We have discussed how the Fed and the Chinese central bank fared in the new climate with a more muted business cycle but much more economic instability coming from the asset markets. We haven’t yet mentioned a central bank which has perhaps done the best job of keeping monetary stability, despite being hampered on more then one front. This bank is relatively new, it’s the European Central Bank (ECB). 

So, how does Europe fare with the new dynamics coming from the asset markets? Let us consider some stylized facts:

• Organized labour much stronger than in the US (or China, which might be surprising for a still nominally communist country)
• The ECB is a relatively new institution, it only exists for a decade or so.
• It has to manage monetary stability of 15 different economies, economies that are quite different in their structural make-up and proneness to monetary instability

Real wage resistance
First, organized labour. Why is this important? Well, strong unions can make the cost of disinflationary policies more expensive, and thereby increase the importance of not letting inflation increase in the first place. Let us explain.

Basically, strong unions are in a good position not to let the real purchasing power of wages (or ‘real wages’) be eroded by inflation (this phenomenon is known as ‘real-wage resistance’).

Once there is inflation in the economic system, wage bargainers will ask for compensation, pushing up wages and thereby creating a wage-price dynamic that is difficult to get out of the system.

We have to note here that some European countries have, despite having rather strong unions, been able to avoid this dynamic by centralized wage bargaining resulting in moderate wage demands.

The economic logic to that is that unions at a national level will realize that high wage demands will hurt the economy overall (as it will lead to inflation and/or a loss in competitiveness), while high wage demands at a sectoral level would not (especially for those sectors which have little or no foreign exposure).

Real wage resistance has important consequences for monetary policy. It makes it more important not to let inflation get out of hand, because the cost of bringing it down once it’s there are higher.

Central bank credibility
The one thing that can lower the cost of bringing inflation down in this dynamic is central bank credibility. If wage and price setters are convinced the central bank is serious about beating inflation, then they will factor that into their inflationary expectations and, ultimately, their wage and price decisions.

So credibility is a wonderful thing, especially for central banks. The problem, though is that it is very hard to acquire and it can be squandered in a second.

The normal way central banks gain credibility is through their track record. If their history shows that each and every time inflation started to rear it’s ugly head the central bank immediately squashed it out of the system no matter what, this will serve as a reminder for wage and price setters that if they get ahead of themselves, the central bank will not hesitate to act.

This in itself lowers inflationary expectations and moderates wages and prices. However, the ECB is a rather new institution, which didn’t have a track record when it started out. This explains why there was such a political hussle about the design of the institution.

Those who wanted it to be modeled on the German Bundesbank were hoping some of the almost mythical credibility of the Bundesbank would immediately rub off on the ECB, and history seems to have been on their side.

This is why the ECB, unlike the Fed, has combatting inflation as it’s only objective (the Fed also has a responsibility for maintaining economic growth and employment), it’s written in stone in it’s constitution. It’s also why it’s located in Frankfurt, the same city as where the Bundesbank still houses.

There were fights between Germany and France over the design of the ECB, France was in favour of a more politicized central bank, but they lost that battle and the ECB remains totally independent. Once in a while, politicians complain that it should lower interest rates, but when the ECB does not oblige (which it invariably doesn’t), it gains credibility.

So, although it had little track record, the ECB did gain some credibility by being modeled on the legendary Bundesbank. In its short history, it has been very successful, as a lack of track record is not the only obstacle it had to overcome.

It manages now 15 quite different economies, altough these share the same money (the euro), they differ in structural characteristics and traditions and at times, economies were at different stages in the business cycle. The ECB had to take a sort of European average.

There are few who doubt that the ECB has done a pretty good job so far. There might have been a housing boom in some countries (Spain, Ireland, Netherlands), but overall, sound money has prevailed and the ECB and the money it manages has quickly gained worldwide acceptance and credibility.

The euro now rivals the dollar as a world currency, and has been a paragon of stability and strength. But, things are getting quite a bit tougher recently..