How to promote growth in the euro area: the contribution of monetary policy

Professor Otmar Issing,Member of the Executive Boardof the European Central BankConference of the National Bank of Belgium

1. Introduction

Over the last decade, considerable progress in a number of economic dimensions has been made within the countries which now form the euro area. Price stability has been restored, monetary policy is now in the hands of a new central bank clearly committed to the pursuit of price stability in the medium-term, and long-term inflation expectations appear to be consistent with the Eurosystem's definition of price stability. On the fiscal front, deficits have been reduced significantly over the 1990s and the aggregate debt-GDP ratio, after having doubled between 1970 and 1996 has started a gradual decline. In many respects, the broad macroeconomic fundamental conditions for growth and for improved economic performance in the area are more favourable now than they have been for many years. Against this background, the key challenge facing Europe is the need to promote sustainable non-inflationary growth so as to exploit the full potential of the area. In this context, it is a timely exercise to examine the possible contribution of various policy areas - including monetary policy - to maximising the sustainable output of the euro area.

Interest in the link between money and economic growth has a long tradition. Up until the middle of the 20 th century the dominant opinion was encapsulated in 'classical view' expounded by, among others, John Stuart Mill. According to this view, money is essentially a veil: the quantity of money determines the overall price level but has no consequences on the level of real output. Of course for a long time observers such as David Ricardo were aware of the temporary stimulative effect on output emanating from increases in the money stock. Much of the discussion of money and output since the middle of this century, as a result of the so-called Keynesian revolution, has also focused on short-term effects of money on output. Interest in the long-run effects of money on output, in particular on the question of whether inflation influences output in the long-run, is a much more recent phenomenon, dating back to the 1950s. The neglect of the longer-run relationship between money and output is somewhat strange since, when cumulated over time, longer-term sustained changes in output have welfare implications which substantially outweigh the effects of normal cyclical fluctuations in output. Indeed as Robert Lucas (1988) points out, "the consequences for human welfare involved in questions like these are staggering: once one starts to think about them, it is hard to think about anything else".

2. Inflation and Growth Theory

It is fair to say that, up to now, the standard theoretical literature on the long-run relationship between money and output has not provided clear-cut conclusions. According to the seminal contribution of Tobin (1965), an increase in the rate of growth of the money stock (i.e. a more inflationary policy) would lead to an increase in the capital stock and thereby a higher level of output. The mechanism is straightforward. A higher rate of inflation reduces the own return on money inducing a portfolio shift on the part of agents in favour of real capital, leading to higher output in the long-run. This result, however, is difficult to take seriously. It would imply, strongly counterfactually, that hyperinflation would lead to dramatically improved performance in real economy! The Tobin result rested on a number of rather restrictive assumptions (e.g. a constant ratio of personal savings to income and a somewhat ad-hoc treatment of the savings and portfolio allocation decision). Just two years later, Sidrausky (1967) overturned this result. By introducing money explicitly into the utility function and treating the intertemporal allocation decision within the framework of dynamic optimisation by infinitely lived economic agents, he re-established the classical result that the long-run capital-labour ratio (and therefore output itself) is pinned down by the rate of time preference and does not depend on the rate of inflation. He thus established, within this framework, the 'superneutrality' of money - that is, the independence of the long run growth path of the economy from the rate of monetary growth and inflation.

However, this superneutrality result was, in turn, shown not to be robust with respect to variations in underlying assumptions in the model. One such variation is to allow labour supply to be endogenously determined. In this case, changes in money growth have the potential to affect the relative marginal utilities of consumption and leisure and therefore the level of steady-state output. The direction of the effect in this case is, however, not clear-cut and depends on the relative sizes of the elasticities of the utility funtion. Indeed, for certain popular classes of utility functions (e.g. the logarithmic) the Sidrausky superneutrality result is restored.

