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Growth and stability in Europe: the role of monetary policy

Speech by Lucas Papademos, Vice President of the ECBat the ceremony marking the 75th anniversary of the Bank of GreeceAthens, 3 November 2003

Your Excellency the President of the Republic,

Mr. Prime Minister,

Dear Colleagues,

Ladies and Gentlemen,

It is both an honour and a pleasure for me to participate in the celebration of the 75th anniversary of the founding of the Bank of Greece. This ceremony, which is being graced by the presence of the President of the Republic and the Prime Minister, commemorates the birth of a great institution in Greece and an important member of the Eurosystem. It is also an institution close to my heart, as I spent a large part of my professional life at the Bank. I am, therefore, delighted to be, once again, among the former colleagues and old friends who have joined us here today. And we are all very pleased that this event is being attended by so many governors and other senior officials from central banks around the world.

Anniversaries are occasions for celebration and reflection. They are occasions for celebrating the accomplishments of the past and for reflecting on objectives and perspectives for the future. Indeed, anniversaries provide an opportunity to establish links between the past and the future: to set or reconfirm goals and strategies in order to meet future challenges in the light of past experience.

The Bank of Greece has, justifiably, many reasons to celebrate and feel proud of its achievements. The Bank is relatively young compared with some of the other European central banks – unless we count the time that has elapsed since the establishment of one of its forerunners: the Treasury of the City of Athens on the island of Delos, which was founded in the 5th century BC. In those days, however, they made no distinction between fiscal and monetary authorities. Classical Athens, therefore, did not respect a cardinal principle of central banking: the necessary division of responsibilities between those “who spend and tax” and those with the task of safeguarding the real value and stability of money. This was not considered essential at the time of commodity money. In modern times, the Bank of Greece, since its establishment 75 years ago, has contributed greatly to economic and social welfare in our country. The Prime Minister and the Governor both referred extensively to the Bank’s contribution and there is no need for me to elaborate further. At present, the Bank can look forward to continuing this tradition of excellence in performing its tasks and attaining its goals. It will have to do so, however, within the new economic environment and the institutional framework which have been established as a result of the process of European integration and the introduction of our new, common currency, the euro.

In keeping with the character of today’s event, I would like to take a long-term view and discuss some fundamental issues regarding the main objectives and tasks of central banks. I will concentrate on issues relating to monetary policy, the primary task of a central bank. These issues are also closely linked to the more general economic goals and policy challenges we are facing in Europe.

I. Growth and stability: some key policy issues

It is generally agreed that macroeconomic policy has two main objectives: high growth and low inflation. Indeed, policymakers have often argued that “the higher the rate of growth the better”, without paying sufficient attention to the need to ensure the sustainability of growth. They have also argued that “the lower the rate of inflation the better”, provided of course that the negative territory of deflation is avoided. In pursuing these objectives, policymakers must provide answers to a number of crucial questions:

  • Are these two objectives related and interdependent?

  • Can they be achieved simultaneously and sustainably using the available policy instruments or are they “competing” goals, necessitating difficult choices and welfare assessments regarding their comparative importance?

  • Are the available policy instruments sufficient and effective as regards the attainment of both of these goals in the short term as well as in the long term?

  • Is there an optimal assignment of policy instruments to the objectives, in the sense that one type of policy, such as monetary or fiscal, is more effective in controlling aggregate output and prices over time?

These questions have been debated both extensively and intensely in the past by policymakers, academics and commentators. A significant convergence of views regarding the appropriate answers has been achieved over the past twenty years. In fact, I believe that a consensus, which was particularly strong in the early 1990s, has been reached among economists and policymakers on some of these issues. This has led the political authorities to legislate mandates for central banks, which define their policy priorities, and to impose constraints on the conduct and stance of fiscal policies. The aim of these mandates and constraints is to help achieve the macroeconomic goals in an effective and sustained manner.

The Treaty on European Union and related EU Council decisions provide the most relevant example. The Treaty clearly defines the objectives and relative priorities of the European Central Bank and the European System of Central Banks. It unambiguously states that the “primary objective” of the single monetary policy is “to maintain price stability”. It also states that, provided the attainment of this overriding objective is not jeopardised, monetary policy “shall support the general economic policies in the Community” so as to “contribute to the achievement of the Community’s objectives”. These include “sustainable, non-inflationary growth”. Moreover, the Treaty and secondary legislation set constraints on budgetary positions over the medium term and define procedures which aim to prevent and correct deviations of such positions from the desired norms. The provisions of the Stability and Growth Pact were adopted precisely because it was accepted and agreed that budgetary discipline is necessary both for the support of the stability-oriented monetary policy and for the establishment of financial conditions conducive to sustained growth.

