Europe's challenges after the establishment of Monetary Union: a central banker's view
Speech by Professor Otmar Issing, Member of the Executive Board of the European Central Bank, at CES-IFO Conference on Issues of Monetary Integration in Europe, Munich, 1 December 2000
The subject of the challenges facing Europe and the European Central Bank (ECB) after the establishment of the Monetary Union is complex and important. Perhaps out of a lack of imagination - so typical of central bankers - let me organise my remarks from a chronological perspective. I shall first present my recollection of the challenges that the ECB had to face and the "battles" in which it was involved in its - very short - past. Then, I shall proceed to what I consider to be the challenges of the present and what, in my view, lurks just around the corner.
Experience of the first two years
The appropriate conduct of monetary policy in an imperfectly known world is by definition a standing challenge for any central bank at any time. It is always difficult to draw a correct picture of the world from sometimes ambiguous and contradicting raw data. And it is hard to devise an appropriate response to new developments that is both free of prejudice, open to new developments, and at the same time coherently designed not to compromise the fundamental principles that need to guide the central bank's policy in the medium run. The ECB has been confronted with these challenges from day one of its debut. For us, the problem of uncertainty in the day-to-day policy management was compounded, at the start of the third phase of monetary union, by the extraordinary challenge of long-term institutional design.
We were hard pressed - as any other central bank was at that time, in the aftermath of the Asian and Russian crises - by the handling of a difficult and unpredictable situation which some regarded as heading for the worse. But at the same time we had to attend to the unique task of laying the foundations for our future action, thereby completing the work that had been initiated by the European Monetary Institute. The Governing Council of the ECB had to be given a position to command the necessary economic details over a new and unique monetary area, whose economic size is only paralleled by the US. At the same time, future monetary policy decisions had to be framed within a strategic apparatus that could be both consistent and credible. The Eurosystem had to be vested with the appropriate instruments and operative procedures to carry out its daily activities in support of the strategy of the new institution. Groundwork was needed to overcome the lack of harmonised and comprehensive data. True area-wide statistics had to be defined and implemented, while the unknown properties of the new series were to be studied carefully.
In this endeavour, we could certainly draw on a consolidated stock of knowledge pre-dating the ECB and grounded in the - sometimes centenary - experience of the participating national central banks. But we also had to create untested instruments from scratch. And the entirely new area-wide perspective that we needed over a group of sovereign states was simply unprecedented in history. How did we surmount the difficulties of the beginning? How did we do in the subsequent two years of monetary union? If you can only make a convincing first impression once, I believe we did not miss that opportunity.
After years of dire warnings it came, I suppose, as a somewhat puzzling surprise to many that the birth of the euro proceeded as smoothly as anyone could have hoped for. Indeed, it was a resounding success. The process of the change-over to the euro was virtually free of technical faults. We created almost overnight a unified money market, which - notwithstanding formidable transaction overload - functioned from the very start almost without frictions. Short interest rate volatility remained well contained, and the main refinancing operations, along with the standing facilities and the reserve requirement system with averaging provisions, have since guaranteed money market developments closely in line with the ECB's intentions. Above all, long-term bond yields in the euro area reflect the confidence that informed investors place on the ECB. Surveys of inflation expectations, which account for the trust and the credit that the general public accords to a currency, are persistently in line with our medium term objective of price stability.
The ECB has, from its very foundation, taken its challenges seriously. The recognition that monetary policy always has to cope with a changing and imperfectly known world has been placed at a premium in the design of the ECB's monetary policy strategy. We could also not ignore the fact that the ECB, as a new-born institution, had with its very appearance marked a historical discontinuity, with potentially profound implications for economic behaviours and measured structural relationships.
The Treaty entrusted the mandate to maintain stable prices to the ECB and to this end it built an independent, supranational institution, put in a safe position to avert outside pressures coming from any quarter. We, on our side, between autumn 1998 and January 1999, had to concentrate our forces on solving a twofold problem of trust and controllability. As already said, we had to inherit, intact, the wealth of credibility that the best monetary tradition in Europe could bequeath to the new institution. And, on the other hand, we were called upon to elaborate an entirely new perspective on a new economic reality, which was undergoing a fundamental mutation - if I may say so - under our noses.
