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European Affairs
Leader In Focus
ECB Can Boost European Growth by Keeping Inflation Down
Jean-Claude Trichet
Governor, Banque de France
Next January 1, the European single currency will become a tangible asset as euro coins and banknotes are introduced throughout a large area of the Continent. This massive and complex operation will be the largest monetary changeover the world has ever seen.
We should not forget, however, that from a historical point of view, the decisive event occurred on January 1, 1999, the birthdate of Europe's monetary union for all economic, monetary and institutional purposes. It is the irreversible nature of that development that has convinced an increasing number of economic players that the success of the euro is necessary for Europe.
The single European currency is a keystone of the European single market and will help to ensure lasting prosperity in Europe, not only for our benefit but for the rest of the world as well.
Despite initial skepticism in some quarters, the fact is that the euro and monetary union have been successful from the outset, and will be even more successful in the future, provided the necessary conditions are fulfilled.
The fundamental reason for the success of the monetary union and the single currency is that they are based on a credible and stability-oriented monetary policy and contribute to an appropriate economic and monetary equilibrium in Europe.
From a technical point of view, the launch of the euro has been an indisputable success. Together, the European Central Bank and the national central banks of the euro area have achieved the objectives they were assigned in three important respects:
The first is operational efficiency, as demonstrated by timely adjustments to banking liquidity and short-term interest rates.
The second is the security provided by the procedures implemented by the Eurosystem for interbank operations and high-value payments. The interbank market was integrated from the start of monetary union in 1999, thanks to the creation of theTarget system for the real-time transfer of high-value payments throughout the euro area and other EU countries.The system processes over four million payments on average each month, representing roughly E1,100 billion daily, of which 40 percent are cross-border payments. Real-time gross settlements in the EU have significantly increased since the euro's introduction.
The third is the smooth functioning of the Eurosystem, an integrated organization in which the decision-making center works in constant contact with the national central banks in charge of implementing operations.
he main reason for this success was the in-depth preparatory work conducted over several years by the central banking community and private financial market operators.
Together with many other factors, this technical and operational success has contributed to the high credibility of the single monetary policy, which is guaranteed, inter alia, by the independence of the European Central Bank and of the national central banks.
The Eurosystem has inherited the store of confidence built up over several decades by the national central banks. In France, for example, a recent opinion survey indicated that 80 percent of citizens trust the Banque de France. In the other euro-area countries, confidence in national central banks is certainly just as high.
It should be remembered that, contrary to what is often said, Europe's monetary union did not start from scratch. For no fewer than 12 years before the launch of the euro, six of its component currencies, representing close to two-thirds of euro area GDP, demonstrated remarkable stability. During that period, their parities never had to be re-aligned within the European Exchange Rate Mechanism.
The Eurosystem relies on the principle of decentralization asserted in the Maastricht Treaty. It is a team, a European monetary team, composed of the European Central Bank and the national central banks of the twelve euro-area countries.
The ECB acts as coach and captain, and the national central banks as the players on the field, in daily contact with market participants. We all share the same team spirit, which is one of the priceless assets of the euro area.
The credibility of the Eurosystem rests, fundamentally, on its stability-oriented monetary policy strategy, mandated by the Maastricht Treaty.
We have decided to be as transparent as possible by announcing a clear definition of price stability - a year-on-year increase in the Harmonized Index of Consumer Prices for the euro area of below two percent. This provides a clear yardstick against which the public can judge our performance.
The main principles of European monetary policy are sometimes not known or not well understood. We aim to create the best monetary framework for economic growth by ensuring price stability in a medium-term perspective. A prominent feature of this approach is that it does not aim to fine-tune economic developments.
Price stability is a yardstick for wage moderation, a crucial element for maintaining competitiveness. A sound competitive position is conducive to balanced and sustainable growth and creates favorable conditions for low market interest rates.
In designing an effective framework for such a policy, European central bankers have faced uncertainties over the economic structures of the euro area and the transmission mechanisms of monetary policy within these structures. For this reason, we have adopted a "full information" approach, which encompasses not only all the relevant information, but also takes into account interpretations that may differ.
This strategy, which is illustrated by our so-called "two pillars," differs in some respects from the strategies pursued by other central banks.
In recognition of the fundamentally monetary origins of inflation over the medium term, we have assigned a prominent role to money, which is the first "pillar."
