Macroeconomic stability and growth in the European Monetary Union
Speech by Eugenio Domingo Solans, Member of the Governing Council and of the Executive Board of the European Central Bank, delivered at The Economist Conference: Portugal and the European Union, Lisbon, 16 December 2002.
It is a pleasure for me to take part in this conference on macroeconomic stability and growth here in Lisbon. For obvious reasons, I will not refer to the specific case of Portugal but will instead talk about the European Monetary Union as a whole.
Macroeconomic stability is a key element of the socio-economic model of the European Monetary Union. It is a precondition for sustainable economic growth and job creation. The main contribution of the Eurosystem to macroeconomic stability comes through the fulfilment of its primary objective, namely maintaining price stability. Compliance with other objectives and tasks of the Eurosystem also contributes to macroeconomic stability.
Another fundamental element for the achievement of macroeconomic stability is, of course, compliance with the Stability and Growth Pact (SGP). I consider the SGP as a European public good, indispensable in an economic and monetary union in which there are national fiscal policies.
It is important to understand why compliance with the SGP makes a significant contribution to macroeconomic stability, equilibrium and dynamism. Beyond certain levels, public deficits and debt would have a negative impact on market interest rates because of the existence of an excessive additional demand for funds and the development of inflation expectations. Public deficits could crowd out private investment and consumption, and hamper economic growth. The idea that who is spending and how expenditure is financed is irrelevant and that what really matters is having an overall amount of total expenditure in order to have economic growth is simply not true, because the economic effects in both cases, public or private spending, are very different. Furthermore, our socio-economic model enshrined in the Maastricht Treaty would prevent any economic policy that was not conducted in accordance with the principle of an open market economy with free competition (Article 3a), and a situation of excessive government deficits (Article 104c).
If public deficits were to affect market rates, the link between the key or official European Central Bank (ECB) interest rates and the market interest rates would become less robust and the monetary policy transmission mechanism less effective. The deficit in certain countries, as opposed to the common monetary policy stance, could, in an extreme case, be a main factor affecting the market interest rate for the whole area. In this perspective, it is crystal clear that the SGP is really a "public good", as I said before. Therefore, those who breach the SGP should be considered "free riders", to use the terminology of public economics. Let us be clear in this respect: normally, behind the non-fulfilment of the SGP there is a case of bad public administration, either past or present.
Let me now refer to monetary policy and its relationship with price stability, macroeconomic stability, economic growth and job creation.
A monetary policy primarily oriented towards price stability is, in the medium term, the best contribution that the Eurosystem can make for sustainable economic growth. Price stability implies an efficient allocation of resources through an informative relative price mechanism, competitiveness, lower interest rate risk premia, appropriate conditions for investment, and so on. All these factors are preconditions for economic growth. There is clearly no greater stimulant for economic growth than price stability, and nothing is more damaging to economic growth than inflation.
To say that compliance with the primary objective of price stability is the best contribution that the Eurosystem can make for sustainable economic growth in the medium term has three different implications. First, mentioning a "primary" objective, as the Treaty does, implies the existence of another or other objectives which should be considered non-primary, i.e. "secondary". Second, if we accept that maintaining price stability is the "best" contribution for sustainable economic growth, it implies that other, less relevant contributions are also possible. Third, using the wording "in the medium term" indicates that in the short term the relationship between price stability and economic growth is different. In other words, a short-term trade-off between stability and growth exists, for example when a disinflationary monetary policy is pursued (an argument in favour of gradualism) or in connection with the well-known convexity of the short-term Phillips curve which shows that when there are relatively low inflation rates, additional gains in terms of price stability involve increasing costs in terms of output and employment. When considering the short-term effects of monetary policy on economic growth, some aspects related to the functioning of monetary policy are relevant, such as its asymmetric effects in opposite stances and therefore the existence of asymmetric policy responses, or the different effects of monetary policy depending on the degree of preparedness or readiness of the markets.