The long-run impact of money on output in these theoretical models is found to depend crucially on the way the use of money is motivated and thus on the way it is introduced into the model. Four alternatives to the assumption that money yields utility directly are

a) the cash-in-advance approach;

b) the money in the production function approach and

c) the shopping-time model and

d) the 'transactions cost approach'. In the cash-in-advance approach, the results are sensitive to whether the cash constraint applies to consumption or investment goods and to whether labour supply is endogenous or not, as shown by Cooley and Hansen (1989) and Stockman (1981). When money is treated as a factor of production in its own right, superneutrality is rejected, but the direction of the effect of money growth on long-run output is ambiguous, depending on the partial derivatives of the production function with respect to money. For the concave case, higher money growth leads to a reduction in steady-state output. In the transactions cost approach - in which the services of money affect the resource constraint facing agents rather than entering directly into the utility or production function - Zhang (2000) shows that, under plausible auxiliary assumptions, higher inflation always leads to lower output in the long-run.

The papers referred to above relate to models in which agents are treated as 'infinitely lived'. The alternative approach is to employ overlapping generations models (e.g. Stein 1970). Here again, the conclusions are not robust. In particular, the outcome is found to depend in particular on the assumptions made regarding the distribution of the seigniorage to the old versus young generation.

Much of the early literature on growth treats the long-run growth rate of the economy as being exogenously fixed by the rate of technological progress and focuses instead on effects on the level of output in the long-run. The more recent 'endogenous growth' literature, in contrast, allows for the possibility that the long-run growth rate of the economy is endogenously determined by, for example, investment in R&D or human capital or increasing social returns. Some attempts have been made within this framework to incorporate effects coming from money, but again the results are ambiguous and depend on assumptions made. In the model of Gomme (1993), higher inflation leads to a temporary reduction in labour supply which - via a learning by doing effect lowers the stock of human capital - thereby lowering the growth rate of the economy. In contrast, in the Ho (1996) model, higher inflation via a Tobin effect raises the capital stock, thereby increasing the long-run growth rate.

Concluding his 1970 survey of money in growth models, Jerome Stein noted that "my main conclusion is that equally plausible models yield fundamentally different results". Two decades later, Orphanides and Solow in their 1990 survey noted that "all we have is more reasons for reaching the same conclusion". In view of these ambiguities, it is hardly surprising that interest in the role of money in growth has waned following a flurry of interest in the 1960s triggered by Tobin's contribution. It is, for example, notable that one of the current leading textbooks on economic growth (Barro and Sala-I-Martin, 1995) contains just a single reference to inflation and no references at all to money!

3. Inflation and Growth: A Broader Framework

Can we then take the ambiguous theoretical results as an indicator that we do not know whether or not price stability improves output over the longer term? It seems to be the case that the ambiguous theoretical results reflect the fact that the focus of these studies is too limited. These studies mainly concentrate on the effects of portfolio substitution between money and real capital in frictionless markets where agents do not face informational constraints. In addition, the way money is introduced into these models hardly captures in a satisfactory way the key role played by money and by the price mechanism in a market economy. Since these issues are very difficult to capture in a simple analytical framework, it is not surprising that they are typically neglected in the theoretical growth literature. However, from a practical point of view, when assessing the impact of inflation on output in the longer term, it is crucial to take these elements into consideration.

The price mechanism plays the crucial role in allocating resources efficiently in a market economy. Inflation seriously disrupts the functioning of this mechanism, leading inevitably to distortions and misallocation of resources. Price stability improves the transparency of the relative price mechanism and helps it to signal the allocation of resources where they can be put to the best uses. It therefore helps to avoid distortions and allocate resources efficiently both across uses and over time. Inflation leads agents to confuse transitory and permanent price changes, and thereby distorts their decision-making over possibly prolonged periods of time which would further hinder the efficient allocation of resources and reduce real output in the longer term. In evaluating investment opportunities, it is essential for good investment decisions, that firms have confidence in the signals conveyed by relative price changes since these are the prices that determine whether an investment project will be profitable or not. For the relative price mechanism to function properly, firms must be able to discriminate between relative price adjustments and general changes in the overall price level. They can only be sure of not making mistakes in a situation of overall price stability. The longer the gestation period of the investment, the more important it is for firms to have confidence in the signals which the relative prices that are relevant to the decisions are conveying. With imperfect signal extraction devices, the producer can make two types of mistake. It can increase production when the price increase is only due to overall inflation or it can fail to increase production when the price increase is due to a favourable relative price movement. In either case, resources are wasted.