In these circumstances, the Governing Council chose to equip itself with an internally consistent and at the same time comprehensive and appropriately flexible approach to policy analysis. It was decided that the best way we could serve the lasting objective to guarantee in a non-discretionary manner a stable measure of value was to adopt a robust analytical framework well-suited to inform policy makers in a world of change. Developing and refining this framework was our main challenge.
This tension was resolved - in my view in an optimal manner - by announcing a quantitative definition of stable prices and by adopting a diversified approach to analysing and assessing information. Defining price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices of below 2 percent," along with the emphasis on the medium term, was designed to enhance clarity, anchor expectations and provide a yardstick against which the new independent institution could be held accountable. In the light of what I have just said about the evolution of inflation expectations in the euro area, that announcement bore its fruit.
Likewise, the eclectic approach to the processing of information, which we call our two-pillar strategy of monetary policy, was intended to guarantee that no piece of evidence relevant to policy decision making was to be excluded from the Council's information set. The prominent role assigned to money as the first pillar of our strategy ensures that monetary developments are never lost from sight, and are attributed the appropriate role that they deserve, given the monetary nature of inflation beyond the immediate horizon. In parallel, the second pillar of the strategy ensures that other forms of analysis, such as the investigation of the interplay between supply and demand and cost-push dynamics, are also incorporated into the policy process. Together, the two-pillars ensure that information and analysis produced on the basis of one methodological perspective are always cross-checked against information and analysis produced on the basis of the other.
Analysis under the two pillars provides the Governing Council with the crucial information regarding the nature of the shocks within the euro area economy and the resulting risks to price stability. The mutually-reinforcing viewpoints of the two pillars have served well as a comprehensive framework for analysis in the past two years of experience. The strategy has provided the basis for a thorough and timely explanation of monetary policy decisions before the general public.
The role of projections within the strategy
At the outset of Monetary Union we promised to be a consistently transparent institution. We have always striven to fulfil this promise. We understand transparency to mean that the internal process by which information is produced and presented to the Governing Council for policy decisions should be consistently reflected in the external account that is given to the public. With this purpose in mind, the Governing Council has recently decided to commence publication of its staff macroeconomic projections in the December issue of the ECB Monthly Bulletin.
While the publication of macroeconomic projections is intended to enhance transparency and underscore the forward-looking orientation of the single monetary policy, it is absolutely crucial that the message we release is well understood by the wider public.
First, the projection that will be published is elaborated by the staff experts of both the ECB and the NCBs. This projection is produced twice a year. Second, we are not going to publish forecasts, but projections. We place particular emphasis on this distinction since the forward-looking exercises are undertaken upon the assumption of "unchanged monetary policy," that is conditional on a path of constant short-term interest rates. The publication of conditional projections is intended to provide a purely counterfactual scenario, which should not be understood as a predictor of the most likely macroeconomic outcome, still less a benchmark for expectations. It should be absolutely clear that the Council will always be ready to act to fend off dangers to price stability that might emerge from whatever source of evidence, be it model-based econometric exercises or more specific assessments of real and monetary developments. Therefore, wage and price setters should continue to base their decisions on the premise that price stability according to the ECB's definition will be maintained.
Third, the mainstream macroeconomic frameworks used in the production of the projections do not accord an important role to money, despite abundant empirical evidence to the contrary. Thus, macroeconomic projections produced on these bases cannot claim to exhaust our knowledge over the reality of an advanced monetary economy. This is the reason why our monetary policy decisions have not responded in the past and will not respond in the future in any mechanical way to deviations of the staff inflation projection from any numerical target. Neither the ECB strategy nor, for that matter, its second pillar can be characterised as pursuing an inflation targeting policy.
The production of projections itself does not exhaust the analysis that takes place under the second pillar. The staff projections cannot in practice include the latest developments in all economic indicators. It is therefore useful to monitor individual indicators in parallel with producing the projections, not least because such analysis also provides an insight into the forces driving the projections. Moreover, under the second pillar of the ECB's strategy, the Governing Council also evaluates the information about financial market expectations derived from financial yields and prices. This is difficult to combine directly in the projection since it would imply some inconsistencies with the assumption of unchanged interest rates on which the projections are based. The Governing Council also considers other forecasts for the euro area produced by international organisations and the private sector. All this information is assessed simultaneously and in conjunction with the monetary analysis under the first pillar.
