How to achieve a durable macro-economic policy mix favourable to growth and employment?
Speech by Professor Otmar Issing, Member of the Executive Board of the European Central Bank. Contribution to the conference on "Growth and Employment in EMU" organised by the European Commission, Brussels Economic Forum, Brussels, 4 and 5 May 2000
Economic recovery in the European Union has gathered momentum and become increasingly widespread. It is based on sound fundamentals: the conditions for investment and growth are favourable, inflation remains low and public finances have improved. However, although new jobs are being created, unemployment remains at an unacceptably high level.
The strategies for how best to achieve sustained growth and - in particular - higher employment are controversial. While there is broad consensus that structural policies must tackle the roots of the serious unemployment problem, namely rigidities in the labour and goods markets, there have been repeated calls for placing job creation also in the context of enhanced macroeconomic policy co-ordination between monetary, fiscal and wage policies.
The central message I wish to convey today, however, is that not much can be expected from attempts to co-ordinate these macroeconomic policies ex ante in order to achieve a macroeconomic policy mix conducive to sustained job creation. On the contrary, such attempts give rise to the risk of confusing the specific roles, mandates and responsibilities of the policies in question. Moreover, they tend to prevent the individual policy-makers from being held accountable and, therefore, reduce the transparency of the overall policy framework for the general public.
Instead, I shall argue that national governments and autonomous social partners should design and implement the policies for which they are responsible bearing in mind the overall stability framework provided for in the Maastricht Treaty. As a result, prudent fiscal policies and moderate developments in wage costs, which take into account the interdependencies between the latter and the stability-oriented single monetary policy, will already go a long way towards providing favourable conditions for growth and employment.
Let me first clarify some of the conceptual issues which form the basis of my line of arguments.
2. What are the issues?
The formation of Economic and Monetary Union (EMU) has created a framework for policy-making in Europe which is unique in history. While the single monetary policy is oriented towards a union-wide objective, namely the maintenance of price stability, the other policy areas - including fiscal and wage policies - largely remain the responsibility of national authorities.
Against this background, calls for enhanced macroeconomic policy co-ordination have come about as a result of the perception that the single monetary policy places constraints on national policies. More specifically, it is argued that these constraints could be alleviated by setting the remaining national policy instruments in a co-ordinated manner in order to achieve macroeconomic outcomes favourable to national policy-makers, while at the same time respecting their important anti-cyclical role.
On a conceptual level, the calls for policy co-ordination are based on the idea that individual policies, which affect one another, should take one another's objectives and actions into account. This idea appears to be an attractive and self-evident proposition. A number of severe practical problems limit its scope, however.
Co-ordination across individual policy areas creates serious problems with regard to gathering and assessing all relevant information in an effective and timely manner. As a result, co-ordinated policy-making is particularly prone to the well-known recognition and decision lags of policy-making.
Policy co-ordination among several policy-makers gives rise to the risk of confusing responsibilities, distorting incentives and reducing the accountability of individual policy-makers. In the worst case scenario, if everyone is regarded as being responsible for everything, no one will take responsibility for anything.
In general, the calls for policy co-ordination disregard the political-economy context of practical policy-making and, therefore, an essential component of reality. To this end, the implementation of co-ordinated policy decisions in the jurisdictions of the individual policy-makers may suffer from a lack of appropriate enforcement mechanisms, which, inter alia, would help to contain free-riding behaviour by national policy-makers.
Since the information, incentive and enforcement problems seem to undermine the practicability of policy co-ordination, one may wonder how these problems can be alleviated or - more importantly - how different policy-makers can take into account one another's objectives and actions from the outset so that policy co-ordination would, in fact, be largely unnecessary.
I am convinced - as an economist experienced in policy-making - that designing the appropriate institutions lies at the heart of the answer to this question. Let us consider the issue of policy co-ordination being conditional on an initial assignment of objectives and instruments to individual policy-makers. Calls for policy co-ordination would, in this case, be based on the assumption that this kind of assignment does not appropriately reflect the interdependencies of the policy-makers' objectives and actions. By contrast, if there is already an efficient initial assignment of responsibilities in place, which does take into account the individual policy-makers' objectives and actions, calls for policy co-ordination, which would be fraught with the aforementioned problems, would not be necessary. To put it simply, an efficient initial assignment of objectives and responsibilities will largely substitute the need for co-ordinated policies later on.