Another benefit of price stability, which yields an efficient use of resources, is that it eliminates the need for private agents to have in place indexation mechanisms and procedures. The costs and complexities involved were clearly apparent in the difficulties which were encountered in the 1970s when attempts were made in many countries to implement systems of 'current cost accounting'. In fact, no satisfactory solution to the problem of appropriately accounting for inflation was found and such systems were rarely implemented in practice given the costs and complexities involved.

Inflation also exacerbates in a very significant way the distortions already inherent in the tax and welfare systems as they affect economic behaviour. Even without inflation, the imposition of personal and corporate income tax distorts the allocations of productive resources in a market-based economy because it leads to a bias towards current consumption relative to savings and investment. Recent work by Martin Feldstein (1999) for the US has shown that the interaction between inflation (even if fully anticipated) and income taxes has the unintended effect of exacerbating these distortions and that a reduction of the inflation rate by 2 percentage points would reduce these deadweight losses by around 1% of GDP annually. Similar results (with even larger losses) have been reported for some Euro Area countries (Germany by Toedter and Ziebarth (1999) and Spain by Dolado, Paramo and Vinals). Price stability also obviates the substantial costs of having to alter price lists on a frequent basis; even if inflation is fully anticipated, prices need to be changed more often and price-changing is usually quite costly, i.e., menu costs have to be incurred (see Mussa, 1977).

On top of these effects on resource allocation, price stability promotes the holdings of real balances resulting in a welfare gain since the social cost of producing these balances remains substantially unaffected; price stability therefore avoids some of the "shoe leather" costs associated with minimising unremunerated money balances in an inflationary environment. Traditional approaches were usually based on a transactions theory of the demand for real balances. Moreover, recently developed consumption-smoothing approaches (e.g. Imrohoroglu (1992)) suggest that the traditional approach ignores certain welfare losses: individual agents cannot always find work and they cannot insure themselves completely against the loss of income since work opportunities are idiosyncratic; they therefore carry real balances to allow them to consume when they cannot work; inflation forces individuals to economise on real money balances and therefore undermines the ability of workers to smooth consumption over time - an effect on welfare not picked up by previous approaches.

The problems for resource allocation become particularly pernicious when inflation is variable and has a large unanticipated component. In this case, inflation risk premia will be built into to long-term interest rates thereby reducing investment and output. Firms will be less reluctant to undertake investments with long gestation periods if they were reasonably sure in advance of the price conditions under which they will be able to sell their product when it is finally brought to the market.

Households will also be more reluctant to undertake long-term saving plans unless they also know with reasonable certainty the purchasing power of their savings when they bring their plans to fruition. In an inflationary environment, there is likely to be excessive investment in 'hedges against inflation' such as property and real assets rather than financial investment, hampering the emergence of efficient financial markets and possibly contributing to unsustainable bubbles in the assets concerned.

When these factors - which are not considered in standard money in growth models frameworks - are taken into account there can be no doubt that inflation is harmful for both output and welfare in the medium term. Given the pernicious effects of inflation on the functioning of the economy it is hardly surprising the Lenin is alleged to have said that that "in order to destroy the bourgeois society, one must destroy its monetary system". Indeed, there is now a general consensus that high inflation is bad for output in the long-run.

4. Could Inflation be Beneficial in Small Doses?

However, one may ask could inflation in 'small doses' be helpful for growth? The most popular idea in this context is that a little inflation is necessary to 'grease the wheels of the economy', a view which goes back to Tobin (1972). It is argued that workers would be unwilling to accept nominal wage cuts or that firms would be unwilling to reduce their prices in nominal terms, a small positive rate of inflation would enable real wage cuts to take place, if required, and/or facilitate changes in relative prices necessary for economic efficiency. A more up to date version of this argument is presented in a recent study of the US case (Akerlof et al, 1996). These authors develop a theoretical model to explain the behaviour of wage, price and unemployment determination under conditions of low inflation and derive empirical estimates of the model parameters. On the basis of this evidence, it is argued that, in the face of downward nominal rigidity, a shift to a zero inflation objective would imply a permanent increase in the equilibrium level of unemployment. More specifically, they argue that a shift from 3% inflation to zero would result in an increase in the US equilibrium unemployment rate of up to 2.6 percentage points. The rationale is straightforward. With a zero inflation rate, individual firms facing adverse firm- specific circumstances will not be able to secure real wage reductions in the presence of downward nominal wage rigidity and, instead, will lay-off workers. Thus, even in equilibrium, it is argued that a permanently higher level of unemployment will prevail under low inflation.