Nevertheless, changing economic conditions, especially the disappointing growth performance of the European economy in an environment of relatively subdued inflationary pressures, have rekindled the debate on the role of monetary policy in supporting economic growth. This debate has been partly triggered by the perceived greater attention to the growth objective paid by other central banks, notably the Federal Reserve System in the United States. It seems, therefore, an opportune time to reassess the general issues concerning instruments and policy goals referred to earlier, in particular the role of monetary policy in fostering sustainable growth while maintaining price stability. This assessment involves addressing several pertinent questions:

  • Can monetary policy contribute to the attainment of higher long-term growth and, if so, how?

  • Can monetary policy help stabilise the economic cycle, that is, can it help minimise short-term fluctuations in aggregate output around the economy’s long-term potential growth path?

  • What are the necessary conditions that must be established for a central bank to deliver price stability effectively and contribute to the attainment of faster growth?

  • What is the role of economic policies ―both fiscal and structural― in promoting growth? How can they support or constrain the conduct of monetary policy and its effectiveness in maintaining price stability and fostering growth?

I will answer these questions in general terms, but I will also focus on issues that are particularly relevant for the euro area.

II. Growth and stability: some facts and comparisons

The answers to the questions concerning the role of monetary policy in fostering faster growth combined with price stability are not only of general or theoretical interest; they are especially important and relevant to Europe at present, in the light of the unsatisfactory average growth performance of the European economy over the past twenty years, including the five years since the introduction of the euro. A few figures are sufficient to highlight this disappointing fact. Since the beginning of the 1980s, the average annual growth rate in the twelve countries that today comprise the euro area has been 2.1%. Dividing this period (1981-2003) into two sub-periods ―the eighteen years before the launch of the euro and the five years (1999-2003) after its introduction― does not lead to a different conclusion. Indeed, it is noteworthy that average annual growth in the twelve euro area countries during these two sub-periods was almost the same. This figure compares unfavourably with the average annual growth of 3.1% in the United States over the 1981-2003 period.

Although trend growth has remained moderate in the euro area for more than twenty years, the progress made during the same period in attaining and maintaining price stability has been impressive. In the early 1980s, inflation had reached a level of almost 12% in the twelve euro area countries following the oil shocks of the 1970s and also as a result of the accommodative monetary policy pursued at that time. During the 1980s and 1990s inflation steadily declined, reaching a low of 1.1% in 1998 and 1999. In the five years (1999-2003) since the introduction of the single European currency, annual inflation in the euro area has averaged precisely 2%, in line with the ECB’s definition of price stability. It is interesting to note that inflation developments in the United States have been broadly similar to those in Europe. Indeed, average inflation in the twelve euro area countries during the period 1981-2003 has been 3.9%, one third of a percentage point higher than the corresponding average in the United States, while in the five-year period following the establishment of the European monetary union the average annual inflation of 2% in the euro area has been one half a percentage point lower than the average annual inflation in the United States.

In Europe, the decline in inflation since the early 1980s and the maintenance of price stability since the late 1980s has to be attributed to the consistent anti-inflationary stance of monetary policy. The reduction of inflationary pressures both in Europe and worldwide has also been facilitated by globalisation, deregulation and technical progress, which have increased competition and enhanced productivity growth. Over the last five years, however, the euro area economy has been subjected to several sizeable adverse price shocks that have fuelled inflationary pressures. Overall, monetary policy has played a decisive role and proved effective in attaining and maintaining price stability in Europe as well as in the United States.

The facts and comparisons I have just presented point to a few additional conclusions. During this period of almost 25 years of disinflation and subsequently of price stability, the growth performance of the euro area economy has remained modest and unchanged on average. At the same time, aggregate output volatility has declined, an outcome that can largely be attributed to the effects of price stability. An environment of low inflation has supported economic growth, helped reduce output volatility and enhanced social welfare in many other ways as well. Nevertheless, it appears that conditions of price stability have not proved sufficient to achieve a higher rate of long-term growth in the euro area. Such conclusions, however, can only be tentative. In order to reach firm conclusions, we must examine thoroughly what economic theory and available empirical evidence can tell us about the role monetary policy can play in fostering growth while maintaining price stability.

