Central bank independence and budget constraints for a stable euro

This paper looks at what economic theory and empirical evidence have to offer about the institutional conditions that are most likely to lead to a stable currency. Both theory and evidence suggest that an independent central bank with the explicit mandate to pursue price stability provides an effective solution to the time-inconsistency problem. The EMU institutional set-up is well-equipped to support a stability-oriented monetary policy. The ECB appears to be the most independent central bank in the world. An added protection of monetary policy from the influence of unsound budgetary policies enhances the prospects of price stability. The Maastricht Treaty and the Pact for Stability and Growth provide effective constraints against excessive deficits and encourage an environment of balanced budgets. The argument that both strong institutional arrangements and sound economic policy-making stem from a "conservative" attitude of the public is not dismissed altogether in this paper. We note, however, that this hypothesis is not formulated in a testable form and has ambiguous practical consequences. The hypothesis, nonetheless, serves as a useful reminder that the ECB should endeavor to draw its legitimacy not only from the text of the Treaty, but also from society as a whole.