The importance of the argument that a small positive rate of inflation can 'grease the wheels' of the economy depends, in practice, on the extent to which nominal wages and prices are downwardly rigid. As regards prices, the empirical evidence on the importance of downward nominal rigidities is mixed (see, Yates, 1995, for a review). For wages, the evidence of downward nominal rigidities is more convincing. Akerlof et al (1996) examine a range of evidence and studies which examine post-war US experience. Generally they report that the incidence of actual cuts in nominal wage rates is very rare in practice, providing convincing evidence of downward wage rigidity in this period studied. However, since the empirical evidence cited largely relates to a period in which inflation was substantially above zero this finding is hardly surprising (Gordon, 1996) and may not be an accurate guide to the situation which would prevail in an environment of low inflation. Moreover, as Gordon notes, the prediction that a lower rate of inflation would imply a higher permanent level of equilibrium unemployment is not confirmed by cross-country analysis of the relationship between inflation and unemployment rates nor by the historical experience of the US . Finally, as noted by Groshen and Schweitzer (1999), inflation adds 'sand' as well as 'grease' to the economy in the sense that inflation disrupts the efficient working of wage and price adjustment. On the basis of their analysis - which importantly is based on data from a low inflation environment - they conclude that "low inflation may not raise unemployment or impair the smooth functioning of the economy".

In any case, the need for downward nominal wage flexibility may be overdone. As long as trend productivity growth is positive, zero nominal wage growth will enable reductions in unit labour costs to take place without explicit reductions in nominal wage rates. Further, to the extent that earnings (and thus actual labour costs) contain flexible elements, such as overtime payments, bonuses etc., wage costs may be reduced without reducing negotiated wage rates.

All in all, it would seem that 'greasing the wheels of the economy' does not constitute a convincing argument against the favourable effects of price stability on output in the long-run.

5. Empirical Evidence

The link between money and growth is clearly a complex phenomenon which means that it is very difficult to encapsulate all of the important aspects in a neat theoretical model in such a way as to yield clear-cut conclusions. But what does the empirical evidence have to say on this issue? While some controversy remains, it is fair to say that the weight of the evidence does point to a negative relationship between inflation and output in the long-run. That is inflation is bad for growth in the long-run. A number of such studies have been carried out, mainly looking at the experiences of groups of countries over extended periods, i.e. cross-sectional analysis. The list of papers which establish such a negative relationship includes Kormendi and McGuire (1985), Grier and Tullock (1989), Fischer (1991), Cozier and Selody (1992) and Barro (1995). The result is not unanimous, however. Mc Candless and Weber (1995), for example, reach the conclusion that there is no correlation between growth and inflation. However, no study of which I am aware manages to find a positive relation, which would support a Tobin effect.

Still, there is some controversy regarding the interpretation of the negative inflation-output relation found in most of the literature. For example, it is argued that the negative correlation between inflation and growth is due to the inclusion in the samples of specific countries and moreover it is difficult to establish a negative relationship when inflation is relatively low (Bruno and Easterly, 1996). However, a recent study by Andres and Hernando (1999), focusing on OECD countries, find that even in low or moderate inflation countries, there is evidence of a robust negative relationship between inflation and output in the long run.

In this context, it is important to note that the output gains from low inflation - even if in a particular year they appear to be small - are permanent. In present value terms, then, the value of these gains is substantial. By way of illustration, discounted at a 3% real interest rate, a 0.5% gain in output per year amounts to 17% of GDP in present value terms. In fact, the empirical evidence suggests even bigger gains than this. For example, the recent study by Andres and Hernando mentioned earlier points to a permanent gain of between 0.5% and 2% of GDP a year and estimates carried out by Feldstein and others also point to gains also lying within this range.