III. Monetary policy and long-term growth

When assessing the role of central banks in fostering economic growth, it is important for conceptual and for policy reasons to distinguish between the potential effect of monetary policy on long-term growth and its influence on economic activity and the rate of growth in the short and medium term. One reason why this distinction is useful is that both theory and evidence suggest that long-term growth is determined primarily by non-monetary factors, at least under conditions of low inflation. Consequently, any permanent effects of monetary policy on trend growth are likely to be relatively modest, although monetary policy may have a significant impact on economic activity over the medium term.

According to neoclassical theory, long-term economic growth is fundamentally determined by exogenous factors: the rates of population increase and technological progress. [1] More recent endogenous growth models (for example, Romer, 1990 and 1994) relate technological progress to human capital, which can be enhanced by knowledge accumulation and investment in research and development. These, in turn, can be influenced by policy instruments, such as public investment and tax incentives. Reforms that improve the flexibility and adaptability of labour and product markets, as well as professional training and education, can also increase potential growth endogenously by raising labour utilisation and productivity growth. The prediction of theory that monetary policy may have only a modest effect on long-term growth does not imply that such an effect is insignificant. Even a small permanent impact on the annual growth rate, compounded over a long period, can lead to a significant change in living standards.

The contribution of monetary policy to long-term growth has long been the subject of theoretical and policy debates among economists. As in any theoretical discussion, the conclusions drawn depend on the assumptions built into the theory. In this case the assumptions regarding the role of money in the economy are crucial: whether it is assumed to be an asset that can facilitate the transfer of wealth across generations, a factor of production and a means of financing, or a factor constraining investment and consumption. The theoretical analyses concerning the effects on long-term growth of a permanent easing of monetary policy ―i.e. the effect of a permanent increase in monetary growth and thus inflation― have not led to unambiguous and robust conclusions.

Some theoretical models, originating in a seminal contribution by Tobin (1965), imply that a permanent increase in monetary expansion can have a lasting, positive effect on growth. The reason for this is that higher inflation and the resulting lower own rate of return on money balances induce economic agents to shift a larger part of their wealth into real capital assets. This, in turn, generates an increase in the capital stock and a higher level of output per person in the long term. Even though this strand of theory has become more sophisticated and complete over the past few decades, serious questions still remain regarding the robustness of the findings and ―most importantly― the plausibility of the underlying assumptions. Moreover, the positive relationship between inflation and long-term growth predicted by these models, if it exists in reality, must be valid for relatively low rates of inflation, otherwise we would reach the absurd conclusion that hyperinflation would drastically improve the real economy’s performance.

Other theoretical paradigms support the view that “money is superneutral”, namely that a permanent change in money growth has no lasting effects on real variables – such as real interest rates, capital accumulation and long-term growth. There are also theoretical models ―based on alternative, more general assumptions about the role of money in the economy, incorporating features of endogenous growth theories and allowing for the presence of nominal rigidities in the economy (in the tax system, for example)― which lead to the conclusion that a permanently faster monetary expansion, causing higher inflation, results in lower capital accumulation and aggregate output growth. The wide spectrum of models and associated results has led economists to express the view that theory does not enable us to reach definite and robust conclusions about the likely effect of monetary expansion on long-term growth, since “equally plausible models yield fundamentally different results”. [2]

It may not come as a surprise to you that I, together with my central bank colleagues, have drawn a less agnostic conclusion. [3] There are several reasons for this. First, the theoretical growth models that employ more general and realistic assumptions regarding (i) the role of money in the economy, (ii) the factors and processes determining long-term growth, and (iii) the existence of institutional structures resulting in several kinds of nominal rigidities imply that a more expansionary monetary policy leading to permanently higher inflation will have, or is likely to have, a negative effect, or at best no effect, on long-term growth. Second, models of economic growth that incorporate the role of money and of monetary policy typically do not capture at all, or fail to capture adequately, the negative effects on economic activity and growth of the increased uncertainty caused by high, variable and unanticipated inflation. This uncertainty impairs the efficiency of market mechanisms and adversely affects real investment, capital formation and growth. Moreover, the distributional wealth and income effects of unanticipated inflation across generations and among social groups have arbitrary and undesirable consequences for social welfare and adversely influence saving and growth. In the real world, an economy experiencing higher average inflation is likely to be more prone to unanticipated fluctuations in inflation and thus to suffer their distributional consequences. Furthermore, inflation, even a low rate of inflation, can induce distortions resulting from its interaction with tax systems that are specified in nominal terms. [4] For all these reasons, it should be expected that a higher rate of inflation due to an expansionary monetary policy would reduce economic growth.

