100 days of EMU: First experiences and further perspectives
Eugenio Domingo Solans Member of the Executive Board of the European Central Bank Speech delivered at the Hochschule für Bankwirtschaft/HfB Frankfurt am Main, 14 April 1999
Allow me to begin by going back two and a half years, to 4 October 1996 to be exact, when I had the opportunity to address the members of the Hochschule für Bankwirtschaft at the diploma ceremony for graduates.
On that occasion, I referred to the process of European Monetary Union and to Spain's position on this issue. I should like to recall one paragraph of my speech:
"Is it really a question of choosing between the number of countries joining the future European Monetary Union or its stability? Quite honestly, I do not think so. I do not mind admitting that if there were a dilemma about this, I should be in favour of stability. I think it would be better to construct the European Union more slowly and give priority to economic stability. But given the efforts the main European countries are making to converge, I am sure that a significant number of them will meet the convergence criteria and be able to join Monetary Union with full guarantees of stability. I am also sure that Spain will be one of them."
I still remember the smiles of most of those attending when I pronounced these last words, clearly reflecting scepticism.
I was convinced that the single currency, which was later named the euro, would be introduced. I was also convinced that Spain would be present among the countries joining this project. I could even accept back then the idea of a Spaniard as member of the Executive Board of the future European Central Bank (ECB). But what I could not predict, because my optimism has its limits, was that this Spaniard would be me.
The fact is that here I am now, pleased to be a citizen of Frankfurt, and to have the opportunity of visiting the Hochschule again, this important centre of Frankfurt. Thank you very much for inviting me.
Although we conventionally consider 100 days to be the minimum period of time necessary to form an opinion on something or somebody, we would all agree that this period is nothing in the lifetime of a currency. The Deutsche Mark has lasted fifty years. Several years went by before it could gain its reputation of stability. Something similar could be the case for the euro.
Nevertheless, if not a sound judgement, it is always possible to convey some first impressions after the first 100 days of the life of a new currency, and after almost one year of the life of the institution responsible for its regulation: the ECB.
In this first appraisal of the euro and the ECB, I shall mainly refer to the functional aspects related to monetary policy, after which I shall say a few words about other ESCB functions. I shall end my contribution with comments on some of the further perspectives of the euro and the ESCB, especially regarding institutional issues, as indicated in the second part of the title of my speech.
100 DAYS OF MONETARY POLICY
The monetary policy of the European System of Central Banks (ESCB) formulated by the ECB and implemented by the national central banks (NCBs) is, without a doubt, a big success.
Speaking of monetary policy means speaking of three different elements, which together form the basic machinery, the correct functioning of which is the main responsibility of the ESCB. These three elements are the following: the objectives, the strategy and the instruments. Let us consider them separately.
The objectives of the ECB were established in the Maastricht Treaty. According to Article 105 of the Treaty, "the primary objective of the ESCB shall be to maintain price stability". Thus, stability is the main goal of the Eurosystem and it is, therefore, the main touchstone to assess its success or failure. The success of the euro and the Eurosystem should first and foremost be measured in terms of its stability. Stability is the basic requirement of a good currency. And the euro enjoys stability, as proven by the latest inflation data for the euro area, corresponding to the month of February 1999, which - measured by the Harmonised Index of Consumer Prices (HICP) - reflected an annual increase of 0.8%.
The success of the euro cannot, however, be measured by the evolution of its exchange rate in relation to other currencies. The fact that since 1 January 1999 the effective nominal exchange rate of the euro has depreciated is of much less relevance than the sound inflation rates. In the long run the strength of a currency and its stability move together.
We say that in order to measure the success of the euro the level of inflation is of relevance and not the exchange rate, mainly because inflation depends basically - but not exclusively - on the action of the Eurosystem, while the exchange rate of the euro depends on the macroeconomic fundamentals of the euro area, the evolution of other currencies and market expectations, against which it is preferable not to act. We would have to ask ourselves to what extent the evolution of the euro reflects the strength of the dollar rather than the weakness of the euro. And, finally, we Europeans must be conscious of the fact that, with the parities of 10 of our currencies irrevocably fixed, the external exchange rate for our respective economies is now of less importance than before.
