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THE years 1999 and 2000 have provided a difficult beginning for the European Monetary Union (EMU) and for its managing institution, the European Central Bank (ECB). The euro, which was almost universally expected to be a strong currency, has depreciated sharply and is now the source of widespread negative commentary. Citizens of Denmark voted against joining the monetary union by a considerably larger majority than had been anticipated, and there is now virtually no chance that a referendum for entering the EMU could pass in the United Kingdom or Sweden. The management of the ECB has been widely criticized, with its president being the frequent target of unkind press comments.

Macroeconomic conditions have varied among members, from rapid growth, which threatens accelerating inflation, in Ireland and Portugal to slower growth and persistently high unemployment in Italy and Germany. These differences in the business-cycle circumstances of the members would suggest strong differences of opinion within the Governing Council of the ECB as to what monetary-policy direction ought to be pursued. There have been rumors in the press of discord within the central bank, but the fact that the ECB does not publish any minutes or other records of the meeting of the Governing Council makes it impossible to know what policy differences exist.

Chancellor Gerhard Schroder's early September comments to the effect that a weak euro was not a problem, because it helped German exports, was certainly unhelpful, and it exposed some clear differences between political leadership in Europe and its central bankers, many of whom have publicly noted the potential inflationary effects of a weak euro. One can only imagine what Chancellor Konrad Adenauer and his economics minister, Ludwig Erhard, would have thought of a leader of the German government who supported a soft monetary policy and a depreciating currency as a means of expanding aggregate demand.

Despite all these problems, the ECB has not been without accomplishments. Unemployment is considerably lower in virtually all of the member countries than in early 1999, and the acceleration of inflation has, thus far, been modest. The decline in the exchange rate for the euro, however, with its implications for local currency prices of major imports such as oil, makes the threat of increasing rates of inflation during 2001-2002 potentially more serious. The pass-through from the exchange rate to the price level often involves considerable time lags, meaning that the full impact of the 1999-2000 depreciation of the euro will stretch into 2001 or possibly even 2002. Nonetheless, real GDP has been growing at a rate of almost 4 percent across the Euro11, unemployment is down, and only future inflation appears to be a serious problem. It has, however, been a difficult first two years for the ECB, and it not likely that the difficulties it faces will ease greatly in the near-term future.

What Monetary Policy in 2001?

In two articles by the present author that appeared in this journal in 1999 and 2000 ("An Easy Monetary Policy in the European Union?," July/August 1999, pp. 29-43, and "Tight Money in Europe," May/June 2000, pp. 83-90), three variations of the Taylor rule were used to predict how the Governing Council of the ECB would direct monetary policy in the short run. It was assumed that each of the seventeen members of the Governing Council voted on the basis of the interests of their individual countries rather than some general European interest, and that national rates of inflation and unemployment were the determinants of where policy should be directed. Each member of the council was presumed to wish to tighten monetary policy if the rate of inflation in his or her country increased or if unemployment declined, and to ease monetary policy in the opposite circumstances.

Although it is impossible to know if the articles correctly predicted individual votes of council members, because no records of votes are released, both monetary-policy predictions were correct. Monetary policy was quite expansionary during 1999, as the first of the two articles predicted, and tightened considerably in recent months as the later article suggested. This cannot be taken as proof that the monetary-policy rules correctly explained how members of the Governing Council behave, because it might be a matter of luck that the models appear to have been successful; that is, the Council could have decided to ease during 1999 and to tighten in 2000 for reasons quite different from those described in the articles. It is at least encouraging, however, that the monetary policies of the ECB have matched those predicted in these two efforts.

This article extends this exercise by using the most recent data available for national rates of inflation and unemployment, and the same monetary policy rules, to suggest the monetary policy direction that the ECB might be expected to pursue during 2001. [1]

The Taylor Rule and Its Variations

The Taylor rule was developed by John Taylor at Stanford to explain changes in the U.S. federal funds rate, which is widely understood to be the short-term policy target of the Federal Open Market Committee of the Federal Reserve System. [2] Its only explanatory variables are the U.S. rates of inflation and unemployment, and an increase in the index number suggests a tighter monetary policy. As that rule is used in this exercise, it gives a considerably heavier weight to inflation than to unemployment in predicting monetary policy changes. A less complicated version of the Taylor rule is the second in this article, and it gives an equal weight to inflation and unemployment. The final variation of the rule is adjusted for the recent experience of each country. It assumes that members of the ECB's Governing Council view the rates of inflation and unemployment in their nations during the previous three years as a norm, and that they are therefore inclined to tighten if current rates of inflation exceed the avera ge for the previous three years and/or if unemployment is less than during this three-year period, and will wish to ease in the opposite circumstance. This index of monetary policy intentions is most easily seen as the rate of inflation minus the rate of unemployment, where each variable has been normalized for the experience of the previous three years. If the index rises, monetary policy should be tightened, and vice versa. A more precise definition of each of the three rules can be found in the July/August 1999 Challenge article cited earlier.