Actually, the Statute of the European System of Central Banks (ESCB) and of the ECB refers in its Article 2 to the objectives (in the plural) of the ESCB. It clearly states (repeating the wording of Article 105 of the Treaty) that "without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty". Among other things, Article 2 of the Treaty refers to "sustainable and non-inflationary growth" respecting the environment and to "a high-level of employment and of social protection".
It should be clear that these are objectives of the European Union and not direct objectives of the Eurosystem's monetary policy. The non-primary objective of the Eurosystem is to support the general economic policies in the Community with a view to contributing to the achievement of these objectives. In conclusion, while economic growth should not be considered an objective for the Eurosystem's monetary policy, it is also clear that the Eurosystem does have responsibilities relating to economic growth and employment. These responsibilities are indirect, conditional and secondary, if you like, but responsibilities nevertheless.
In order to assume these responsibilities, the Eurosystem creates the best monetary conditions to support economic growth and job creation, provided that no risk exists for the compliance with its primary objective of price stability.
Establishing the appropriate monetary conditions for price stability should be seen as a necessary condition to achieve economic growth and job creation but, unfortunately, it is not sufficient in itself. Other aspects should be considered, such as budgetary discipline, moderation of wage developments, economic dynamism and flexibility.
Allow me now to briefly stress the importance of economic dynamism and flexibility which enable economic activity to adapt to the changing conditions of the environment and enable external shocks to be absorbed. Economic dynamism and flexibility, which imply the existence of market-oriented supply-side policies, are a condition for efficiency and competitiveness, two aspects which, as was agreed at the Lisbon and Barcelona European Council summits, need to be enhanced in the European economic system.
It is important to remember, in conclusion, that economic growth and job creation are not only affected by the demand side of the economy, but also by the supply side.
The ECB and the whole Eurosystem have other objectives and tasks besides price stability and supporting the general economic policies in the Community which are mentioned in the Treaty. They concern areas such as foreign exchange operations and foreign reserves, payment systems, banknotes, statistics, prudential supervision and financial stability. Fulfilling these objectives and tasks in an efficient way constitutes an additional contribution of the Eurosystem to macroeconomic stability in general and to price stability in particular.
Vice versa, a monetary policy mainly focused on price stability and supported by a robust strategy and an efficient operational framework contributes to the achievement of other objectives of the Eurosystem, such as the integration of money and financial markets, the smooth functioning of payment systems and financial stability.
Having a flexible and all-encompassing monetary policy strategy, as is the case of the Eurosystem, is beneficial not only for taking appropriate decisions to comply with the main objective of price stability, but it is also helpful for the fulfilment of other objectives and tasks of the central bank. In particular, the first pillar of the ECB's monetary policy strategy, which contains the relevant information about monetary and financial conditions of the economy, allows the ECB to monitor developments relevant for macroeconomic financial stability other than price stability. Having systematic information related to the liquidity conditions of the system, which of course does not mean or imply targeting the liquidity of the system, allows central banks to pre-empt possible undesirable financial developments which could eventually negatively affect price stability and economic growth. In the perspective of macroeconomic financial stability, the first pillar of the ECB's monetary policy strategy has merits which become evident in particular if it is understood that its scope goes beyond M3 and that it also provides systematic information about a variety of other monetary and financial indicators.
Last but not least, let me now refer very briefly to the role of financial stability in the context of macroeconomic stability and dynamic and sustainable growth. Few people can be more interested in financial stability than monetary policy-makers, the primary reason being that without financial stability, i.e. without stable financial markets, the transmission mechanism of monetary policy would become less effective and, in hypothetical cases of serious financial crises, highly inefficient.
Second, in a market economy, sustainable economic growth can only be achieved in the long term if financial resources are distributed efficiently. An optimal use of the resources in the European economy, which allows capital to flow towards the best investment opportunities, independently of the countries in which these arise, can only be delivered by a sound and stable financial system that is integrated beyond the national borders.
I can assure you that the ECB stands ready to contribute to the achievement of the strategic goal for the European Union decided here in Lisbon in the year 2000: "...to become the most competitive and dynamic... economy in the world, capable of sustainable economic growth...".