The "Psychology" of the European Currency, as viewed by the European Central Bank
Prof. Eugenio Domingo Solans, Member of the Governing Council and of the Executive Board of the European Central Bank (ECB), Speech delivered at the Symposium "The Psychology of the European Currency", organised by the Dresdner Bank, Frankfurt, 5 December 2001.
I am grateful for the invitation to participate in this Symposium on the euro, organised by the Dresdner Bank. I must confess that, when I received the invitation, my first reaction was one of surprise at the title of the Symposium, which is about the psychology of the euro. Nevertheless, after short reflection, I found that the subject is indeed appropriate. After working in the private banking sector for thirteen years and as a central banker for more than seven years, I have learned that psychological aspects linked to currencies, banking activity, monetary policy, etc. are of the utmost importance. The common denominator underlying private and central banking activity and the use of money is confidence, a concept closely related to people's psychology. Confidence is the meaning of the Latin word "fiducia", from which the modern term "fiduciary" is derived, as is used in most European languages when referring to the use of paper currency and, in general terms, the issuance of securities that are accepted in the market because of the reputation of the issuer.
The euro cash changeover, which will be implemented by more than 300 million Europeans across twelve countries in less than four weeks, will in itself be an extremely important fiduciary operation involving trust in our currency, in our financial and banking system and in the role of the Eurosystem as the guardian of the euro.
Step by step, year after year, the Eurosystem, which was endowed from the very outset with formal legal powers by the Treaty of the European Union, has gained additional moral authority among the European public. To use Latin terms again, I would say that the strength of a central bank should be based both on "potestas" and on "autoritas". "Potestas" is power based on legal coercion, while "autoritas" refers to the moral influence based on prestige and dignity and is, therefore, closely related to psychology. As a matter of fact, central bankers like to refer to the central bank's authority as moral suasion. Nobody has defined the meaning of "autoritas" better than the great German historian Theodor Mommsen who wrote, referring to the ancient Roman Senate which lacked legal coercive power, that "no one could decently elude compliance with its advice".
However, we are certainly not here to discuss Mommsen and the Roman Empire, but the psychology of our single currency. Perhaps it would be a good idea to do so by considering the euro a psychologist, a psychologist who has been able to bring European society, in general, and economic agents in Europe, in particular, to his couch. To cut a long story short, I think that our psychologist, the euro, has been extremely successful in opening the minds of the Europeans, among other things, to more intense competition in the European financial markets and to a wider perception by economic agents of the "market" concept.
I will spend some minutes with you by referring to one of the main benefits our psychologist, the euro, has brought to our mentalities: the enhanced competition in the euro area financial markets and the acceleration in the consolidation process of our formerly segmented European national economic spaces.
Two events of considerable significance for the economic and political order of the world have unfolded in the past decades. One – European integration – has been motivated by political will and vision. The other – economic globalisation – is the fruit of technological progress and the free forces of the market. These two series of events have very different roots. Yet, they are intricately linked in many of their effects. This may be so because both European integration and economic globalisation challenge, to a certain extent, the traditional concepts of national borders and national sovereignty. But of the two processes, European integration is without a shadow of doubt the most advanced at this moment. The introduction of a single currency, in particular, has triggered an unprecedented acceleration of the economic integration of the 12 nation states that have already adopted it. For that reason, the effects of the euro on Europe's economy and, in particular, its financial markets provide an invaluable insight into the potential impact of globalisation.
It is of course impossible to discuss all these effects in detail in only a few minutes. In the following, I will concentrate on just a few lessons learnt from the introduction of the euro that are of particular significance for appreciating the effects of globalisation. These lessons are:
First, the critical mass achieved by the full integration of twelve national markets into one has effectively improved the prospects for an efficient allocation of capital to the most productive investment opportunities, hence for higher sustainable growth.
Second, the removal of the obstacles to competition that national borders represented has unleashed a process, the effects of which possibly extend well beyond what had originally been anticipated.
Third, the introduction of the euro has highlighted the need for a common set of rules as a means to enhance market freedom and efficiency. This is a lesson that is particularly worthwhile in the context of increased economic globalisation.
The notion of a causal link between financial development and economic growth has been analysed thoroughly over the years, and is probably now as familiar to academia as it is to practitioners.
In this context, a first essential contribution of the euro to the European economy is that, partly by allowing financial markets to reach a critical mass, it also facilitates the development of a more complete, more diversified, more liquid and more efficient financial system. The improvement it brings is felt in both qualitative and quantitative terms.
One illustration of this statement is the spectacular development of the overnight interest rate swap market following the introduction of the euro. A deep and liquid overnight interest rate swap market provides many benefits to its private sector users by, in particular, facilitating the management of the interest rate risk associated with money market instruments separately from their credit risk. Overnight interest rate swaps also provide a common reference for the pricing of a wide range of money market instruments, thereby creating a link between various segments of the market. For this reason, overnight interest rate swaps can possibly be seen as providing, in addition to private benefits, some form of public good benefit, by playing a role in market efficiency and perhaps even in financial stability.
