European Monetary System and European Currency
Based onselected papers kindly provided by the European Central Bank
Compiledby Dm. Evstafiev
for thestudents of the School of Political Science
at St.Petersburg State University
St.Petersburg
1999
Developmentsin the Financial Sector in Europe
following the Introductionof the Euro
Speech by Dr. Willem F.Duisenberg,
President of the EuropeanCentral Bank,
to be delivered at theThird European Financial Markets Convention
Milan, 3 June 1999
1. Introduction
The period of the five monthsfollowing the introduction of the euro has been very rich in new events, withsignificant developments taking place both in the continental securitiesmarkets and in the financial system as a whole. Although experience has beengathered over a relatively short period of time, I am tempted to make twoobservations of a fundamental nature.
The first observation is thatdevelopments following the introduction of the euro do not imply that the euroarea is set to become a financial fortress whose financial markets andinstitutions would be cut off from the rest of the world. In fact, marketparticipants residing outside the euro area seem to be taking a keen interestin the financial markets of the euro area. «Core Europe», so tospeak, has become more interesting to outsiders as the breadth and liquidity ofits financial markets has increased.
The second observation is that theeuro can be expected to have a significant influence on the structure of thefinancial system by bringing about more securitisation. A traditional featureof the financial system of continental Europe has been a marked dependency onthe funds intermediated by banks. This feature contrasts with the financialsystem of the United States which is much more securitised. For instance,corporate bonds have not been very widely issued in the euro area, and stockmarket capitalisation — relative to the size of the economy — is much lower inthe euro area than in the United States. There are good reasons to believe thata process of securitisation will gather pace in the euro area now that thesingle currency is in use. This view seems to be shared by many observers and Ishall, in the course of my remarks, provide some arguments in its favour.
In my remarks today, I should like todiscuss the structural changes in the financial sector, in particular thosethat have occurred as a result of the launch of new product types and thechanging nature of public and private institutions. I shall addressdevelopments in the money markets, the bond markets and the equity markets aswell as the process of adaptation of banking institutions to their newenvironment.
2. Money markets
The money markets of the euro areabecame rapidly integrated after the introduction of the euro despite the factthat their structures had previously been quite different at the nationallevel. Transaction volumes and measures of bid-ask spreads on the various moneymarket instruments both indicate that the markets reached a very high level ofliquidity very rapidly in the course of January 1999 and have subsequentlyretained it.
The high degree of integration of theeuro area money markets is, first of all, a result of the single monetarypolicy, which is conducted through the harmonised operational framework of theEurosystem. This integration has also been made possible by the significant andincreasing integration of payment systems. Cross-border payments processed byTARGET accounted for more than 37% of the value of all real-time payments(domestic and cross-border) effected by credit institutions in March and April1999. Moreover, the continuously high use which our counterparties make of thecorrespondent central banking model (or CCBM) for the cross-border transfer ofcollateral in monetary policy operations is an important indication ofarea-wide integration. This is evidenced by the fact that cross-bordercollateral currently represents around 25% of the total amount of collateral incustody in the context of the Eurosystem's monetary policy operations.
Taking a closer look at the variousinstruments traded in the money markets, a feature that is worthy of note isthat market participants in the 11 countries of the euro area have shown anincreasing tendency to demonstrate a similar reliance on each instrument type.For example, what we call «overnight indexed swaps», which are swapsindexed on the overnight reference interest rate EONIA, have become animportant derivative instrument in the money markets of the euro area. This canbe seen from the low level of quoted bid-ask spreads and the high turnoverrelative to other major international markets. Both indicators show a highlevel of liquidity in this instrument. Another type of instrument of interestin the money market (but also at the fringe of the bond market) is that of therepurchase agreement. The development of more integrated repo markets in theeuro area will obviously accompany the development of area-wide securitiestrading, settlement and custody systems. This will reduce transaction costs andimprove efficiency for the cross-border transfer of securities throughrepurchase operations.
Looking ahead, other developments inthe money markets are expected in the coming months. There are aims toestablish new area-wide standards for the repo markets, with a view toovercoming the separation between different models in the national markets.These new standards could obviously co-exist with other standards and broaderconventions for international transactions. In fact, over the last few monthsthe European Central Bank (ECB) has been examining whether this co-existencecould affect the integration of money markets. We have come to the conclusionthat, in particular owing to the efforts of the sponsors of the differentstandards, this should not be considered a threat.
Finally, it should also be noted thatnational and international central securities depositories are currentlydeveloping links with one another, which will enable participants in onecountry to make direct use of securities deposited in other countries.Twenty-six of these links (concerning mainly Belgium, Germany, France,Luxembourg, the Netherlands, Austria and Finland) may be used by theEurosystem.
3. Bond markets
I should now like to turn to bondmarkets and first to comment on the position of euro area bond markets in theglobal market. Some data sources on international securities issuance availableso far show a pattern of increased reliance on euro-denominated bonds at thebeginning of 1999, in particular as opposed to US dollar-denominated bonds.While it remains difficult to draw firm conclusions on the determinants of bonddenomination choices without considering information on the nature of bondholdings and trading patterns, recent bond issuance volumes indicate that theeuro has the potential to become an important currency for international bondissuance.
The importance of the euro area bondmarket is also apparent in measures of secondary market activity, i.e. turnoveror trading volumes. In particular, trading volumes on exchange-traded bondfutures are indicative of the overall degree of market activity. Volumes tradedin euro-denominated bond futures were low shortly before the changeover to theeuro, when the bond markets in the euro area were exceptionally quiet. Sincethen, volumes have increased markedly and they currently stand at consistentlyhigh levels, which indicates a continuously high degree of turnover ineuro-denominated bond markets in general.
Turning to the internal structure ofthe bond markets of the euro area, I should like to make an initial observationrelated to the recent marked increase in euro-denominated corporate bondissuance, which was accompanied by an increase in the average size of issues.This tendency is likely to continue in the future, in particular to the extentthat bonds may be used by firms to finance increasing mergers and acquisitionsactivity in the euro area. The underlying reasons for increased bond issuanceby euro area firms are clear, both on the supply and on the demand side. On thesupply side, large firms with good credit ratings will find opportunities inthe increased depth and liquidity of the euro area bond market. On the demandside, the respect by governments of the parameters of the Stability and GrowthPact over the medium term should leave more room for the private sector toissue debt securities. In addition, the euro area must be in a position to savein order to be able to take care of its future pension payments, and a part ofthese savings is likely to be invested in corporate debt securities. Anincrease in global demand for euro-denominated debt securities is also expectedas the euro becomes a major reserve currency. Moreover, the demand for higherrisk euro-denominated debt securities is likely to increase, particularly asthe current low level of sovereign yields increases incentives to search forhigher yields.
With regard to the government bondmarkets, an issue of importance for the euro area that I should like to stressis the fact that governments now find themselves in a rather new position asissuers. This reflects a number of developments, two of which I shouldparticularly like to mention. First, the major public issuers have attempted toposition themselves as providers of benchmarks for euro-denominated bondmarkets. Second, certain issues of government bonds have effectively gainedlarger portions of secondary markets, in particular in relation to developmentsthat have occurred on bond futures markets.
Market participants have responded tothese developments in the bond markets with a range of concurring or competinginitiatives and alliances. In the derivatives industry, market participantshave established new alliances. On the trading side, electronic cross-borderplatforms for bonds have been created or are in the process of being developed.On the clearing side, integrated platforms for different markets have beenlaunched or are being finalised, while, finally, on the securities settlementside, initiatives have also been launched. It is important to note that whilesome of these developments are internal to the euro area, others aim atcreating links with financial markets outside the euro area. One may reasonablyexpect that all of these new circuits, as well as others, may in the future beenlarged to encompass a growing number of market participants.
4. Equity markets
Turning to equity markets, structuraldevelopments of most interest relate to the infrastructure of stock exchangeson the one hand and equity derivative exchanges on the other. First, within theeuro area, equity investment and trading activities appear to be less and lessinfluenced by country-specific factors and increasingly subject to area-wideconsiderations. Consistent with this development, area-wide equity indices havebeen developing. Market participants are showing considerable interest in thesearea-wide indices, in particular as they are also now adopting investmentpositions on area-wide industrial sectors, using the sub-indices made availablefor that purpose. An indication of the degree of interest raised by area-wideindices is the relatively fierce competition for benchmark status that hasdeveloped between the various proponents of area-wide indices.
Second, market developments inrelation to stock index futures and options will reflect the rise of area-wideindices. This may in turn lead to either consolidation or productspecialisation of equity derivative exchanges. For my part, I consider thedevelopment of fair competition between exchanges to be a positive factor interms of the improvement of the range of products and services available to thefinancial industry.
Third, in the equity market the eurohas also provided a powerful incentive for the creation of new — and possiblycompeting — alliances among exchanges. Before the launch of the singlecurrency, circuits had been created for the launch of integrated «newmarkets» within and beyond the euro area, encompassing the shares of smalland medium-sized companies with a high potential for growth. The development inthe integration of exchanges has also continued more recently, and, as youknow, it has not been limited to the euro area.
5. Banking
In the field of banking, thesecuritisation trend appears to demand strategic and organisational adjustmenton the part of banks. The relative importance of the more traditional types ofbanking activity can be seen to be decreasing, even though it should bementioned that traditional banking activities have nonetheless continued togrow at a rate exceeding that of growth of nominal GDP. In the euro area,growth in recent years has been much more rapid in assets under the managementof mutual funds and other institutional investors than in the assets of banks.This reflects a tendency towards decreasing the relative weight of bankdeposits compared with securities in financial wealth.
The euro area banking industry hasreacted to this development already by diversifying into the asset managementarea. Banking groups have been able to «internalise» a significantpart of the securitisation tendency as they control a large majority of themutual funds. As a result of the securitisation trend, there has been anincrease in the share of security holdings among bank assets, and an increasein the share of capital gains — although those are quite cyclically sensitive — as well as in fee income stemming from asset management services. Meanwhile,the relative importance of interest income has declined correspondingly. At thebank level, dividend income from equity participations has generally becomemuch more important, indicating an increase in the importance of the profitgenerated by non-bank subsidiaries.
Beside the establishment of non-banksubsidiaries, there have been other strategic and organisational changes thathave resulted in banks strengthening their securities-related activities. Inparticular, significant motives behind the recent merger trend seem to includethe desire to increase bank size and hence to be able to operate efficiently inwholesale securities markets as well as to be able to cater for the needs oflarge international corporations for investment banking services.