Regarding the objective of price stability, let me remind you that reaching price stability is the main responsibility of the ECB, but it cannot be achieved by the ECB alone. Stability concerns the whole society, and this is precisely why we speak of a "stability culture". Governments in particular are, of course, also involved in the achievement of stability by applying an appropriate economic policy. Complying with the Stability and Growth Pact or implementing structural reforms in the markets to foster competition are key elements in this respect.
The remaining task in connection with the primary objective of the ESCB was undertaken by the ECB last autumn and consisted in providing a quantitative definition of price stability. This definition, in the exact terms approved by the Governing Council of the ECB, reads as follows: "Price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%". And the Governing Council added that price stability will be "maintained over the medium term".
I should like to make some comments regarding this definition of stability. First of all, I should like to underline that this is a definition and, therefore, it is a lasting commitment, and not simply an objective for a limited period of time to be revised on an annual basis, for instance. Second, you should note that we use the term "increase" and not "variation", meaning that a decrease in the HICP (or deflation) is not consistent with the idea of stability. Third, we specify the index to be used to measure inflation, the HICP. Although we should always be open to future improvements, let me state that this index, prepared by Eurostat, is good enough. It takes into account very hi-tech items such as computers, and it is a "price index" and not a "cost of living index". This explains the fact that it does not fully cover owner-occupied housing costs, for example, it excludes imputed rents. Fourth, what the ECB must really consider is the euro area-wide trend of inflation and not the specific figures for each country. Fifth, we understand that it is appropriate to allow a range of stability and not a single figure, in order to give room for some possible measurement bias in the HICP (Boskin effect) and also, in my opinion, to introduce the idea of intensity of stability, which I shall explain later. Sixth, it must be stressed that stability has to be understood in a medium-term perspective, disregarding short-term volatility. And, finally, why precisely below 2%? This limit is, of course, a convention. It could be 2.5% instead, just the same as the speed limit could be 90 kmph instead of 80 kmph. But, on the other hand, stability cannot be defined as an increase in prices of, say, up to 4%, just as 160 kmph is not a real speed limit. The substance underlying the 2% limit is that the price increase should take measurement bias into account. This limit should be low enough to avoid significant distortions in price setting and to make any general indexation process unnecessary. Following our example, the limit must take into account the lack of precision of the car's speedometer and discourage reckless driving.
To sum up, the ECB has completed an important task defining in very precise terms the concept of stability, which is its main responsibility.
Besides stability, which is the primary objective of the ESCB, the Maastricht Treaty refers to a secondary objective in Article 105: "Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community, with a view to contributing to the achievement of objectives of the Community as laid down in Article 2". Among other things, Article 2 refers to "sustainable and non-inflationary growth respecting the environment" and to a "high level of employment and of social protection". Although, without a doubt, the outstanding objective of the ESCB, its real "raison d'être", is to pursue stability, this secondary objective implies that the ECB, when taking decisions on monetary policy, has responsibilities in the field of economic growth and employment. General, indirect and conditional responsibilities, but responsibilities nevertheless.
Let me add that denying these responsibilities does not enhance the ESCB's commitment to stability. On the contrary, fundamentalism is not the best approach when trying to convince others of an idea. In order to be convincing I rather prefer to use rational arguments, which imply, among other things, an awareness of the global picture surrounding an idea. Let me also add that we must be aware that the main risk for the present consensus on the "culture of stability" stems, precisely, from the unacceptably high level of unemployment in our countries.
