Outlook for the European Economy
Professor Otmar Issing, Member of the Executive Board of the European Central Bank, The Institute of International Finance, Washington DC, 3 October 2004
I am very honoured to have been invited here today. I would like to thank the Institute of International Finance, and Charles Dallara (Managing Director of IIF) for this invitation, and for giving me this opportunity to share my views on the “Outlook for the European Economy”. To do so, I will start by taking a broad definition of Europe and highlight some of its recent historical developments. Then, I will focus more narrowly on the euro area, and give my assessment of the current economic and financial situation, and the prospects for the future.
What is Europe?
Giving a speech on the Outlook for the European Economy is always a challenge. To begin with, you may ask yourself: “What is Europe?” From a geographical perspective, one would certainly include Norway, Switzerland, and ask oneself how far one would go, including Russia. But from a political and economic perspective, the focus is often different. Less than two decades ago, the focus used to be on “East” versus “West”. But, now the focus is increasingly on the EU member states versus countries on their way to becoming members. And, within the EU, we also talk of the euro area – the economic entity consisting of the 12 EU countries that have adopted the euro as their common currency.
I hope that you will allow me to focus on the part of Europe, I know most about: namely, the EU and the euro area in particular.
Having narrowed my focus somewhat, let me start by reminding you that the 1st of May this year was a historic day. In terms of population, this day marked the largest enlargement of the EU since the creation in 1957— as it was then called - of the European Economic Community. With its 25 member countries, the EU now has a population of 455 million people. This means that the EU as a whole has the third largest population in the world – after only China and India – and making it larger than the US and Japan combined. In economic terms, total GDP in the EU was more than twice the GDP of Japan, and close to that of the US.
With some regret I note that, in Europe, there is a habit of focusing mostly on our problems, and the enlargement has been no exception. Obviously, enlarging the EU with 10 new member countries with a combined population of 75 million is no easy task. And it would be naïve to claim otherwise.
However, the enlargement signifies something much more positive. It signifies the progress that has been made since the same countries that are now members of the EU were the same ones that in the 20th century were engaged with one another in bloody conflicts. Indeed, the enlargement is a testimony to the fact that, we have realised that we share fundamental values which we, collectively, want to promote: peace, democracy, the rule of law and respect for human rights.
In terms of the economic prospects, there are also reasons to be optimistic. Before entering the EU, both the current and new member states prepared themselves intensively. For example, the new members had to demonstrate that they had functioning and competitive market economies. While most of the new members have a long way to go to reach average income levels in the EU, the foundations for them to further catch up have been laid. It is also important to mention that with capital, goods and labour allowed to move freely within the EU, the new members will put pressure on all of us to become more competitive. And, I think this is good news.
For the remainder of my speech, I will focus on the euro area, and its economic prospects.
The euro area
Before addressing the current state of the euro area economy and its outlook, let me briefly highlight the large strides we have made towards closer integration.
In less than six years, the euro has been firmly and credibly established as a stable currency, also internationally. The euro area has witnessed a period of low rates of inflation and low levels of long term interest rates. Most participating countries have had their lowest market interest rates for decades. The introduction of the euro in January 1999, and, finally, in the form of banknotes and coins in January 2002 went very smoothly. The euro has become part of people’s daily lives.
Equally important, the ECB's monetary policy has been successful in keeping inflation and inflation expectations under control.
All of this was achieved even in the face of substantial adverse shocks, and exceptional economic, financial and geopolitical uncertainty, and with no real precedent to learn from.
Although history provided no examples of monetary unions of the magnitude we were about to create, we benefited from a large academic literature on monetary unions. One of the main points emphasised in this literature is the importance of having rules that ensure fiscal discipline amongst the participating member states. This was clearly understood and was reflected in the Maastricht Treaty by a set of fiscal rules referred to as the Stability and Growth Pact.
As you know, the fiscal rules have given rise to a lively debate in Europe in recent years. Taking a step back, I see this discussion as a reflection of the fact that Europe is still struggling for a political identity. On the monetary policy front, a clear responsibility and competence have been given to the ECB. By contrast, fiscal policy is decided in 12 different countries, each with their own agendas and priorities. With only 5 ½ years of experience, it is perhaps not surprising that Europe is still in the process of fully adjusting to a new situation - with one currency, and one central bank with a clear mandate for price stability. Naturally, this monetary policy mandate has implicit consquences for fiscal policies and wage setting behaviour, and this is what Europe still needs to fully adjust to.
Adjusting to new circumstances is never easy. Especially during periods of slow growth. As you know, the euro area has only recently come out of a 2 year period of slow growth. Now, though, we see increasing signs of an ongoing recovery.
