The euro area - first experience and perspectives
by Professor Otmar Issing, Member of The Executive Board of the European Central Bank, at The Morgan Stanley Dean Witter Conference "Germany - Structural Revolution",on 26 January 2000 in Berlin
Ladies and gentlemen, it is a pleasure for me to speak here at the Morgan Stanley Dean Witter (MSDW) conference. Since the introduction of the euro, the MSDW Global Economics Team seems to have focused its attention on the analysis of the euro area developments, and has been a critical, but fair observer and commentator of the Eurosystem's monetary policy decisions.
The single currency offers a great opportunity to achieve the objective of sustained and widespread price stability in Europe. For the euro to become a "success story" as the single currency for around 300 million people, the public confidence in the stability of the new currency and in the Eurosystem, i.e. the European Central Bank and the national central banks (NCBs) of the 11 participating Member States, plays a crucial role. The Eurosystem has already achieved a great deal of progress during the past thirteen months in building up its credibility and gaining a sound reputation in the financial markets for its monetary policy.
The introduction of the euro also carries a number of benefits, which should help the euro area achieve higher growth and lower unemployment. For countries participating, EMU has eliminated nominal exchange rate volatility and associated costs of exchanging different currencies within the euro area. This avoids a misallocation of resources, and hence fosters growth. The single currency makes prices across the euro area directly comparable, which increases competitive pressures and hence efficiency and growth. Further benefits result from the reduction of risk premia built into real interest rates and from the elimination of premia resulting from less liquid markets. This should stimulate investment, and again foster growth.
However, the euro is not and cannot be a cure for structural problems facing the euro area. In particular, the introduction of the euro has not and will not by itself automatically increase the euro area economy's long-term growth potential. There has been extensive debate on the question of whether the economy of the United States has entered an era of a "New Economy". Growth would be sustainably higher than in the past, inflation would not be a primary concern, while cyclical fluctuations would be much more limited than formerly. The cause for all of this would be more widespread penetration of information technology in an environment of flexible labour, product and capital markets. However, while some argue that this is the case in the United States, for the euro area to become a "New Economy", particularly in the macroeconomic sense of high sustained non-inflationary and employment creating growth, is a goal rather than reality.
However, I do not want to sound pessimistic. Europe can become a dynamic economy. The degree to which the economic potential of the euro is realised, indeed depends first and foremost on stability-oriented policies. The single monetary policy can provide a solid basis for economic growth and employment, but it needs to be accompanied by sound fiscal and appropriate labour market policies as well as by decisive and comprehensive efforts to eliminate structural rigidities in labour and product markets.
In my remarks today I should start by briefly summarising the first experience gained with the euro area in its first year. I shall then focus my attention on the perspectives and forthcoming challenges facing the euro area economy.
2. First experience gained with the euro area
Let me describe the first experience gained with the euro area from the ECB's point of view, which is first and foremost the experience with the Eurosystem's monetary policy strategy. This strategy provides financial markets and the public with our framework on the basis of which monetary policy decisions can be taken internally and explained externally in a consistent and predictable manner. In our view, the monetary policy strategy has passed its first tests successfully.
At the core of the strategy is a clear primary objective for price stability. The definition for this objective contributes to stabilising market expectations. The Eurosystem defines price stability as an year-on-year increase of below 2% in the Harmonised Index of Consumer Prices (HICP) for the euro area. The Eurosystem aims to maintain price stability in line with this definition over the medium term.
Let me briefly outline how the Eurosystem's monetary policy strategy helps the Governing Council of the ECB to fulfil its task of maintaining price stability in the euro area. The first pillar of that monetary policy strategy assigns a prominent role to money. There is a broad consensus that inflation is actually a monetary phenomenon in the medium and long term. Therefore, monetary developments provide important information for any monetary policy that is aimed at safeguarding price stability.
To emphasise the prominent role assigned to money, the Governing Council announced a quantitative reference value for monetary growth in terms of the broad definition of M3 in October 1998. The decision for a reference value rather than a target for monetary growth was in particular been taken against the background of structural breaks potentially induced by the changeover to the single currency. On the other hand, the available empirical evidence showed that the relationship between area-wide demand for M3 and its macroeconomic determinants is quite stable and predictable. The first reference value was set at a rate of 4½% per annum. At its meeting in early December last year, the Governing Council reviewed this reference value and concluded that the assumptions underlying its derivation remain valid. Thus, there was no reason to change the reference value of 4½% M3 growth per annum. The Governing Council has decided henceforth to review the reference value on a regular annual basis, with the next review to take place in December 2000.