My personal understanding of this secondary objective of the ESCB is that, in the long run, the best contribution that the ECB can make in favour of sustainable growth and of a high level of employment is, precisely, providing an atmosphere of stability. Stability implies efficient allocation of resources, competitiveness, lower interest rate risk premiums, investment, job creation and protection of the value of incomes, savings and wealth. All these factors are preconditions for economic growth, a high level of employment and social protection or, in other words, preconditions for the fulfilment of the secondary objective of the ESCB. In securing its objective of stability, the Eurosystem creates the conditions for complying with the other objectives of the European Union.
Does this mean that the motto of the ECB should be "only stability matters" or "the greater stability, the better"? Of course not. We should recognise that, in the short run, there could be a trade-off between the degree of stability and growth. Let me stress that I am speaking of a trade-off between the degree of stability and growth, and not between stability itself and growth. To put it in a more technical way, monetary policy affects both prices and quantities in the short run.
Intensity of stability matters in the short run. In terms of economic growth, a degree of stability of, for example, a 0.5% increase in the HICP would not mean the same as a degree of stability of, for example, 1.5% increase of HICP, especially if a significantly tighter monetary policy is required to achieve the former. The required degree of monetary policy tightness will depend, among other factors, on the economic cycle and on exogenous variables such as commodity prices. In the short run, assuming an inflationary scenario, the pace or rhythm of movement towards stability can also have effects in terms of economic growth. The right moment to make decisions, the timing, also matters: it must be neither too early nor too late, so as not to affect growth expectations. To summarise, in the short run, "stability: the deeper, the faster, the sooner, the better" is not always the best guidance for monetary policy. Actually, hitting the mark is more than a technique, it is a real art form: the so-called "art of central banking".
Another very important decision of the ECB was the choice of monetary policy strategy. Strategy is the guidance which makes good decisions possible and which is, therefore, a vital element of the internal decision-making process. Moreover, a well-defined strategy explains the reasons for taking a certain decision, and thus enables the markets and the public to understand, interpret and judge correctly the central bank's performance. You should bear in mind that the way in which a measure is interpreted is as important for monetary policy as, so to speak, the "mechanical" effect of the measure itself. A misinterpreted measure can reverse the impact it was intended to have. A correct strategy promotes credibility and confidence and therefore enhances the effectiveness of monetary policy. Last but not least, the strategy of monetary policy, as well as a precise definition of its primary objective, is closely linked to the idea of accountability.
The European Monetary Institute (EMI) and later the ECB were confronted with three possible, let us say, "pure models" of monetary policy strategy: the exchange rate strategy, the intermediate monetary targeting strategy and the direct inflation targeting strategy.
The first one (the exchange rate strategy) was discarded by the EMI from the very beginning. It can be useful in the case of a small open economy, which has close economic links to a major one with a high degree of stability. In that specific case, pegging the exchange rate to the stable currency is a way to "import" stability and avoid any disturbance in the economic exchanges between the two countries, but it implies giving up monetary policy autonomy. Needless to say this is not the case for the euro area given its size or for the euro vis-à-vis any other currency in the world.
Regarding this point, let me make some more general comments about the possibility of co-ordinating or limiting the fluctuations of the euro exchange rate in relation to other currencies outside the ESCB, in particular the US dollar. Having regard to the desirability of reducing, as far as possible, the relative volatility of the dollar and the euro, it should nevertheless be affirmed that the establishment, officially or unofficially, implicitly or explicitly, of certain fluctuation bands between the exchange rates of the dollar and of the euro would represent an error of economic policy. This idea is therefore dismissed by the ECB. It is important to emphasise in this connection the impossibility of simultaneously achieving two independent objectives - price stability and exchange rate stability - with the single instrumentation of monetary policy.
The only specific case in which this possibility occurs is, indeed, pegging the exchange rate to a stable currency as a way to secure stability in line with an exchange rate strategy for monetary policy, as I have already said. Otherwise, if there were a set fluctuation bands for the euro exchange rate, the said exchange rate objective could come into conflict with price stability and the ECB would not be fulfilling its primary objective. Simultaneously having pegged exchange rates, free movement of capital and monetary autonomy is simply impossible. This is precisely the reason why the countries of the Eurosystem have transferred their monetary autonomy to the ECB, which acts as a single monetary authority within an economic area whose exchange rates are completely fixed (the single currency) and with free movement of capital (the single market). And exactly the same argument explains why two different monetary authorities, each with its own decision-making autonomy (the US Federal Reserve and the ECB) in an environment of free movement of capital, cannot hope to peg or even to co-ordinate the exchange rates of their respective currencies successfully in the face of deep-rooted divergent trends in the markets.