Fourth, constructing projections is a difficult undertaking: the longer the horizon, the more uncertain the outcome of the statistical exercise. In view of this, the ECB will publish ranges of the staff projection figures, which are based upon the average absolute errors made in previous NCB and Eurosystem projections. The adoption of ranges is in accord with the best practices in use among central banks and reflects our realistic and honest admission that future developments are uncertain.
In summary, I wish to underscore that the Governing Council should not be held accountable against its published projections. The Governing Council of the ECB is only responsible for the maintenance of price stability. This is its Treaty mandate. Anything, which detracts from the Governing Council's accountability for price stability would be counterproductive and misleading. What we are going to publish is the outcome of a technical process, which is used - and has been used since the beginning - as one input into the Governing Council's deliberations. The important - but partial - perspective that it provides does not embody, or (worse) pre-empt, the exercise of judgement which solely resides in the Council. In the discussions leading to its policy decisions the Council reconciles the analyses conducted under the two complementary pillars underlying our monetary policy strategy. We have not changed our strategy or any part of it in any respect just by deciding to disclose the inputs to the process that has informed and prepared policy choices since the beginning of Monetary Union.
HICP or "core inflation"?
At present, as we all know, the continuous striving of stability-oriented central banks to keep their word on price stability is being put to a hard test. If I had to pick one single challenge that intrigues central bankers these days, I would name the consequences of the recent oil price shock for the design of a monetary policy course geared to price stability. The memory of the seventies, I guess, is still too vivid in our minds for us to be too relaxed about such - if exogenous - sources of potential instability. To be sure, common wisdom and theoretical thinking supporting policy have changed dramatically over the quarter of a century that has elapsed since the industrialised world was first confronted with a comparable episode of turbulence. Today virtually no dissenting opinion would challenge central bankers' firm orientation to act in a pre-emptive manner, before the initial price shock becomes ingrained into people's expectations. Today most central banks around the world speak with one voice on the appropriate response to the challenge posed by energy prices, and are no longer left alone in their endeavour to preserve the domestic value of the currency.
However, it is not unusual to hear calls for stability-oriented central banks to reconsider the definition of the inflation measure that they should elect as the privileged indicator of performance in delivering stable prices. Arguments are sometimes advanced in favour of giving prominence to measures of "core" or "underlying" inflation, which exclude volatile components. "Core" inflation should act, according to this view, either as an objective, or as an indicator of the medium-term outlook for price trends. The European statistical agency, Eurostat, on its side, publishes several measures of the Harmonised Index of Consumer Prices (HICP) excluding a number of volatile items, such as unprocessed food and energy.
Supported by the vast menu of the available measures of inflation, the ECB continues to inspect the various indices and to compare the evidence that can be extracted from more or less inclusive statistics. HICP indices excluding energy, in particular, help illustrate the headway that the tripling of the international price of oil since February 1999 has made at present towards influencing general price developments in the economy at large.
However, our diversified approach to the collection of information should not generate misunderstanding. It should be very clear that our commitment to guard against risks to price stability over the medium run was not made in terms of an "underlying" or "core" definition of inflation. And for good reasons. The loss in purchasing power that the public perceives and against which it demands protection cannot be mitigated just by restricting the basket of goods on which we ascertain our success in guaranteeing a stable value of money. It is this demand for effective protection that the ECB feels the obligation to address in the medium term.
But there are also technical reasons for having a broad, rather than a narrow, measure of inflation for monitoring purposes. The concept and the degree of inclusiveness of "underlying" price increases is itself subject to an ongoing debate, which has not come to any sufficiently firm conclusions to inspire confidence in - prudent - central bankers. Again, building on the unfortunate experience of the seventies, we know that a major relative price shock such as the recent rise in the value of energy can be conducive to both indirect and second-round effects on the general level of prices. The former type of effects traces the pass-through of the initial shock into the pricing behaviour of producers who use energy as an input. The latter round of effects arises from the successive reflection of early price increases on wage claims and, ultimately, pay settlements.
