The euro and the process of European integration
Speech delivered by Dr. Willem F. Duisenberg, President of the European Monetary Institute, at the Seventh Bernard Mandeville Lecture in Rotterdam - the Netherlands, 5 March 1998 (translated from the original Dutch)
Mandeville, after whom this series of lectures is named, emphasised even before Adam Smith that individuals who strive for their own interests may unintentionally bring something about which is in the interests of all. He can thus be seen as one of the founders of the philosophy behind the market mechanism. What is required to make this market mechanism function properly is a set of institutions. A healthy currency unit and a central bank to watch over it belong to this group of necessary institutions. The question as to the extent to which institutions can be designed, or rather must be the result of a spontaneous, evolutionary process of individuals striving for their own interests, is a fundamental issue. Mandeville would tend towards the latter view. I am, as you know, no philosopher, so I will not attempt to formulate a fundamental answer to this fundamental question. Intuitively, or if you prefer, amateurishly, I am inclined to think that this is not a simple matter of 'either... or', but that both approaches can play a role. Any other response would sound strange coming from the President of an institution which has the singular task of designing new institutions - the euro and the European Central Bank - and making them work to everybody's satisfaction. These opening remarks bring me straight to the matter in hand: the huge institutional change in monetary affairs in Europe which is now at hand.
1998 is an important year for Europe. This year - in eight weeks' time to be precise - the decision will be taken as to which countries will introduce a single currency, the euro, on the first of January 1999. In just three weeks’ time the decision-making process will start formally with the publication by the European Monetary Institute and the European Commission of reports assessing the progress made by the various countries with regard to economic convergence. The European Commission will attach a recommendation to its report as to which countries are ready for the introduction of the euro. The European Parliament will publish an opinion and national parliaments will also debate the selection issue. All this will culminate in the first weekend in May, first in a recommendation by the Finance Ministers, and the same weekend, in the decision by the Heads of State or Government on the participating 'euro countries'. Subsequently, bilateral exchange rates will be announced against which the currencies of the euro countries will be converted to the euro. With the appointment of the members of the Executive Board of the European Central Bank, according to the Treaty of Maastricht, this institution will be established, and 'my' institution, the European Monetary Institute, will go into liquidation. This will presumably take place around the end of May and beginning of June. Up to the end of the year, the ECB will prepare the actual introduction of the euro and the single monetary policy.
I see the introduction of the euro in a broad perspective. The introduction of the euro and the associated single European monetary policy are not isolated steps, but a part - albeit a very important one - of the process of European integration which effectively started immediately after, or even perhaps during, World War II. Thus it is a process, and a process which involves more than just economics. Economists very often analyse the euro simply in economic terms. There is nothing wrong with this, because the economic aspect is important. However, what is objectionable is that people all too often draw conclusions about the euro based on purely economic arguments. Thus one loses sight of the broader context of the euro. Before I come to that, there is another mistake which is often made and has to do with taking too narrow a view. This is that people often point to the risks of the introduction of the euro on the implicit assumption that the alternative to European Economic and Monetary Union, hereafter referred to as 'EMU', is an everlasting and risk-free continuation of the world as we know it. That is not so. EMU is not without risk, but nor is the alternative. It is easier to appreciate this if we look at EMU in a broader context.
The background to the process of European integration is, as I see it, above all organising Europe in such a way that the great conflicts of this century, two world wars, do not recur in the future. One way of achieving this is to incorporate Germany into a European structure. Without this policy, ultimately all problems confronting Europe directly or indirectly would end up on Germany’s plate. That would force Germany into a leadership role, which we do not want, and Germany no longer wants. As Thomas Mann put it, and others have repeated: it is a choice between a European Germany or a German Europe. European integration is the choice of Europe, including Germany, as the first alternative.
The great changes which took place in eastern Europe almost ten years ago reinforced the need for European integration. The almost automatically unifying element of the confrontation with Communism thereby disappeared. The position of unified Germany was potentially, and in the long term, stronger. Germany not only became larger: through the developments in the east it also came to occupy a more central position in Europe, as it were.