The trend towards securitisation canbe regarded as one of the reasons for the structural changes in the bankingsystem that appears to have accelerated recently. There have naturally alsobeen other reasons why banks have sought to merge, predominantly the need tocut capacity and to reduce costs. These cost-driven mergers have taken placeprimarily among smaller banks.
6. Conclusion
In my remarks today, I have referredto a number of changes and market initiatives in the euro area financiallandscape. These developments point to the increasing importance of the fixedincome and equity markets that many expected in Stage Three of Economic andMonetary Union (EMU), providing new opportunities for borrowers and investorsand causing pressure to adjust for financial institutions. In this respect, Ishould like to mention the importance of removing the remaining regulatorybarriers to the further development of the securities markets. To this end, theEuropean Commission has recently published an Action Plan of regulatory changesto improve the single market for financial services that would certainly — whenimplemented — boost the integration and market-driven development of theEuropean securities markets.
Finally, I should like to concludewith some remarks about the role of the Eurosystem (the term that we use tomean the ECB and the 11 national central banks of the Member Statesparticipating in Stage Three of EMU) in the developments in the financialsector in Europe. First of all, the Eurosystem contributes to developments inthe financial sector by providing it with a stable and credible monetarypolicy. With a strong and credible commitment to its primary objective, pricestability, the Eurosystem has created a situation in which the financial sectorcan concentrate on those issues that are of the greatest relevance to itsactivities.
The Eurosystem does not play a directrole in structural developments in the financial sector. With its singlemonetary policy framework and TARGET in particular, the Eurosystem has createdan infrastructure that has proved to be useful for the establishment of anintegrated money market in the euro area.
In addition, the Eurosystem carefullymonitors structural developments in the financial sector to the extent thatthey might have an impact on the conduct of monetary policy. To make a finalpoint, in observing developments in the financial sector, the Eurosystemconstantly takes account of the fact that one of its tasks, laid down in theTreaty establishing the European Community, is to «contribute to the smoothconduct of policies pursued by the competent authorities relating to (…) thestability of the financial system» [(Article 105 (5))]. Analysis of thecommon developments in the European financial system represents such acontribution.
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Economic and Monetary Unionin Europe — the challenges ahead
Speech by Professor Dr.L.H. Hoogduin,
on behalf of Dr. Willem F.Duisenberg,
President of the EuropeanCentral Bank,
at the symposium sponsoredby the Federal Reserve Bank of Kansas City
on «New challenges formonetary policy»
on 27 August 1999 inJackson Hole, Wyoming
Fromthe European perspective, the title of this year's Jackson Hole symposium — «new challenges for monetary policy» — is particularly appropriate.Economic and Monetary Union (EMU) in Europe is a unique project and itsconsummation with the introduction of the single monetary policy on 1 January1999 took place less than eight months ago. Today, given the time available, Iwill not endeavour to review all the challenges which are raised by EMUcomprehensively. I shall have to be selective, largely focusing on the primaryobjective of the Eurosystem, which is to maintain price stability in the euroarea. In this context, let me briefly explain our terminology, which mayperhaps not be known to everybody as yet. The «Eurosystem» is thename we gave to the European Central Bank (ECB) and the currently elevennational central banks of those countries which have introduced the euro. The«euro area» comprises these eleven countries.
Ishould like to start with some observations on the objective and limitations ofmonetary policy in the euro area. Owing to the successful process ofdisinflation and convergence within Europe over the past decade, the launch ofthe euro last January took place in an environment of price stability that fewobservers would have predicted only a few years ago. Consumers and firms arealready reaping the benefits of this environment. The relative price signals onwhich the efficiency of the market mechanism relies are not obscured byvolatility in the general level of prices. By avoiding the costs anddistortions inflation would impose on the economy, price stability iscontributing to the growth and employment potential of the euro area.
Thiscontribution is substantial. Unfortunately, it is all too easily taken forgranted. Memories of the still recent past relating to the consequences of highand unstable inflation tend to fade rapidly. We are sometimes already hearingthe argument that, given that price stability has been achieved, monetarypolicy should now be re-oriented away from its primary objective of pricestability towards other goals. One of the challenges facing the Eurosystem isto maintain the support of the broad public constituency necessary to resistthese calls, which — as I hardly need to point out to such a distinguishedaudience of central bankers and monetary economists — are misguided andultimately counter-productive. However, it can be said that the situation isthe same as that in the world of sports; winning a championship and reachingthe top is difficult, but staying there is even harder.
Theinstitutional framework for European monetary policy, as created by the MaastrichtTreaty (i.e. the Treaty on European Union, which has become part of the Treatyestablishing the European Community, or the EC Treaty, in short) is well suitedto meeting this challenge. Most importantly, the single monetary policy hasbeen clearly assigned the primary objective of maintaining price stability inthe euro area. To facilitate the achievement of this goal, the ECB and thenational central banks have been accorded a high degree of institutionalindependence so as to protect monetary policy decisions from undue externalinterference.
TheTreaty imposes several duties and tasks on the ECB. However, there is no doubtthat the objective of price stability is over-riding. For example, the Treatystipulates — if I may quote — that the Eurosystem «without prejudice tothe objective of price stability, … shall support the general economic policiesin the Community, with a view to contributing to the achievement of theobjectives of the Community», which include «sustainable and non-inflationarygrowth» and «a high level of employment».
Giventhe clear priority attached to the primary objective of price stability, howdoes the ECB address these other Treaty obligations? Let me make three pointsin this regard.
First,among economists and central bankers, there is overwhelming agreement thatthere is no long-run trade-off between real activity and inflation. Attemptingto use monetary policy to raise real economic activity above its sustainablelevel will, in the end, simply lead to ever higher inflation, but not to fastereconomic growth. I am convinced that the best contribution monetary policy canmake to sustainable growth and employment in the euro area is to maintain pricestability in a credible and lasting manner, allowing the considerable benefitsof price stability to be reaped over the medium term. This is the economicrationale underlying the EC Treaty and the Eurosystem's monetary policystrategy.
Second,it is generally acknowledged that monetary policy does affect real activity inthe short run. Although the focus must always be on price stability, in manycases the policy action required to maintain price stability will also helpsustain short-run economic and employment prospects. The reduction of theEurosystem's main refinancing rate on 8 April was a case in point. Followingthe Asian and Russian financial crises last year, global demand weakened.Weaker external demand led to a shift in the balance of risks to pricestability in the euro area towards the downside, as demand pressures abated. Asmonetary indicators did not signal inflationary risks at that time, theGoverning Council of the ECB concluded that a cut of 50 basis points in themain refinancing rate best served the maintenance of price stability. Thislower level of interest rates may also be supportive of real activity andemployment in the short-run. Our eyes must always be firmly focused on thegoal, on our goal, to maintain price stability in the medium term. Our monetarypolicy does not explicitly aim at influencing the business cycle. However, assaid in many cases, the necessary monetary policy measures to achieve our goalalso tend, almost automatically, to work in the right direction from a cyclicalpoint of view.
Thisleads me to my third point. In situations where monetary policy might face ashort-term trade-off between adverse developments in real activity anddeviations from price stability, the over-riding priority accorded tocountering the latter must be made absolutely clear. Any ambiguity on this pointwill simply endanger the credibility, and therefore the effectiveness, of themonetary policy response. This does not mean that the policy action must bedraconian. The medium-term orientation of the Eurosystem's monetary policystrategy permits a gradualist and measured response to previously unforeseenthreats to price stability, should this be regarded as appropriate, dependingon the nature of the threat. Such gradualism may help to avoid the introductionof unnecessary uncertainty into the real economy.
Recognitionand an understanding of these three central points are essential for theimplementation of a successful monetary policy. Communicating both theobjective and the limitations of monetary policy to the public is a vital issueto which I will return later in my remarks. But it would be remiss at thispoint if I did not address what is surely the greatest economic challengefacing the euro area at present, namely the unacceptably high level ofunemployment. There is a broad consensus that unemployment in the euro area isoverwhelmingly structural in nature. Monetary policy cannot solve this problem.National governments bear the main responsibility for structural economicreforms. In particular, further reforms of the tax and welfare systems arerequired in many EU countries in order to increase the incentives to create newjobs and to accept them. Wage moderation can also have a significant beneficialimpact. Monetary policy makes its best supportive contribution by providing theenvironment of price stability in which structural reforms can work mosteffectively.
Itshould be recognised that the implementation of EMU has made it even moreurgent to improve the flexibility of labour and goods markets. In this context,it would very likely be the wrong answer if governments were to try to create a«social union», harmonising social security systems and standards ata very high level. The ECB will continue to cajole governments intoimplementing necessary and long overdue reforms, but the final hard decisions — and I acknowledge that they are hard decisions, since the considerable benefitsof structural reform often only become apparent with time — lie with thenational authorities. In those countries where appropriate structural reformshave been implemented and wage growth has been moderate, unemployment is eitherlow by euro area standards or is falling more rapidly. These experiences offerimportant lessons for other countries in the euro area. Fortunately, a broaderawareness of the necessity of structural reforms recently seems to be emergingin Europe. Of course, ultimately only sustained action will count. The cyclicalrecovery that is underway is no substitute for such action.
Thusfar, I have largely discussed the goal of the single monetary policy. How isthis goal to be achieved? At the heart of the answer to this question is theEurosystem's monetary policy strategy. The strategy has two closely relatedaspects. First, the strategy must structure the monetary policy-making processin such a way that the Governing Council of the ECB is presented with theinformation and analysis required to take appropriate monetary policydecisions. Second, the strategy must ensure that policy decisions, includingthe economic rationale on which they are based, can be presented in a clear andcoherent way to the public. The communication policy as part of the strategyobviously has to be consistent with the structure of the internaldecision-making process.
Indesigning the Eurosystem's strategy, the Governing Council of the ECBrecognised the new circumstances faced by monetary policy in the euro area.Where there were previously eleven open, generally small economies, there isnow one large, relatively closed single currency area. The challenges impliedby this transformation in the landscape of monetary policy are profound.
Relativelylittle is known as yet about the transmission mechanism of monetary policy inthe euro area after the transition to Monetary Union. One important challengefor the Eurosystem is to obtain a better knowledge of the structure andfunctioning of the euro area economy and the transmission mechanism of monetarypolicy within it, so that policy actions can be implemented accordingly.Together with experts in the national central banks, the ECB has embarked on anintensive programme of analysis and research into these issues.