Prior to the introduction of the euro, only a few national markets benefited from the existence of a reasonably well-developed overnight interest rate swap market. Since 1999, market participants across the entire euro area have had access to an active overnight interest rate swap market denominated in their own currency. In those countries that did not have such a market beforehand, the euro has contributed to completing their financial markets by filling an important gap. In those countries which did have such a market, the euro has contributed to increasing the depth and liquidity of a core component of the financial market. For all, a qualitative and/or quantitative improvement has taken place.
This illustration can be extended to a large number of market segments, where the creation of a large currency area has allowed previously incomplete national financial markets to be rounded off. Prior to the introduction of the euro, for instance, several countries either did not have a government bond futures market, or that market was very illiquid. For market participants in these countries, Monetary Union has meant that a very active, deep and liquid government bond futures market, with contracts denominated in their own currency, became available.
But the most remarkable channel through which the introduction of the euro has contributed to a further rounding-off not only of the financial markets, but also of the financial system as a whole, is probably to be found on the side of the corporate debt markets. Traditionally, the euro area economy, or most of it at any rate, has been dominated by bank lending. This contrasts with other economies, such as the United States, where securities markets have long played a far more significant role in channelling savings towards investment. In particular, market financing is normally not dependent on long-established banking relationships, as is the case of bank credit. An enhanced role for market financing may therefore encourage a swifter reallocation of funds from cash-rich but economically declining sectors towards fast-growing sectors. It is the view of many authors that a well-developed corporate bond market facilitates innovation and supports the transition of medium-sized firms into large enterprises.
Without denying the key role played by bank finance, what really matters is to offer alternatives to borrowers. In this respect, security markets offer a real alternative to bank finance for potential large borrowers and where the benefits highlighted above can be reaped effectively. Even though the stock of outstanding debt securities, or the stock market capitalisation of the euro area (relative to GDP), remains well below that of the United States, both the equity market and the private bond market have experienced unprecedented development over the past few years. Between January 1999 and mid-2001, for instance, the outstanding amount of bonds issued by non-financial corporations in euro has increased by almost 70%.
The lesson that can be learnt here is the following: prior to the introduction of the euro, borrowers in the legacy currency markets were considerably constrained in terms of the capital they could raise in the domestic securities markets. Following the introduction of the euro, issuers have access to a broader and more diversified base of potential investors, which makes it possible to raise capital at far more favourable terms and conditions than before. An example of this point are the widespread comments heard since 1999 that many of the large mergers and acquisitions in the euro area would not have been possible if the purchasers had not been able to finance the transactions by raising capital through the bond market.
At this point, it may be useful to underline one prerequisite for the competition between bank finance and non-bank finance to provide all the benefits that one might expect. This prerequisite is that banks can effectively compete on the same scale as financial markets. What this means is that commercial banks must be able to become pan-euro area or even global institutions, in the same way as securities markets have become integrated at the level of the euro area or even globally. From that point of view, cross-border mergers or acquisitions in the euro area banking sector are developing too slowly. It is important that efforts are made to facilitate this activity, or at least to avoid discouraging it, by identifying and removing remaining obstacles.
If one effect of the euro has been to contribute to completing the financial system, another effect has been the strengthening of competition in a manner that has sometimes exceeded expectations, or in sectors where it was perhaps not so widely expected.
The belief that free and fair competition is beneficial to economic and social progress is a basic principle in all market economies across the world. This belief is explicitly recalled in the Treaty establishing the European Community, as well as in the Statute of the European System of Central Banks and of the European Central Bank. The single currency certainly contributes to creating an environment of free and fair competition, favouring an efficient allocation of resources. Indeed, of all the factors causing the segmentation of the national markets of the European Union prior to 1999, the existence of different currencies probably represented the most powerful. Accordingly, at the time of the introduction of the euro, widespread expectations developed that Economic and Monetary Union would unleash previously restrained competition forces, which would lead to both qualitative and quantitative improvements in the functioning of euro area financial markets.
Indeed, the evidence gathered to date shows that the effects of competition forces have been considerable. A first form of competition, where the effects of the euro are noticeable, is that of competition between private market participants. This is probably one of the areas that has been commented on more often and that does not therefore require lengthy illustrations. It probably suffices to recall the reduction of costs for end-users in financial markets such as the fees levied on stock exchange transactions or bid-ask spreads for transactions in major debt securities.
A second consequence that may be recalled is the trend towards rationalisation and consolidation in almost all sectors of the financial system. The trend towards a consolidation of the infrastructure in the euro area does not yet, however, seem to have reached an optimal state, and more activity is to be expected in that field.
Another field in which competition has developed strongly as a direct consequence of the introduction of the euro is that of competition between sovereign issuers. Indeed, where sovereign issuers benefited from what was essentially a monopoly position in their national market, they now compete with each other for a broader pool of savings.