It is this propagation mechanism that we have to monitor attentively and - if needed - we must interrupt at an early stage. But by focusing at a narrower measure of HICP inflation, the sequence and the history of these chain reactions would be largely lost. We would only be deceiving ourselves into thinking that a "core" measure of inflation was a more forward-looking indicator than more traditional and comprehensive statistics. In fact, by losing today's signs of risks to future price stability from sight, we would actually depart in some relevant respects from the fundamental medium term orientation of our strategy. It is this medium-term orientation that we have to preserve as a valuable acquisition of our past.
In summary, there exists a fair amount of confusion on the issue of "core inflation." When the Governing Council of the ECB announced its monetary policy strategy in October 1998, it was well aware that there is a difference between the lags with which monetary policy can impact on prices and the much more immediate effect that previously unexpected shocks can exert on prices in the short run. This is why a medium term horizon over which price stability is to be maintained was emphasised from the outset. Let me quote from our very first Monthly Bulletin issue of January 1999.
"The statement that 'price stability is to be maintained over the medium term' reflects the need for monetary policy to have a forward-looking, medium term orientation. It also acknowledges the existence of short-term volatility in prices, resulting from non-monetary shocks to the price level that cannot be controlled by monetary policy. The effects of indirect tax changes or variation in international prices are good examples. The Eurosystem cannot be held responsible for these short-term shocks to the price level, over which it has little control"
From the start, the commitment was not to undo temporary and erratic changes in prices, but to stifle the process of diffusion by which original shocks tend to spread and perpetuate themselves. Since some short-term volatility in the price level is inevitable, it can be helpful to use HICP indices excluding certain components as analytical tools to identify and illustrate the forces driving headline price dynamics. But the use of such statistics will not distract us from our resolve to bring back HICP inflation to below 2 percent in the medium term.
As already said, financial markets have shown trust in the seriousness of our commitment.
Price stability in a modern society
Credibility for low inflation, the cornerstone of an effective monetary policy, is inherently fragile. Slipping inadvertently into a high-inflation scenario because of errors in perspective would be unforgivable on our part, and, as we know from experience, it would be costly afterwards. The monetary union in Europe needs a currency guaranteeing a stable purchasing power to maintain trust in its economic and social institutions. It needs it because it is - and it is expected to become even more in the coming years - a dynamic and productive society. And it does need it because it is undergoing a difficult demographic transition, with important consequences for the demand that people will express for economic security and personal safety.
Europe is a dynamic society and we know that in a dynamic world, where competitive forces become increasingly intense and economic decisions have to be taken at shorter notice, price stability minimises the noise surrounding price signals. Hence, it lessens the risk attached to market activities and long term planning, thus boosting the economic reward to investment, production and trade. But Europe is also - let us not forget this - an ageing society. Hence, the terms of the implicit pact that links successive generations through a chain of mutual transfers have progressively shifted into the limelight of public attention and general concern. Again, a stable currency eases the anxiety of the various cohorts of economic agents looking forward to their old age, and makes this intergenerational connection, which lies at the core of our society, a harmonious exchange.
Episodes such as the oil crisis remind us that central banks, no matter how well-designed their institutional foundations, how well-intentioned and personally committed their management, do not operate in a vacuum. Technological factors and agents' attitude towards consumption, saving and work combine with governments' thrift and the workings of law and regulations to determine the real basis for economic welfare. Credibly reassuring market participants and the public at large about price stability over the medium run, and acting in a determined manner to fulfil this promise, is the best contribution that a prudent monetary authority can make to social welfare. Any attempt on our part to correct this balance of real forces in the short run at the expense of the stability of the currency would only be futile and self-defeating.
The Treaty establishing the European Community recognises this fundamental dichotomy. Consequently, it forged a thoughtful and harmonious institutional construction, in which overlaps of competence are carefully avoided. For our part, we welcome the construction designed by the Treaty and respect the separation of policy responsibility on which it rests. The ECB's mandate to maintain price stability is perfected by the independence it was assigned.