Oneobvious problem related to the fact that the euro area did not exist as asingle currency area in the past regards the availability of statistical data.Compared with national central banks, we do not have the same amount of longhistorical time series of monetary and economic indicators, based on harmonisedstatistical concepts, at our disposal. However, we have already developed quitereliable estimates for a number of these historical series, and the quality andavailability of current statistics on the euro area has increased significantlyover the last few quarters, for example in the areas of money and banking andbalance of payments statistics, but also across a wide range of economicstatistics. This process of improving the quality and the availability ofstatistical data covering the euro area will continue.
Itwould have clearly been unwise for the ECB to develop a strategy which reliesmechanically on the signals offered by a single indicator or forecast in orderto take monetary policy decisions. Indeed, such a simplistic approach tomonetary policy-making is unwise in all circumstances. Our knowledge of thestructure of the euro area economy and the indicator properties of specificvariables — although improving rapidly — is simply too limited.
Theprimary objective of monetary policy has been quantified with the publicationof a definition of price stability, against which the Eurosystem can be heldaccountable. This definition illustrates our aversion to both inflation anddeflation, since it defines price stability as annual increases of below 2% inthe Harmonised Index of Consumer Prices (HICP) for the euro area. To maintainprice stability according to this definition, monetary developments are closelymonitored against a quantitative reference value for the broad benchmarkaggregate, M3. In parallel, a broadly based assessment of the outlook for pricedevelopments in the euro area is undertaken. This assessment encompasses a widerange of indicator variables, including inflation projections produced bothinside and outside the Eurosystem. Using all this information, the GoverningCouncil comes to a decision on the level of short-term interest rates that bestserves the maintenance of price stability over the medium term.
Onthe basis of this strategy, I am confident that the Governing Council has taken- and will continue to take — appropriate monetary policy decisions. Theeffectiveness of these policy decisions will depend, in large part, on thecredibility of the single monetary policy. Transparent and accountablepolicy-making can help to build up a reputation and, hence credibility.Transparency and accountability, in turn, rely on clear and effectivecommunications between the Eurosystem and the public.
Inthis regard, the Eurosystem faces an especially formidable task. As mentionedearlier, the euro area currently consists of eleven different sovereignnations, each with its own distinct monetary history and heritage. With eachpolicy announcement or Monthly Bulletin, the Eurosystem must thus communicatewith the public of eleven different countries and must speak in all elevendifferent official languages of the European Union. Such a situation isunprecedented. This diversity of language, history and culture across the euroarea raises further challenges for the ECB.
Overthe years, each national central bank had developed its own strategy and,linked to this, its own «monetary policy language» for communicatingwith the public in the nation it served. This language reflected the uniquecircumstances of the country in question. The process by which the publiclearnt this monetary language from the statements and behaviour of the nationalcentral bank was largely subconscious. Over time, the strategies and therelated language and conventions of monetary policy came to be so wellunderstood as to be almost second nature. In these circumstances, privateeconomic behaviour was shaped by the monetary policy environment.
Manyof us have experienced the problem of trying to learn a second language inadult life. This rarely comes as easily as learning your native tongue as achild. It is certainly not a subconscious process, but rather one that requireseffort and perseverance. It is often difficult to overcome the habits andconventions of one's first language, which are inevitably somewhat at odds withthose of a foreign tongue. Of course, it is easier to learn a language that sharescommon roots with one's own. Nevertheless, to obtain any degree of fluency,there is no alternative to long hours practising pronunciation, studyinggrammar and learning vocabulary. Even then, the idioms and slang of the newlanguage are sometimes hard to follow. There are no easy short cuts.
Withthe adoption of the euro last January, the public, financial markets andpolicy-makers in the euro area have all had to get used to a new monetarypolicy environment and have, thus, had to learn a new «monetary policylanguage». The Eurosystem's monetary policy strategy has been designed, inpart, to make this learning process as straightforward as possible. Continuitywith the successful strategies of the national central banks prior to MonetaryUnion was one of the guiding principles governing the selection of the monetarypolicy strategy. Nevertheless, given the changed environment for monetarypolicy, a new strategy with a new vocabulary had to be developed, reflectingthe unique and novel circumstances facing the Eurosystem.
Somecommentators have suggested that the Eurosystem simply adopt the strategy usedby another central bank or by a national central bank in the past. Tellingly,such observers often suggest the strategy they know best: Americans suggestusing the Federal Reserve as a model; Britons, the Bank of England; Germans,the Bundesbank. However, the Eurosystem cannot simply adopt a strategy designedby another central bank for a different currency area under different economiccircumstances. A strategy that might have been suitable in one situation may bequite inappropriate for the unique and novel circumstances facing theEurosystem, given the very different economic structure and environmentconfronting it.
Akey feature of the ECB's communication policy is the monthly press conferencegiven by the ECB's Vice-President and myself, usually immediately following thefirst Governing Council meeting of each month. During these press conferences,I make an introductory statement summarising the Council's discussions andconclusions before answering questions from journalists. As the statement isagreed, in substance, with all the Council members beforehand it is similar towhat others call minutes. The press conference provides prompt information inan even-handed way, and it offers the opportunity for immediate two-waycommunication. As far as I am aware, no other central bank communicates withthe public in such a prompt manner immediately after its monetary policymeetings.
Thesepress conferences are a tangible expression of the Eurosystem's commitment tobe open, transparent and accountable in its conduct of monetary policy. In myview, our commitment to openness should not be in doubt. However, ensuring thatthis openness translates into effective communications continues to be achallenge. Journalists, financial markets and the public are still learning thenew strategy and language of monetary policy in the euro area.
Byits nature, the challenge of improving communications between the Eurosystemand the public is two-sided. On the one hand, the ECB must use a clear andtransparent language consistent with the strategy it has adopted. It must helpthe public understand the changes of emphasis and communication necessitated bythe new monetary policy environment in Europe. We have made important progressin this regard over the last eight months, but I acknowledge that we still havesome way to go. The ECB must do its utmost to be understood by its counterpartsin the media that act as important intermediaries to the public at large. Bylearning from one another, we can improve the transparency, democraticaccountability and effectiveness of the single monetary policy.
Beforeconcluding, I should like to add a brief comment on the likely futureenlargement of the European Union (EU) and, prospectively, the euro area.Currently, the EU negotiates the accession of six countries to the EU. Once theaccession of new Member States is decided, these countries have to fulfil theso-called convergence criteria, if they want to join the euro area. The euroarea can finally only be enlarged if the European Council, following anassessment by the ECB and the European Commission, decides that further MemberStates of the EU are ready to adopt the single currency. New countries joiningthe euro area will be a challenge for us. For example, we will have tointegrate the respective economy fully in our area-wide analysis of monetary,financial and other economic developments in the euro area. Enlargement is achallenge we clearly welcome. I have no doubts that we can master it, not leastas the EC Treaty outlines a clear and transparent procedure for countrieswishing to join the euro area. In simple terms, this can be viewed as involvingthree phases. First, a candidate country must join the European Union, forwhich certain requirements must be met. Second, the candidate is expected tojoin the new exchange rate mechanism, ERM II. Third, as mentioned earlier, thecountry must fulfil the convergence criteria. In addition to fiscal disciplineand inflation control, these criteria include a relatively low level oflong-term interest rates and stable exchange rates.
Letme conclude. Monetary policy cannot solve all of the economic challenges facingthe euro area, in particular those concerning the urgent need to reduce thehigh level of structural unemployment. National governments are responsible forcarrying out the required structural reforms. The Eurosystem makes its bestcontribution to area-wide growth and employment prospects by credibly focusingon the maintenance of price stability in the euro area.
Iam confident that the monetary policy strategy adopted by the Governing Councilof the ECB last October has been successful — and the monetary policy decisionsthat have been based on it over the last eight months — serve the fulfilment ofthis objective. Nevertheless, we will not become complacent; on the contrary,we will have to continue to invest substantially in analysing the structure ofthe euro area economy, and in understanding the monetary policy transmissionmechanism and the information content of the various monetary and economicindicators.
Monetarypolicy is most effective when it is credible. Transparent and accountablepolicy-making can help to build up a reputation and credibility. Effectivedirect communications with the public, including the financial markets, otherpolicy makers and the media requires that we speak with one voice in aneven-handed way with our diverse counterparties and audience. Successfullyrefining our area-wide communications, aimed at making our strategy, and themonetary policy based on it, transparent so that it can be well understood bythe large and varied population we serve, is one of the challenges faced by theEurosystem and, by implication, one of our priorities.
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EMU AND BANKING SUPERVISION
Lecture by TommasoPadoa-Schioppa
Member of the ExecutiveBoard of the European Central Bank
at the London School ofEconomics, Financial Markets Group
on 24 February 1999
TABLE OF CONTENTS
I. Introduction
II.Institutional framework
III. Industryscenario
IV. Currentsupervision
V. Crisismanagement
VI. Conclusion
Tables
I.INTRODUCTION
1.I am speaking here, at the London School of Economics, only a few weeks afterone of the most remarkable events in the history of monetary systems: theestablishment of a single currency and a single central banking competence fora group of countries which retain their sovereignty in many of the key fieldswhere the State exerts its power. To mint or print the currency, to manage itand to provide the ultimate foundation of the public's confidence in it hasbeen, from the earliest times, a key prerogative of the sovereign.«Sovereign» is indeed the name that was given in the past to onecurrency. And a British Prime Minister not so long ago explained her oppositionto the idea of the single currency with the desire to preserve the image of theQueen on the banknotes.
2.For centuries money has had two anchors: a commodity, usually gold; and thesovereign, i.e. the political power. Less than 30 years after the last bond togold was severed (August 1971), the second anchor has also now been abandoned.Although I personally think that political union in Europe is desirable, I amaware that the present situation, in which the area of the single currency isnot a politically united one, is likely to persist for a number of years. Thismeans that we have given rise to an entirely new type of monetary order. Forthe people, the success of this move will ultimately depend on the ability ofgovernments and political forces to build a political union. For the centralbanker and for the users of the new currency, the success will be measured bythe quality of the currency itself, and such quality will be measured in thefirst place in terms of price stability. This is not only a requirementexplicitly set by the Treaty of Maastricht, it is also, in the opinion of most,the «new anchor» that purely fiduciary currencies need after the goldanchor is abandoned.
