Should the ECB have broader objectives beyond price stability?

Eugenio Domingo SolansMember of the Governing Council and the Executive Board of the European Central Bank.A speech given at the Wilton Park conference on "EMU: ECONOMIC AND POLITICAL IMPLICATIONS FOR THE "INS", "OUTS" AND EUROPEAN BUSINESS" at Wiston House, West Sussex, on 24 May 1999

Thank you for inviting me to participate as a speaker at the Wilton Park Conference on Economic and Monetary Union. It is an honour and a real pleasure for me.

The question in the title of my session "Should the ECB have broader objectives beyond price stability?" deserves a clear and immediate answer: yes, the ECB should have and, as a matter of fact, it does.

Article 105 of the Maastricht Treaty [1] states that "the primary objective of the ESCB shall be to maintain price stability" and adds that "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 the objectives of the Community as laid down in Article 2".

Among others, these Community objectives are, in accordance with Article 2, "sustainable and non-inflationary growth respecting the environment" and "a high level of employment and of social protection".

It is, therefore, clear that the ECB must focus its decisions, as a matter of priority, on the objective of stability which is its real "raison d'etre"; in addition, and without prejudice to this aim of stability, the ECB also has responsibilities relating to economic growth, employment and social protection.

These responsibilities are general, conditional and secondary, if you like, but responsibilities nevertheless.

Thus, it seems clear that beyond the primary objective of price stability, the ECB also has an implicit secondary objective: to support the other economic policies and, in doing so, to contribute to economic growth, and to reach a high level of employment and social protection.

If we accept more than one general objective for monetary policy, it seems important to stress the need to prioritise these objectives and, in the case of the ESCB, to give top priority to the objective of stability. Any doubts about this could undermine the confidence of the public and the markets in the ESCB's commitment to stability, trigger inflationary expectations, and eventually - and paradoxically - hinder or jeopardise economic growth and job creation.

Before getting into the impact of monetary policy on economic growth, let me say a few words concerning the close relationship which exists between stability and social protection. In the first article I published, [2] only 30 years ago, when I was only 23 years old, I dared to qualify inflation as "immoral", for several reasons. Inflation unfairly deteriorates personal income and wealth. It distorts the proper functioning of public redistributive schemes, such as progressive taxation. It fosters speculation. It harms the weakest and the most vulnerable. My branding inflation as "immoral" caused surprise when I mentioned it after my appointment as a member of the Executive Board of the ECB. I must say I was surprised at the surprise. Without a doubt, one of the best allies of social justice is, precisely, stability. Surprising again, if you consider that, very often, those less inclined to support institutional arrangements and policies in favour of stability are precisely those who actively pretend to take a leading role in public in favour of social justice.

Let us now focus on the relationship between the ECB's monetary policy, price stability and economic growth.

I am convinced that, in the medium term, the best contribution that the ECB can make in favour of sustained economic growth is, precisely, to create an environment, an atmosphere of stability. Stability implies efficient allocation of resources, competitiveness, lower interest rate risk premiums, investment. All these factors are preconditions for economic growth 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 necessary conditions to comply with the European Union's objective of economic growth. There is clearly no greater fertiliser for economic growth than price stability, and nothing is more refractory to economic growth than inflation.

I said that stability is "the best contribution" to growth, but I believe that it is not the only possible contribution. In other words, I understand that we cannot comply with the implicit secondary objective of the ECB stemming from the Treaty by means of simple adherence to its primary objective.

The ECB's motto cannot be "only stability matters" or "the greater stability, the better". This could be true in the long run, where monetary policy only affects prices (stability) but not quantities (growth). But in the short term, monetary policy affects both prices and quantities and, therefore, we must accept the possibility of the existence of a trade-off between stability and growth, in line with the traditional Phillips curve as reformulated by Samuelson and Solow.

The existence in the short term of a trade-off between stability and growth implies for the ECB the need to consider the possibility of a compromise between the degree of stability and the level of economic growth, and I emphasise that I said "degree of stability" and growth, and not a compromise between "stability" itself and growth.

Stability is a concept rather than a single figure. Any price increase low or short enough so as not to cause distortions in price-setting (in connection with the Austrian approach), and low or short enough so as not to require the implementation of a general indexation procedure (in connection with the classical and neo-classical neutrality approach to money) is compatible with the concept of stability. The ECB understands that this is the case when the year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area as a whole stays below 2% over the medium term.

A price increase of below 2% for the whole euro area not only does not prevent the existence of national or regional levels of HICP increases above and below the common level, it even implies the existence of such national or regional levels. Therefore, one must accept as normal that in some specific countries the inflation rate could be higher than 2% without any inconsistency with the stability of the whole area. The differences in inflation can be the result of the Balassa-Samuelson effect, or the result of a combination of a high level of nominal demand and supply rigidities. Nevertheless, if we accept that inflation is a monetary phenomenon and that the monetary policy stance determines the level of inflation in the medium term, we must conclude that these national differences in the HICP increase cannot be too large.