6. Shorter-term Considerations

Up to now, the discussion has focused on the relation between inflation and growth in the long-run. The distinction between long and short-run, though by no means satisfactory, is relatively standard in macroeconomic analysis. The conventional wisdom is that while there is no-tradeoff between inflation and unemployment in the long-run (indeed as pointed out above, in the long run price stability is likely to increase output), trade-offs may arise in the short-run. This view implies that disinflation can involve short-run, temporary costs in terms of foregone output. These temporary costs are traditionally measured in terms of 'sacrifice ratios', such as those calculated by Ball (1994).

More recently, in the European context, a number of commentators have suggested policies aimed at disinflation or, more relevant in the current context, monetary policies aimed at preventing the re-emergence of inflation may lead to more protracted, and in the extreme case, permanent adverse effects on output [1] . The mechanism invoked is hysterisis, as defined, for example, in Blanchard and Summers (1986). The idea is that even a temporary shock may have permanent effects on unemployment. This could happen for a number of reasons. Once people become unemployed, they loose human capital and motivation and may become less attractive to potential employers. Alternatively, in an insider-outsider wage setting framework, unions are seen as setting wages taking account only of the interest of those employed currently; wages are thus set higher than the level that is necessary to enable employment to increase to the extent necessary to reduce unemployment. On the basis of this argument, it is argued that temporary shocks can have permanent effects on output. Thus it is suggested that central banks should be extremely cautious in tightening policy since any adverse output effects could prove protracted and costly; as a corollary, it is suggested that central banks should "give growth a chance" even if this means "taking risks with inflation".

While it is certainly true that, given the severe rigidities in European labour markets, the possibility of such hysteresis cannot be ruled out, I believe that the policy conclusions which seem to be drawn in some quarters as an implication are misplaced and, indeed, dangerous.

First, the existence of hysterisis places a premium on ensuring that the central bank avoids a situation in which disinflation becomes necessary. Given the favourable starting position of the ECB, this argues for a forward-looking and pre-emptive approach which prevents inflation from emerging in the first place and in particular avoids inflation becoming engrained into people's expectations. By pursuing a forward-looking pre-emptive approach directed towards maintaining price stability, which provides an anchor for price expectations, the central bank thus avoids the stop-go pattern of the past with its inevitable adverse consequences for output and employment.

Second, much, if not all, of the hysteresis observed in Europe is itself due to institutional and structural rigidities in labour and product markets. The problem of hysteresis has to be tackled at the level of the factors that cause it by means of structural reform. Attempting to tackle this problem with monetary policy would represent a serious misassignment of a policy instrument.

Third, even if it were desirable, we have to acknowledge that attempts by the central bank to fine tune economic activity are likely to prove counterproductive in view of the uncertainties involved. Nearly fifty years ago, Friedman (1953) showed how, given the information and other lags involved, well-intentioned attempts by central banks to fine-tune output could easily have the opposite of the intended effects and lead to a path for output which would be more volatile and unstable than in the absense of such policies. While fine-tuning may work well in very simplified theoretical models, in practice there are a number of uncertainties involved which will result in it failing in practice. For a start, the central bank needs to have a good assessment of the current state of the business cycle in real time. Yet here, the evidence, as shown in a number of recent papers (see, for example, Orphanides (1999)) is not encouraging. Estimating the output-gap even for past data is very difficult; in real-time, it is virtually impossible to arrive at satisfactory measures. The work by Orphanides suggests that misperception by the central bank of the current state of the economy has been a major source of policy error in the US in the 1970s. In any case, even if the output gap could be accurately measured, monetary policy impacts on the economy with long and variable lags. There is thus no guarantee that by the time a monetary policy impacts on the economy, it will be appropriate for the conditions then prevailing. These uncertainties, which in 'normal circumstances' are formidable, are even more acute in the case of the euro area where a new monetary regime applied in the context of a new monetary area creates a host of uncertainties regarding the response of the economy to monetary policy.