3.My remarks, however, will focus on another, less fundamental but stillimportant novelty of the monetary constitution that has just come intoexistence. It is the novelty of the abandonment of the coincidence between thearea of jurisdiction of monetary policy and the area of jurisdiction of bankingsupervision. The former embraces the 11 countries that have adopted the euro,while the latter remains national. Just as we have no precedent of anycomparable size of money disconnected from states, we have no precedent for alack of coincidence between the two public functions of managing the currencyand controlling the banks.
Inthe run-up to the euro this feature of the system was explored, and someexpressed doubts about its effectiveness. I will tonight examine the problemsof banking supervision in the euro area. The plan of my remarks is the following.I will first review the existing institutional framework for the prudentialcontrol of banks in EMU. I will then examine the likely scenario for theEuropean banking industry in the coming years. Against this institutional andindustry background, I shall then discuss the functioning of, and thechallenges for, banking supervision and central banking in the euro area, bothin normal circumstances and when a crisis occurs.
II.INSTITUTIONAL FRAMEWORK
4.The origin and developments of modern central banks are closely linked to keychanges undergone by monetary systems over the past two centuries. Such changescould, very sketchily, be summarised as follows. First, paper currencyestablished itself as a more convenient means of payment than commoditycurrencies. Second, commercial bank money (bank deposits) spread as aconvenient substitute for banknotes and coins. Third, the quantity of money wasdisconnected from the quantity of gold. Thus, a double revolution in thetechnology of the payment system, the advent of banknotes and that of chequesor giros, has shaped the functions that most central banks performed over thiscentury: monetary policy and prudential supervision. Man-made money mademonetary policy possible. The fact that a large, now a predominant, componentof the money stock was in the form of commercial bank money made bankingsupervision necessary.
Ensuringconfidence in the paper currency and, later, in the stability of therelationship, one could say the exchange rate, between central bank andcommercial bank money, were twin public functions, and, in general, they wereentrusted to the same institution. Just as money has three well-known economicfunctions — means of payment, unit of account and store of value — so there arethree public functions related to each of them. Operating and supervising thepayment system refers to money as a means of payment; ensuring price stabilityrelates to money as a unit of account and a store of value; and pursuing thestability of banks relates to money as a means of payment and a store of value.In each of the three functions commercial banks have played, and still largelyplay, a crucial role.
Inan increasing number of countries the original triadic task entrusted to thecentral bank has now been abandoned in favour of a «separationapproach», according to which banking supervision has been assigned to aseparate institution. Following the recent adoption by the United Kingdom andLuxembourg of the separation approach, only two of the 12 countries representedin the Basle Committee on Banking Supervision (Italy and the Netherlands) havethe central bank as the only authority responsible for banking supervision. Inall systems, however, whether or not it has the task of supervising the banks,the central bank is deeply involved with the banking system precisely becausethe banks are primary creators of money, providers of payment services,managers of the stock of savings and counterparties of central bank operations.No central bank can ignore the need to have a concrete and direct knowledge of«its» banking system, i.e. the banking system that operates in thearea of its monetary jurisdiction.
Personally,I have an intellectual attachment to, as well as a professional inclinationfor, the central bank approach to banking supervision, due partly to the factthat I spent most of my professional life in a central bank which is also tothis day the banking supervisor. Yet I can see, I think, the arguments thathave led a growing number of industrialised countries to prefer the separationapproach. Such arguments basically point to the potential conflict betweencontrolling money creation for the purpose of price stability and for thepurpose of bank stability. On the whole, I do not think that one model is rightand the other wrong. Both can function, and do function, effectively; ifinappropriately managed, both may fail to satisfy the public interest for whichbanks are supervised.
5.Against this background, let me now describe the institutional frameworkcurrently adopted by the Treaty. As my description will refer to the area inwhich both the single market and the single currency are established, it willnot specially focus on the problems of the so-called «pre-in»countries, including the United Kingdom.
Thecurrent institutional framework of EMU (i.e. the single market plus the singlecurrency) is a construct composed of two building blocks: national competenceand co-operation. Let me first briefly review the main aspects of these twobuilding blocks and then see how the Eurosystem relates to them.
First,national competence. In a market based on the minimum harmonisation and themutual recognition of national regulatory standards and practices, theprinciple of «home country control» applies. According to thisprinciple every bank has the right to do business in the whole area using asingle licence, under the supervision, and following the rules, of theauthority that has issued the licence. The full supervisory responsibility thusbelongs to the «home country». This allows, inter alia, the certainidentification of the supervisor responsible for each institution acting as acounterparty to the monetary policy operations of the Eurosystem. The onlyexception to this principle — the «host country» competence for thesupervision of liquidity of foreign branches — is no longer justified now thatthe euro is in place; hence it should soon be removed.
Second,co-operation. In a highly regulated industry such as banking, a single marketthat retains a plurality of «local» (national) supervisors requiresclose co-operation among supervisors to safeguard the public good: namely,openness, competition, safety and soundness of the banking industry. EUdirectives (the 1st and 2nd Banking Directives and the so-called BCCIDirective) lay the foundations for such co-operation, but they do not containspecific provisions or institutional arrangements to this end. They limitthemselves to stating the principle of co-operation among national authoritiesand to removing obstacles to the exchange of information among them.
6.How does the Eurosystem relate to this construction? Essentially in two ways.First, the Treaty assigns to the Eurosystem the task to «contribute to thesmooth conduct of policies pursued by competent authorities relating to theprudential supervision of credit institutions and the stability of thefinancial system» (Article 105 (5)). Given the separation between monetaryand supervisory jurisdictions, this provision is clearly intended to ensure asmooth interplay between the two. Second, the Treaty gives the Eurosystem atwofold (consultative and advisory) role in the rule-making process. Accordingto Article 105 (4), the ECB must be consulted on any draft Community andnational legislation in the fields of banking supervision and financialstability; and, according to Article 25 (1) of its Statute, the ECB canprovide, on its own initiative, advice on the scope and implementation of theCommunity legislation in these fields. It should be borne in mind that centralbanks are normally involved in the process of drawing up legislation relatingto, for example, regulatory standards, safety net arrangements and supervisionsince this legislation contributes crucially to the attainment of financialstability.
7.Two observations should be made about the institutional framework justdescribed. First, such an arrangement establishes a double separation betweencentral banking and banking supervision: not only a geographical, but also afunctional one. This is the case because for the euro area as a whole bankingsupervision is now entrusted to institutions that have no independent monetarypolicy functions. The separation approach that was chosen for EMU haseffectively been applied not only to the euro area as a whole, but to itscomponents as well. Indeed, even in countries where the competent authority forbanking supervision is the central bank, by definition this authority is,functionally speaking, no longer a central bank, as it lacks the key centralbanking task of autonomously controlling money creation.
Thesecond observation is that the Treaty itself establishes (in Article 105 (6)) asimplified procedure that makes it possible, without amending the Treaty, toentrust specific supervisory tasks to the ECB. If such a provision were to beactivated, both the geographical and the functional separation would beabandoned at once. The fact that the Maastricht Treaty allows the presentinstitutional framework to be reconsidered without recourse to the very heavyamendment procedure (remember that such procedure requires an intergovernmentalconference, ratification by national parliaments, sometimes even a nationalreferendum) is a highly significant indication that the drafters of the Treatyclearly understood the anomaly of the double separation and saw the potentialdifficulties arising from it. The simplified procedure they established couldbe interpreted as a «last resort clause», which might becomenecessary if the interaction between the Eurosystem and national supervisoryauthorities turned out not to work effectively.
III.INDUSTRY SCENARIO
8.When evaluating the functioning of, and the challenges to, banking supervisionin the current institutional framework, two aspects should be borne in mind.First, the advent of the euro increases the likelihood of the propagation offinancial stability problems across national borders. For this reason aco-ordinated supervisory response is important at an early stage. Second, thesources of banks' risks and stability problems depend on ongoing trends thatare not necessarily caused by the euro, but may be significantly accelerated byit. On the whole, we are interested not so much in the effects of EMU or theeuro per se, as in the foreseeable developments due to all factors influencingbanking in the years to come.
9.It should be noted at the outset that most banking activity, particularly inretail banking, remains confined to national markets. In many Member States thenumber, and the market share, of banks that operate in a truly nationwidefashion is rather small. Although banks' international operations haveincreased, credit risks are still predominantly related to domestic clients,and the repercussions of bank failures would be predominantly felt by domesticborrowers and depositors.
10.Assessing the internationalisation of euro area banks is a complex task becauseinternationalisation can take a number of forms. One is via cross-borderbranches and subsidiaries. Although large-scale entry into foreign bankingmarkets in Europe is still scarce, reflecting persisting legal, cultural andconduct-of-business barriers (less than 10% on average in terms of bankingassets in the euro area; Table 1), there are significant exceptions. The assetsof the foreign branches and subsidiaries of German and French banks account forroughly a third of the assets of their respective domestic banking systems(Table 2). The Dutch banking system is also strongly diversifiedinternationally.
Anotherway to spread banking activity beyond national borders is consolidation.Cross-border mergers or acquisitions still seem to be the exception, althoughthings have started to change. The recent wave of «offensive» and«defensive» banking consolidation has mainly developed withinnational industries, thus significantly increasing concentration, particularlyin the smaller countries (Table 3); it may be related not so much to the directimpact of EMU as to globally intensified competition and the need to increaseefficiency.
Inthe coming years internationalisation is likely to increase, because, with theeuro, foreign entrants can now fund lending from their domestic retail depositbase or from euro-denominated money and capital markets. The relatively largenumber of foreign branches and subsidiaries already established could be asufficient base for an expansion of international banking activity (Table 4)since a single branch, or a small number of branches, may be sufficient toattract customers, especially when they are served through direct bankingtechniques, such as telephone and Internet banking. Also, the cross-bordersupply of services on a remote basis is likely to spread as direct bankingtechniques develop. As to cross-border mergers and acquisitions aimed either atachieving a «critical mass» for wholesale financial markets, or atrapidly acquiring local expertise and customers in the retail sector, they mayremain scarce because the cost savings from eliminating overlaps in the retailnetwork are likely to be limited and the managerial costs of integratingdifferent structures and corporate cultures are substantial.