Instead of establishing exchange rate fluctuation bands, European experience has shown that certain good common macroeconomic fundamentals represent the best strategy for achieving a better co-ordination of exchange rates.
Let us go back to the ECB's monetary policy strategy. Discarding the exchange rate strategy for the reasons explained above, the ECB selected a monetary policy strategy of its own which contains elements of pure intermediate monetary targeting and pure direct inflation targeting.
By doing so, the ECB avoided any kind of polarisation between these two strategies. They are, certainly, different, but not opposite nor contradictory. They complement each other. And indeed, it is possible to take elements from one or the other and build a new and authentic strategy.
As you probably know, the ECB's own strategy, which in my opinion deserves a better label than the descriptive "stability-oriented monetary policy strategy", comprises two pillars. First, a quantitative reference value for the growth rate of M3 of 4½%. This percentage derives - in the context of a medium-term framework - from Fisher's quantity equation, using the definition of stability and realistic hypothesis of the trend growth of GDP (between 2% and 2.5%) and the trend decline in velocity of money (between -0.5% and -1%). The second pillar of our monetary policy strategy consists of a broadly based assessment of the outlook for price developments and risks to stability obtained from a wide range of economic indicators (growth prospects, wage developments, fiscal variables, the euro exchange rate, raw material prices, import prices, monetary and credit aggregates, long-term market interest rates, and so on). Notice that the link between the secondary objective of the ESCB and its strategy occurs in this second pillar, where growth prospects are an important indicator of price developments.
Why a new strategy with two pillars? Because we are dealing with a new currency regulated by a new institution in a new economic area. The term "new" conveys the idea of "uncertainty" to the prudent. The best way to clear up uncertainties is to rely as much as possible not on one or the other, but on all successful past experiences of the NCBs, and not to make only one strong bet.
Thus, the ECB's monetary policy strategy takes or combines elements of the two strategies used by most NCBs of the euro area, which is not the same as combining the two strategies. Instead of a monetary target, the ECB prefers to have a monetary reference value, because, for the time being, the ECB cannot afford to miss a target, as the Deutsche Bundesbank did, without losing credibility. No one should expect a systematic and mechanical reaction of the ECB when deviations from the reference value occur. Moreover, the ECB does not publish inflation forecasts, nor does it set an annual inflation objective, as the Bank of England does now and the Banco de España did in the past, although it has a precise definition of stability.
The touchstone of a good monetary policy strategy is how clear and predictable the so-called reaction function of monetary policy is. In my opinion, the ECB's monetary policy strategy makes it possible to understand decisions, whether "passive ones" (not changing anything) or "active ones" (moving interest rates). The expectations and reactions surrounding the 8 April interest rate move are a good example of this.
The ECB's monetary policy strategy has been accused of opacity, of a lack of transparency. I do not think this is true. I think rather that one must not confuse opacity with discretion, transparency with automatism. I can accept that there is no automatism in the ECB's strategy, in the sense that monetary policy decisions do not feed back from a change in specific variables. In the dilemma between rules and discretion, I admit that the ECB is closer to discretion. After all, who really believes in rules robust enough to eliminate the need for discretion in monetary policy decisions? Who really thinks that the Friedman rule or the Taylor rule is more than a meritorious academic contribution to monetary policy theory, useful only as background material? Who genuinely believes that these and other similar rules can be used as a real guide to take monetary policy decisions?
