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Monetary stability and economic growth or: Why stable prices are good for private enterprise in France and the Netherlands

Speech delivered by Dr. W.F. Duisenberg, President of the European Monetary Institute, to the French/Dutch Chamber of Commerce in The Hague, 14 October 1997

I shall today address a subject which is very familiar to central bankers: namely, the relationship between monetary stability, monetary policy and economic growth. More particularly, I would like to focus my remarks on the benefits of stable prices for private enterprise.


As you know, the core task of a central bank is to safeguard the purchasing power of money or, to put it differently, to create a zone of monetary stability. The concept of monetary stability comprises in any case the requirement that money has a stable internal value or, to express this in more familiar terms, that there is price stability. Under specific circumstances, namely when foreign countries also adhere to price stability, this also creates favourable conditions for a stable external value of the currency, in other words, exchange rate stability. Let me dwell for a moment on these two aspects of monetary stability, their interlinkages and their relative weight in formulating monetary policy in Europe.

A growing number of central banks throughout the world have been given the legal mandate to ensure price stability. Such a mandate also applies in the case of the European System of Central Banks (ESCB), as the Maastricht Treaty explicitly states that "the primary objective of the ESCB shall be to maintain price stability". Following a definition which has been advocated by my colleagues Paul Volcker and Alan Greenspan, price stability obtains when the public no longer takes account of actual or prospective inflation in its decision-making. What this definition actually means in operational terms is somewhat difficult to specify, given the various available statistical measures of inflation - that is, of the increase in the general price level. Moreover, there is a degree of upward bias in measured inflation. Taking this into account, however, one could say that a rate of consumer price inflation not exceeding 2% is probably not far off what central banks would normally be quite satisfied with. Some European central banks have indeed set themselves quantitative monetary or inflation targets that reflect this benchmark for price stability.

Let me now move on to the external aspect of monetary stability, namely that of a stable exchange rate. For several EU countries it has proved highly beneficial in the past decades to aim for a stable external value of the currency against the strongest and most credible EU currencies as the key to achieving price stability. In small open economies, the existence of close trade relations is a further major justification for such an indirect approach to fighting inflation, as a stable currency removes an artificial barrier to international competition and thus promotes trade with other partners. In contrast, some central banks of other, usually larger, EU countries have preferred to focus their monetary policy directly on the achievement of price stability and thereby also to lay the foundations for a stable exchange rate. While this has allowed them to set official interest rates in line with domestic price requirements, these were nonetheless influenced by the interaction between exchange rate developments and inflation. As experience has shown, the success of either form of monetary policy orientation depends crucially on the support of economic policies directed at sound public finances, responsible wage behaviour and efficient markets.

In Stage Three of EMU, the ESCB will carry out its mandate of ensuring price stability in a somewhat different economic environment, comparable to the situation of the Federal Reserve in the United States. The euro area will be a large internal market with strong trade relations among its partners stimulated by the existence of a single currency. As a natural consequence, trade flows with the rest of the world will be rather small. This allows the ESCB to focus primarily on "domestic" inflationary risks and to consider fluctuations in the euro exchange rate only to the extent that these significantly affect "domestic" prices. This also explains why it has now been agreed that any so-called orientations that might be formulated by the ECOFIN Council in the field of exchange rate policy for the euro area will be limited to exceptional circumstances. As stated in the Treaty, such general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.

Against this background, some people have asked me "Where does all this leave economic growth?" Behind this question seems to be the idea that the ESCB could - or even should - use monetary policy to promote growth and employment in EMU, especially in view of the high level of unemployment in Europe. In answer to this question, I refer to the Statutes of the ESCB which stipulate that "without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to the achievement of the objectives of the Community", which include inter alia sustained non-inflationary growth and a high level of employment. Also relevant in this context is the sentence that the ESCB "shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources".

Before I go on to discuss the relationship between monetary policy and economic growth in more detail, it may be useful to recall the costs of inflation - or, to put it differently, the reasons why a climate of price stability provides substantial benefits, especially for private enterprise. My remarks should make clear that I see no conflict between price stability and a balanced development of economic activity in EMU; on the contrary, a stable price environment provides excellent conditions for a flourishing market economy and thus supports a healthy creation of employment. Indeed, the best way for monetary policy to contribute to the achievement of the objectives of the Community is precisely by focusing on price stability.


To arrive at a clearer understanding of the economic and social costs of inflation it is helpful to distinguish between anticipated and unanticipated inflation. Let me start with the case of inflation which is fully expected. Although the public will normally have taken account of expected price increases in their economic decision-making, this aspect of inflation nonetheless imposes non-negligible costs. They relate in particular to attempts by the public to economise on non-interest-bearing money holdings, the need to constantly revise price lists, and the misallocation of resources due to the operation of tax systems which are not fully indexed. At first sight these costs might appear somewhat trivial. The truth of the matter is, however, that the efficiency losses can be very large.

