.

At its second meeting, the Council discusses issues related to other tasks and responsibilities of the ECB and the Eurosystem. The minutes of the meetings aren’t published, but to promote transparency, the monetary policy decision is explained in detail at a press conference by the president of the Governing Council held shortly after the first meeting each month.

Characteristics of the ECB

An important characteristic of a modern central bank is its independence from the fiscal authority, which is important for a central bank to maintain price stability. In the case of the Euro-zone, although there’s only one monetary authority (the ECB), there are many fiscal authorities in the Euro-zone, matching the number of Euro-zone countries.

However, neither the ECB nor any NCB is allowed to seek or take instructions from any EU institution or any government. The ECB is also financially independent from the EU and has its own budget. Its capital is subscribed and paid up by the central banks of the Eurosystem.

The ECB is aware that it functions independently in a democratic society and, therefore, values accountability. Here are the ways accountability is maintained:

  • The ECB is committed to regular and accurate reporting of its activities and decisions to the public. The ECB publishes a Monthly Bulletin, and the members of the Governing Council deliver speeches to share with the public the ECB’s ideas on relevant topics.

  • Immediately following the first Governing Council meeting of each month, the ECB president and vice president hold a press conference to provide in-depth explanations of the ECB’s monetary policy decision and its rationale.

  • Because the European Parliament derives its legitimacy directly from the citizens of the EU, the ECB has dialogue with the European Parliament.

    • The president of the ECB informs the European Parliament’s Committee on Economic and Monetary Affairs (ECON) about its monetary policy on a quarterly basis.

    • The president of the ECB presents the ECB’s annual report before the plenary session of the European Parliament.

    • Other members of the ECB’s Executive Board appear before the European Parliament to address specific issues.

    • The ECB provides replies to written questions of the members of the European Parliament.

    • The ECB is also involved in informal discussions with the members of the European Parliament about the ECB’s monetary policies, as well as subjects related to the ECB’s expertise.

For a discretionary monetary authority that identifies its policies as events unfold, transparency is also important. A transparent central bank makes its objectives and decision process clear so that markets aren’t surprised when the central bank announces its monetary policy decision.

Transparency in monetary policy promotes efficient and accurate market expectations, which helps rapidly transmit any monetary policy decision into relevant economic variables such as consumption and investment. The ECB considers three aspects of transparency:

  • The ECB wants to be clear that its primary objective is price stability.

  • The ECB wants to be realistic about monetary policy and communicate with the public on what monetary policy can and cannot do.

  • The ECB considers the timely provision of its assessment of the cur-rent economic situation and policy decisions as crucial aspects of its transparency.