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The euro: making progress

Dr. Sirkka Hämäläinen, Member of the Executive Board, Confederation of Swedish Enterprises, Seminar on the implementation of the euro Stockholm, 7 April 2003

Presentation: pdf 1000 kB.

Ladies and gentlemen,

I am delighted to attend this conference and to talk to you about our experience with the euro. It is really interesting to be here at a time when Sweden is preparing to decide whether to join the euro area. Over the coming months, as the debate intensifies further, it will be a challenge to give people as full and objective an account as possible of what the euro is and how it could affect Sweden and the rest of Europe. Sweden has a long tradition of transparent and well-informed public debates on complex issues, so we can look forward to lively times.

I would like to structure my presentation today around three points. First, I would like to discuss some of the key political and economic driving forces behind the adoption of the euro; they offer persuasive arguments in favour of the new currency. Second, I would like to review the euro's effects and achievements so far. Finally, I would like to consider some of the challenges facing EU countries and the role of the euro in this context.

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Money extends deeply into the foundations of society, so it is useful to start from a somewhat wider range of political and economic issues. Let me first say that I think it is fair to describe the euro as an innovation. Although history provides many examples of currency unions and fixed exchange rate regimes, both long-lived and short-lived, none has been comparable to the Monetary Union we have today in the euro area. Integration and a single currency have been achieved by the determined efforts of the political decision-makers of the Member States. This achievement is the result of peaceful, democratic decision-making based on a thorough analysis and clear awareness of the challenges involved. The single currency was preceded by determined adjustments, by consistent convergence processes of Member States and by a careful build-up of institutional structures combining both supranational and intergovernmental elements.

The original political objective, namely to guarantee peace throughout Europe following two destructive wars, should not be forgotten, even though improving European competitiveness and economic growth in an increasingly interdependent world has become an ever higher priority over the years. The creation of a single market with the free circulation of goods, services, capital and people should be seen as an answer to globalisation and strong global competition; the two phenomena which apply to all areas, even to government policy.

A fundamental condition for the single market has been exchange rate stability, i.e. the single currency, which allows the price mechanism to guide supply and demand as efficiently as possible. From the single market perspective, national currencies constitute a barrier to trade and long-term growth.

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It is sometimes said that the euro is a "currency without a state". In fact, it is a currency with several states. It is also claimed that monetary integration has made the gradual political union of European states inevitable, an idea that provokes as much opposition as it gains support. As I am not a politician, I will leave this question for the politicians to ponder. But because as a central banker I am involved in public policy-making, I would like to say a few words about the nature of public policy and its implications.

The purpose of public policy is by definition to provide a public good or to defend a public interest. The fact is that some policies can be exercised more effectively in common, rather than at a local level; this is the basic logic behind the European Union and integration. Many public goods, like environmental protection or monetary and financial stability, can be pursued more effectively at supranational level; pollution does not stop at national borders, and money and capital move freely between countries. By contrast, there are areas in which public goods are best provided or produced at a regional or local level; this is the essence of the EU's principle of subsidiarity.

The EU has brought about innovation and progress in the way Member States formulate and exercise their joint responsibilities in agreed fields. They accept national losses in the short term in order to ensure efficiency in the longer term. In an increasingly global environment, the number of issues that cannot be appropriately handled at a local or national level is rising. In the monetary field, the desire for efficiency and common benefits has resulted in the creation of the euro, which serves the markets for goods, services, capital and labour in the EU.

Sharing a currency implies that there is a strong sense of community among the users of that currency. After all, ever since the gold standard was abandoned, currencies have only been backed by the trust placed in them by their users. It is both a strong unifying feature of a community and a symbol of that community. The relative ease with which euro banknotes and coins were introduced and accepted by people 15 months ago shows that there may be a stronger sense of community in Europe than many had thought. This feeling is not just an emotional phenomenon; it is also an economic factor that is reflected in trade, money and capital movements.

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I would also like to touch on the issue of Europe as an optimum currency area, a subject which Professor Mundell, one of the founders of the theory of optimum currency areas, has already discussed here today. A number of criteria, such as the degree of trade and financial integration, diversified industrial structures, and factor mobility are seen as necessary for introducing a common currency. The euro area satisfies many of these well-known criteria, but there is a acknowledged shortage, for instance, of labour, price and wage flexibilities, which could help to absorb localised shocks.

I want to underline the importance of these flexibilities. The ECB has consistently called for continued structural reforms in Member States to increase the flexibility of markets. The more adaptable markets are, the greater a country's chances are of performing well and succeeding in the Monetary Union. But the same is also true outside the Monetary Union.

