On January 1, 1999, 11 European countries gave up the independence of their monetary policy by joining the European Monetary Union (EMU). Since that time, these countries have shared a common currency, the euro, and, more important, are all now under the direction of a common European Central Bank (ECB) that controls monetary policy for the entire euro area. In accordance with Article 105(1) of the Maastricht Treaty, the primary objective of the ECB is to maintain price stability. The institutional designs of the ECB as well as their stated primary objective lead most economists to believe that the new ECB is a relatively inactive central bank in the pursuit of short-run macroeconomic stabilization. Thus most, if not all, of the countries in the EMU are now under a central bank that is much less active than was their previous national central bank. In this article, we examine whether this shift in the activism of the monetary regime has resulted in more or less macroeconomic stability for these countries.
Even before the official starting date for the EMU, a substantial academic literature speculated on how the move toward a common central bank would affect the macroeconomic stability of these countries. This literature has generally concluded that the movement toward a common central bank would make these economies more unstable because of the inability of a common central bank to tailor monetary policy to the needs of each country. As each country experiences country-specific shocks, the ECB will not be able to counter these shocks as well as a system of autonomous central banks. Thus, this previous academic literature has concluded on theoretical grounds that the EMU-member countries will suffer wider swings in real economic activity after the move to a common central bank. (1)
A monetarist critique of this position, however, has yet to appear in the literature. The monetarists have long argued that monetary policy is the main source of economic instability, even when the policy is well-intentioned. Brunner (1985:12) states the monetarist position concisely: "Discretionary management ultimately fails to deliver, even with the best intentions, on its promise." The monetarists believe that problems with lags and proper timing result in policy errors that induce less, rather than more, economic stability. If this position is correct, it suggests that having a common central bank that is unable to "optimally" respond to individual country-specific shocks could actually result in greater economic stability in the EMU member countries, not less. In other words, a common policy that is less responsive to country-specific shocks will result in greater stability because there will be fewer macroeconomic swings induced by monetary policy errors. However, for some countries that used to have a very inactive national central bank (such as Germany's Bundesbank), the new ECB might actually be more active than the old national central bank. In this case, the monetarist position would argue that these economies would become more unstable after moving under a more active ECB.
Three decades ago, a substantial academic debate raged about the relative effectiveness of fiscal and monetary policy at providing economic stabilization. Now, a consensus appears to have emerged that fiscal policy is generally less effective than monetary policy to promote short-run economic stability. (2) In this modern view, fiscal policy should primarily be concerned with promoting long-run economic growth through maintaining reasonably low marginal tax rates, constraining deficit finance, and removing regulations and taxes that interfere with domestic or international economic transactions. Monetary policy, on the other hand, is now accepted as the primary method with which countries can conduct economic stabilization. The main debate that remains is whether well-intentioned monetary activism is actually effective at promoting stability, a debate that is more important today than ever before with fiscal policy no longer being considered an effective stabilization tool. …