The reference value is a medium-term concept and differs from a yearly monetary target in several respects. First, it is not a reference value for a calendar year, but an expression of a medium-term development over several years. For this reason, the generous liquidity situation in 1999 will have to be borne in mind when assessing the information content of monetary developments in the future. Second, the reference value does not entail a commitment on the part of the Eurosystem to correct mechanistically deviations of monetary growth from the reference value. Rather, monetary developments are thoroughly analysed in respect of their causes and implications for future price stability.
The ECB does not focus solely on money. The problem with looking only at money is that, in the short run the relationship between money and prices can be distorted by portfolio shifts and institutional factors. Short-term developments in money therefore need to be analysed very carefully. Against this background, the Governing Council has always communicated to the public that it cannot and will not react mechanically to deviations of actual monetary growth from the reference value. Also in this sense, the concept underlying the Eurosystem's strategy is different from monetary targeting in the traditional sense. Monetary policy should always react to all the information available with a view to maintaining price stability in the medium term. For this reason, the Eurosystem's strategy is based on two pillars.
The second pillar of the monetary policy strategy is a broadly based assessment of the outlook for price developments and the risks to price stability in the euro area as a whole. This assessment encompasses a wide range of indicator variables, including macroeconomic projections produced both within and outside the Eurosystem. Within the stability-oriented monetary policy strategy, the exchange rate is an important variable for the Eurosystem as it is one of the determinants of the outlook for price stability. If exchange rate developments pose a threat to price stability in the euro area, this threat will be taken into account together with the information on price developments revealed by all other indicators. The exchange rate on the other hand, in the context of the clear mandate and the appropriate strategy cannot be a target of monetary policy.
I am convinced that our strategy has worked very well and will continue to be appropriate for the euro area. The chosen strategy is forward-looking in nature and oriented to the medium term. It truly reflects the complexity of the economy, it allows to take into account the possibility of a regime shift at the start of Stage Three, and it is sufficiently flexible to allow for appropriate responses to specific shocks. The monetary policy strategy eschews mechanistic reactions to any single indicator, including monetary aggregates, exchange rate developments or inflation forecasts. To put it briefly: After one year of experience I am even more convinced than before the start of EMU that we have found the proper answer to this historically unique challenge of a new currency and a new central bank for such a large economic area.
The ECB has committed itself to be open, transparent and accountable for its decisions and its performance vis-à-vis the European public and the European Parliament, its elected representative. For this reason, the ECB provides the general public with detailed background information on its monetary policy and the Governing Council's decisions. For example, immediately after the first Governing Council meeting each month, the President and the Vice-President hold extended press conferences, with the President's introductory statement as well as the transcript of questions and answers being almost immediately released on the ECB's World Wide Web page. This practice is similar to the publication of minutes, and has the advantage of presenting the Council's assessment of the economic situation almost instantaneously after the meeting. The ECB also publishes a Monthly Bulletin, which provides additional background information to explain in more detail its current assessment of monetary, financial and other economic developments. In addition, speeches such as mine today and other public appearances of members of the Executive Board, for example at hearings of the European Parliament, are an important channel of communication with the public. And last but not least, once a year, the ECB releases an Annual Report on its activities to the European public.
3. Perspectives and challenges facing the euro area
Let me now try to look ahead towards the perspectives facing the euro area and the challenges that policymakers will have to address. The reduction of unemployment is the major challenge currently, and for the foreseeable future, facing most euro area Member States, and the larger ones in particular. An estimated 12.6 million people in the euro area are looking for employment today. This represents almost 10% of the workforce and it does not even include those who may have given up looking for a job even though they are willing to work.
Fortunately, an economic recovery is now under way. Real GDP growth increased during the second half of 1999 and leading indicators point towards a continuation of strong growth in the euro area during this year. Forecasters both in private institutions such as Morgan Stanley Dean Witter as well as institutions like the IMF, the OECD and the European Commission have revised their forecasts upwards. Most forecasts expect that real GDP growth in the euro area will come close to 3% in 2000 and 2001. That should also lead to a cyclical recovery of employment in the euro area. The challenge for both monetary policy and economic policies at this juncture is to maintain non-inflationary growth in the euro area, that is to ensure that the current cyclical recovery is the beginning of a long period of growth without inflation, creating many jobs and hence effectively tackling the unemployment problem.