This is perhaps most evident in the case of the tax argument. Taken by itself, the imposition of personal and corporate income taxes distorts the allocation of productive resources in a market-based economy because it leads to a bias towards current consumption relative to savings and investment. Recent academic studies have found that the interaction between inflation and income taxes has the unintended effect of exacerbating these distortions. Calculations for the United States suggest that the negative impact of 2 percentage points extra inflation could be as high as 1% of GDP on a permanent basis, in other words output is 1% lower each year. Although this outcome is sensitive to the underlying assumptions, similar work undertaken for some EU countries (Spain) broadly confirms the conclusion that reducing inflation and thereby the magnitude of tax distortions brings substantial benefits which, over the longer term, exceed the transitional disinflation costs. Given the adverse effects associated with inflation, it is thus worthwhile accepting the transitional sacrifices in output of moving to price stability.

The costs associated with unanticipated inflation are perhaps even more evident, as they arise above all from the uncertainty that goes with it. Clearly, an environment of stable prices offers a much more reliable basis for corporate decision-making. In evaluating investment opportunities, it is crucial for firms to be able to rely on the signals conveyed by relative price changes, as these will tell them whether or not it is profitable to engage in a certain productive activity. For this mechanism to function properly, firms must be able to discriminate between relative price adjustments and general changes in the price level. However, this is a particularly difficult exercise in periods of high and variable inflation. This also explains why the prospect of a single currency produces large benefits; it allows cross-border relative price comparisons to be made without the distorting influence of exchange rate fluctuations. The more reliable the information on relative prices, both nationally and across borders, the more an efficient allocation of scarce resources and the ability of a market economy to function properly is promoted.

The same positive result for resource allocation arises from the fact that in a non-inflationary environment firms are more willing to enter into long-term investment contracts. After all, when considering a long time period for evaluating costs and revenues they face a smaller risk of unanticipated inflation wiping out expected real profits. At times of high and variable inflation, however, they tend to prefer projects which promise a quick return on investment. In addition, the expected real return must be higher, because - with a higher degree of uncertainty over inflation - firms are confronted with a higher real cost of borrowing. This can be explained by the fact that financing costs tend to include an insurance premium to cover the risk of unexpected changes in the price level. A climate of stable prices thus offers companies substantial benefits in terms of lower real interest rates.

This brings me to one of the main arguments against inflation, namely the unintended redistributive consequences. Inflation effectively functions as a tax which, at random and without justification, causes a redistribution of income and wealth, especially if it comes unanticipated. Who will profit and who will lose from it, depends on whether and to what extent people are able to predict and neutralise the effects of inflation. The outcome of this process is uncertain, but all too often it is the weaker in society who cannot protect themselves and bear the brunt. Accepting high inflation is thus equivalent to allowing a social injustice to endure. Ultimately, this undermines the cohesion of society.

Another point to note in this context is that at times when wage increases are the driving force behind inflation, the macroeconomic income distribution tends to change to the benefit of employees and to the detriment of profits. On the one hand, wage rises in excess of labour productivity growth fuel domestic inflation, to the extent that firms succeed in passing on the increase in unit labour costs in domestic sales prices. On the other hand, firms facing international competition normally have to cut profit margins in response to higher unit labour costs, in order not to lose their share of the market. In many European economies - including France and the Netherlands - this two-way mechanism was clearly visible in the simultaneous rise of inflation and labour's share of GDP in the 1970s and early 1980s. A reverse process was set in motion in the course of the 1980s: parallel to the decline in inflation the share of profits in GDP increased, which in turn offered opportunities for investment, output growth and employment.


Having arrived at a clear view of the benefits of price stability, it is time to devote a few words to the question of what may be expected from the monetary policy of the ESCB in terms of support for growth and employment. Here, it would seem that some observers still live in the "era of great expectations" which characterised the 1970s, when expansionary policies were adopted in order to stimulate domestic demand, while neglecting their adverse consequences for price stability. Society has paid a high price for this illusion in terms of stagnating economic growth combined with high and volatile inflation. The lesson which should be taken to heart is that expectations must be realistic and not overburden the monetary policy of the ESCB. Let me elaborate this point.