11.However, banks' internationalisation does not provide the full picture of theinterconnections of banking systems. As «multi-product» firms, banksoperate simultaneously in many markets which have different dimensions: local,national, continental (or European) and global. The advent of the euro islikely to enlarge the market for many banking products and services to the continentaldimension; this will «internationalise» even those banks that remain«national» in their branch networks and organisation.
Theformation of the single money market in the euro area has largely taken placealready. The dispersion in the euro overnight rate across countries, asreported by 57 so-called EONIA banks, fell in January from around 15 to 5 basispoints. The variation between banks has been significantly greater than betweencountries. The TARGET system has rapidly reached the dimension of Fedwire, witha daily average value of payments of E1,000 billion, of which between E300 andE400 are cross-border. The ever stronger interbank and payment system linksclearly increase the possibility of financial instability spreading from onecountry to another. Through these links the failure of a major bank couldaffect the standing of its counterparties in the entire euro area. On the otherhand, the deeper money market could absorb any specific problem more easilythan before.
Asregards the capital markets, the effects of the euro will take more time tomanifest themselves, but are likely to be substantial. The single currencyoffers substantial opportunities for both debt and equity issuers andinvestors. The increase in the number of market participants operating in thesame currency increases the liquidity of the capital markets and reduces thecost of capital. The low level of inflation and nominal interest rates anddiminishing public sector deficits are additional supporting factors of capitalmarket activity, especially private bond market activity which has so far beenrelatively limited (Table 5). Banks will thus operate in increasinglyintegrated capital markets and will be exposed to shocks originating beyondtheir national borders.
Asto corporations, they may concentrate their operations (treasury, capitalmarket and payment management) in a single or few «euro banks», whilethe disappearance of national currencies may break links between firms andtheir home country «house bank». This dissociation would make thedomestic economy indirectly sensitive to foreign banks' soundness, thuscreating another propagation channel of banking problems across countries.
12.When considering the industry scenario for the coming years, the viewpoint hasto be broadened beyond the impact of the euro. Rather than the exclusive, oreven primary, force for change, the euro is expected to be a catalyst forpre-existing trends driven by other forces. The recent ECB report prepared bythe Banking Supervision Committee on «Possible effects of EMU on the EUbanking systems in the medium to long term» gives a comprehensive analysisof such trends, which can be summarised as follows. First, regulation: theindustry has yet to feel the full impact of such fundamental, but relativelyrecent, regulatory changes as those related to the single market legislation.Second, disintermediation: other financial intermediaries and institutionalinvestors will grow relative to banks, pushed by demographic and socialchanges, as well as by the increasing depth and liquidity of the emerging euroarea-wide capital market. Disintermediation is expected to take the form ofincreasing recourse to capital market instruments relative to bank loans byfirms, and diminishing investment in deposits by households relative to mutualfunds and related products. Third, information technology: bank products,operations and processes are changing rapidly, while technology offersincreasing possibilities for dissociating the supply of a large number ofservices from branches and face-to-face contact with customers. The currenttendency in the EU banking systems to reduce over-branching and over-staffingwill grow stronger.
Thesefactors will increase competition, exert pressure on profitability and obligebanks to reconsider their strategies. Such effects are already visiblethroughout the EU. They produce changes in organisation, new products andservices, mergers, strategic alliances, co-operation agreements, etc. They alsoinvolve strategic risks, because the pressure for profitability and some lossesof revenue due to the euro, for example from foreign exchange, may push somebanks to seek more revenue from unfamiliar business or highly riskygeographical areas. Inadequate implementation of new technologies or failure toreduce excess capacity may also affect banks' long-term viability. In the shortterm, the structural adaptation process could be made more difficult by thecombination of factors like the protracted financial difficulties of Asia andRussia, or the preparations for the year 2000.
IV.CURRENT SUPERVISION
13.Against the background of the institutional framework and the industry scenarioI have outlined, let me now turn to the functioning of banking supervision inthe euro area. Two preliminary observations. First, the objective of financialstability pursued by banking supervisors is only one in a range of publicinterests, which also includes competition policy and depositor and investorprotection policy. Second, current supervision and crisis management involvedifferent situations and procedures and will therefore be examined in sequence.
14.Starting with current supervision, let me consider banking regulation first. Asobserved earlier, the regulatory platform for the euro area banking industrycombines harmonised rules with country-specific (non-harmonised, but mutuallyrecognised and hence potentially competing) rules.
Theharmonised part of the platform includes most of the key prudential provisionsthat have been developed in national systems over the years. More than 20 yearsago (1977), the 1st Banking Co-ordination Directive adopted a definition of acredit institution and prescribed objective criteria for the granting of abanking licence. In 1983 the first Directive on carrying out supervision on aconsolidated basis was approved, and in 1986 the rules relating to thepreparation of the annual accounts and the consolidated accounts of banks wereharmonised. In 1989 the 2nd Banking Co-ordination Directive (which becameeffective on 1 January 1993) marked the transition from piecemeal tocomprehensive legislation, introducing, inter alia, the principle of «homecountry control». A number of other specific directives have subsequentlyaddressed the main aspects of the regulatory framework — notably, own funds,solvency ratios and large exposures. A Directive imposing deposit guaranteeschemes supplemented the legislation in support of financial stability. All inall, the European Union, including the euro area, now has a rathercomprehensive «banking law» consistent with the Basle Committee'srules and with the 1997 Core Principles of Banking Supervision.
Thecountry-specific, non-harmonised, part of the platform is also quite relevantand very diversified. It includes, among other things, the differentorganisational arrangements for the conduct of banking supervision (centralbank, separate agency or a mixed arrangement); the tools used by bankingsupervisors (e.g. supervisory reporting, on-site inspections); provisions forthe liquidation and restructuring of banks; and the definition and legalprotection of financial instruments and contracts. Even the key notion of aregulated market is harmonised only to a very limited extent.
15.Such «neutrality» and «incompleteness» on the part of theEU legislator with respect to key aspects that are normally incorporated in theregulatory framework is a unique feature of EU banking regulations and islikely to trigger a deregulatory process, pushed by competition among thenational systems and the different financial centres in the euro area, andbeyond that in the EU. Against the background of the increasing competition andother changes in the banking industry, one can expect that the regulatoryplatform will evolve in the years to come. Additional EU legislation may provenecessary to complete and strengthen the harmonised part. One important part ofcommon legislation, namely the draft Directive on liquidation andre-organisation measures for credit institutions, has not yet been adopted and,indeed, has been stalled for years. This Directive is needed to bring legalcertainty to the framework for banking crisis management. In this regard, itwould be useful for the Eurosystem, if necessary, to be able to exclude counterpartiesfrom the single monetary policy on prudential grounds. Also, the non-harmonisedpart of the platform will come under pressure to converge, as I have justmentioned, through the process of «regulatory competition». Like anyother rapidly changing industry, the banking sector will require carefulattention by regulators. As indicated earlier, the ECB will have thepossibility of contributing to the rule-making process through its advisorytasks under Article 105 (4) of the Treaty and Article 25.1 of the Statute ofthe ESCB.
16.On the whole, and taking a euro area perspective, thelegislative-cum-regulatory platform of the banking industry, although ratherunusual and very diversified in comparison with those of most currencyjurisdictions, does not seem to present loopholes or inconsistencies that mayhamper the pursuit of systemic stability. Seen from the point of view of theregulatory burden, it is a light system. It will become even more so ifcompetition among national banking systems and financial centres encouragesnational regulators to free their banks from regulatory burdens that are notrequired by the EU Directives. Conversely, seen from the point of view of itsflexibility, i.e. how quickly it can adapt to new situations, it is, on the contrary,a heavy system. This is the case both because the EU legislative process isslow (three years or even longer may be needed to pass Directives) and, perhapsmore importantly, because many provisions are embodied in the Community primarylegislation (i.e. Directives) rather than in Community secondary legislation(amendable through simpler comitology procedures).
Theestablishment of EMU does not seem to determine a need for revising the pillarsof the current legal framework. What seems to be necessary, however, is a moreflexible legislative procedure which allows for a faster and more effectiverevision of Community legislation, whenever needed in relation to marketdevelopments.
17.Let me now turn to the execution of banking supervision. It should immediatelybe recalled that supervision, contrary to regulation, is a national task,exercised by what the jargon of the Directives calls the «competentauthority». Since the euro area has adopted a separation approach betweensupervisory and central banking functions, it is natural to examine first thefunctioning of the «euro area supervisor» (i.e. the co-operativesystem of national supervisors) and then turn to the tasks and needs of the«euro area central banker» (i.e. the Eurosystem).
18.The euro area supervisor can be regarded as a rather peculiar entity composedof national agencies working in three modes: stand-alone, bilateral andmultilateral. Let us briefly examine each of them.
Thestand-alone mode is the one in which the supervisor exclusively operates in thenational (or even local) context. Today it is by far the most predominant mode.In most cases, this approach is sufficient to achieve the objectives of bankingsupervision because most banks in Europe are operating in a context that doesnot even reach the nationwide market of the country of origin. Such adecentralised model is even more effective because it allows the efficient useof information that may not be available far from the market in which the bankoperates. That is why it is actually applied even within countries. In Italy,for example, over 600 of the 900 licensed credit institutions at end-1998 wereentirely supervised by the Banca d'Italia branch of the town in which the bankis licensed.
Thebilateral mode involves co-operation between two supervisory agencies. It isused for cross-border supervision of the same type of financial institutions,such as credit institutions, or the supervision of different types of financialinstitutions operating in the same market, such as credit institutions andsecurities firms. The instrument that has been devised to organise bilateralco-operation between banking supervisors is the Memorandum of Understanding(MoU). With the implementation of the 2nd Banking Co-ordination Directive, theMember States began to negotiate extensively MoUs in order to establish thenecessary co-operation between «home» and «host country»authorities to supervise efficiently institutions that have cross-borderactivities or foreign country establishments.
Bythe end of 1997, 78 bilateral MoUs had been signed between the EEA bankingsupervisory authorities. The key aims of MoUs are to establish a regularexchange of information between national supervisory authorities. While the«gateways» for the exchange of information have been laid down inCommunity legislation, MoUs provide a practical framework for communication tobe carried out between supervisors. Moreover, MoUs define procedures andreciprocal commitments between pairs of EU supervisors related to the variousparts of the supervisory process, such as establishment procedures and on-siteexaminations.