Among central bankers and economists, overwhelming agreement exists that there is no long-run trade-off between real activity and inflation. Attempts to use monetary policy to raise real economic activity above its sustainable level will over time simply lead to ever higher inflation, not faster economic growth. The best contribution which monetary policy can make to sustainable growth and high employment in the euro area is to maintain price stability in a credible and lasting manner, allowing the considerable benefits of price stability to be reaped over the medium term.
A recent study published in the November issue of the ECB's Monthly Bulletin once again confirms that price stability is essential as a foundation for strengthening output and employment prospects and thereby creating lasting improvements in living standards for Europe's citizens. There is convincing evidence presented by the experience of individual countries now forming the euro area. Long-term real interest rates have fallen most substantially in those countries which entered the 1990s with relatively high inflation rates. With the sustained reduction of inflation in the period preceding the transition to Stage Three of EMU in January 1999, it was in these countries that the benefit of moving towards an environment of price stability was greatest and, therefore, where the reduction in inflation risk premia was most substantial. In this way, these countries have lowered the effective cost of investment, which over the medium term should improve growth and employment prospects. When price stability prevails over the medium-term, the relative price signals on which the market mechanisms rely are not obscured by changes in the general price level. The market is therefore able to allocate scarce resources more efficiently to their most productive uses. As can be seen since the mid-1990s, the credible establishment of price stability throughout the euro area has helped to reduce the uncertainty with regard to future price developments and has thereby reduced the inflation risk premium in long-term interest rates. That improves the financing conditions for investment, helps avoid arbitrary redistribution of wealth and income, and thereby improves overall economic welfare. Through these and other channels, the current environment of stable prices is contributing to the growth and employment potential of the euro area.
It should be absolutely clear that monetary policy alone cannot do the job. The full benefits of the euro will only be reaped if there is appropriate support from other policies, especially fiscal and labour market policies, and if structural reforms are carried out in these areas. In this regard, sound fiscal policies in the EU Member States are of utmost importance. More specifically, Members States must continue to strive for policies aimed at the medium-term objective of budgetary positions close to balance or in surplus, as stipulated in the Stability and Growth Pact. Sound government finances are important to strengthen the conditions for price stability and for the strong and sustainable growth necessary to support employment growth. At the same time, high burdens of taxes and social security contributions continue to restrict economic dynamism across Europe. Governments are starting to address this issue in their budgetary planning and more progress would be desirable over the coming years.
The problem at this juncture is that a number of countries are still far from reaching the target of budget surpluses or even balanced budgets. Substantial structural imbalances continue to restrict the flexibility of public sector budgets to react to cyclical fluctuations and also limit the scope for tax cuts. To be sure, the need for sustained fiscal consolidation seems to have been acknowledged across the euro area. The latest estimates of fiscal positions in euro area Member States show that the average general government deficit-to-GDP ratio in 1999 declined to 1½% and that most Member States' targets for their budgetary positions have been achieved. Looking ahead, a further decline in deficits is anticipated as a consequence of the cyclical upswing and the further reduction in interest payments in relation to GDP. Nevertheless, the average deficit for the euro area forecast for 2000 implies limited consolidation and only a small decline in debt ratios. Public finances need to be safeguarded against the burdens arising from excessively high debt ratios and the consequences of ageing populations.
I should like to emphasize that the ECB is of course not concerned about higher real economic activity growth in the euro area. In fact, we do believe that the euro area has the potential for much stronger non-inflationary growth rates. What is needed to achieve high non-inflationary growth in the euro area is decisive efforts by all policy-makers in the euro area Member States towards fundamental and far-ranging structural reforms of the product, and in particular the labour markets. There is little doubt that the root causes of unemployment in the euro area are structural rigidities in the labour market and tight regulation in product markets. It is obvious that structural problems require structural solutions. Implementation of structural reform aimed at reducing rigidities in product and labour markets is indeed urgently needed to prevent the emergence of real bottlenecks and ensuing price pressures. Indications of skilled labour shortages have already started to become apparent in some Member States, in spite of still high unemployment rates in some cases.