Theoretical arguments, however, as well as their underlying assumptions, can be challenged. Their validity must be tested on the basis of the available empirical evidence. Moreover, the quantitative significance of theoretical predictions regarding the impact of inflation on growth must be assessed. For we can all agree that “the proof of the pudding is in the eating”. Most of the many empirical studies produced over the past two decades find that inflation and long-term growth are negatively related systematically. [5] As could be expected, the negative effects of monetary expansion and inflation on long-term growth are stronger when inflation is higher. It is worth noting, however, that recent studies have established the existence of a negative association between long-term inflation and growth, even when inflation is relatively low. [6] These findings, which are obviously of relevance to the European economies, demonstrate, to paraphrase the well-known warning to smokers, that “inflation is hazardous to the health of the economy” even in relatively small doses. Very few empirical analyses have estimated a positive long-term relationship between inflation and growth, which holds for very low rates of inflation. The robustness of these results, however, has been questioned.

The general policy conclusions that can be drawn from this review of economic theory and available evidence are twofold. First, monetary policy should not be expected to increase economic growth sustainably by tolerating higher inflation. On the contrary, an expansionary monetary policy resulting in higher average inflation can be expected to adversely affect long-term economic growth. Second, monetary policy can promote sustainable growth by maintaining an environment of price stability. The conclusion that monetary policy cannot raise long-term growth does not, of course, imply that it cannot influence economic activity over the medium term and that it cannot play a role in stabilising aggregate output fluctuations.

IV. Monetary policy, economic cycles and inflation dynamics

Can monetary policy help stabilise the economic cycle? And if a counter-cyclical monetary policy were feasible, would it also be desirable, in the sense that it could be implemented effectively without jeopardising the attainment of price stability? These questions have been widely debated since Keynes (1936) made the case for stabilisation policies in general and for assigning a stabilising role to monetary policy in particular, at least under certain circumstances. This debate is still alive and occasionally intense among academic economists, as indicated by a recent important paper by Robert Lucas (2003), as well as among policymakers and commentators. In Europe, this debate has also been fuelled by the weak performance of its economy in recent years.

Before addressing the feasibility and desirability of a counter-cyclical role for monetary policy, it is useful to assess briefly the need for and the scope of such a role. Raising this issue may seem surprising, given the cyclical behaviour of economic activity over the last three years in Europe and globally. A longer-term assessment is warranted, however, since the potential for stabilisation policies depends on the size, nature and causes of cyclical output fluctuations. Several recent studies offer evidence that aggregate output volatility has steadily declined and recessions have become milder in most industrial countries over the past twenty years, with the notable exception of Japan. The apparent moderation of the economic cycle is attributed to several factors: the increasing relative importance of services in aggregate output, continuous advances in information technology fostering higher productivity growth, improvements in inventory management, and the stabilising effects of globalisation, financial liberalisation and macroeconomic policies. In particular, the successful disinflation of the US and European economies achieved in the 1980s and 1990s and the focus of monetary policy on securing price stability have significantly contributed to reducing aggregate output volatility.

The trend decline in aggregate output volatility in industrial countries would seem to limit the scope for a counter-cyclical monetary policy. Nevertheless, the magnitude, frequency and effects of several types of shocks, for instance oil shocks, cannot be predicted on the basis of past experience. Furthermore, recent developments suggest that some other sources of instability may become more relevant. For example, large swings in asset prices to levels which deviate substantially from estimated equilibrium values consistent with fundamentals and the rapid growth of debt in a number of large economies may trigger or accentuate real output fluctuations. In fact, pronounced output fluctuations in industrial countries have often been associated with asset price cycles. Hence, there is renewed interest in the potential stabilising role of monetary policy, especially in an environment of low inflation.

The feasibility and effectiveness of a counter-cyclical monetary policy hinges, of course, on whether it can influence aggregate real output significantly and in a reasonably predictable way over the short and medium term. The theoretical analyses and empirical investigations concerning this issue are extensive. Given the time constraint, I neither intend nor dare to provide even a brief review of the alternative theoretical approaches which have been employed, the sometimes conflicting results which have been presented, and the opposing views which have been expressed concerning their policy implications. [7] I will limit myself to some key, and by now generally accepted, conclusions drawn from modern theory and the available empirical evidence, particularly for the euro area economy.