In this context I would say that the Maastricht Treaty already provides for an assignment of duties with a sound and clear allocation of responsibilities to the policy-makers in the euro area, thus making the scope for additional policy co-ordination rather limited. This assignment clearly defines the European Central Bank's role and provides rules for the other policy-makers' contributions to economic stability.
3. Responsibilities under the "Maastricht assignment"
The central legal basis for economic policy co-ordination within EMU is specified in Article 103 of the Maastricht Treaty, which states that "Member States shall regard their economic policies as a matter of common concern and shall co-ordinate them within the [European] Council". On the basis of this principle, the framework for the definition of overall economic policy objectives and orientations is provided by the "Broad Economic Policy Guidelines" adopted by the Council each year.
With regard to monetary and fiscal policies, the assignment of responsibilities is defined by the Maastricht Treaty and the Stability and Growth Pact respectively. The Treaty has assigned the maintenance of price stability as the primary objective to the single monetary policy under Article 105. Without prejudice to its primary objective, the single monetary policy shall support the general economic policies of the European Community. The Stability and Growth Pact provides guidelines for fiscal discipline at the national level by strengthening the excessive deficit procedure of the Treaty and by prescribing sanctions for breaches of the 3% limit of the deficit-to-GDP ratio. It also specifies a commitment to achieving medium-term budgetary positions "close to balance or in surplus" and incorporates multilateral surveillance procedures.
Assigning the overriding objective of price stability to the single monetary policy - thereby reflecting that inflation is ultimately a monetary phenomenon - highlights the benefits of the basic division of responsibilities provided for by the Maastricht Treaty. The single monetary policy - safeguarded by an independent central bank - enhances the credibility of monetary policy, increases its transparency and also facilitates its accountability. Similarly, the Stability and Growth Pact provides the right incentives for the conduct of sound and disciplined fiscal policies across all national governments, while keeping room for manoeuvre for automatic stabilisers and prudent anti-cyclical policies.
While the Maastricht Treaty and the Stability and Growth Pact make provisions for monetary and fiscal policies - either in the form of the single monetary policy or in the form of disciplinary rules for national governments - wage developments largely remain the result of bargaining among autonomous social partners at the national level. It is evident, however, that the social partners should act in their own interest by ensuring that price stability and a high level of employment are compatible. Given the fact that the relationship between wage developments, productivity growth and price stability plays an important role in this respect, real wage increases which do not exceed trend productivity growth will facilitate the maintenance of price stability and simultaneously promote employment. Obviously, in times of high unemployment, when there is a need to stimulate job creation, employment-oriented wage settlements should not fully exploit productivity increases. Moreover, wage settlements should account for sectoral and regional differences in productivity and labour market conditions. With regard to the role of national governments in this context, overall wage moderation could be encouraged by modest wage settlements in the public sector.
If all policy areas concerned respect the aforementioned allocation of responsibilities and act accordingly, they will already be making the best possible contribution to the Community objectives as provided for by the "Broad Economic Policy Guidelines". Of course, an open exchange of information between individual policy-makers will assist the overall outcome if it manages to improve the understanding of the responsibilities of the respective policy areas. This exchange of information will be facilitated, for instance, by the "Macroeconomic Dialogue" under the European Employment Pact, which was endorsed at the Cologne European Council meeting in June 1999.
Any form of dialogue, however, should clearly be distinguished from an attempt to co-ordinate macroeconomic policies ex ante, which would give rise to the information, incentive and enforcement problems mentioned previously. Indeed, ex ante co-ordination would tend to blur the fundamental responsibilities of the different policy areas. Moreover, it would distort incentives and reduce the accountability of individual policy-makers.
Allow me now to elaborate a little further on the ways in which the single monetary policy contributes to a stable policy framework conducive to growth and employment.
