The European Central Bank (ECB) was established following the decision of a number of European countries, including Germany, France and Italy, to adopt a common European currency.
Individual central banks had to relinquish their powers to manage money supply and set domestic interest rate levels. A few countries, such as the UK, opted out although in time that may well change.
There are clear advantages and disadvantages of having a common European currency. Cross-border transaction costs are reduced in part because there are no foreign exchange related charges for business conducted between members. Risks arising from companies having foreign exchange positions are also reduced. Business travelers and tourists in Europe no longer have to carry cash in a dozen different currencies.
The disadvantages stem from a lack of labor mobility and variations in national fiscal policies. In a unified economy such as the US workers will react to a downturn in one part of the country by moving to a part of the countr y with better economic prospects. This is much harder to accomplish in a continent with many different languages and where there is a limited tradition of cross-border labor movement.
National central banks’ ability to use monetary policy to influence economic growth, the level of unemployment and inflation have been largely subjugated to the ECB. They cannot cut interest rates, for example, to give a boost to a local economy in recession or hike rates to choke off inflation. The extent to which this lack of flexibility will result in future problems remains to be seen.
The ECB has specific quantitative inflation targets to meet but also has the power to take action against countries that fail to keep their government’s financing deficit as a percentage of GDP below a predetermined level.