The governors of the national central banks of the EC member states recently proposed a Draft Statute for the institutional structure of the European Central Bank (ECB), which will have significant consequences for the political economy of European monetary policy and particularly for the trade-off between inflation and stabilization. In Discussion Paper No. 563, Research Fellows Alberto Alesina and Vittorio Grilli first assume that Europe has achieved political unity and derive a model in which wage contracts are set and inflationary expectations formed at the beginning of each period. The economy then experiences a shock, after which the ECB sets the inflation rate. They find that European voters choosing the ECB's governor by majority rule will choose a candidate more inflation-averse than the median European voter, and the new ECB will be as independent as the present Bundesbank.

Alesina and Grilli then consider the transition to a political union and assess the effects of monetary union on national welfare functions based on the common inflation rate and divergences of national outputs from target levels. They disaggregate these into those deriving from political divergences (differences in preferences) and economic dissimilarities between the countries (captured by the `covariances' between country-specific and `European' shocks).
Considering political differences alone reveals that a monetary union improves welfare if the ECB's preference is more `conservative' than national preferences, so that countries with higher inflation biases stand to gain most. The economic differences indicate, however, that countries whose output variance differs from the overall European level will lose from a union: the ECB will stabilize too much or too little. A comparison of member countries' `economic distance' from the EC average in terms of central bank independence and inflation performance during the 1980s indicates that those with most to lose in terms of stabilization stand to gain most in terms of monetary policy credibility: the peripheral countries Spain, Greece, Ireland and Portugal have the most dependent central banks and the highest inflation.

Alesina and Grilli also investigate the ability of the system of appointments and voting rules embodied in the Draft Statute to represent the views of European voters by comparing their predicted outcomes with the results of the member countries' last national elections. They find that the European median in voting shares is significantly to the left of that of the European Council. The `left' holds some 44% of the popular vote, but under the two variants of the rules proposed in the Draft Statute it would hold only 15% or 30% of the votes on the Board of the ECB.

The European Central Bank: Reshaping Monetary Politics in Europe
Alberto Alesina and Vittorio Grilli

Discussion Paper No. 563, July 1991 (IM)