Monetary union: Top-heavy ECB faces test by the markets

FROM THIS weekend the European Central Bank will formally take over the running of monetary policy for nearly 300 million people in 11 countries. In a truly historic shift of power it will displace the mighty Bundesbank, the Bank of France and all the other central banks of Euroland.

What nobody knows is whether it will be any good at its job, whether it has been set up in a way that will enable it to operate efficiently. The omens are not good.

To be successful, a central bank needs to demonstrate quick thinking and flexibility; an ability to respond to a changing financial environment. The US Federal Reserve moved smartly in the autumn to rescue Long-Term Capital Management, and head off a potential market panic. In its own way, the Bank of England has engineered a U-turn in policy in a few short months, cutting interest rates aggressively as the economic climate has altered. In both cases the decision-making process worked.

But the way the European Central Bank has been set up is much more top- heavy. An executive of six people, headed by the Dutchman Wim Duisenberg, is the heart of the Bank, but it is not the body that will make interest rate decisions. That is the domain of a so-called governing council, which consists of the six executive members and the central bank governors from each euro member country. This means a 17-person committee, which will rise to over 20 if and when second-wave countries join the single currency.

Not only is this clearly an unwieldy number, it is quite likely to set the scene for a power struggle between the six executives and the 11 governors, who may find themselves cast in the role of guardians of their own nation's interests. The role of the governors is highly ambiguous. They are supposed to put aside their personal or national viewpoints and take a European perspective, but that will be a difficult path to tread, especially if their domestic economies are out of synch.

The lack of an executive majority on the committee, the size of the committee and the uncertain role of the governors make it at least possible that the governing council will not be a quick-witted body. Just how slow- witted it is will only become clear the first time there is a crisis in Euroland.

The contrast between this set-up and the Bank of England's arrangements is stark. The Bank's Monetary Policy Committee is made up of just nine people, of whom five are Bank executives and four are outside economists. There is no representative of a particular region or sector of the economy. This is an arrangement that has annoyed some parts of the business community but it allows members of the MPC to be personally accountable for their decisions.

The financial markets have come to understand the nuances of this system and the thinking of the committee. Within two weeks of the monthly MPC meeting, the minutes are published. These show the arguments that have been put forward at the meeting, and reveal which members favoured which interest rate options and which way they voted. The markets get a further insight into the committee's thought processes from the Bank's quarterly Inflation Reports and the inflation and growth forecasts they contain.

This is a remarkably open and transparent system, and in the eyes of many this transparency helps the smooth operation of monetary policy by the Bank of England.

The European Central Bank takes a completely different view. The ECB is not going to publish minutes of its meetings and there will be no way of finding out how members of the governing council voted. Nor will there be any publication of inflation forecasts.

The ECB is quite clear about why it is taking this stance. It does not want people knowing which way the votes are cast, because this would compromise the independence of the governing council members. In other words the members ought not to be put in a position where they might be subjected to pressure from their governments to vote for or against a particular interest rate move.

Wim Duisenberg argues that the markets will receive all the information they need from press conferences and speeches that he and others will give. But this is clearly a far less transparent way of operating than we have become used to in Britain, and it remains to be seen if the ECB will operate efficiently in such a secretive environment.

This lack of openness raises a related issue of the bank's accountability. The ECB will be an institution that has to answer to hardly anyone.

Unlike any other central bank, there is no government for it to be answerable to. It is forbidden by treaty to seek or accept political guidance. Wim Duisenberg is obliged to report at least once a year to the European Parliament and the Council of Ministers, but in no real sense is he responsible to them. He cannot be sacked (although he says he might resign halfway through his eight-year stint), and the other executives also have eight-year non- renewable contracts.

There is one other area of weakness that might sooner or later be tested. The ECB is not responsible for supervision of the banking system in the euro area. That remains, for the moment at least, the province of the national supervisors. How the ECB would act if a major financial institution needed rescuing is a large and unanswered question. But co-ordinating a lifeboat in the way the Fed did in the US this autumn might prove to be beyond it, with potentially catastrophic consequences.

Europe's new central bank is being launched into relatively calm economic waters. But it has a number of serious design flaws. Only when the waters turn more choppy, as they inevitably will, will we learn if the flaws are fatal ones.