Finally,the multilateral mode is the one in which a group of supervisors workscollectively as, say, a single consolidated supervisor. Such a mode is requiredwhen the problems involved are area-wide. They may be area-wide for a number ofreasons with regard to the institutions, or groups, involved: their dimension;their linkages with a number of different markets in various countries; the rolethey play in the payment system or in other «systemic» components ofthe market, etc. Multilateral co-operation can also enhance the quality ofsupervision by examining common macroeconomic influences on the banking systemand common trends in the financial system that may not be revealed from thenational perspective only.
Today,the Banking Supervision Committee is the key forum for multilateralco-operation. It is composed of representatives of the banking supervisoryauthorities of the EU countries, either forming part of the respective NCB orseparate bodies. The Banking Supervision Committee's main functions are thepromotion of a smooth exchange of information between the Eurosystem andnational supervisory authorities and co-operation among EU supervisoryauthorities. Another forum for dealing with the requirements of themultilateral mode is the Groupe de Contact, a group of EU banking supervisoryauthorities which, for many years, has discussed individual banking cases in amultilateral way, but at a lower organisational level than the high-levelBanking Supervision Committee.
19.So far, the need to develop the multilateral mode has been relatively limited,as the emergence of a single banking market in the European Union has been slowand the euro was not yet in place. Thus, the fact that the multilateral modehas not gone, for the moment, beyond periodic discussions among supervisors andoccasional industry-wide analyses should not be a cause for concern.
Iam convinced, however, that in the future the needs will change and themultilateral mode will have to deepen substantially. Over time such a mode willhave to be structured to the point of providing the banking industry with atrue and effective collective euro area supervisor. It will have to be enhancedto the full extent required for banking supervision in the euro area to be asprompt and effective as it is within a single nation.
Thereare no legal impediments to that. The existing legislation, whether Communityor national, permits all the necessary steps to be made. Information can bepooled; reporting requirements and examination practices can be developed andstandardised; common databases can be created; joint teams can be formed; andanalyses of developments across the whole banking system can be conducted. TheCommunity legislation providing for the unconstrained exchange of confidentialinformation between supervisors does not distinguish between bilateral andmultilateral co-operation, but the common interpretation is that it covers bothmodes. It will be the task of the Banking Supervision Committee, for its part,to develop the multilateral mode among EU banking supervisors.
20.If the above concerns primarily the euro area supervisor, what about the euroarea central banker, i.e. the Eurosystem? The euro area central banker hasneither direct responsibility for supervising banks nor for bank stability. Itis, however, no stranger in this land. It has a vital interest in a stable andefficient banking industry; it is, therefore, keen to see its actioncomplemented with an effective conduct of the supervisory functions by thecompetent authorities; it needs a clear and precise knowledge of the state ofthe euro area's banking industry as a whole and of its major individual players;and it may have a role to play, as we shall see, in the management of crises.
Forthe Eurosystem, natural reference models are provided by the central banks ofcountries that apply the separation approach, for example: Germany before theeuro; the United Kingdom after the creation of the Financial ServicesAuthority; or Japan. In all these cases the central bank has a well-developedexpertise in the micro and macro-prudential field; each distinctively plays arole in the macro-prudential field by addressing threats to the stability ofthe banking system and analysing the soundness of the structural features ofthe system. For their own purposes, these central banks also have precise andcomprehensive information about the banks in their respective country. This isobtained either from performing practical supervisory duties, as in the case ofthe Bank of Japan or the Bundesbank; or from the national supervisoryauthority; or through direct contacts with the banking industry, as in the caseof the Bank of England.
TheBanking Supervision Committee is in a good position to co-operate with theEurosystem in the collection of information. Indeed, the so-called BCCIDirective has removed the legal obstacles to the transmission of confidentialinformation from competent supervisory authorities to «central banks andother bodies with a similar function in their capacity as monetaryauthorities». This includes national central banks and the ECB. Of course,the provision of supervisory information is voluntary and its development willhave to be based on an agreed view of the central banking requirements theEurosystem will have in this field.
V.CRISIS MANAGEMENT
21.In normal circumstances central banking and prudential supervision have anarm's length distance between them. In crisis situations, however, they need toact closely together, often in co-operation with other authorities as well.Charles Goodhart and Dirk Schoenmaker have made here at the London School ofEconomics a valuable contribution to analysing the handling of major bankingproblems in the history of industrial countries. One of their conclusions isthat, in most instances, central banks have indeed been involved. Bankingproblems are so close to monetary stability, payment system integrity andliquidity management that this finding hardly comes as a surprise. The adventof the euro will not, by itself, change this state of affairs.
22.When discussing crisis management, it should not be forgotten that, whilecentral banks have a direct and unique role to play when the creation ofcentral bank money is involved, this represents just one category of emergencyaction. Another category refers to the injection — by politically liableFinance Ministries — of taxpayers' money into ailing or insolvent creditinstitutions. There is also a third, market-based, category, consisting of theinjection of private money by banks or other market participants. These threetypologies of emergency action all require the involvement of policy-makers, butthey must not be mixed up when evaluating the existing arrangements. Therefore,before discussing the much debated question of the lender-of-last-resort, letme briefly comment on the two, probably less controversial cases where centralbankers are not the providers of extra funds.
23.First, the «private money solution». This market-based approach isclearly the preferable option, not just to save public funds and avoidimbalances in public finances, but also to reduce the moral hazard problemgenerated by public assistance to ailing institutions. Indeed, policy-makersare increasingly aware that the expectations of a helping hand can increasefinancial institutions' risk appetite in the first place. However, even when amarket-based solution is possible, on the grounds of private interest, privateparties may not be able to reach a solution for lack of information orco-ordination. Public authorities have therefore an active role to play for themarket solution to materialise. The recent rescue package co-ordinated by theFederal Reserve Bank of New York to prevent the LTCM hedge fund from collapsingis a good example of public intervention being used to achieve a privatesolution.
Actingas a «midwife» in brokering a private sector deal is not the onlyexample of managing crises without injecting public funds. Banking supervisorshave at their disposal a number of tools to intervene at the national level tolimit losses and prevent insolvency when a bank faces difficulties. These toolsinclude special audits, business restrictions and various reorganisationmeasures.
Inthe euro area, national supervisors and central banks will continue to be thekey actors in the pursuit of market-based solutions to crises. The Eurosystem,or the Banking Supervision Committee, would become naturally involved wheneverthe relevance of the crisis required it.
24.Second, the «taxpayers' money solution». Taxpayers have been forcedto shoulder banks' losses in the past, when public authorities felt thatotherwise the failure of a large portion of a country's banking system or of asingle significant institution would have disrupted financial stability andcaused negative macroeconomic consequences. In such instances banks have beentaken over by the state, or their bad assets have been transferred to aseparate public entity to attract new private investment in the sound part ofthe otherwise failed banks. The US savings & loans crisis of the 1980s, thebanking crises in Scandinavia in the early 1990s and the current banking crisesin Japan and some East-Asian countries are examples of system-wide insolvencyproblems that have triggered taxpayers' support. Crйdit Lyonnais and Banco diNapoli are recent examples of public support to individual insolvency problems.
Theintroduction of the euro leaves crisis management actions involving taxpayers'money practically unaffected. The option of injecting equity or other fundsremains available for the Member States, since these operations are notforbidden by the Treaty. Nevertheless, the European Commission will be directlyinvolved in scrutinising and authorising such actions, since any state aid mustbe compatible with the Community's competition legislation. This happened, forexample, in the cases of Banco di Napoli and Crйdit Lyonnais.
Thehandling of solvency crises is not within the competence of the nationalcentral banks nor that of the ECB, although national central banks are likelyto be consulted, as they have been in the past.
25.Third, the «central bank money solution». This is thelender-of-last-resort issue that has brought the Eurosystem under vigorouscriticism by distinguished academics and the IMF's Capital Markets Division ofthe Research Department. The criticism has been that the alleged absence of aclear and transparent mechanism to act in an emergency raises doubts in themarkets about the ability of the Eurosystem to handle crisis situations. It issaid that the uncertainty generated by the present arrangements would entailnew risks, including the possibility of investors requiring an additional riskpremium at times of financial market volatility and, ultimately, of thecredibility of EMU being damaged. Two examples of these concerns deserve anexplicit mention. The IMF «Report on Capital Markets», September1998, stated that «it is unclear how a bank crisis would be handled underthe current institutional framework …which is not likely to besustainable». Similarly, the first report of the CEPR (Centre for EconomicPolicy Research) on monitoring the ECB entitled «The ECB: Safe at AnySpeed?» expressly suggested that the Eurosystem lacks crisis managementcapacity and is too rigid to pass the A-Class test to keep the vehicle on theroad at the first steep turn in financial market conditions in Europe.
26.My response to this criticism is threefold. To my mind, the criticism reflectsa notion of lender-of-last-resort operations that is largely outdated; itunderestimates the Eurosystem's capacity to act; and, finally, it representstoo mechanistic a view of how a crisis is, and should be, managed in practice.
27.The notion of a central bank's lender-of-last-resort function dates back morethan 120 years, to the time of Bagehot. This notion refers to emergency lendingto institutions that, although solvent, suffer a rapid liquidity outflow due toa sudden collapse in depositors' confidence, i.e. a classic bank run. A bankcould be exposed to depositors' panic even if solvent because of the limitedamount of bank liquidity and an information asymmetry between the depositorsand the bank concerning the quality of bank's assets that do not have asecondary market value.
Nowadaysand in our industrial economies, runs may occur mainly in textbooks. They havelittle relevance in reality because, since Bagehot, many antidotes have beenadopted: deposit insurance, the regulation of capital adequacy and largeexposures, improved licensing and supervisory standards all contribute to thepreservation of depositors' confidence and minimise the threat of a contagionfrom insolvent to solvent institutions.
Aless unlikely case is a rapid outflow of uninsured interbank liabilities.However, since interbank counterparties are much better informed thandepositors, this event would typically require the market to have a strongsuspicion that the bank is actually insolvent. If such a suspicion were to beunfounded and not generalised, the width and depth of today's interbank marketis such that other institutions would probably replace (possibly with theencouragement of the public authorities as described above) those whichwithdraw their funds. It should be noted, in this respect, that the emergenceof the single euro money market lowers banks' liquidity risk, because thenumber of possible sources of funds is now considerably larger than in thepast.
Givenall of these contingencies, the probability that a modern bank is solvent, butilliquid, and at the same time lacks sufficient collateral to obtain regularcentral bank funding, is, in my view, quite small. The textbook case foremergency liquidity assistance to individual solvent institutions has, as amatter of fact, been a most rare event in industrial countries over the pastdecades.