4. The contribution of the single monetary policy
The single monetary policy is responsible for maintaining price stability in the euro area as laid down in the Maastricht Treaty. To this end, the Eurosystem has adopted a medium-term-oriented monetary policy strategy which is forward-looking and enables prompt action to be taken in order to address any potential threats to price stability. Moreover, the Eurosystem's definition of price stability gives a clear quantification of how its mandate is to be interpreted by the Governing Council of the ECB.
Theory and empirical evidence clearly confirm that there is no long-term trade-off between price stability and economic growth. Attempting to use monetary policy to fine tune economic activity or to gear it above a sustainable level will, in the long run, simply lead to rising inflation, and not to faster economic growth. Instead, by maintaining price stability over the medium term, the single monetary policy makes the best contribution it can to achieving a high level of output and employment, thereby supporting the general economic policies of the Community, as required by the Treaty.
Indeed, maintaining price stability over the medium term has beneficial effects on general economic performance - including growth and employment - and it also serves the interests of social justice. In particular:
in an environment of price stability, the market mechanism will allocate resources efficiently to their most productive uses;
confidence in lasting price stability removes the inflation risk premium on interest rates, thereby ensuring low real interest rates, which, in turn, will foster investment, growth and employment; and
price stability helps to protect the weakest members of our society, that is to say those most exposed to the costs of inflation.
In maintaining price stability over the medium term, the Eurosystem's stability-oriented monetary policy strategy aims to take advantage of recent advances in economic research on optimal monetary policy, without losing sight of a few fundamental principles which have been at the heart of monetary economics for a long time. To this end, it comprises two pillars. First, money is accorded a prominent role, which stems from the relationship between money and prices over the medium and long term - the relevant horizon for monetary policy-making. Second, a comprehensive assessment of the outlook for price developments is made, focusing both on likely future paths of consumer prices in the euro area as a whole and on the balance of risks to price stability.
The two-pillar strategy of the Eurosystem helps to organise all the available information in a manner which permits both the internal decision-making process to be structured more efficiently and the resulting decisions to be more easily conveyed to the public. The monetary policy strategy therefore constitutes an important vehicle for communicating monetary policy decisions and explaining the reasoning behind the decisions to the public. In this context, the clear definition of price stability is to be interpreted as an attempt to give a specific benchmark against which the monetary policy-maker can be held accountable.
Given the Eurosystem's strategy, there should be no doubt that the single monetary policy will adequately take into account fiscal policies and wage settlements in order to maintain price stability over the medium term. Thereby, the single monetary policy gives reassurance about future price developments, which, in turn, should help governments to plan their budgets and to guide wage settlements. Vice versa, sound government finances, aiming for a permanent reduction in budget deficits and debt levels, will be a means of strengthening the conditions for price stability and increasing the economy's growth potential. Similarly, lasting wage moderation, which does not lead to inflation expectations and which takes into account the high level of unemployment within the euro area, will improve the outlook for price developments as well as the overall prospects for employment and growth.
5. The role of structural reforms
Most will agree that Europe is hampered by a number of structural impediments, which are highly detrimental to employment, investment and growth. Structural rigidities in the labour markets, for instance, and misguided incentives provided by the national social security and welfare systems are considered the major causes of the unacceptably high level of unemployment in the euro area. Similarly, a high tax burden and excessive regulations in the goods markets constitute severe obstacles to investment and growth.
Obviously, macroeconomic policies cannot be used to mitigate the main causes of Europe's serious unemployment problem. Other policies, aimed at the micro level, have the necessary instruments to do so and are, therefore, responsible for ensuring sustained growth and employment prospects. Essentially, structural reforms in the labour and goods markets must be undertaken as the key element of a comprehensive strategy for improving investment, growth and employment prospects in Europe. In this context, I highly welcome the conclusions of the recent meeting of the European Council in Lisbon, which expanded further on this issue by examining the objectives of the existing reform process and the instruments aimed at strengthening the performance of the European economy. Given the existing reform process, however, emphasis must now be placed on its effective application. Moreover, although a common understanding of the required elements is important - as well as their mutual reinforcement - the responsibility for their implementation should remain mainly with the national policy-makers and their available instruments.