Fourth, the credibility of the central bank's commitment to price stability in the medium term would be put in jeopardy. Central bank credibility can only be built up over a period of time on the basis of a proven record of stability-orientated policies. Once lost, the reputation of a central bank can only be restored with great difficulty and at substantial costs. This would typically involve a tighter policy for a protracted period than would otherwise be the case in order to restore inflation and price expectations to appropriate levels. Of course, precisely such a situation would exacerbate the unemployment problems associated with hysteresis. As is well known from the academic literature on "rules versus discretion", private agents continually need to be reassured of the central bank's commitment to price stability and that the central bank has not relegated these objective in favour of short-term and unsustainable gains in output. A monetary policy excessively orientated towards smoothing cyclical fluctuations, a task to which it is in any case ill-suited, is always vulnerable to such a loss of credibility. A new central bank such as the ECB, without an established track record of its own, is in no position to take such risks.

Overall, while the presence of rigidities, and perhaps even hysteresis, is plausible in the case of Europe , this provides no justification for focusing policy on shorter term cyclical considerations. In view of the extreme uncertainties involved, any such attempt is doomed to failure. The result would be a significant deterioration in inflation performances without any tangible gains in output in the medium term. On the contrary, in the longer term weaker growth and higher unemployment would be the result. Such a misplaced policy would involve the central bank taking unwarranted risks with inflation and with the credibility of its commitment to the goal of price stability in the medium term.

7. Growth Performance in the Euro Area

The above considerations suggest the following conclusion. While the partial analysis embodied in pure theoretical models yields, perhaps not surprisingly, ambiguous results, there are strong and well based a priori arguments for believing the best contribution that monetary policy can make to long-term output performance is to maintain a steady medium-term price stability orientation. The available empirical evidence on balance supports this assessment. It also continues to be robust, even if one allows for possible hysteresis effects from the short-run to the long run. Indeed, I think it is fair to say that this approach is by now the established conventional wisdom in industrialised countries. In the case of Europe , this consensus on the contribution of price stability in promoting long term growth is explicitly enshrined in the statute of the ESCB which states unambiguously that "the primary objective of the ESCB shall be to maintain price stability." The ECB is convinced that by rigorously fulfilling this mandate, monetary policy is making its most effective contribution to realisation of strong output growth and satisfactory employment prospects.

This of course does not mean that public policy in general cannot make a contribution to improving growth performance. Central bankers also have a contribution to make in terms of this policy discussion. As those of you familiar with the ECB's publications and the speeches of Governing Council members are well aware, the ECB takes this obligation seriously. At a European level, the ECB is an active participant in the discussions about how to improve the prospects for sustainable employment-generating growth. The ECB is involved through its participation in the Economic and Financial Committee and Economic Policy Committee. In these fora there is an annual discussion of the Broad Economic Policy Guidelines and the Stability and Convergence Programmes of EU countries. The ECB also participates in the twice- yearly Macroeconomic Dialogue with governments and social partners in the EU. The discussions at the European level provide a useful opportunity to create a consensus on the need for reform in both the fiscal area and in the field of structural policy. It also affords it an opportunity to exert some peer pressure to get the reform momentum going.

Our view - which I think at this stage is largely the consensus view - is that the key to maximising the economic performance of the Euro area is a comprehensive program of structural reform. This requirement particularly relates to the labour market.

On the surface, the productivity growth performance of the euro area compares favourably with other areas, including the US, However, as pointed out recently by an OECD study (OECD, 2000), a large part of the apparent strong productivity growth in Europe reflects the elimination of employment opportunities for less skilled workers with lower productivity, who either became unemployed or discouraged from participating in the labour market. The contrast with the US over either the last 10 or 30 years could hardly be more stark. In Europe , unemployment has risen substantially while labour force participation has stagnated with the result that the percentage of the working age population in employment has fallen by 4 percentage points over the last 30 years. Contrast this with the US experience, where the percentage of the working age population in employment has increased by around 10 percentage points and unemployment is currently at historic lows [2]

Resolving the deficiencies of the labour markets in the euro area is thus the key to achieving satisfactory economic performance. The causes of the problem are well known and have been analysed in detail by a number of organisations, including the OECD and EU Commission. The main factors which are identified as underlying the poor labour market performance of the euro area include: adverse impacts of minimum wage and employment protection legislation; disincentive effects created by income tax and benefit systems and, especially, by their interaction; inflexibilities in wage bargaining processes; and inadequacies in the fields of training and education.