The current economic situation in the euro area
Indeed, the latest data show that, in annualised terms, real GDP grew by 1.2% in the first half of 2004, compared to 0.5% for 2003 as a whole. Moreover, the latest indicators of output and demand remain consistent with ongoing growth in real activity
Looking ahead, the conditions for a continuation and broadening of the recovery remain in place. Economic growth outside the euro area remains robust, and should continue to support euro area export growth. On the domestic side, investment should benefit from the positive global environment and the very favourable financing conditions. Moreover, private consumption should continue its gradual recovery, broadly in line with growth in real disposable income.
Against this background, the economic recovery in the euro area is expected to persist and to become more broadly based over the coming quarters. This is also reflected in our latest ECB staff projections. They envisage euro area real GDP growth of between 1.6% and 2.2% on average in 2004, rising to between 1.8% and 2.8% in 2005. These growth rates are close to most estimates for long-run potential growth. Available forecasts from international organisations and other sources convey a broadly similar picture.
I should note that this scenario of an ongoing and further progressing economic recovery is, as always, subject to some risks – in both directions. On the upside, the ongoing momentum of the recovery may again imply more positive developments for economic growth in the coming quarters. On the downside, there are still concerns about continuing economic imbalances in other parts of the world. These imbalances could affect the sustainability of the economic recovery.
Another downside risk to the growth projections relates to oil prices. In particular, the oil price increase observed over the last year and particularly the fact that oil prices have remained at a higher than expected level for quite some time could imply risks to growth. However, when assessing its impact, it should be taken into account that the recent rise in oil prices has been significantly smaller than in previous episodes when oil price increases had a major impact on the world economy. This is not only true when looking at developments in oil prices in USD terms, but particularly when expressed in euro terms, as the past appreciation of the euro had a dampening effect. In addition, in real terms, oil prices are significantly below the peaks they have reached in the past. Moreover, when compared with the 1970s and 1980s, the oil intensity of production in the euro area and elsewhere has fallen significantly. In 2001, the oil intensity of the euro area, measured as oil consumption in relation to real GDP, decreased by almost 49%, compared with its peak in 1973. Finally, while previous oil price increases have mainly been driven by supply factors, the recent increase is also partly due to higher demand for oil, on the back of the strong global expansion. All these factors put the downside risks to economic activity coming from oil prices, which I do not neglect, into perspective. Nevertheless, persistently high and even further increasing oil prices would be a reason for concern.
However, recent oil price developments have had a visible direct impact on price developments in the euro area with annual HICP inflation in August at 2.3%, unchanged from July. On the basis of current market expectations for oil prices, it appears unlikely that annual inflation rates will return to levels below 2% in the remainder of this year.
Looking ahead, however, there are no indications at present of stronger underlying inflationary pressures building up domestically. Recent wage developments have been moderate, and this trend is expected to continue for some time to come in view of the still high level of unemployment in the euro area. If this is the case, and provided that one-off shocks to prices from other sources such as those seen in 2004 are not repeated, annual inflation rates should drop below 2% in 2005, in line with our definition of price stability.
Against this background the latest ECB staff projections put average annual HICP inflation at between 2.1% and 2.3% for 2004 and between 1.3% and 2.3% for 2005.
Let me summarise the assessment of the euro area economy by repeating that there is ongoing evidence that the economic recovery is well underway. This is good news. However, to foster confidence in the short to medium-term, to ensure that economic growth is sustainable over a longer horizon, and to raise potential growth, we need to address more fundamental weaknesses in our economy.
This means pursuing structural reforms that are designed to increase the flexibility of markets, increasing employment, promoting innovation and securing the sustainability of social security systems in the EU. There is a lot to do on this front but fundamental changes are already underway. Unlike a few years ago, it is now widely recognised that the accelerated implementation of structural reform, framed within the Lisbon agenda, is the key to making the EU economies more competitive and dynamic. Moreover, as I mentioned earlier, the new member states to the EU are putting pressure on all of us to increase our competitiveness.
Ladies and gentlemen, let me briefly conclude by summing up what all of this means for the outlook for Europe. First, integration in Europe is ongoing. No one expects this to be an easy process. But, and this is my second point, on the economic front, available data point to an ongoing economic recovery. Along with the progress I see happening on the structural reforms agenda, the economic upswing provides a tailwind which should make the integration process somewhat easier.
Let me also underline that we, at the ECB, are doing all what we can for Europe to cope with these challenges. Our best contribution, in conformity with our mandate, is to preserve one of the cornerstones of successful integration: namely, price stability and to be credible in so doing not only on a short to medium term basis but also on a medium to long term basis. In fulfilling efficiently this role, the ECB brings about today a major contribution to European prosperity, growth and job creation: in consolidating a low level of medium and long term market rates for the 306 million citizens of the euro area; in preserving the purchasing power of the household which is a necessary condition for consumption growth; and in augmenting the level of confidence of economic agents which is so important in the present juncture in Europe.
Ladies and gentlemen, thank you for your attention.
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