Why below 2%? This limit is, of course, a convention. It could be 2.5% instead, just the same as one could set the speed limit at 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% stability limit is that price increase should take measurement bias into account (the Boskin effect), it should allow variations in relative prices in economies with rather downside inflexible prices and wages, and it should be low enough so as to avoid distortions in price-setting and make any general indexation process unnecessary. Following our example, the limit must take into account the lack of precision of the car's speedometer, it must make it possible to overtake other vehicles safely and discourage reckless driving.

Taking for granted that the previous conditions are fulfilled (room for measurement bias, room for variations in relative prices, no distortions, no need for general indexation) and that, therefore, stability exists, the ECB's monetary policy has room for manoeuvre to create the best monetary conditions in order to support the general economic policies of the European Union and, in particular, to create the best monetary conditions for exploiting the considerable growth potential of the euro area.

Against this background the ECB decided on 8 April 1999 to lower interest rates by 0.5 percentage point, a decision which, in addition, could help reduce uncertainties and restore confidence in the economy.

In this context, let me say a few words about the general orientation of the ECB's monetary policy.

We understand that it should be a medium term-oriented monetary policy. Its short-term anti-cyclic effects - if any exist - are very limited and have to do with the influence on the confidence and expectations of economic agents. The medium term, lags, etc. are factors linked to the "mechanical" channels of transmission of monetary policy.

The short term and "activism" are closely linked. No one can expect "activism" from the ECB's monetary policy. Our monetary policy is primarily intended to provide a general framework, a general environment, a general atmosphere of stability. In doing so, it creates the best conditions for economic growth and job creation.

Provided that stability exists, in connection with the implicit secondary objective of supporting the general economic policies of the European Union, the monetary policy of the Eurosystem contributes to creating the economic conditions which are essential for exploiting the growth potential of the euro area. However, let me stress that it does so in a passive way, without any activism: like the air we breathe, rather than air from an oxygen tank.

Fresh air as opposed to air from an oxygen tank: this is my metaphor to compare the passive monetary policy of the ECB with an active one. My President, Wim Duisenberg, has another, which has to do with television. In this case, activism means engaging in "zapping" instead of, I would imagine, sitting quietly watching the film and waiting to discover that - oh surprise! - the butler is the murderer. The metaphors of one's President are always better.

Being passive does not necessarily prevent our monetary policy from having anti-cyclic effects. Anti-cyclic and counter-cyclic do not mean exactly the same. The ECB's monetary policy does not try to counter every cyclical fluctuation, but it helps to prevent pronounced cyclical fluctuations. It tones down the economic waves; it extends the economic wavelength and, by doing so, creates the conditions for sustainable economic growth.

Another characteristic of the ECB's monetary policy is the absence of automatism, in the sense that monetary policy decisions do not follow on from changes in specific variables. In striking a balance between rules and discretion, the ECB is closer to discretion. However, please do not confuse discretion with opacity, automatism with transparency. After all, who really believes in rules robust enough to eliminate the need for discretion in monetary policy decisions? Who really thinks that monetary policy can be conducted with an automatic pilot? Who really thinks that, apart from being meritorious theoretical contributions and good references, the Friedman rule or the Taylor rule are key solutions for taking monetary policy decisions?

Another principle of the ECB's monetary policy is the adoption of a global Eurosystem perspective. According to this principle, it would be erroneous to interpret the monetary policy decisions of the ECB from a national standpoint. Owing to the characteristics of monetary policy, no one should expect it to conform to all the peculiarities of the countries, regions or sectors of activity of the euro area.

We must accept that implementing monetary policy in a large area implies limitations and complications. Nonetheless, these limitations are not only counterbalanced, but also surpassed by the advantages resulting from having a single currency in a single market.

One of these limitations has to do with the fact that a single monetary policy implies a single nominal repo rate for the whole area and a single nominal short-term money market rate for the whole area. Starting from this point, the effects of monetary policy among different regions or countries of the area would be different, depending on several relevant factors. One factor is the different level of inflation in each country implying different levels of real repo rates for each country and different real short-term money market rates for each country, which could give rise to pro-cyclical local effects. At the same time, the transmission mechanisms of monetary policy are different in each country, reflecting differences in the structure of the financial systems and in the habits of the public; therefore, the effects of monetary policy will not be exactly the same. The specific national economic policies of the governments, in making good use of the possibilities of fiscal policy and other measures linked to the supply side of the economies, are the proper way to overcome these limitations of monetary policy.

It is wise to recognise the general limitations of monetary policy and the specific ones of the Eurosystem. However, let us also recognise the advantages of a common stability- oriented monetary policy for the whole area, which clearly outweigh the drawbacks. Euro area citizens can expect a lot from the Eurosystem's monetary policy, but not too much. Rather than a technique, monetary policy is really an art form: the so-called "art of central banking". And do not forget that, unlike those made by engineers, mistakes made by artists are always forgiven.



[1] The Treaty on European Union.

[2] "Sobre la inflation y las estructuras" en "XLIV Dia Universal del Ahorro" n ° 9. Fondo cultural de la Caja de Ahorros Provincial de la Diputacion de Barcelona, 1969, pp. 121-128.

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