No central bank has compiled in its manual of procedures such a wide range of monetary policy instruments as those listed in the so-called "General Documentation" of the ESCB. (From the European Central Bank publication entitled "The single monetary policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures", dated September 1998.) There is no special merit to this. Open market operations of various types, with several maturities and frequencies and for different purposes, are easy to specify, taking advantage of the rich experience of our NCBs. At the same time, establishing standing facilities or a remunerated minimum reserve is within the reach of any central bank.
All these instruments with their different varieties and procedures have their pros and cons, advantages and drawbacks. The merit lies in being able to assess these pros and cons in a proper manner and in choosing the best instrument and procedure for each situation. The merit also lies in changing the instruments and procedures whenever necessary. The ECB has done so and is prepared to do so in the future.
In the first days of single monetary policy, there was little doubt of the advantages of a fixed rate tender with a certain percentage of allotment for the weekly main refinancing operation. It makes it possible to control both price and quantities. It avoids giving wrong signals to the market and liquidity can be kept under control. The idea of control is fundamental at the very beginning of the life of a currency and an institution. In the meantime, the ECB has improved some specific procedures in order to avoid or, at least, to minimise problems arising from the fact that the availability of collateral varies.
However, as I said before, no system is without drawbacks. In the case of a fixed rate tender with allotment, problems can arise in the case of some banking institutions (or "counterparties" as we call them) operating in financial systems with a scarcity of collateral for several reasons: a low level of public debt, less tradition of loan securitisation, etc. As examples of Eurosystem decisions to improve the procedures in order to avoid or minimise these kinds of problems, I shall mention two steps. One was clarifying to the counterparties that the correct interpretation of the General Documentation allows tender bids which are not actually covered by collateral at the time of the submission of bids, and that the only requirement is the financial capacity to have the collateral on the date of settlement of the tender. Of course, the final settlement of the tender operation is subject to the availability of sufficient collateral to cover the allotted amount. The second step, taken on 8 April 1999 when we decided to reduce the interest rates, was to establish a symmetric interest rate corridor between the repo rate on the one hand and the marginal lending facility and the marginal deposit facility on the other. The markets could - and it actually seems that they did - infer that the overnight rate will tend to move around the middle point of the marginal facilities corridor. If this is so, it is better for the time being (but not necessarily forever) to have a symmetric corridor in order to signal that there is no reason for the overnight rate to stay necessarily above the repo rate. By doing so, we avoid systematic arbitrage gains stemming from financial institutions asking for more liquidity than they actually need. This is legitimate provided that they do not ask for more liquidity than the amount of collateral they can afford, but it gives a clear advantage to institutions operating in financial systems with a large stock of collateral.
Another good example of the Eurosystem choosing the appropriate instrument of monetary policy and of changing details of its application concerns the longer-term refinancing operations, which have a monthly frequency and a maturity of three months. Unlike the main refinancing operations, these consist of a variable rate tender, which is not intended to have its usual signalling effect. As you may know, the signalling effect of monetary policy is important and must be taken into account whenever choosing the appropriate instrument and using it. For the sake of efficiency, the Governing Council of the ECB decided on 4 March 1999 to modify the tender method applying to longer-term refinancing operations, switching from a variable single rate auction (the so-called Dutch method) to a variable multiple rate auction (the American method).
Rather than describing to you all the Eurosystem's monetary policy tools in the part of my speech devoted to monetary policy implementation, I preferred to give you some examples of which instruments were chosen and on which grounds, and to demonstrate that an important task in these first 100 days of European Monetary Union has been to improve these instruments with a view to efficiency and fairness.
OTHER FUNCTIONS OF THE ESCB
Nothing is more important for the conduct of monetary policy than good statistics. In this respect, I should like to highlight the progress, which the ESCB has made in this field, thanks to the efforts of the staff of both the ECB and of the NCBs. The ESCB has direct responsibility for preparing money and banking statistics and those relating to financial accounts. It also has shared responsibility with EUROSTAT (European Commission) for balance of payments statistics. Although the work has not yet been concluded, I wish to emphasise that the progress made has been considerable and that we now have the basic statistical information required for our monetary policy strategy and for taking appropriate decisions. As I often say when I comment on this point, you do not need a scalpel to cut a slice of bread.