These conclusions are based on a consensus theoretical macroeconomic framework, which combines both neoclassical and New Keynesian elements. It captures the behaviour of forward-looking economic agents who attempt to take optimal decisions over time and have “rational” expectations that are based on all available information, including the anticipated behaviour of policymakers. At the same time, it allows for market imperfections and nominal rigidities, which play an important role in shaping the dynamics of aggregate output and inflation and hence the transmission of the effects of monetary policy on the economy. This framework has provided the basis for many econometric models used by central banks, including the European Central Bank, in analysing and simulating the dynamic behaviour of output and prices and their links with the instruments of monetary policy.

The consensus macroeconomic theory and the empirical evidence support the view that, in general, monetary policy can significantly influence economic activity in the short and medium term. The magnitude of the effects of monetary policy on the economy and the time lags in their transmission depend on a host of factors: behavioural parameters, structural and institutional features of the economy that can affect the nature and speed of market response to shocks and policy changes, as well as the expectations of the public regarding future developments and policies. Needless to say, the values of these parameters are not known with certainty and they may also vary over time partly as a consequence of the cyclical position of the economy. Furthermore, the nature and formation of the public’s expectations are of crucial importance in shaping the dynamics of the monetary policy transmission mechanism. Thus, both the magnitude of and the time lags in the effects of policy on the economy are uncertain and variable, partly as a result of the influence of various factors, including the effects of policy-induced changes in expectations.

What does the available empirical evidence tell us about the features and dynamics of the monetary policy transmission mechanism? Many empirical studies have been carried out concerning this mechanism for the United States and other industrial countries. The available evidence for the euro area economy is new and relatively limited. Yet, the results obtained by researchers at the European Central Bank and other central banks of the Eurosystem are significant and relevant, including the finding that there are remarkable similarities in the cyclical behaviour of the economies of the euro area and the United States and in the response of each to monetary policy. [8] I would like to briefly mention a few additional general findings. First, a change in the monetary policy stance, i.e. a change in the central bank’s policy rate, leads to an adjustment in aggregate output that reaches a peak after a period of between one and two years and then gradually diminishes to zero. The effect on the price level of a change in the policy stance is typically estimated to be much more gradual, but permanent. Second, these patterns of aggregate output and price level responses emerge consistently across a variety of empirical models. But the time profile of the effects of monetary policy on aggregate output and the price level cannot be estimated with precision. Third, the magnitude of these effects depends on the cyclical position of the economy, on the initial interest rate level and on whether the change in the policy stance is expansionary or restrictive.

The implications of the consensus theoretical framework and the bulk of the empirical evidence for the scope and effectiveness of a counter-cyclical monetary policy can be summarised as follows. Although monetary policy can in principle play a stabilising role, in practice the conduct of such a policy is difficult and requires considerable caution. It may also prove not to be very effective in dealing with aggregate output fluctuations. It may even be counterproductive, in the sense that it could lead to an increase rather than a moderation of aggregate output volatility. The effectiveness of a counter-cyclical monetary policy is limited by the uncertainty surrounding the magnitude of and the time lags in its effects on aggregate output. Other limiting factors are the uncertainties in assessing the precise cyclical position of the economy (the size of the “output gap”), in identifying the type and persistence of shocks and in evaluating their impact on the economy. One reason why it may not be desirable for monetary policy to play an active stabilisation role is that there is evidence that a large part of output volatility can be attributed not to nominal or demand shocks, but to “real” shocks, for example those related to technological change, which cannot be effectively offset by monetary policy. [9]

These considerations have led me to the conclusion that the conduct of an activist counter-cyclical monetary policy aimed at fine-tuning the economy involves risks which are likely to outweigh potential benefits. A policy of this type should therefore be avoided under “normal circumstances”, namely when the central bank is confronted with cyclical fluctuations of average magnitude. Nevertheless, it is possible to envisage “particular circumstances”, triggered by severe shocks, when monetary policy can play a role in stabilising output around its potential growth path. Such a policy would have to be implemented with great caution and in a manner that is consistent with the central bank’s commitment to its primary objective of maintaining price stability. It would also have to be explained in a clear and convincing way, so that the monetary authority’s credibility and the public perception of its commitment to price stability would not be adversely affected. [10] Past experience shows that there have been occasions when monetary policy has successfully played a stabilising role. There have also been many occasions, however, when ambitious attempts to fine-tune the economy have failed and resulted in increased inflationary pressure and output volatility.