At the same time, a number of further structural features in product markets hinder the growth performance of the euro area. These include the relatively high share of government in economic activity, and the associated high level of taxes, restrictions on competition in product markets and insufficiently developed financial markets. It is encouraging that in a number of these areas - e.g. deregulation and the development of financial markets - substantial improvements are already underway.

8. A New Economy in Europe ?

Much of the previous discussion has focused on the effects of monetary policy on longer term growth performance. An important influence, of course, goes in the other direction, namely the influence of growth prospects of the economy on monetary policy. This in itself is a major topic and has a number of aspects. One issue on which I wish to focus today is the possibility of a so- called 'New Economy' in the Euro area and its implications, if any, for the monetary policy of the Eurosystem.

The growing interest in the press and in financial market commentaries in the New Economy is largely inspired by the unprecedented peacetime expansion which the US economy has experienced in the 1990s, which has been characterised by an increasingly favourable combination of low unemployment and relatively subdued inflation. While initially, many observers were sceptical, the evidence seems increasingly to favour the view that something special has happened in the US economy. Indeed, in recent testimony, Alan Greenspan has said "the best I can say to you is that it is certainly true that we have a new economy. It is different. It is behaving differently and it requires a different type of monetary policy to maintain its stability and growth than we had in the past." [3] What appears to be meant is that the speed limits of the economy have been increased. The economy can now operate at higher rates of growth than in the past without generating an acceleration of inflation.

According to most accounts, the New Economy is driven by four mutually reinforcing factors. First, there is the remarkable technological progress in a range of fields, especially data- processing and telecommunication. In addition, improved managerial techniques - facilitated by IT advances - have also apparently succeeded in harnessing these new technologies so as to boost productivity. Second, the process of globalisation and increased competition, in the markets for goods and some services, have stimulated improved efficiency and reduced pricing power. There is also a direct favourable effect on inflation coming from significant output price reductions in the information and communication technology industries themselves. Third, the highly competitive and unregulated market structure of the US economy has facilitated the emergence of new lines of business and the harnessing of the new technologies to promote efficiency. This has been helped by a deepening of financial markets (also facilitated by the advances in information technology) which has enabled entrepreneurs in the high-tech sector to start up whole new lines of activity. Finally, the US has benefited from a very favourable and stable public policy environment - with a commitment to sound public finances and price stability at the macro level and a business-friendly low-tax low-regulation approach at the micro level. This has reduced uncertainty, encouraged entrepreneurial activity and facilitated the expansion of investment.

At the same time, there are some 'holes' in the New Economy story. Some observers have noted that the favourable performance of the US in the 1990s can be attributable to a very lucky and unique combination of events, which coincided and allowed the US to grow faster than would be regarded as normal without generating inflation. Examples are weak oil and commodity prices and a strong dollar. As regards technology, evidence that technological progress has lead to notable increases in productivity growth outside the 'high-tech' sector is not yet compelling at the macro level. In any case, some of the more extreme versions of the New Economy story - the death of inflation and the end of the business cycle - would appear to be overdone and, indeed, downright dangerous.

Still, in view of the US experience, it is legitimate to speculate as to the prospects for a New Economy in the euro area. Could the factors, which are supposedly behind the New Economy in the US, exert a similar favourable influence in the euro area? The potential is clearly there to be exploited. First, regarding technology, there is considerable scope for the euro area to benefit from these emerging technologies, although it is notable that on most indicators of the use of these technologies (apart from mobile telephony), the Euro area lags well behind the US . In those countries where these technologies are prevalent (e.g. the Nordic countries), we have little evidence up to now of a New Economy as such. This points to the fact that technological factors per se are not sufficient to explain the New Economy features observed in the US . Other factors in Europe which would be conducive to improved economic performance include the growing integration of the euro area into the global economy, increasing competiton - reflecting both the single market and the single currency - and some initial progress in the field of goods market deregulation.