In the three exercises that follow, it will be assumed that each member of the Governing Council is inclined to tighten if the monetary policy rule index rises by one percentage point or more, to ease if it falls by one percentage point or more, and to maintain an unchanged monetary policy if the index moves in either direction by less than a percentage point. The Governing Council has seventeen members, consisting of the six members of the Executive Board and the eleven governors of the central banks of the member nations. Six countries (Germany, France, Italy, Spain, the Netherlands, and Finland) currently have two members on the Council and therefore have two votes; the other five members of EMU each have one vote.

Statistical Results

There appears to be a dear consensus in the first rule to tighten monetary policy in the near-term future, as can be seen in Table 1. There are 10 votes to tighten, 1 to ease, and 6 to maintain an unchanged policy. France, at +0.9, might easily be inclined to tighten, which would produce 12 votes for a more restrictive stance.

In Table 2 there is still a majority to tighten, under the second rule, but it is a narrow majority. Under the voting rule of this exercise, which is to tighten if the index increases by a point or more, ease if it falls by a point or more, and retain an unchanged policy if it changes by less than a point, there are 9 votes to tighten, 1 to ease, and 7 for an unchanged policy. Belgium and France, at + 0.9, might be inclined to vote to tighten, which would produce 12 votes for a more restrictive policy.

Under the third decision rule, as can be seen in Table 3, there are 12 votes to tighten, 1 to ease, and 6 for no change. Belgium and France, at +1.1 and +1.0 respectively, might be less than firmly committed to a tightening, but that would still leave a narrow majority of 9 votes for a more restrictive policy.

There appears to be a consensus to tighten monetary policy in Europe across all three versions of the Taylor rule discussed here. Only Luxembourg should prefer a more expansionary policy. There is an encouraging consistency in country votes across the rules. Nine of the eleven countries are predicted to vote in the same direction under all three rules. The only countries that produce different outcomes under different rules are Belgium, which would vote to tighten with two of the rules and for no change under the third, and France, which would leave the policy unchanged under two rules arid tighten under one. The fact that majorities can be found under all three rules for a tightening, and that almost all of the countries vote the same way under all three, lends some confidence to the conclusion that a further tightening of monetary policy can be expected during 2001.

Democracy in EMU?

As unelected officials in EU offices in Brussels gather more power at the expense of elected governments in the member nations, there have been frequent complaints about a "democracy deficit" in Europe. Although central bankers are never elected directly, but instead are appointed by elected officials, it might be useful to note the extent to which the distribution of votes on the Governing Council of the European Central Bank represents, or misrepresents, the relative populations of the member countries. There are about 170 million people in countries that are members of EMU, so there are about 10 million people per vote on the Governing Council. Table 4 lists the member countries, rank ordered from the most overrepresented on the council to the most underrepresented. The data in the table allow for those countries that have two votes and those that only have one.

Luxembourg, Finland, and Ireland are badly overrepresented, while Germany, France, and Italy are the most underrepresented. There are 102 times as many people in Germany per vote on the council as there are in Luxembourg. Before one concludes that this is unacceptable, it should be noted that the ratio of the population of California to that of Wyoming is 66:1, and each of these states has two seats in the U.S. Senate.

The Exchange Rate and Domestic Macroeconomic Conditions: A Parallel of Interests

The conclusion that purely domestic factors in most EMU member countries suggest a tightening of monetary policy is extremely convenient because it parallels the policy implications of the euro's exchange-rate problem. At slightly below 85 cents at the time of this writing, the currency has depreciated by almost 30 percent since it began trading in January 1999. The tightening of U.S. monetary policy has added to other downward pressures on the euro, and the adoption of a considerably fighter monetary policy by the European Central Bank is the only obvious way to defend its currency. Nobody at the ECB should have been surprised that central bank intervention in the exchange market without a change in monetary policy, as attempted in the fall of 2000, accomplished very little. There is overwhelming evidence that such intervention succeeds beyond the very short run only if it is accompanied by a supportive adjustment of monetary policy, that is, by a tightening when the currency is depreciating. Any defense of the euro that can be expected to succeed must imply a considerable tightening of the European Central Bank's monetary policy relative to that prevailing in the United States.