First, the contribution that monetary policy can make towards balanced growth and employment is above all to provide for a stable price climate. However, it would be a tragic mistake to assume that the ESCB bears sole responsibility for establishing and maintaining price stability for the euro. Monetary policy needs to be supported by sound budgetary policies and wage developments in line with productivity growth. In other words, the overall policy mix must be appropriate. Without adequate support from other policy areas, the ESCB may be forced to take measures in the fight against inflation which entail a short-term loss in output and employment. This might have adverse consequences for the public's opinion of monetary policy. However, these short-term sacrifices are justified in order to safeguard the foundations for balanced growth and employment in the longer run. This also explains why it is so important that the Maastricht Treaty assigns a high degree of independence to the ESCB in carrying out its mandate. The credibility of its monetary policy is further supported by the budgetary provisions of the Treaty which oblige Member States to avoid excessive budget deficits. As clarified in the Stability and Growth Pact, excessive deficits are only allowed in clearly defined exceptional circumstances. In addition, the Stability and Growth Pact specifies a procedure for a rapid correction of excessive deficits in euro countries should they nevertheless arise.

Second, one should realise that monetary policy in EMU applies to the euro area as a whole. As a consequence, it cannot be used for solving regional problems or country-specific economic shocks. These require above all well-functioning labour and product markets which allow wages and prices to adjust if local economic conditions have changed. In addition, national budgets must have sufficient room for manoeuvre to let automatic stabilisers work. As a further element of the Stability and Growth Pact, all Member States have therefore committed themselves to the achievement of a budgetary position close to balance or in surplus over the medium term. Under normal circumstances, this should allow budget deficits to fluctuate around zero, while at the same time respecting the 3% ceiling as specified in a protocol to the Treaty.

Third, it is a well-known fact that the effects of monetary policy occur with long and variable lags. For this reason, it is impossible to use it for fine-tuning purposes. Monetary policy can only pursue price stability in the medium term. Once price stability is ensured, monetary policy may be used in such a way as to contribute to an automatic stabilisation of the business cycle, which means that this stabilisation does not require discretionary measures.

Fourth, sustainable growth and a healthy creation of employment require more than just an appropriate monetary policy. This can be aptly illustrated by the current unemployment problem in Europe. As its underlying causes are structural, its solution requires structural remedies and not an expansionary monetary policy. As the experience of recent years shows, those Member States that have undertaken fundamental labour market reforms have achieved both a strong recovery of employment and stable prices. At the same time, they often successfully managed to reduce their budget deficits. Accordingly, if all policy areas contribute to creating the right conditions, price stability will over the longer term go hand in hand with a balanced economic development.

The task is thus to ensure that in Stage Three of EMU an appropriate overall policy mix is achieved. For the monetary policy decisions of the ESCB to be well-informed and optimal with respect to its primary and secondary objectives, there is evidently a need for a regular dialogue and exchange of information on issues of common interest with third parties. This applies in particular to national economic policies, wage developments and the overall fiscal policy stance in the Monetary Union; under exceptional circumstances this could also include the exchange rate policy for the euro area. The question is how to organise such a constructive dialogue. The current situation in the Member States is that the Governor of the national central bank has a natural counterpart in the Minister of Finance, with whom frequent contacts exist, often on a weekly basis. In my previous capacity as Governor of the Nederlandsche Bank, I had, for example, regular lunch appointments with the Minister of Finance to discuss matters of common interest. In Stage Three of EMU the situation is more complicated, but the Treaty does contain some provisions in this regard (see Article 109b). On the one hand, the President of the ECOFIN Council (and also a member of the European Commission) may participate in the meetings of the Governing Council of the ECB and submit motions for deliberation, without the right to vote. On the other hand, the President of the ECB will be invited to take part in meetings of the ECOFIN Council when matters relating to the objectives and tasks of the ESCB are on the agenda. Finally, in addition to national delegations (including the independent national central banks), two representatives of the ECB will participate in the preparatory meetings of the Economic and Financial Council, the successor to the current Monetary Committee. It would thus seem to me that the Treaty contains sufficient institutional provisions for the co-ordination between economic and monetary policy in the euro area.


Let me now come to a conclusion. First, I have argued that for the ESCB the concept of safeguarding monetary stability is to be interpreted as equivalent to the task of ensuring price stability. Given the large size of the euro area, the stability of the exchange rate of the euro area cannot be a direct policy focus but will have to be the outcome of the successful implementation of stability-oriented policies. Second, I have made clear that price stability is one of the pre-conditions for a flourishing market economy. Third, I have pointed out that for price stability in EMU to go hand in hand with sustainable growth and a healthy creation of employment, it is essential to have an appropriate overall policy mix. Fortunately, the Treaty contains sufficient institutional provisions to achieve a well-balanced combination of economic and monetary policy in EMU. I thank you for your attention./.


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