In addition to this motif there is another motif, which is narrower and also has an economic component. This is the advance of the de facto German monetary hegemony over the last decades. The Deutsche Bundesbank in effect largely determines the levels of interest rates in other European countries. And however successful those countries may have been, partly as a result, in achieving price stability, larger countries in particular cannot in the long term accept being tied to Germany’s apron strings in monetary matters. A European Central Bank places monetary policy within a European framework. In this way, it is an example of the movement from a German Europe to a Europe in which Germany is included. To this end, Germany is prepared to replace the Deutsche Mark with the euro. This should not be judged lightly. Germany is thereby, of its own volition, giving up a symbol, I would even say the symbol, of successful German policy since World War II, and relinquishing economic and administrative power. In this light it is quite understandable that Germany has continually asked for guarantees and makes repeated pleas for a stable euro.
The process of integration in Europe is always, first and foremost, managed by means of the economic component. Integration may be expected to have a positive effect on prosperity: this is clearly documented in economic theory; but we can also expect that common economic interests will make conflicts less likely.
European integration started with the establishment of the European Coal and Steel Community in the early fifties, intended above all to remove two of the major constituents of heavy military armament, energy and iron, from national or, if you will, nationalistic decision-making, and has proceeded step by step to the Single Market programme and now to the introduction of the euro. The euro can be seen as the final piece in the Single Market. Failure to introduce the euro could put this in jeopardy. After all, one should not underestimate the extent to which depreciation of the currency can again lead to a flare-up of protectionist 'counter-measures'. The Single Market only operates well if there is sufficient exchange rate stability. In a Europe with free movement of capital it is no longer possible to guarantee this by means of a system of stable but adjustable exchange rates. Such systems have proved vulnerable and can fall prey to speculative attacks, which may be unwarranted by the underlying economic conditions. Even the traditionally super-strong link between the Dutch guilder and the Deutsche Mark is not permanently assured without EMU. However, the process of integration will not be completed with the introduction of the euro.
The process of European integration will also continue because many countries in central and eastern Europe will wish to join the EU. The accession of these countries can only take place in stages. The introduction of the euro is the last stage, which must not be forced. First, these countries must integrate their economies solidly into the EU. Then participation in the new exchange rate mechanism can follow. Ultimately, the euro can be introduced. The prospective entrants will have to meet the same requirements as the countries which will introduce the euro at the start of next year. That will take considerable time - time which must also be used to consider any changes in the working methods of the ESCB if that is to consist of between 20 and 30 national central banks. There are issues here which may be even more difficult than the decision concerning which countries will participate on the first of January 1999. It would be advisable to consider these matters in good time. This would prevent the man in the street and politicians alike later being caught off guard and feeling overtaken by events, as often seems to be the case in European debates.
How must the process of European integration be judged on the basis of its own objectives, as I have just formulated them? I say: positively. Participating countries have now known peace for more than 50 years and much has been achieved in the economic field. Of course I am not deaf to all criticism, nor unaware of friction among Member States, and the failures that sometimes occur. I also recognise that the next step, the introduction of the euro, is not without risk and undoubtedly there will be problems to be overcome. Whatever else it may be, it will not be dull.
However, my attitude is that taking this step offers great opportunities and that the risks are manageable, as long as one is not blind to them. To break off the process of European integration at this point - which is what failure to introduce the euro would mean - would throw Europe into great confusion. No viable political alternative exists.
Why, therefore, the introduction of EMU and the euro? First of all because of the political reasons discussed. They are no less important than economic reasons, nor is there any reason for economists to sneer at them. Peace and security can also be analysed in economic terms. I would add the footnote that the introduction of the euro will not automatically have an integrating effect. Some people feel that it will actually increase the potential for conflict, not only between those who are in and those who are out, but between those who are in, among themselves. I am not that pessimistic, but I am convinced that the euro can only contribute to political integration if all EU countries have the prospect of joining EMU, and if the countries which have joined demonstrate the political will to accept that the introduction of a single currency and a single monetary policy means that interest rates must be brought to the level which is best for the entire euro region and not for individual countries.