28.What if this rare event were nevertheless to occur and cause a systemic threat?The clear answer is that the euro area authorities would have the necessarycapacity to act. This is not only my judgement, but also that of theEurosystem, whose decision-making bodies have, as you can imagine, carefullydiscussed the matter. I am not saying that we are, or shall be, infallible; noone can claim such a divine quality. I am saying that there are neitherlegal-cum-institutional, nor organisational, nor intellectual impediments toacting when needed. In stating this, I am aware that central banks may be theonly source of immediate and adequate funds when a crisis requires swiftaction, while solvency remains an issue and failure to act could threaten thestability of the financial system.
Inthese circumstances the various national arrangements would continue to apply,including those concerning the access of central banks to supervisors'confidential information. As is well known, such arrangements differ somewhatfrom country to country.
29.The criticism I have referred to also underestimates the Eurosystem's capacityto act. To the extent that there would be an overall liquidity effect that isrelevant for monetary policy or a financial stability implication for the euroarea, the Eurosystem itself would be actively involved.
TheEurosystem is, of course, well equipped for its two collective decision-makingbodies (the Board and the Council) to take decisions quickly whenever needed,whether for financial stability or for other reasons. This readiness is neededfor a variety of typical central bank decisions, such as the execution ofconcerted interventions or the handling of payment system problems. Indeed, ithas already been put to work during the changeover weekend and in the first fewweeks of this year.
Aclear reassurance about the capacity to act when really needed should besufficient for the markets. Indeed, it may even be advisable not to spell outbeforehand the procedural and practical details of emergency actions. As GerryCorrigan once put it, maintaining «constructive ambiguity» in thesematters may help to reduce the moral hazard associated with a safety net. Iknow of no central bank law within which the lender-of-last-resort function isexplicitly defined.
Thequestion of who acts within the Eurosystem should also be irrelevant for themarkets, given that any supervised institution has an unambiguously identifiedsupervisor and national central bank. As to the access to supervisoryinformation, the lack of direct access by the Eurosystem should not be regardedas a specific flaw of the euro area's institutional framework, as has beenfrequently argued, since this situation also exists at the national levelwherever a central bank does not carry out day-to-day supervision.
30.Finally, the criticism reflects an overly mechanistic view of how a crisis is,and should be, managed in practice. Arguing in favour of fully disclosed,rule-based policies in order to manage crises successfully and, hence, maintainmarket confidence, is almost self-contradictory. Emergency situations alwayscontain unforeseen events and novel features, and emergency, by its verynature, is something that allows and even requires a departure from the rulesand procedures adopted for normal times or even in the previous crisis. Who caresso much about the red light when there is two metres of snow on the road? Asfor transparency and accountability, these two sacrosanct requirements shouldnot be pushed to the point of being detrimental to the very objective for whicha policy instrument is created. Full explanations of the actions taken andprocedures followed may be appropriate ex post, but unnecessary and undesirableex ante.
31.So far, I have focused on the provision of emergency liquidity to a bank. Thisis not the only case, however, in which central bank money may have to becreated to avoid a systemic crisis. A general liquidity «dry-up» mayreflect, for example, a gridlock in the payment system or a sudden drop instock market prices. The actions of the Federal Reserve in response to thestock market crash of 1987 is an often cited example of a successful centralbank operation used to prevent a dangerous market-wide liquidity shortfall.This kind of action is close to the monetary policy function and has beencalled the «market operations approach» to lending of last resort. Insuch cases, liquidity shortfalls could be covered through collateralisedintraday or overnight credit, or auctioning extra liquidity to the market. TheEurosystem is prepared to handle this kind of market disturbance.
VI.CONCLUSION
32.In my remarks this evening, I have looked at the euro area as one that has acentral bank which does not carry out banking supervision. This would benormal, because in many countries banking supervision is not a task of thecentral bank. What is unique is that the areas of jurisdiction of monetarypolicy and of banking supervision do not coincide. This situation requires,first of all, the establishment of smooth co-operation between the Eurosystemand the national banking supervisors, as is the case at the national levelwhere the two functions are separated. The most prominent reason for this is,of course, the scenario where the provision of liquidity from the central bankhas to be made in a situation that is generated by problems of interest to thesupervisor. But beyond that, I do not know any country in which the centralbank is not very closely interested in the state of health of the bankingsystem, irrespective of its supervisory responsibilities.
33.In my view, we should move as rapidly as possible to a model in which thepresent division of the geographical and functional jurisdiction betweenmonetary policy and banking supervision plays no significant role. I do notmean necessarily a single authority or a single set of prudential rules. RatherI mean that the system of national supervisors needs to operate as effectivelyas a single authority when needed. While the causes of banking problems areoften local or national, the propagation of problems may be area-wide. Thebanking industry is much more of a system than other financial institutions.
34.I am clearly aware that we are far from having a common supervisory system. Butsince the euro has just been launched and will last, we have to look in prospectiveterms at what needs to be set in place. There is no expectation, at least to mymind, that the division of responsibility in the euro area between the centralbank and the banking supervisory functions should be abandoned. Although theTreaty has a provision that permits the assignment of supervisory tasks to theECB, I personally do not rely on the assumption that this clause will beactivated. What I perceive as absolutely necessary, however, is thatco-operation among banking supervisors, which is largely voluntary but whichfinds no obstacles in the existing Directives or in the Treaty, will allow asort of euro area collective supervisor to emerge that can act as effectivelyas if there were a single supervisor. This is desirable in the first instanceto render the supervisory action more effective against the background ofcurrent and future challenges and, second, to assist the Eurosystem in theperformance of its basic tasks.
TABLES
Table 1. Market share of branches and subsidiariesof foreign
credit institutions as % of total domestic assets,1997
From EEA countries From third countries TOTAL
Branches Subsidiaries Branches Subsidiaries
AT 0.7 1.6 0.1 1.0 3.4
BE 9.0 19.2 6.9 1.2 36.3
DE 0.9 1.4 0.7 1.2 4.2
ES 4.8 3.4 1.6 1.9 11.7
FI 7.1 0 0 0 7.1
FR 2.5 NA 2.7 NA 9.8
IR 17.7 27.8 1.2 6.9 53.6
IT 3.6 1.7 1.4 0.1 6.8
NL 2.3 3.0 0.5 1.9 7.7
SE 1.3 0.1 0.1 0.2 1.7
UK 22.5 1.0 23.0 5.6 52.1
Source: ECB report «Possible effects of EMUon the EU banking
systems in the medium to long term» (February1999).
Table 2. Assets of branches and subsidiaries ofdomestic credit
institutions in foreign countries
as % of total domestic assets, 1997
In EEA countries In third countries TOTAL
Branches Subsidiaries Branches Subsidiaries
AT 2.6 NA 3.7 NA NA
DE 12.0 7.3 7.8 0.9 27.9
ES 5.5 1.4 2.1 5.9 14.9
FI 5.9 0.3 6.6 0.3 13.1
FR 9.1 6.9 9.4 3.8 29.2
IR 8.3 14.9 1.3 10.1 34.6
IT 7.2 2.7 3.8 1.5 15.2
SE 7.2 NA 5.4 NA NA
Source: ECB report «Possible effects of EMUon the EU banking
systems in the medium to long term» (February1999).
Table 3. Concentration: Assets of the five biggestcredit
institutions as % of total assets
1985 1990 1997
AT 35.8 34.6 48.3
BE 48.0 48.0 57.0
DE NA 13.9 16.7
ES 38.1 34.9 43.6
FI 51.7 53.5 77.8
FR 46.0 42.5 40.3
IE 47.5 44.2 40.7
IT 20.9 19.1 24.6
NL 69.3 73.4 79.4
SE 60.2 70.02 89.7
UK NA NA 28.0
Source: ECB report «Possible effects of EMUon the EU banking
systems in the medium to long term» (February1999).
Table 4. Number of branches and subsidiaries offoreign credit
institutions, 1997
From EEA countries From third countries TOTAL
Branches Subsidiaries Branches Subsidiaries
AT 6 20 2 11 39
BE 25 16 15 15 71
DE 46 31 31 45 153
ES 33 21 20 6 80
FI 9 0 0 0 9
FR 46 118 43 98 305
IR 18 21 3 7 49
IT 36 4 17 4 61
NL 11 8 11 19 49
SE 14 0 3 1 18
UK 106 18 149 114 387
Source: ECB report «Possible effects of EMUon the EU banking
systems in the medium to long term» (February1999).
Table 5. Private non-financial enterprises' bonds,credit
institutions' bonds and government bondsoutstanding as % of GDP,
1997
Private Credit Government
non-financial institutions' bonds
bonds bonds
AT 2.7 31.1 30.6
BE 10.0 38.3 111.0
DE 0.1 54.6 37.6
ES 2.6 4.5 52.9
FI 3.7 7.1 35.5
IE 0.01 1.6 32.2
IT 1.6 19.4 100.4
NL NA 43.1 53.4
SE 3.6 38.6 46.5
Source: ECB report «Possible effects of EMUon the EU banking
systems in the medium to long term» (February1999).
Euro and Europeanintegration
Speech delivered by EugenioDomingo Solans,
Member of the GoverningCouncil and the Executive Board of the
European Central Bank,
at the «Euro andDenmark» exhibition in Aalborg, Denmark,
on 10 September 1999
INTRODUCTION
Itis a real pleasure for me to participate in the «Euro and Denmark»exhibition in Aalborg. It is the first time since my appointment as a member ofthe Executive Board of the European Central Bank (ECB) in May 1998 that I havehad the opportunity to speak in Denmark. Thank you for your invitation and forasking me to share my views on the euro and on European integration withinvestors and experts of this «pre-in» country.
Ishould like to refer to two main topics. First, and more extensively, allow meto explain the ECB's view and my own view on the role of the euro as aninternational currency. After this I intend to make some brief comments on thekey role that the euro and the Eurosystem are playing in the process ofEuropean economic integration.
BeforeI begin, I should like to add that it goes without saying that theinstitutional position of the ECB — and therefore my own official position — concerning Denmark's entry to the euro area is one of strict neutrality. Thisis an issue which has to be decided by the Danish people, whenever and inwhatever way they deem appropriate.