V. The role of monetary policy

The foregoing review and assessment of theory and available evidence leads to a number of general conclusions regarding the impact of monetary policy on the economy and its role in securing price stability and fostering economic growth. The empirical evidence overwhelmingly confirms that monetary policy can effectively control the price level over the medium and longer term. Inflation may not be everywhere and always a monetary phenomenon, as Milton Friedman once claimed. Nevertheless, inflation is fundamentally a monetary phenomenon, in the sense that monetary factors and central bank policies dominate and determine the evolution of the price level over time. Consequently, it stands to reason that monetary policy is assigned the attainment and maintenance of price stability as its primary objective.

The performance of this task is not straightforward, however, because the dynamics of inflation are complex, especially in the shorter term, being influenced by a variety of non-monetary factors and policies. Moreover, the relationship between inflation and monetary policy instruments is also complex and surrounded by uncertainty. As I explained earlier, it partly depends on developments in the real economy and is crucially influenced by the private sector’s inflation expectations, which affect price and wage-setting, as well as financial market developments. These expectations are largely shaped by the actions ―current and anticipated― of the central bank. Hence, the formulation and conduct of monetary policy is inevitably based on imperfect knowledge of a complex monetary transmission mechanism. Monetary policy must guide and anchor the private sector’s inflation expectations to the objective of price stability. To this end, it must have a forward-looking and medium- to longer-term orientation. Policy decisions cannot be based solely or primarily on current developments and short-term considerations. They must be consistent with and conducive to ensuring price stability over the longer term. This is a challenge for central banks. Hence, the effective conduct of monetary policy requires their continuous and credible commitment to the stability objective and the support of other policies.

With regard to the effects of monetary policy on economic activity, on the whole theory and evidence support the view that it cannot have a direct positive effect on the long-term rate of growth, although it can promote growth indirectly by establishing an environment of price stability. In contrast, an over-ambitious, expansionary monetary policy aimed at supporting growth above the economy’s productive potential is bound to fail. In fact, if it persists, it will adversely affect trend growth, on account of the rising inflation it will generate. Over the medium term, a change in the monetary policy stance can have a powerful effect on the level of economic activity, but this effect diminishes and dissipates over time. The available empirical evidence in general, and for the euro area in particular, implies that monetary policy cannot affect either the rate of growth or the level of aggregate output in a systematic and permanent manner. Price level and aggregate output developments are therefore not interdependent and cannot be controlled simultaneously by monetary policy alone in the long term.

The preceding arguments lead to two additional conclusions regarding the role of economic and monetary policies, which are particularly relevant for Europe. First, they confirm the appropriateness of the ECB’s mandate, which assigns price stability as the primary objective of monetary policy. Second, they also confirm the relevance and validity of an important principle of economic policy, advanced by Jan Tinbergen (1956), who was awarded the first Nobel Prize for economics. According to this principle, in order to simultaneously achieve the two policy objectives of price stability and sustainable high growth, which ultimately are not interdependent, it is necessary to employ at least two policy instruments that can have an independent impact on these variables. The optimal assignment of policies to objectives should depend on their relative effectiveness in influencing aggregate output and the price level systematically and permanently.

VI. The effectiveness of monetary policy and the role of economic policies

The main policy for increasing long-term growth in Europe is structural reform geared towards improving productivity growth and labour utilisation in order to raise potential growth and enhance the international competitiveness of the European economy. Reforms should aim to remove the remaining obstacles to the completion of the single European market, strengthen competition and facilitate the efficient functioning of market mechanisms. Moreover, the implementation of policies and reforms that can help boost investment in human and physical capital and support innovation and entrepreneurship will contribute decisively to raising trend economic growth.

The Lisbon reform strategy, which aims to make the European Union the “most competitive and dynamic knowledge-based economy in the world by 2010” remains broadly appropriate. It could be more effective if it were more focused on a number of key priorities. The crucial issue, however, is to implement the envisaged reforms in a timely and effective manner. The pace of implementation and the scope of reforms have been rather disappointing until this year, when some progress was made towards addressing the structural weaknesses of the European economy, notably in labour markets and in pension and health care systems. More comprehensive and determined reform efforts will be needed, however, if the objectives of the Lisbon strategy are to be achieved.