Challenges for fiscal policy
Indeed, while the struggle to preserve the value of money will remain our daily exclusive occupation, it is conceivable that the next major challenge in policy making may lie elsewhere. Perhaps the greatest battle that governments will have to fight in the coming decades will be the maintenance of a virtuous balance between long-sought fiscal prudence and a standing commitment to ease social hardships. Unemployment - albeit declining - remains too high. The capacity of Europe to absorb its resourceful labour force remains disappointingly weak.
The Stability and Growth Pact will assist governments in this battle. The past three decades have taught us that fiscal laxity, far from enhancing the flexibility of public finances as macroeconomic shock absorbers, only ties the hands of policymakers in the long run. Whether the outcome of discretionary political choices - to inflate public bureaucracies or permit unsustainable early retirement dates for pensioners - or simply the budgetary by-product of adverse demographic trends, fiscal structures have grown more rigid over the last decades. In such circumstances, fears of spiralling debt dynamics have often obliged debt-ridden countries to act pro-cyclically in the midst of severe recessions. This pattern of forced reaction to macroeconomic adversities has on occasions in the past contributed to - rather than countered - vicious circles of low growth and endogenous deficit crises.
By contrast, once fully phased in, the Pact will discourage deviant behaviours in fiscal policy and, at the same time, restore governments' capability to provide automatic stabilisation when general income conditions worsen. Fiscal balances close enough to zero or displaying a surplus in normal circumstances will create sufficient room for manoeuvre at times in which the economy operates below its potential. In that ideal situation, the financial effort required of countries in the past decade to rebalance their public finances will ultimately pay off in full.
However, I am afraid that future is still some way ahead of us. It is true that we have all been witness to remarkable progress in underlying fiscal conditions in the run-up to the launch of the euro. This year - I believe for the first time in some decades - five out of eleven euro-area member countries will probably close the books with a balanced budget or even a surplus, rather than a deficit, even abstracting from the proceeds associated to the sale of UMTS licenses. We commend this development. But, recently, we have also detected signs of fatigue, particularly in those countries where robust growth would allow scope for a more resolute drive towards the adjustment that is still needed.
The need for structural reform
Certainly, we cannot ask more of the Stability and Growth Pact than it can possibly deliver. The Pact can make budgets more responsive to economic conditions, but it cannot address more fundamental issues. In particular, long-term unemployment cannot be tackled through subsidies and extended money hand-outs. An effective cure against structural unemployment requires on the part of governments an uncompromising commitment to reform the structural and regulatory underpinnings of our economies. I regard this as perhaps the major challenge that national authorities will have to face at the start of the new millennium.
It is therefore crucial to recognise that appropriate economic institutions are vital if the jobless are to be brought to more tolerable numbers over an entire business cycle. New institutional arrangements must revive the incentives to create new vacancies and to seek new jobs. The experience of the United States suggests that liberalisation and increased competition in markets for goods, services and factors of production are essential if a new form of economic dynamism is to be realised. There are indications that Europe is - albeit slowly - following that lead.
The most dynamic industrialised economies of the past decade are those which pioneered the drive towards dismantling monopolies and converting industries traditionally dominated by one or two - often state-dominated - firms into more competitive and contestable markets. The intensification of competition that has ultimately resulted from liberalisation and deregulation has made for downward pressures on prices. It is hard to say, at this stage, whether the compression of mark-ups and heightened price competition that is visible on the other side of the Atlantic are durable features of a new economic era. Or, whether these forces will dissipate once convergence to the new equilibrium is complete. But they have certainly mitigated frictions and lifted obstacles to growth in the recent past.
In Europe, the introduction of the euro has already contributed to an intensification of competitive pressures across firms, since cross-national comparisons of prices have become more transparent. We expect that the introduction of euro banknotes and coins early in 2002 will further confine the pricing leverage of domestic producers, and restrict the capability of retailers to cultivate privileged market positions.