I would, however, like to make two comments here. First, we should be more concerned about labour flexibility than mobility. The location of production is becoming less important, while the ability of workers to rapidly learn new skills and processes is becoming more important. This underlines the need for effective education and training, a better incentive structure in unemployment compensation systems and, in particular, more flexible attitudes.

Second, we should be concerned about overall wage discipline and wage stability in addition to relative flexibility. A floating exchange rate regime with more variable inflation tends to lead to large fluctuations – or flexibility – in real disposable labour income. Finland was a good example of this before it joined the euro area – and Sweden has experience of this, too. A single currency needs to ensure that excessively high nominal wage increases in boom periods are avoided in order to preserve competitiveness when the economy slows down. The real disposable income fluctuations are stabilised by this discipline.

In general, I would also caution against a too positive interpretation of the autonomy in monetary policy. An independent, autonomous monetary policy makes sense in a country where there is a strong reason to believe that it is inherently different from the rest of the area. The EU and euro area countries, however, are relatively similar in economic terms and are well integrated with each other. The differences experienced in the past have largely resulted from different economic policy reactions, including monetary policy reactions. Historically there have been very few external asymmetric shocks.

There is a striking consensus in all EU countries – as well as in other developed countries – on the need for low inflation, the independence of central banks and on the benefits of stability-oriented economic policies. Monetary policy decided by an independent central bank and geared to maintaining price stability, prudent fiscal policies, and structural policies aimed at improving flexibility and enhancing the growth potential of an economy, are widely accepted common goals. These goals have greatly reduced the risk of asymmetric developments and of asymmetric responses to common shocks.

Indeed, the full optimum currency area criteria are hardly ever met within national borders either. Many countries do not have much higher labour market mobility nationally than they do internationally. There are big regional differences in the structures and developments in countries like the United States, Italy, Finland and even Sweden.

In public discussions it is often argued that autonomous national monetary policies and flexible exchange rates are a kind of insurance against possible asymmetric shocks or against possible differences in business cycles. However, like all insurance, and in this case especially, it comes at a price – in the form of risk premia which could affect economic developments. Even more worrying, however, is that the insurance per se invites the kind of behaviour which hampers long-term moves towards stability. The possibility of exchange rate adjustments may, for instance, produce deviations from sustainable wage developments and, in particular, excessively high wage increases in boom periods.

In short, the relationship between the optimality of a currency area and the existence of a single currency works in both directions. Failing to recognise the need for sustainable convergence and flexibility prior to the introduction of a single currency would, of course, be a fundamental mistake. That is why so much importance has been attached, and continues to be attached, to the Maastricht criteria. But, at the same time, failing to recognise the feedback effects that a single currency has on the economy, and in particular on necessary structural improvements, would also be a fundamental mistake.

The single currency is an integral part of the single market. As such, it guarantees stability and transparency, which will make progress towards a genuinely internal market much easier. Given the overwhelming consensus on the use, objectives and effectiveness of monetary policy today, the loss of national sovereignty over monetary policy is much less of a problem now than in the past.

However, each country needs to thoroughly assess its particular prerequisites for coping with a monetary policy set for the area as a whole.

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Let me now focus on the achievements of the euro over the past four years. Although this is a very short time-frame for making any meaningful assessment, I still think it is possible to say that the euro and the single monetary policy have largely fulfilled expectations. Apart from giving a boost to the single market and accelerating the growth of trade and financing in the euro area, it has in particular produced stability in the euro area. Let me substantiate this remark.

The stability of the currency is self-evident in the euro area. The disappearance of exchange rates and exchange rate risk between the countries which adopted the euro eliminated one important element of volatility and uncertainty [chart 1]. This has created a level playing-field, both for domestic firms and for foreign firms that conduct business across our continent. It has triggered a clear deepening and broadening process in the euro area-wide financial markets, with a much greater choice of innovative instruments and lower financing costs than before. It has eliminated the costs of currency exchange and risk hedging, and it has produced full price transparency and thus keener competition. Small and medium-sized innovative enterprises, as well as consumers, have benefited and continue to benefit from these developments.

A corollary of the disappearance of exchange rates is the relative interest rate stability which euro area economies have enjoyed [chart 2 and 3]. The instability that existed in most European countries prior to the introduction of the euro, when exchange rate volatility was connected with interest rate volatility, has been quickly forgotten. However, those who remember the many episodes of instability between the 1970s and the mid-1990s certainly admit that, without the single currency, events such as the financial crisis in autumn 1998, the 11 September terrorist attacks, or the recent economic slowdown, would probably have triggered much greater volatility in, and between, many European countries.