This pillar is based on the announcement of a reference value for annual growth in the broad monetary aggregate M3, which we have set at a maximum of 4.5 percent. This differs from traditional monetary targeting, since the concept of a reference value implies that the Eurosystem is not compelled mechanistically to correct deviations in monetary growth in the short term.
Monetary developments, however, cannot be the only guide for assessing threats to price stability. We also need to review a comprehensive set of early indicators of future inflation, including consumer prices, producer prices, unit labor costs, commodity prices, exchange rates, aggregate demand and so on. This constitutes the second "pillar."
This approach differs from so-called inflation targeting, not only because we have assigned a prominent role to a monetary aggregate but also because we do not want to be a prisoner of a single mathematical model in predicting risks to price stability.
In brief, we consider that central banks should not base their monetary policy decisions upon any single indicator, model or simple policy rule.
Our two-pillar approach represents a balance between the requirements of clarity and simplicity on the one hand, and openness and honesty on the other. Furthermore, it ensures continuity with the monetary policies of the participating national central banks. This appears to have been understood by financial markets and by the public at large.
In particular, the relatively low yields on long-term bonds denominated in euros confirm that markets have confidence in our approach and that the Eurosystem has protected the legacy of credibility it inherited.
The credibility of the euro also results from the fact that the Eurosystem is one of the most transparent central banks in the world. Once a month, immediately after the Governing Council meeting, the President holds a press conference that gives a clear account of the diagnosis of the Governing Council and is posted in real time on the ECB website.
The Eurosystem was the first central bank to introduce, on January 1, 1999, the concept of regular, frequent, real-time information in the domain of monetary policy. This illustrates just how unfair some criticisms are!
It is noteworthy that soon after we had embarked upon this new concept of real-time transparency, other important central banks decided to follow in our footsteps.
If an independent institution is to exercise responsibility in a modern democracy, or in a subtle set of democracies like the European Union, it must be accountable to public opinion at large.
The public statements of Wim Duisenberg, the President of the ECB, and of the governors of the national central banks are crucial. Tirelessly explaining the reasoning behind the decisions of the Governing Council is a key part of our collective task, which is currently underestimated.
Mr. Duisenberg attends hearings at the European Parliament in Brussels at least as often as Alan Greenspan, the Chairman of the U.S. Federal Reserve, appears on Capitol Hill. National bank governors are responsible for disseminating the same message - meaning that the Eurosystem's message is expressed in 11 different languages and passed through the filter of 12 different cultures.
To improve communication even further, the Eurosystem decided in December 2000 to publish staff economic projections for the euro area.
This is why I believe that the Eurosystem represents the best practices of the world's main central banks, in terms of accountability in a democratic society.
We have come a long way. A few years ago, it was necessary to convince a great number of skeptics, in the United States as well as in Europe and around the world, that we were really going to introduce the euro.
Many observers pointed to alleged contradictions and inconsistencies, claiming, for example, that the economic divergences and structural differences among euro-area countries were too large for a viable monetary union and a single monetary policy.
Other objections included the absence of instruments to respond to asymmetric shocks, and the European economies' lack of flexibility and labor mobility. The conclusion was that the euro and the single monetary policy would never exist!
Reality has refuted this conclusion. But the very same arguments are sometimes deployed to suggest that the euro-area economy has some inconsistencies that could endanger its prosperity. How can we respond to this very important question?
First of all, I must stress that the Governing Council formulates a single monetary policy for the euro area as a whole. Each governor is fully independent within the Council, ignores any national bias and deliberates and decides according to economic and monetary conditions in the entire euro area.
Of course, monetary union does not necessarily imply that, at any given point in time, all the participating countries will experience the same rate of inflation or growth, even though the adoption of the euro was based on the successful completion of a convergence process.
Let us look at inflation, for example. Present differentials do not seem very large, in comparison with the United States, which is a long-standing monetary union of comparable size.
Data on major U.S. cities show that price differentials have at times been very substantial. Last year, for example, average weekly earnings in the U.S. non-durable goods sector ranged from $437 in Mississippi to $644 in New Jersey.
I am convinced that we shall witness the increasing integration of European countries, and that economic developments in the area will become more and more synchronized. Indeed, several academic studies have shown that business cycles are becoming more correlated across Europe.
Secondly, it has also often been asked whether economic and monetary union can succeed without closer political union. In practice, for it to function well, all member states must be aware of the spill-over effects of their national policies, especially their budgetary policies.
So, we favor the strong co-ordination of economic policies contained in the Treaty itself - provided, of course, that the independence of the ECB and of the Eurosystem is strictly observed.