The introduction of the euro also has clear economic advantages. It removes the uncertainty over exchange rates from a large part of Europe. That is good for trade, and particularly for countries such as the Netherlands, which conduct a great deal of trade within Europe. It increases the transparency of the European market, which makes it easier to benefit from economies of scale, but - or rather, in addition - it encourages competition. The European System of Central Banks will also try to bring about price stability over a large area which, if successful, will be an important condition for a sustainable, real (i.e. actual) growth in income and employment. The economic advantages of EMU increase in proportion to the size and stability of the euro region. Perhaps it is ironic that the advantages are greater the more countries which have in the past had long periods of stability problems are included in a stable EMU. The art, of course, is to combine size and stability as well as possible.
This does not detract from the fact that risks may emerge and questions may be raised and that we must be prepared to learn from experience. That is why EMU is not the end of the process of integration, but the start of a learning process. In the rest of my lecture I would like to discuss a number of frequently raised issues and fears, without of course, making any claim to completeness.
One of the first views expressed is that unemployment is too high for the European Central Bank to give top priority to achieving price stability, as the Treaty of Maastricht does. This attitude is based on a - sadly persistent - misunderstanding, which is that unemployment in Europe can be solved by lax monetary policy. However, unemployment in Europe is primarily a structural phenomenon, which requires measures to allow markets to function better. The best contribution monetary policy can make to growth and employment is to ensure price stability. Artificially stimulating employment by means of lax monetary policy does not lead to lasting low levels of unemployment, but ultimately it does lead to higher inflation. In that sense, it is a policy of shooting oneself in the foot.
Another issue is why the European System of Central Banks has been made so independent of politics. Does that not mean that monetary policy has insufficient democratic legitimacy? Making the central banks independent is a world-wide trend. This is prompted by the realisation that monetary policy can have a direct effect on growth and employment in the short term, but only directly affects inflation in the long term. There is always a temptation to use monetary policy to stimulate the economy in the short term. The growth in employment - later shown to be artificial - and the consequent improvement in election prospects come first, inflation and economic instability come later. Politicians recognise the seductive call of these sirens and they want to avoid giving in to this strong temptation. Therefore, they allow themselves, like Odysseus, to be bound to the mast by giving an independent central bank the task of ensuring price stability as its sole purpose.
In practice, this construction causes tension on one point, or, to stay with Homer, has one Achilles' heel. In the short term it is true that monetary policy affects growth and employment. This makes the conduct of policy very delicate and the reading of the economic situation very precarious. The conduct of policy will also depend on the state of budgetary policy and on wage developments. This all leads to a desire in society to call the central bank to account for the choices it has made. This is understandable and, in my opinion, justifiable, but one has to be careful not to throw the baby of independence out with the bathwater of accountability. After all, the fact that monetary policy only has short-term effects on growth and employment is the very reason for placing the central bank at a distance from politics. The desire for accountability must not run over into exerting pressure on the central bank.
My conclusion for the European System of Central Banks is that monetary policy must be as transparent as possible. That means that the ESCB must always make clear in word and deed how it sees the situation and that it explains its measures. To the public and to politicians; to governments and parliaments; to the European Council of Ministers and to the European Parliament. It also means that the ESCB must quantify precisely what it understands by price stability and must announce in advance what its target is. The target itself must be clearly formulated and any deviation must be explained.
Transparent monetary policy is not only important, and perhaps not even primarily important, in terms of the accountability of the central bank. It can also promote the efficiency of policy by creating the right expectations in the participants in the economic process concerning what the monetary authorities hope to achieve: monetary policy must be predictable. This contributes to achieving stable prices with as little friction as possible.
The ESCB is a system for the entire euro region and that must be manifest in the communication of its decisions. The remark that the ESCB is for the entire euro region also means that not all communications need pass exclusively via the centre. The national central banks can also play a useful role. They can communicate in their own language, taking into account the particular circumstances of their own country. The point is that communication should be carried out consistently throughout the euro region.
It is crucial that the Eurotower in Frankfurt, the seat of the ECB, does not become an ivory tower. The ESCB must be open to contact with politicians, both sides of industry and parliaments. In these contacts it must not only provide explanations but also be a good listener. The sine qua non is that the independence of the ESCB should be respected in these contacts.