Discernible progress with regard to labour market reform has also proved a good leading indicator for unemployment reduction and robust growth. High rates of turnover in the labour market are a signal that employers enjoy greater flexibility in tailoring their staff numbers to production needs. We know how innovative ideas and advanced technologies spread in waves, and how these waves can become a vehicle of economic dynamism and, ultimately, of social promotion. But the introduction of a new technology requires flexibility of other factors, including labour, if production processes are to be reorganised most efficiently. If there are limits and restrictions to the choice of the most profitable combination of productive factors, firms will be inefficient and the full possibilities of a new technology will not be exploited.
In this area, as well, we see indications that the traditional hurdles to innovation and competition in our labour markets are - slowly - being removed. It appears to be increasingly important in national wage negotiations to assess the implications of domestic pay settlements for regional competitiveness. Sectoral and regional differences in productivity and in levels of unemployment - not the traditional cost-push dynamics of the past - are becoming the benchmark against which social parties assess the sustainability of wage advances at the national level. Deregulation and productivity-driven wage negotiations have still to impose themselves as a common and lasting practice. However, we do see cross-border competition already placing strain on economic decisions taken within domestic borders.
Empirical results lend support to the idea that financial market deepening contributes to overall economic growth. The related argument has also been made that financial market deepening would improve especially the prospects of young, dynamic and risky firms. These are typically the enterprises, which tend to bring new technologies to the market. In other words, the type of firms that create the waves of creative destruction noted by Schumpeter. But with a less developed market this is precisely the category of firms that, in the absence of sufficient tangible collateral, would have their credit rationed. We expect that further deregulation as well as common European standards fro regulation and the progressive integration of national financial markets in a unified area transacting in the euro will increasingly grant easier access to venture capital and allow agents to pool risks both domestically and internationally. The private sector will thus be in a better position to cope with shocks to disposable income and cash flow than was the case in the past.
Continuing efforts to enhance incentives at the micro-economic level are of paramount importance to prepare the ground for a durable change in macroeconomic performance. So far, the economic landscape in Europe has been transformed by the introduction of the single currency and the creation of the ECB, firmly oriented towards the maintenance of price stability. This development has acted as the catalyst for a first round of institutional and economic change - I have mentioned the Stability and Growth Pact, the timid traces of ongoing reform in the markets for labour, products and capital, the unified financial market. We are confident that governments will not shy away from initiating a second round of serious reform.
At stake is the capacity of Europe to grow in a non-inflationary manner at permanently higher rates, to prevent its traditional resource constraints from biting at early stages of recovery, and to pursue a smoother and more balanced pattern of growth around capacity levels than seen in the past. In a word, at stake is Europe's ability to promote the benign forces unleashed by what has been labelled the "New Economy," if and when this should materialise. We still do not know whether the economic performance of the US in the second half of the 1990s warrants an affirmation of a "New Economy." Or, whether its remarkable economic progress can be explained by a number of favourable but largely transient factors. But the lesson that we can draw from recent history is that a flexible and deregulated economy can take advantage of structural developments, as well as turn transient factors into stable acquisitions. Europe must be in a position to do the same.
Let me conclude on a note that has steadily accompanied Europe's history since the end of the war. The last fifty years have seen an impressive progress towards closer integration among countries that had been fierce enemies for much of their past. This historical course has, to a certain degree, always required that governments maintained a balance between the advantages of increased co-ordination and consensual action, and the need to uphold the healthy forces of competition.
I believe that care should be taken that this balance is maintained in the future. Any design of further political integration will have to be founded on a sound, successful economy. Hence, the quest for more integration will have to eschew the danger of creating "political cartels," which would be as detrimental to Europe's economy and society, as business cartels are to market activities. Healthy competition among jurisdictions - within a unified area founded upon shared principles and a single currency - is of no less importance to promote progress than competition among enterprises in a market economy. It is therefore indispensable that we allow time for the gestation of a sustainable political structure that will eventually complement the stage of integration that monetary union has already induced.
The ECB, on its side, will be vigilant on monetary union. I do not believe that a stable monetary regime must necessarily have its root at the level of the nation state. Nevertheless, as a new money that, by replacing many currencies, has severed the traditional link assigning one means of payment to one nation state, the euro does face a unique challenge in winning the trust and the hearts of the people. The ECB can already claim credit and take pride for having fulfilled its mandate so far. We will not squander in the future the asset of trust that people have given to us.