Even more importantly, the euro zone has institutional mechanisms conducive to an appropriate policy mix: The Stability and Growth Pact includes important fiscal requirements for member states.
There were three economic justifications for adopting this pact:
First, by providing for fiscal policy co-ordination among the member states, the pact ensures a good policy mix within the euro area. This is essential for monetary policy, in order to counterbalance the fact that Europe does not have a federal government and, thus, cannot operate a significant federal budget.Close mutual supervision and co-ordination of fiscal policies are the responsibility of the ministries of finance within the framework of the euro zone and in the EU institutions. A suitable policy mix is achieved by keeping below the three percent budget deficit threshold and adhering to the medium-term objective of keeping budgets "close to balance or in surplus."
Second, thanks to the dissuasive effects of a penalty system for excessive deficits, the pact helps to prevent well-managed economies from having to bear an unjustified risk premium, in terms of interest rates, as a result of other economies' bad management.
Third, the pact allows us to disprove the assertion that the euro area has no automatic stabilizers in the event of asymmetric shocks to a member state's economy. By requiring that governments aim for a fiscal position "close to balance or in surplus" in the medium term, the pact enables them to let fiscal deficits increase when they run into specific problems without exceeding the three percent reference value.
n short, the pact allows governments to create a fiscal buffer during periods of normal economic activity that can be drawn on to counter economic divergences or asymmetric shocks during less favorable circumstances.
Some economists have also criticized the euro zone for not being an optimal currency area, and expressed concern about giving up the option of altering the exchange rate as a response to asymmetric shocks. One of the most remarkable effects of European integration, however, has been the increasing symmetry of shocks.
Other economists suggest that dealing with divergences and asymmetries should not prove any more difficult within the euro area, at least in its major countries, than within a long-established monetary union such as the United States.
While it is widely acknowledged that the introduction of the euro has been broadly successful, one must also ask what needs to happen to confirm and enhance that success in the medium and long term.
It is encouraging in this respect that in a number of ways the euro itself appears to be a catalyst for ensuring that the conditions of its future success are met. The euro, for instance, helps to achieve the construction of the single market.
The single currency enables the productive sector to make significant economies of scale and allows European savings to be allocated to the most efficient investments. It also enhances market transparency, and boosts competition and innovation, to the benefit of consumers.
The single market could not be fully achieved while monetary barriers continued to prevent the free flow of goods, services, capital and, in a way, people, by imposing unpredictable and erratic exchange-rate movements and transaction costs.
The last step in this process will be taken with the cash changeover at the beginning of next year. That will allow all our citizens to enjoy the advantages of using
the same monetary instrument throughout a large part of Europe, just as Americans do in the United States.
The euro is also generating significant changes in the broader economic and financial environment, acting as a strong catalyst for mergers and acquisitions. The European mergers and acquisitions market is among the most dynamic in the world - second behind the United States, with operations totaling over a900 billion last year.
The single monetary policy has fostered structural changes in the financial industry, by creating more opportunities and better conditions for investment and financing. This is true both for euro-area money markets and for medium and long-term capital markets.
Since the beginning of 1999, cross-border transactions have risen to more than 50 percent of total activity in all segments of the money market. The integration of interest-rate markets within the euro area is a key achievement, which deserves to be underscored. These structural changes have encouraged companies to concentrate their euro cash management activity within the euro area in order to benefit from better liquidity.
We have also made significant progress toward integrating long-term capital markets, for both euro-denominated bonds and equities. According to recent statistics, the euro and the dollar were the two leading currencies for bond issuance in the first quarter of 2001, with each currency accounting for around 45 percent of international bond issues.
Furthermore, the removal of exchange-rate risk since the euro's introduction has encouraged European investors substantially to diversify their bond portfolios, enabling them to gain higher rates of return for a given level of portfolio risk.
One should not forget the euro's role in promoting recent trends towards mergers or close cooperation between stock exchanges, securities settlement systems, clearing houses and other such organizations.
The euro has indisputably prompted large-scale market restructuring throughout Europe. Stock market capitalization of euro-area equity markets totaled more than a5.7 trillion at the end of 2000, compared with only a3.6 trillion at the end of 1998.
There are still some barriers to the further integration of EU capital markets. In this regard, the Eurosystem has welcomed moves by the European Council, at its meetings in Lisbon last year and in Stockholm this spring, to speed up the completion of the internal market for financial services.