The democratic legitimacy of the ECB is based on the fact that its duties are laid down in law, that the members of its Executive Board are appointed by elected politicians and that it offers explanations and is accountable in various ways for its analyses and the measures based on them. Admittedly this does not go as far as in politics, since those to whom it is accountable cannot impose any sanctions on the ECB, but that is just an inevitable consequence of opting for independent decision-making. And that is a choice which was made for good reasons.
Another frequently asked question is: have the economies in Europe really converged sufficiently to be able to implement a single monetary policy? This is the key question, and it is not easy to answer. I do not agree with those who say that the creation of the right institutions is enough for the creation of a monetary union. My vision is closer to the economic theory of optimum currency areas, which says that certain conditions must be met if an area is to introduce a single currency. These conditions are not automatically met by introducing a single currency and setting up the right institutions. The latter can help, it is true, but it is not sufficient. It is therefore right that convergence criteria in the areas of inflation, long-term interest rates, exchange rate stability and government deficits and debt were formulated in the Maastricht Treaty. I do not deny that these criteria are, to a certain extent, arbitrary, almost by definition. Economic theory cannot come up with precise quantitative criteria to establish the viability of a monetary union. It will always require a certain amount of political will, and there will always be a certain amount of risk. The convergence will never be perfect. Therefore, the decision about the introduction of EMU is ultimately also a political decision.
How is economic convergence going in Europe? You will appreciate that I will not talk about individual countries. In general, however, one may say that in many areas good, sometimes even remarkable, progress has been made. With regard to inflation and long-term interest rates, 14 of the 15 Member States already clearly meet the criteria. Also, over the last few years there has been a remarkable degree of exchange rate stability between the European currencies. Finally, government deficits and debt: there are still countries in a situation in which a sound analysis is required under the terms of the Treaty. This requires that a multitude of factors be taken into account, such as medium-term economic and budgetary prospects. The EMI will produce the said sound analysis in the report to be published on 25 March. The European Commission will also publish a report, as I said earlier. The decision will ultimately be taken by the Heads of State or Government. Although it is thus too early to draw conclusions, one thing is certain: among the participants in EMU there will be a large number who will have their work cut out in the next few years in the area of public finances. But that would have been equally true without EMU. Politicians are well aware of this: in the 'Stability and Growth Pact’ they agreed to endeavour to achieve budgetary positions that are close to balance or even in surplus.
A question which is linked to the previous one is whether labour and product markets in Europe really have the necessary flexibility to cope with the introduction of a single currency. This is a pertinent question, which arises from the idea that the official convergence criteria are not complete. There is a risk here and also a role for policy. The role of policy will be to go further towards allowing markets to operate more flexibly. Politically, this is not an easy matter, since it requires painful measures, the effects of which are not immediately perceptible. However, I would stress that this policy is necessary not only to ensure the smooth operation of EMU, but also to solve the biggest economic problem in Europe, namely high unemployment. Thus it is a double-edged sword: what is good for EMU is also necessary for the solution of the unemployment problem.
Another, related, question is: How can the euro countries adapt to economic setbacks which only affect them, or affect them more than other countries (what we call 'asymmetric shocks'), now that they can no longer use the instrument of devaluation and aim for a lower interest rate than other countries? This question is related to the previous one, and the answer is thus in part the same. One way of addressing this type of shock is to let wages and prices react flexibly to them. In addition I would point out that the appropriateness of the exchange rate as a mechanism for absorbing country-specific shocks must not be exaggerated. Devaluations only work if the workforce does not translate the resulting price rises into wage rises. If it does, as has often been the case historically, the result of devaluing a currency is simply higher inflation, and postponement of the inevitable adjustment to changed circumstances.