The consequences of the new form of competition between sovereign issuers have also been widely commented on, but a few facts may be recalled. In the late 1980s and early 1990s, a few European countries, such as France and Spain, had undergone a reform of their government bond market, with a view, among other goals, to enhancing the liquidity of this core market. With the advent of the competitive environment brought about by the introduction of the euro, those governments that had not previously done so have engaged in similar restructuring exercises. Clearly a form of emulating process has developed, where all sovereign issuers are attempting to bring their own government debt market into line with the best standards. An indication of this activity is provided by the multiplication of buy-backs and exchanges of sovereign government bonds in the euro area.
All in all, perhaps because this is one of the sectors where the increase in competition has been the most obvious, the sector of sovereign issuance is one where this new competition has delivered some of the most spectacular benefits to investors.
There exists, however, at least another form of competition that has been less widely commented on and that deserves some attention. This is competition between legal and regulatory environments. Although in this respect, free circulation of capital across Europe and beyond was a main driving force, the introduction of the euro acted as a catalyst of these developments and brought increased pressure to bear on legislators and regulators alike to provide their national financial centres with a truly competitive legal and regulatory environment.
Competition between legislative and regulatory environments is also of interest when analysing the consequences of regional or global economic integration. In the context of an increasingly global economy, competition between legislators may increase. It may be fundamentally good if it leads to the best practice. On the other hand, it may become eminently dangerous if it were to lead to a form of regulatory dumping. This is another topic altogether, but not an insignificant one.
As emphasised earlier, the relevant concept, in the field of European economic integration as well as in that of worldwide globalisation, it that of an open market economy with free competition, favouring an efficient allocation of resources. We should not forget, however, that a market economy is not only an economic model. It is also a model of social organisation, based on a number of rules. This refers to basic principles of law, such as the respect of private property (including intellectual property) or the obligation to fulfil the terms of a contract. This also refers to more elaborate rules, such as the regulation of financial markets or financial intermediaries. Binding rules are essential for creating a climate of discipline and confidence in the economic and financial system. Without this confidence in the system, there is no real economic freedom. At any rate, there is no level playing field, and competition cannot be fair, nor efficient.
In Europe, the need for a common set of rules as a prerequisite for free and fair competition has been recognised very early and accommodated by Community legislation that takes precedence over national legislation. In the monetary field, the existence of a universally accepted legal tender is itself one of the fundamental rules that bind any economy and society together. The creation of the euro has been a step of monetary unification aimed at levelling the playing field in an integrated economy.
However, there remain too many fields in which inconsistencies between national legislation hamper the full integration of the financial system, thereby preventing the benefits of the euro from being reaped in their entirety. One among many examples refers to the heterogeneity of bankruptcy laws, which reduces the substitutability between financial contracts issued in various European jurisdictions, and is detrimental to the development across borders of, inter alia, bank credit, securities issuance and collateralised transactions.
Forty-seven years ago, on 7 December 1954 to be precise, when almost everything concerning European integration was still to be done, Ludwig Erhard gave a speech at an international forum in Paris (the Club "Les Echos") in which he mentioned the three national economic fundamentals for building up a more wide-ranging community in Europe, namely a "sound currency", a "balanced budget" and "free competition".
The "sound currency" is no longer a national competence in most European countries in which money has been both denationalised and depoliticised. The sound currency in the euro area is the Eurosystem's responsibility, performed through the application of three simple rules: central banking and central bankers' independence, not only from political power, but also from economic powers, media powers, etc.; no monetary financing of governments and other public sector agencies and, finally, conducting monetary policy with unambiguous priority to price stability. Certainly the "sound currency" is a precondition for the success of European integration, is the Eurosystem's contribution to it.
The second pillar of our building is a "balanced budget", in the words of Erhard, and strict compliance with the Stability and Growth Pact, in today's terminology. Let me emphasise the word "strict". No re-interpretation, no second readings, no flexibility should be allowed in this domain. Those who were not able to put a roof over their houses when it was sunny and warm are obliged to do so when it starts to be, if not cold, chilly, if not rainy, cloudy. That is life.
Finally, the third pillar of our European building should be "free competition". As I have elaborated before, the euro has played an important role as a catalyst of competition in the financial markets. But let us be aware that much remains to be done in many areas. These are the resisting subjects of the European economy: more competition, more flexibility, more capacity to adapt to external changes resulting from an environment in permanent motion.
I shall now conclude. The more we progress in integrating areas of our economy, the greater the need for integration in other areas. The more we enhance competition in some sectors of the European economy, the greater the need to enhance competition in other sectors. These additional needs of integration and competition will require further actions and the development of new functions to satisfy those needs. And additional actions and functions will eventually result in the setting-up of new institutions. This is the way in which monetary integration has developed in Europe. The sequence often followed by European integration was needs–functions–institutions. Without prejudice to paying attention to impressive top-down approaches for further European integration (European Federation, European Constitution, etc.), our psychologist – the euro, remember – would also prescribe pragmatic bottom-up therapies. In this vein, after attaining a "sound currency" and a "balanced budget", why not try to enhance "free competition" further and promote more flexibility?