Thus, the existence of the euro has already helped significantly to stabilise economic and financial conditions in Europe. Volatility in Sweden has decreased in the same way largely due to the successful pursuit of stability-oriented monetary and economic policies in the 1990s, policies that form the core of the EU convergence criteria for the single currency.

The stability achievements of the euro area are clearly seen in the price developments [chart 4]. Since the introduction of the euro four years ago, inflation has hovered around the 2% level, which we in the ECB consider to be the upper limit for price stability in the medium term. Similarly, inflation in Sweden has been close to its target of 2% and thus very similar to that in the euro area. Short-term interest rate developments have been somewhat more stable and inflation rate movements marginally wider in Sweden than in the euro area.

Third, looking at public finances over the past four years, it is clear that they have not developed as well as we had hoped [chart 5]. However, a significant effort was made prior to Stage Three of EMU, a result which is indeed difficult to imagine without the convergence criteria and the Monetary Union commitments. Current fiscal policy tensions within the euro area represent a kind of test and learning process. They prove that the Stability and Growth Pact criteria are neither arbitrary nor irrelevant, and they show how important it is to adhere to the agreed policy framework. Fiscal discipline is crucial in good times as it creates room for automatic stabilisers to operate in bad times. The euro area countries have received a lesson, and they are experiencing painful pressures due to the weak economic environment.

Over the last few years Sweden has performed much better in this respect than the euro area on average.

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Other major challenges are facing the euro area – and the EU, too. The challenges confronting those still to join the euro area can easily be deduced from what I said earlier, so I will restrict my last few comments to the euro area.

As I said at the beginning of my presentation, I believe that the euro should be seen as a reaction to the changing world around us. It aims to achieve competitive European markets that impose no barriers to demand or to the allocation of resources. However, we should be fully aware that the euro alone cannot tear down all the barriers. We cannot do much about some of the remaining barriers, such as language differences or transportation costs. However, there are many barriers which the single currency could help to abolish and whose abolition would markedly increase the benefits of the single currency. Those barriers relate to national regulations and a lack of harmonisation; here, strong efforts are needed.

In the field of finance, for instance, the introduction of the euro was a giant leap in the right direction, but financial markets are still fragmented. Some segments have become highly integrated, such as the government bond or the overnight interest rate swap markets. Different regulatory regimes, varying market practices and heterogeneous national infrastructures, however, continue to hamper money and capital movements in the euro area.

Most euro area countries have tough challenges ahead in their product and labour markets; they have to resist interventionist or protectionist policies. Many of the reforms are part of the Lisbon agenda, which aims to improve in many ways the EU's competitiveness in the long term; it also includes the Financial Services Action Plan. One aspect of the reforms focuses on opening up national markets, reducing red tape and harmonising regulatory frameworks. But policy-makers also face a significant challenge in enforcing effective competition within open markets. In this regard, competition authorities and other regulatory bodies will play a crucial role in achieving the objectives set out in Lisbon.

I want to emphasise that the structural problems in the euro area are not a result of the integration. On the contrary, without integration, these problems would undoubtedly be worse. Integration, and the single currency in particular, have made the changes more urgent.

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Let me now conclude. The euro has lived up to expectations in its four years of existence. Most importantly, it has delivered the internal price and financial stability that it was supposed to. Even before the start of Stage Three of EMU, it gave a strong impetus to the pursuit of stability-oriented economic policies, and I dare say that this was also the case for countries outside the current euro area. Progress has been consolidated over the past four years and the sustainability aspects of the Maastricht convergence criteria have been fulfilled.

Admittedly, we have seen some unsatisfactory developments on the fiscal side, but on the whole the euro area is in a better position than the individual member countries were before the single currency. But goals need to be more ambitious in order to take account, among other things, of the major demographic problems lying ahead for Europe.

On the indirect effects of the euro, such as increased trade, greater efficiency in production and further economic reform, there are positive signs, although it may still be too early to give definitive answers. Certainly progress in terms of integration has been convincing. But there are also areas where progress has been very slow and restricted to some countries only. The euro is, however, acting as a catalyst for change in both behaviour and expectations, which will make the area it serves increasingly like a true optimum currency area.

Although I have said a lot about the rationale for the euro, I would like to repeat my key message in this respect. The main driving force for the euro, as well as many other developments in the EU, has been the need to adapt to a changing world. Each country is facing roughly the same challenges and each country needs to decide how it will tackle those challenges. Maintaining the system and structures of the past is not the best way of tackling them. As the world changes, so must we, and in this light, the euro should be seen more as an opportunity than a risk.

Thank you very much for your attention

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