There are many examples of what can be done. First, there are measures to ensure that low-productivity workers are not forced out of the labour market. To this end, the burden of taxes and non-wage labour costs could be reduced for low-paid workers. In addition, minimum wage schemes need to take account of the need to preserve jobs for low-productivity workers. Second, there are "active labour market measures" which provide programmes of education, training and work experience targeted at the long-term unemployed. Third, reforms to the tax and benefit systems could be implemented which ensure that people are significantly better off in work than out of it.
I should like to emphasise that the structural reform agenda available to national governments to promote economic development extends well beyond the reform of labour markets. For example, national governments can take steps to promote entrepreneurship and make it easier for people to start and run businesses and thus create new jobs. This could involve encouraging competition through measures to promote the entry of new firms, such as reducing the administrative burdens they face and making markets more competitive. Furthermore, governments can speed up the liberalisation of previously highly regulated sectors, in particular network industries such as telecommunications, energy, transport, water and postal services. A good deal of liberalisation of these industries has been achieved across the euro area during the recent past, and the impact has been, and continues to be seen not least in the development of prices. However, there are still significant country and sector-specific differences in the timing and scope of market opening. Further advances in the liberalisation are clearly highly desirable as the price and quality of output of these industries is not only important for the competitiveness of the European industry, but also for the standard of living of European consumers. National governments may also wish to take steps to raise productive investment in research and development to increase growth in expanding high-tech industries.
Social partners also have to play an important role within EMU in order to foster growth and improve employment prospects. Social partners remain principally responsible for reconciling high employment with appropriate wage settlements. Generally speaking, it is of utmost importance that wage cost developments in Member States are allowed to reflect different economic and employment situations. The current situation with regard to employment and unemployment, differs indeed widely within the euro area. But whilst this is not by itself to be seen as a problem, it should be clear that a "one-size-fits-all"uniform wage policy could be fatal. Moreover, social partners should take into account the needs of both "insiders" and "outsiders"; wage settlements which only reflect the interests of the employed may set a too high wage level for the unemployed to find work.
For wage developments to contribute to an employment-friendly policy setting in the euro area, the social partners should pursue a course in line with the following desired characteristics. To start with, nominal wage increases in euro area Member States must be consistent with price stability; thereby in the euro area, aggregate wage increases will be consistent with keeping price increases within the price stability objective of the ECB. Secondly, real wage increases in relation to labour productivity growth should take into account the need to strengthen, where necessary, and subsequently maintain the profitability of employment-creating investment. In principle, as a very broad guideline real wage increases in line with productivity gains would ensure no upward pressure on unit labour costs while not necessarily contributing to further employment and growth. Thirdly, in order to improve employability, wage agreements should take into account differentials in productivity levels according to qualifications, skills and geographical areas. And finally, especially within the euro area, it will be of crucial importance to avoid a convergence of nominal and real wages across countries and regions out of line with productivity; therefore, wage imitation effects should be avoided. Labour cost differences between Member States should continue to reflect discrepancies in labour productivity.
To conclude, I am convinced that EMU provides a great opportunity to create and maintain a large zone of price stability and economic prosperity in Europe, including a substantial reduction of unemployment. The short-term outlook for the euro area appears to be favourable for an upswing in economic growth accompanied by price stability. With the appropriate policies in place, the momentum of growth might eventually turn out to be stronger than currently expected. Monetary policy will support a lasting path of growth by maintaining price stability and keeping inflation expectations low. Such a policy ensures the most favourable financing conditions as it limits risk premia in interest rates, and it allows social partners to conduct wage negotiations which focus on job creation rather than on how to protect the purchasing power of workers against inflationary losses in the wake of uncertainties.
While the ECB will play its role in this regard, governments and social partners also have important responsibilities. In particular, further progress needs to be made in the consolidation of public finance, beyond the current cyclical improvements, and structural policies to improve the functioning of both labour and product markets need to be rigorously pursued. Policy-makers in all areas must therefore take the new environment of EMU, and its consequences, into account accordingly when formulating their policies. By setting and maintaining these conditions, policy-makers will maximise the chances for economic growth, and thereby contribute to fully exploit the growth potential of Europe.