It is my understanding that, after 100 days of running, the payment systems function of the ESCB has had a positive result on balance. Following an expected learning and adjustment period to become accustomed to the new procedures and techniques, the real-time gross settlement system (TARGET) is functioning well. And, more importantly, the ESCB has alternative methods and contingency solutions, which can always be introduced if considered necessary or opportune.
As the person directly responsible for the information and communication systems of the ECB, I must say - and this is not to my credit but to the credit of the staff of the ECB - that the information systems in general, and, in particular, both the technical infrastructure allowing the instantaneous transmission of data on monetary policy, and the communication systems required to co-ordinate the activity of the NCBs and of the ECB, are functioning perfectly.
Another one of my specific responsibilities at the ECB involves the production and issuance of euro banknotes. Several milestones were reached already on our road to prepare the euro banknotes, which will be issued in the year 2002. Thus, we decided in favour of a no pooling decentralised solution for the production of banknotes by the NCBs. We have finalised the so-called "zero production run", which involved the printing works of the participating countries. The main purposes of this test were, first, to check the compliance of the "test banknotes" against the technical specifications and, second, to prove that all printing works are in a position to produce the euro banknotes to the same high quality standards. The result of this test was positive, as only some minor technical specifications need to be modified slightly. The printing works will now start their final preparations for the commencement of the mass production of the euro banknotes. The Governing Council also decided to establish an Analysis Centre for Counterfeit Euro Banknotes. As is already indicated by its name, the main purpose of this Analysis Centre will be to technically analyse and classify new types of printed counterfeits, and to store the related technical data in a database. The Analysis Centre will be located at the ECB in Frankfurt.
FURTHER PERSPECTIVES OF THE EURO AND THE ESCB
The future perspectives of the euro and the ESCB, to come to the last part of the title of my contribution, are clearly linked to the ideas of confidence and credibility.
The main goals I am striving to achieve concerning the future perspectives of the euro and of the ESCB are, indeed, confidence and credibility. All the technical achievements in monetary policy, payment systems, information systems, statistics, etc. are worth nothing if the euro and the ESCB do not manage to win the confidence of the 292 million citizens of the euro area, as the Deutsche Bundesbank did with the 82 million German citizens.
The key to gaining confidence in the ESCB is, first, to be efficient, to be successful, in meeting the primary objective of price stability, for which an appropriate monetary policy is a necessary but not sufficient condition. As stated before, in order to achieve stability, it is necessary to combine and co-ordinate with other economic policies, such as fiscal policy (Growth and Stability Pact) and those relating to the supply side of the economy (liberalisation, deregulation and flexibility).
It is also essential for the credibility of the ESCB that there is respect for its independence, with regard to the various functional, organic and personal aspects which independence encompasses.
Independence does not mean no co-ordination or no communication, or a lack of transparency, or a lack of accountability. Accountability to the European Parliament and good communication with the public and with the markets is an essential condition for the credibility of the ESCB and for the efficiency of its monetary policy. As I said before, it is important to remember that the impact of the monetary policy measures depends both on their mechanical effect and on their perception and interpretation by the public and by the markets.
A further key to the success of the ESCB is that it should act as what it is, a system, that is to say a harmonious and interdependent whole. Co-ordination between the ECB and the NCBs, which up to now has been fully achieved, mainly thanks to the actions of the Governing Council and of the committees, is another factor for the euro.
Last but not least, a further key to the credibility of the euro and of the ESCB is the adoption of a European-wide perspective, with no national bias.
Efficiency, independence, accountability, transparency and communication, co-ordination and a European-wide perspective: these are the main ruling principles of the ESCB. They are certainly demanding conditions, but they are necessary in order to achieve credibility on the part of Europeans and those who wish to view the euro as a currency on which they can rely.
Thank you very much.