The euro is also acting as a powerful catalyst for structural reforms in non-financial domains. A single currency makes it much easier to compare prices, taxes and earnings in the different member countries. It could also encourage the "cross-fertilization" of best practices in areas such as labor markets, education and training, job creation incentives and effective welfare safety nets.
The Stockholm European Council confirmed the overall objective of structural reform and even added key areas, such as the consequences of aging and the role of biotechnology for coordination with a view to enhancing Europe's growth potential.
All European countries must resolutely pursue the structural reforms they have begun. A lot has already been done, particularly in implementing the single market. Unemployment, however, is still unacceptably high, although the jobless rate has declined significantly in most economies over the past three years.
According to a number of authoritative official studies, around 75 percent of euro-area unemployment appears to be structural, or due to an environment that hampers job creation.
Economic and monetary union certainly stimulates structural reform in the labor market. With increased capital mobility and a smoothly functioning single market, companies will become more and more sensitive to the competitive environment in choosing locations in the euro area.
A strong emphasis will continue to be placed on competitiveness. Before the euro, economic policy managers constantly monitored the balance of payments and the foreign-exchange and interest-rate markets as key indicators of national economic performance.
With a single currency, however, a loss of competitiveness will not show up quickly on these traditional radar screens. As a result, economic managers have to be even more vigilant in monitoring competitiveness indicators, especially unit production costs and the tax and regulatory framework. From now on, the sanctions for economic policy errors will come more slowly and insidiously via rising unemployment and weak growth.
The close multilateral surveillance provided for in the Eurogroup (the 12 Ministers of Finance of the euro area together with European Commission and ECB representatives) should enable us to monitor competitiveness trends in each individual economy, as well as throughout the area, and to suggest appropriate corrections where necessary.
European central bankers are sometimes portrayed as excessively cautious with regard to economic growth. On the contrary, they are very much in favor of growth, because the objective of monetary policy, price stability, paves the way for robust and sustainable growth over the medium and long term.
There are three main channels through which price stability encourages growth. First, it keeps the productive sector competitive by moderating wage increases and holding down unit production costs.
Second, it makes investors more confident that their savings will hold their value in the long run, which helps to keep down low-, medium- and long-term interest rates.
Third, it fosters domestic demand by preserving the purchasing power of households through low inflation. This last contribution to growth is particularly important at present in the euro area.
By boosting the confidence of Europeans in the ability of the Eurosystem to deliver price stability, we preserve consumer confidence, and thus contribute to maintaining and reinforcing consumer demand.
The Eurosystem contributes to sustainable, non-inflationary medium-term growth not only through central bank monetary policy aiming at price stability but also via its other recommendations.
The kind of steady growth that could reduce unemployment to its minimum level will be achieved more easily if Europe resolutely adopts an open mind toward the "factors of production" - labor, investment and technical progress - that are the wellspring of growth.
For some time, persistent high unemployment, the structural causes of which were not well understood, led Europe to adopt Malthusian attitudes. There was wariness toward technical progress and productivity-enhancing investment, which were seen as threats to jobs. Efforts were made to bring down unemployment by reducing the available work force.
Fortunately, a profound change in perspective is underway in Europe, and we are discarding these attitudes. This change has been prompted notably by the new information and communication technologies, by a growing consensus on the need to augment the growth potential of the European economy through structural reforms, and by the realization that the emergence of pre-inflationary bottlenecks could be an obstacle to sustainable, non-inflationary growth.
There is a growing consensus that, in order to consolidate this change in attitude, we should adopt a threefold strategy. We should:
Invest actively and loosen capital constraints. Productivity and capacity investments are essential at a time when capacity utilization rates are at historic highs, and many companies are experiencing production bottlenecks.
Ease labor constraints and improve the functioning of labor markets. The aim of increasing Europe's employment rate to 70 percent in 10 years' time, from 61 percent today, adopted by the European Council in Lisbon, is particularly timely. It marks a conceptual turning point;
Actively seek productivity improvements, which lie at the heart of economic growth, by embracing technical progress, the digital revolution, the new information and communication technologies, biotechnology and material sciences.
his openness to technical progress and rapid productivity enhancement, which was very much in evidence at the European Council meetings in Lisbon and Stockholm, is one of the keys to maintaining low inflation and robust and sustainable growth.
I also believe that the ECB, through its interest rate policy, is bringing about a very important contribution to the growth of domestic demand in Europe by fostering consumer confidence and ensuring credible medium-term price stability.