This does not detract from, indeed it emphasises, the importance of adequate adjustment mechanisms. High mobility of labour is, I believe, unlikely to play any great role in Europe for the time being. The language barriers in particular are too high for that. In addition to flexibility of wages and prices, the design of EMU also provides for another important adjustment mechanism. The Stability and Growth Pact encompasses this. By keeping their budgetary positions roughly in balance in normal circumstances, governments create a margin to deal with disappointing economic trends without having to make cut-backs. Allowing the deficit to increase in such circumstances automatically counterbalances the economic problem. Of course, the ceiling for the deficit in the Maastricht Treaty must not be exceeded, except under truly exceptional circumstances. We are talking here about the familiar 3% of GDP. The margin this provides should not be underestimated. For the Netherlands it represents more than NLG 20 billion.
This budgetary mechanism is not only available for country-specific shocks, it also helps to soften the blow of unfavourable trends affecting the euro area as a whole. The existence of this mechanism at national level makes loan financing at European level to offset country-specific shocks superfluous.
National budgets can only fulfil their shock-absorbing role if they really are close to balance under normal circumstances. If not, then the shock is not absorbed, but hits the 3% safety rail prematurely. In view of the level (around 3%) of many government deficits at the moment, one must inevitably conclude that government deficits must continue to be reduced in the coming years.
The next issue I want to address is whether monetary union can exist without political union, or whether we need a budgetary counterpart to the ESCB? It is undoubtedly true that the establishment and functioning of a monetary union is easier if at the same time there is also a political union. There is then a single budgetary authority for the single monetary authority to deal with. It also simplifies the creation of a basis for monetary policy which by its very nature is single and indivisible in a region where developments will never quite be synchronised. However, in reality Europe is not at that stage, or has not yet reached that stage. Yet there are provisions in the Treaty, subsequently elaborated further, for example in the Stability and Growth Pact, which aim to create the conditions under which a monetary union would be workable without a political union in Europe. Think, for example, of the relationships, formal and informal, which are envisaged between the European Council of Finance Ministers, ECOFIN and the ECB.
These relationships aside, the Stability and Growth Pact is an initiative to ensure that budgetary policy does not cramp the conduct of monetary policy. By reducing and practically eliminating government deficits, this can be guaranteed. The Pact is rather vaguer about assessing the budget situation in the euro region as a whole. It is conceivable that the sum of the budget balances, while individually in line with the Stability Pact, could produce an overall result which is unsatisfactory - for example, where the euro region as a whole has a balance of payments deficit. Then further co-ordination of the budgetary policies of the individual countries might be necessary. In any case, such a situation is not an immediate concern, since the euro region is expected to have a modest balance of payments surplus. All in all, there are sufficient channels for co-ordination and the exchange of information. Much will naturally depend on how these are used in practice. The agreements which have been made so far are not necessarily the last word. We will have to learn from experience. Further evolution may take place on the basis of that experience.
Now I come to the last question: Will the ESCB pursue too tight a monetary policy just to establish its credibility? An easy one for a change. This fear is unfounded. The ESCB must pursue whatever policy is necessary to achieve and maintain price stability. Don’t forget that this is laid down in the Treaty. Taking an extra-strong line would not contribute to the realisation of this goal. The point is to strike the correct balance between inflationary and deflationary risks, and to set interest rates in such a way that price stability is the most likely outcome. Monetary policy is partly an art. Monetary policy decisions cannot be taken mechanically; they can't be calculated. That is nothing new, but certainly at the start of EMU, when the financial sector will be in transition, predicting economic trends and the effect of policy measures may be more difficult than usual.
In this context, it is very important that inflation rates in many European countries currently are not only close together, but also low. Inflation in the European Union is running at less than 2%. Many European national central banks consider this level to be in keeping with price stability. Complete absence of measurable inflation is not required, because the measurement of actual inflation is beset by errors, on balance on the positive side. If this situation can be maintained until January 1999 - and that is the objective of the current policy - then the ESCB will be able to start its work under favourable conditions. Tight monetary policy from the outset of the single currency will then be unnecessary.
I draw three conclusions:
EMU must be seen as a process in a broad economic and political context.
EMU is not the end of this process, but another step on the way.
EMU offers economic and political opportunities. However, there are also risks, and the opportunities must not be passed up. Political will, sensible economic policy and the will to learn from experience are essential conditions for making EMU a success.