However, there are still a number of restraining factors in Europe . As I noted earlier, an appropriate market structure is essential for a New Economy to emerge. It is well known that the euro area is hampered by a number of severe structural rigidities, which would diminish the benefits of new technological possibilities. These include rigidities affecting especially the labour markets, a relatively high tax burden and a regulatory environment, which is much less favourable to entrepreneurial activity than is the case in US. In addition, financial markets - especially regarding the provision of risk capital - are less developed in Europe although notable advances have been made in recent years.

All in all, as Hermann Remsperger recently pointed out, one can see some "traces" of the New Economy" in Europe. However, in order to realising the full potential provided by the new technologies and opportunities, a comprehensive process of structural reform is essential.

The possibility of a New Economy obviously poses challenges for monetary policy. The first is an identification issue: how do we know if it is there? Traditional techniques, such as growth accounting, are not helpful, particularly in the context of monetary policy which has to operate in real time. The statistical basis on which the performance of the economy is judged generally lags behind developments in the economy and, in the case at hand, faces formidable measurement problems (e.g. in measuring output in services and in correctly valuing intangibles such as R&D). Third, in a real time context, it is extremely difficult to disentangle cyclical movements in output from longer-term structural developments. Confronted with very considerable uncertainty with respect to the likely influence of the information technology revolution on economy-wide productivity and output growth, the best prescription for central bankers is to keep an open mind about likely developments.

Even if this uncertainty did not exist, the appropriate response of monetary policy is not straightforward, as the US experience demonstrates. On the one hand, the New Economy could be viewed as a favourable supply shock which would allow the economy to grow more rapidly without generating inflationary pressures. On the other hand, as Alan Greenspan has recently pointed out, [4] agents could anticipate future improvements in economic prospects and, reflecting increases in asset prices and higher income expectations, raise expenditures to levels beyond the current productive capacity of the economy, giving rise to potential excess demand and incipient inflationary pressure. In addition, a protracted increase in the growth rate of the economy would lead to a rise in equilibrium real interest rates. In these circumstances, the central bank is very much in uncharted waters.

I would suggest that the monetary policy strategy of the Eurosystem is well placed to deal with these challenges. Given its medium-term orientation, it does not focus on cyclical fine-tuning of real activity and is thus not particularly dependent upon specific measures of potential output and the output gap. The 'full-information' approach upon which policy decisions are taken - reflected in the two pillars of the strategy - should help to minimise any risks of inappropriate actions, especially since it is designed in a very flexible way which enables it to react to any indicators regarding the future prospects of price stability, including those which would suggest the arrival of a New Economy. The Eurosystem's monetary policy would no way be an impediment to faster growth, which might emerge as a result of New Economy effects. It can safeguard price stability while allowing the economy to realise its growth potential.

9. Conclusions

To sum up, the formal theoretical literature regarding the impact of money on the long-run growth path of output yields ambiguous results. This ambiguity can be traced to the difficulties of incorporating into these models the key roles performed by money in a satisfactory way. When account is taken of this role, there are well-based a-priori grounds for believing that inflation is damaging to long-run economic performance and welfare. While empirical evidence in economics is rarely definitive, the available evidence appears to be robust in showing that low inflation is good for output in the long-run; no study of which I am aware suggests an opposite effect. All in all, the conclusion I derive from all this is that a medium-term monetary policy oriented to price stability is the best contribution that a central bank can make to long-run economic performance. The evidence for this contribution is robust, even when one allows for so- called hysteresis effects and the purported 'costs' of low inflation due to downward nominal rigidities.

The key to improving the growth performance of the euro area lies in the field of structural reform in goods, and particularly, in labour markets. A comprehensive program of such reforms should enable the euro area to realise the full potential from technological innovations and the opportunities provided by competitive global markets. The monetary policy of the Eurosystem - focused on the achievement of price stability in the medium term - will provide a stable monetary framework within which this potential can be realised.

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[1] This line of argument seems, for example, to have been taken up by the first CEPR Monitoring the ECB Report, (see Begg et al (1998)) and by a number of academics.

[2] The relative performance of US and euro area labour markets has been discussed extensively, most recently in an article in the ECB Monthly Bulletin of May 2000

[3] Testimony to the Senate Banking Committee, 23 February 2000 .

[4] Testimony before the House Committee on Banking and Financial Services, February 17,2000 .

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