The structural reforms envisaged in Europe will not only increase its long-term growth and improve its international competitiveness. They will also enhance the effectiveness with which monetary policy can achieve its objective of price stability. By raising productivity growth and increasing the efficiency and flexibility with which labour and product markets respond to shocks and policies, structural reforms will favourably influence the monetary transmission mechanism. This will enable monetary policy to offset or mitigate the effects of shocks and preserve or restore price stability faster and with reduced aggregate output volatility.

The twin objective of price stability and faster durable growth in Europe cannot be secured, however, by assigning primary responsibility for price stability to monetary policy and for sustainable growth to structural reforms. It is also essential that prudent national budgetary policies complement and support the ECB’s monetary policy and the structural adjustment efforts. Fiscal policy has an important role to play in the implementation of the structural reform agenda via growth-enhancing spending measures, a reduction in government expenditure that can cause inefficiencies and market distortions, the introduction of pension and health care system reform, and the establishment of a tax system and incentives that can promote investment. Sound public finances are necessary not only in order to support the stability-oriented single monetary policy over the medium and longer term, but also because they are conducive to faster sustainable growth. There is ample evidence to support this statement. Furthermore, the experience of a number of countries demonstrates that credible medium-term fiscal consolidation policies have often been followed by an acceleration of growth as a result of increased investor and consumer confidence and the implementation of budgetary measures that promote economic efficiency and restructuring and reduce the fiscal burden on the economy. [11] At the current juncture, when public finances in a number of Member States have seriously deteriorated, in some cases breaching the 3% of GDP deficit limit of the Stability and Growth Pact for a number of years, there is an urgent need for substantial and timely corrective measures in line with the requirements of the Pact. It is especially important for the strengthening of the long-term growth performance of the European economy not to undermine the effectiveness and credibility of the Pact as a framework that can ensure sound public finances over the medium and longer term.

VII. Concluding remarks

As I noted at the beginning of my speech, anniversaries such as this one are occasions for celebrating past achievements and reflecting on what lies ahead. The latter part is especially challenging, however. Two and a half millennia ago, Thales of Miletus proclaimed that “the past is certain, the future obscure”. It need not be that daunting, despite the uncertainty with which a forward-looking monetary policy is inevitably confronted. This is because we have learnt from the past, from mistakes and successes. Central bankers and the economics profession have investigated causes and effects, tested hypotheses and analysed dynamics and processes. As I have illustrated extensively, we have reached sound and firm conclusions about the role of monetary policy in attaining the objectives of price stability and durable economic growth. Moreover, these insights are enshrined in the “monetary constitution” of Europe, which provides a solid foundation for this Bank, and the Eurosystem as a whole, to successfully master the challenges of the future. So when, in another 25 years’ time, the Bank of Greece celebrates its 100th anniversary, future speakers might wish to delve into the archives to see what was said back in 2003. My anniversary wish for this institution is that they will be able to repeat my opening remark: “The Bank of Greece has, justifiably, many reasons to celebrate and feel proud of its achievements.”

Thank you very much for your attention.


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  1. [1] See Solow (1956 and 2000).

  2. [2] Stein (1970) and Orphanides and Solow (1990) present comprehensive surveys of theoretical models of money and economic growth and both reach such a conclusion.

  3. [3] See Papademos (2003) for a more extensive review and assessment of the contribution of monetary policy to economic growth.

  4. [4] Fischer and Modigliani (1978) and Fischer (1994) present comprehensive accounts and analyses of the real effects and social welfare costs of inflation.

  5. [5] Barro (1997) and Fischer (1994) discuss the empirical evidence on the long-term relationship between inflation and growth.

  6. [6] Andrés and Hernando (1999) have shown that there is evidence of a robust negative relationship between inflation and long-term output growth in countries with low inflation.

  7. [7] Papademos (2004) examines and assesses the theoretical analyses and the empirical evidence concerning the feasibility and effectiveness of a counter-cyclical monetary policy.

  8. [8] See Angeloni, Kashyap and Mojon (2003) and Papademos (2004).

  9. [9] See Lucas (2003).

  10. [10] Blinder (1998) discusses the notion of central bank credibility and its importance for the effective conduct of monetary policy. Lohmann (1992), Persson and Tabellini (1993) and Rogoff (1985) analyse the effects of institutional arrangements on the credibility of a central bank’s commitment to its objectives.

  11. [11] See Alesina and Perotti (1996) and Briotti (2005).


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