While some progress has already been made to reduce corporate tax rates and while deregulation is under way in a number of sectors, such as telecommunications and electricity, improving competitiveness is considered a prerequisite for promoting efficiency and stimulating innovations in new technologies, such as information, communication and media. Given that the creation of an information and knowledge-based economy lies behind the extraordinary and favourable combination of low unemployment and subdued inflation that prevails in the United States today, one could speculate that we may also see the birth of a New Economy in Europe. The potential is clearly there to be exploited if the required structural reforms in the goods and labour markets take place. By adopting the new technologies, which have been developed and tested in the United States over the past decade, Europe's economy has the potential to achieve the kind of performance seen in the U.S. New Economy even more rapidly than was the case in the United States itself. As was forcefully emphasised by the Lisbon Presidency Conclusion, a shift to a knowledge-based economy would indeed be a powerful engine for sustained growth.
Beyond the creation of more flexible labour and goods markets, there are additional factors which may justify an optimistic forward-looking assessment of Europe's growth potential. First, globalisation continues to foster competition, which is exemplified by the restructuring of the corporate sector currently under way. Second, the completion of the Single Market facilitates the broadening and deepening of capital markets which is conducive to financial innovation and an increased provision of venture capital. The former, together with the patterns developing in portfolio allocations among European households (towards a higher share of equities and mutual funds), is particularly important for the growth of the new technological sectors of the economy, which rely heavily on equity financing. Finally, the stable policy framework in Europe - with a strong commitment to price stability, sound public finances and moderate wage settlements - makes a substantive contribution to favourable growth prospects.
Reflecting these favourable growth prospects, the European Commission revised its euro area growth forecast upwards to 3.4% in 2000 from 2.9%. Thus, as the European Commission phrased it, the euro area would grow faster in 2000 than at any other time since 1989. Similarly, the IMF revised its forecast from 2.8% to 3.2% in its recent World Economic Outlook. Given this strong upward revision, it is difficult to understand the economic reasoning behind the IMF's message that the ECB's monetary policy "appropriately remains accommodating" and that "it is important currently to avoid holding back the ongoing recovery through a rapid tightening of policy". These recommendations need to bear in mind the fact that, despite some reforms, the euro area is still hampered by severe structural rigidities - as was also extensively reviewed in last year's World Economic Outlook. Alan Greenspan, for instance, has identified inflexibility in labour markets as a reason for the new technologies not having the same impact in Europe as they did in the United States. Further to this, he argued that "US businesses and workers appear to have benefited more from these recent developments than their counterparts in Europe or Japan. Of course, those countries have also participated in this wave of invention and innovation, but they appear to have been slower to exploit it. The relatively inflexible and, hence, more costly labour markets of these economies are a significant part of the explanation."
For the euro area, an activist or even pro-cyclical monetary policy, which does not take into account the rigid market structures and the substantial time lags of its transmission, would generate threats to price stability and undermine the prospects for long-term growth.
Arguing once more in favour of medium-term-orientated policy-making, allow me to draw the following conclusions.
The single monetary policy should be credibly geared towards the maintenance of price stability over the medium term as prescribed by the Maastricht Treaty. Together with national fiscal policies which adhere to the provisions of the Stability and Growth Pact and prudent employment-oriented wage settlements which account for sectoral and regional productivity differentials, the single monetary policy will then go a long way towards safeguarding favourable prospects for non-inflationary growth and increased employment in Europe.
Attempts to co-ordinate the monetary, fiscal and wage policies ex ante are risky. All in all, they are fraught with information, incentive and enforcement problems, thereby running the risk of confusing the responsibilities of the individual policy-makers. Moreover, ex ante co-ordination would reduce the transparency of the overall policy framework and make it more difficult for the policy-makers to be held accountable. Indeed, not least to cope with these problems, the ECB was designed as an independent institution with a clear mandate to achieve price stability.
Ultimately, ensuring sustained growth and employment essentially depends on the adoption of a comprehensive process of structural reforms in the goods and labour markets. Given the improved economic outlook in the European Union, the time is now ripe to translate the relevant governments' intentions into deeds.