A softening of the U.S. economy, which seems to be on the near horizon, would allow an easing of U.S. monetary policy, which would greatly reduce the problems facing the Governing Council of the ECB. If U.S. monetary policy becomes more expansionary in 2001, a less severe tightening would be required in Europe to stabilize the euro and perhaps even bring it back toward parity with the dollar. The more important point, however, is that the ECB does not face a "conflict case," which is when the domestic and international goals of the central bank directly conflict. If, for example, the ECB wished to reverse a depreciation of the euro when most EMU countries were in a recession, such conflict would exist. The European recession implies an expansionary monetary policy, while the defense of the exchange rate necessitates a tightening. Either direction in which the ECB moves would ease one problem at the cost of making the other worse. At present, however, there is no such conflict. Domestic macroeconomic conditio ns in a majority of the member countries, as represented by the inflation and unemployment data in the three decision rules, and the recent behavior of the euro exchange rate, both imply a considerable tightening of monetary policy by the European Central Bank.

Conclusion

The success of two previous efforts of predicting ECB monetary-policy decisions, even if perhaps the result of good luck, makes it useful to use the same three versions of the Taylor rule and current data to suggest the direction in which the Governing Council may move in 2001. Using mid-to late 2000 national data for inflation and unemployment, it appears that there should be a clear majority for a further tightening of policy. Unemployment rates are down across much of Europe, and inflation is beginning a modest acceleration. The past depreciation of the euro can be expected to make inflation somewhat worse in the EMU countries during the next year. Both to defend the exchange rate for the euro, and in response to recent changes in inflation and unemployment rates, the European Central Bank has sound reasons to continue its current trend toward a tighter monetary policy well into 2001.

ROBERT DUNN, JR., is a professor of economics at The George Washington University.

Notes

(1.) For those countries that appear in the statistical pages of the Economist, inflation and unemployment data from a late October 2000 issue were used. For the small number of countries (Portugal, Ireland, Finland, and Luxembourg) that are not listed in those tables, the September issue of the OECD's Main Economic Indicators was the source of inflation and unemployment data.

(2.) John Taylor, "The Inflation/Output Variability Trade-off Revisited," in Goals, Guidelines, and Constraints on Monetary Policy, ed. J. Fuhrer (Boston: Boston Federal Reserve Bank, 1994).

                   Taylor Rule: 1999 and 2000 Compared.
                1999  2000 Change     Vote
Austria         +3.7  +6.7  +3.0     Tighten
Belgium         +0.8  +2.4  +1.6     Tighten
Finland [*]     +2.1  +5.0  +2.9   Tighten (2)
France [*]      +0.5  +1.4  +0.9  No change (2)
Germany [*]     -1.7  +3.9  +5.6   Tighten (2)
Ireland         +5.9 +10.9  +5.0     Tighten
Italy [*]       +1.9  +2.0  +0.1  No change (2)
Luxembourg      +5.9  +0.6  -5.3      Ease
Netherlands [*] +5.9  +5.9   0    No change (2)
Portugal        +3.4  +9.8  +6.4     Tighten
Spain [*]       -0.3  +3.7  +4.0   Tighten (2)
(*.)Countries with a national as a member of the Executive Board
of the ECB, and therefore with two votes on the Governing Council.
                      A Simpler Taylor Rule for EMU:
                              1999 vs. 2000.
            1999 2000 Change     Vote
Austria     +3.4 +6.0  +2.6     Tighten
Belgium     -3.3 -2.4  +0.9    No change
Finland     -0.9 +0.7  +1.6   Tighten (2)
France      -3.2 -2.3  +0.9  No Change (2)
Germany      0   -4.3  +4.3   Tighten (2)
Ireland     +3.2 +7.9  +4.7     Tighten
Italy       -2.4 -2.1  +0.3  No change (2)
Luxembourg  +5.7 +2.6  -3.1      Ease
Netherlands +5.6 +5.9  +0.3  No change (2)
Portugal    +2.8 +7.3  +4.5     Tighten
Spain       -6.8 -3.5  +3.3   Tighten (2)
              Historical Taylor Rule: 2000 and 1999 Compared.
            1999 2000 Change     Vote
Austria     +0.5 +3.0  +2.5     Tighten
Belgium     -1.4 -0.3  +1.1     Tighten
Finland     +3.0 +4.8  +1.8   Tighten (2)
France      +1.6 +2.6  +1.0   Tighten (2)
Germany     -2.3 +2.2  +4.5   Tighten (2)
Ireland     +3.2 +7.7  +4.5     Tighten
Italy       +1.2 +1.6  +0.4  No change (2)
Luxembourg  +1.3 -1.8  -3.1      Ease
Netherlands +2.8 +1.9  -0.9  No change (2)
Portugal    +0.5 +4.3  +3.8     Tighten
Spain       +5.3 +6.9  +1.6   Tighten (2)
                      National Population per Vote on
                     the Governing Council of the ECB.
              Millions of
Country     people per vote
Luxembourg        0.4
Finland           2.5
Ireland           4.0
Netherlands       8.0
Portugal         10.0
Belgium          10.0
Austria          19.0
Spain            19.5
Italy            29.0
France           29.5
Germany          41.0
Source: World Bank, World Development
Report, 2000/2001, pp. 274-275.

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