The job of a central bank in a currency union can be particularly tough. Economic problems in a single member, that would not arise or could be managed easily in a federal state, can threaten the entire currency union. As the European Central Bank discovered during the 2010-12 euro crisis, this can threaten both its primary mandate – price stability – and secondary objectives, such as financial stability. In response, the euro area now has common bank supervision and resolution, the European Stability Mechanism, ECB emergency liquidity instruments for sovereigns and, in principle at least, improved coordination of member-state economic policies.
Are these changes enough to make the ECB’s job more like that of a normal central bank? Since 2012, the policy challenges faced by the ECB and its responses have mostly mirrored those of its counterparts, but with two important exceptions. The ECB’s 2015 decision to start bond purchases came much too late. And the ECB hesitated to raise interest rates, even after the invasion of Ukraine pushed annualised inflation to 7.4%.
These delays had a common cause: the euro area’s political and fiscal fragmentation. The ECB was structurally handicapped by concerns about the distributional impact of bond purchases and about the financial-stability impact of monetary tightening.
The ECB has room to continue evolving and improving; it has already developed tools such as the Transmission Protection Instrument, to intervene in the bond markets of a solvent country that meets specific eligibility criteria. But truly addressing its structural handicap requires changes outside the ECB’s control.
Full fiscal union is neither needed nor likely, but the ECB needs a liquid and safe bond market and some mechanism to ensure that the combined stabilisation effort of fiscal and monetary authorities is sufficient. This will require a larger EU budget involving common bond issuance, effective implementation of the new fiscal governance framework and steps to reduce the exposure of banks to their domestic sovereigns, while providing flexibility in times of stress.
Read the paper 'The Euro at 25: Fit for purpose?' by Lucrezia Reichlin, Jean Pisani-Ferry and Jeromin Zettelmeyer that reviews the record of European Central Bank policymaking since the 2010-12 euro crisis here.