THEEURO AS AN INTERNATIONAL CURRENCY
Thethree basic functions of the euro
Everycurrency fulfils three functions: store of value, medium of exchange and unitof account. Concerning the first function (store of value), the euro is usedand will increasingly be used as an investment and financing currency by marketplayers, and as a reserve currency by public authorities. Regarding the secondfunction of money (medium of exchange), the euro is used and will increasinglybe used as a payment or vehicle currency for the exchange of goods and servicesand for currency exchange itself. It will also have an official use as anintervention currency. Finally, as regards the third function of any currency(unit of account), the euro is used and will increasingly be used by economicagents as a pricing or quotation currency and as a pegging currency by theauthorities responsible for exchange rate issues.
Letme give you some information about the present use of the euro in each of theseareas. I shall first refer to the private use of the euro, after which I shallconsider its official public usage.
Theeuro as a store of value
Theavailable information seems to confirm that the euro already plays asignificant role as an investment and financing currency in internationalfinancial markets. Without going into precise details (1), regarding theinternational debt securities market (money market instruments, bills andbonds), it can be said that in the first two quarters of 1999 net internationalissues denominated in euro amounted to EUR 83.9 billion, compared with EUR 74billion for the US dollar and EUR 50.9 billion for former euro area nationalcurrencies and ECUs during the same period of 1998. In other words, in thefirst two quarters of 1999 net international issues of debt securitiesdenominated in euro were 13.4% higher than those denominated in US dollars, and64.8% higher than those denominated in former euro area national currencies andECUs issued during the same period of last year.
Withregard to equity markets, the weight of euro area stock exchanges in terms ofcapitalisation ranks a clear second, far behind the United States.
Asto the banking sector, the latest data show that, at the end of March 1999,above 40% of deposits and loans vis-а-vis non-residents were denominated ineuro, with the share of the US dollar almost as high.
Theeuro as a medium of exchange
Asfor the second function of money (medium of exchange), the euro needs more timeto develop as a payment currency for goods and services in international tradeand as a vehicle currency in the foreign exchange markets. Although no precisedata are available at this stage, the value of world exports denominated ineuro is not likely to differ significantly from that of euro area exports. Bycontrast, the value of world exports settled in US dollars is nearly four timesas high as that of US exports. This difference can easily be explained by thecombined and reinforcing effects of network externalities and economies ofscale in the use of a predominant international currency, as is the case withthe US dollar.
Theeuro as a unit of account
Theuse of the euro as a unit of account (its third general function) is closelylinked to its use for the other two main functions. The use of a currency as aunit of account is, in a way, the basis for its use as a store of value or as amedium of exchange. The value stored in euro, or the payments made in euro,will tend to be recorded in euro. Therefore, we can conclude that the euro isplaying an ever larger role as a unit of account for all the financial assetslinked to the use of the euro as an investment and financing currency, and hasa much less relevant role as a standard for pricing goods and services, owingto the widespread use of the US dollar as a payment and vehicle currency ininternational trade. The convenience of using a single standard for pricingcommodities in the international markets, allowing traders to make directcomparisons between prices, makes it difficult for the euro to acquire asignificant role in this respect. We can conclude that the development of theeuro as a unit of account will follow the pace at which the issuers orsuppliers of assets, goods or services priced or quoted in euro obtain apredominant position in the international markets.
Theofficial use of the euro
Theeuro also has official uses as reserve, intervention and pegging currency, allthree functions being strongly interrelated in most cases.
Withregard to its official use, the euro is currently the second most internationalcurrency after the US dollar, this being a legacy of the former euro areanational currencies.
Comparedwith the former euro area national currencies, there has been a technicaldecline in the share of the euro as a reserve (and, therefore, as anintervention) currency, mainly owing to the fact that such former nationalcurrencies became domestic assets within the euro area. However, there are goodreasons to expect an increase in international public use of the euro as areserve and intervention currency, inasmuch as the public authoritiesunderstand that it is worthwhile to allocate their foreign reserves among themain international currencies and to give the euro a relevant share inaccordance with its internal and external stability and the economic andfinancial importance of the euro area.
Inconnection with the use of the euro as a pegging currency, approximately 30countries outside the euro area currently have exchange rate regimes involvingthe euro to a greater or lesser extent. These exchange rate regimes are:currency boards (Bosnia-Herzegovina, Bulgaria, Estonia); currencies pegged tothe euro (Cyprus, FYROM [the Former Yugoslav Republic of Macedonia] and 14African countries in which the CFA franc is the legal tender); currenciespegged to a basket of currencies including the euro, in some cases with afluctuation band (Hungary, Iceland, Poland, Turkey, etc.); systems of managedfloating in which the euro is used informally as the reference currency (CzechRepublic, Slovak Republic and Slovenia); and, last but not least, EuropeanUnion currencies pegged to the euro through a co-operative arrangement, namelyERM II. As you well know, Denmark and Greece joined ERM II on 1 January 1999with a ±2.25% fluctuation band for the Danish krone and a ±15% fluctuation bandfor the Greek drachma. Although the euro remains in second position after theUS dollar in terms of its official use, the role of the euro will increase inthe future, without a doubt.
Theposition of the Eurosystem concerning the international role of the euro
Asa general conclusion stemming from the previous analysis of the use of the euroin the world economy, we can affirm that the euro is the second most widelyused currency, behind the US dollar and ahead of the Japanese yen. The privateuse of the euro as an investment and financing currency and its official use asa reserve, intervention and pegging currency are increasing rapidly, while itis developing at a slower pace as a payment currency in the exchange of goodsand services. The use of the euro as a unit of account is linked to its use asstore of value and a medium of exchange.
Takingthe current situation as a starting point, the Eurosystem's position concerningthe future international role of the euro is crystal clear: we shall not adopta belligerent stance in order to force the use of the euro upon the worldeconomy. We are convinced that the use of the euro as an international currencywill come about anyway. It will happen spontaneously, slowly but inexorably,without any impulses other than those based on free will and the decisions ofmarket participants, without any logic other than that of the market. In otherwords, the internationalisation of the euro is not a policy objective of theEurosystem; it will neither be fostered nor hindered by us. The development ofthe euro as an international currency will be a market-driven process, a freeprocess, which will take place, without a doubt.
Factorsdetermining the importance of the euro in the world economy
Weunderstand that the euro fulfils the necessary conditions to become a leadinginternational currency with the US dollar and not against it. There is enoughroom for both currencies in the world economy.
Thenecessary conditions for a currency to become an international currency arebased on two broad factors: low risk and large size. The low risk factor isrelated to the confidence inspired by the currency and its central bank, whichin turn mainly depends on the internal and external stability of the currency.The low risk factor tends to lead to diversification among internationalcurrencies, since diversification is a means to reduce the overall risk; itacts, so to speak, as a centrifugal force. By contrast, the large size factorrelates to the relative demographic economic and financial importance of thearea which supports the currency; in other words, the «habitat» ofthe currency. The large size factor generally tends to lead to centralisationaround one or several key international currencies. It can be seen as acentripetal force, as a virtuous circle, which will tend to lead to anincreasing use of the euro as an international currency. Let us consider thesetwo factors in more detail.
Thestability of the currency and the credibility of the ECB
Thefirst factor concerns low risk, credibility and stability. The stability of theeuro is a priority for the ECB. Compared with the idea of stability, thestrength of the euro is of lesser importance. This does not mean that theexchange rate of the euro does not constitute an element to be considered inthe monetary policy strategy of the ECB. However, the basic factor that willdetermine the importance of the euro as a widely used currency in the worldeconomy, in addition to the demographic, economic and financial dimensions ofthe euro area, is, without a doubt, the stability of the new currency,understood as a means to maintain the purchasing power of savings.
Inthe global economy the transmission of financial crises by means of differentmechanisms (devaluations of weak currencies, subsequent increases in interestrates, etc.) is frequently mentioned. Less is said about the spillover ortransmission of positive economic circumstances, such as stability. TheEurosystem will «export» stability to the rest of the world economy,and not only in the case of those countries which decide to tie theircurrencies, formally or otherwise, to the euro (through the ERM II or otherarrangements). In a global economy the euro area cannot be an island ofstability, but it can transmit its stability to the rest of the world economyas the links between regions increase.
Stabilityis the basic requirement for a good currency. It is what we at the ECB want forthe euro. We want a stable euro, not necessarily a strong euro. In the longterm the euro will derive strength from its stability.
Thestability of the euro is the basis for the confidence in and the credibility ofthe ECB, without which a large international role for the euro would beunthinkable. Stability is the proof of the effectiveness of the institution.Yet in order to be credible it is not sufficient for the ECB to maintainstability. Other parameters of its action must be considered: accountability,transparency and communication, a Europe-wide perspective.
Theconditions for the credibility of the euro are certainly demanding. However,the achievement of these conditions is the aim of all those of us who haveresponsibilities in relation to the operation of the Eurosystem.
The«habitat» of the euro
Thesecond factor, which we have called the large size factor or the habitat of theeuro, is important because without a certain critical mass, a currency cannothave international relevance, however high its degree of stability. In additionto quality, quantity is required, as suggested by the example of the reduceddegree of international use of the Swiss franc in relation to other stablecurrencies, such as the US dollar or the Deutsche
Markuntil 1998.
Thefigures relating to the population and the GDP of the euro area illustratethis. With 292 million inhabitants, its population exceeds that of the UnitedStates (270 million) and that of Japan (127 million). The GDP of the euro areais, on the other hand, equal to 76% of the GDP of the United States (EUR 5,774billion compared with EUR 7,592 billion), though it is higher than that ofJapan (EUR 3,327 billion). The source of this information, which refers to1998, is Eurostat.
However,even more important than the current figures is the potential for the futuredevelopment of the euro area, in terms of population and GDP, if and when theso-called «pre-ins» (Denmark, Greece, Sweden and the United Kingdom)join the Eurosystem.
Theentry of these countries would result in a monetary area of 376 millioninhabitants, 39% larger than the United States and almost triple the size ofJapan, with a GDP of EUR 7,495 billion, only slightly less than that of theUnited States and 125% higher than that of Japan.
Allthese facts and figures which demonstrate the demographic and economicimportance of the European Union would be further strengthened by enlargementto Eastern Europe. Our continent has a historical, cultural and geographicalidentity — from the Iberian Peninsula to the Urals, with certain additionalexternal territories — which, in the future, may also come to form an economicunit. However that is, for the moment, a distant prospect.
Thedegree of openness of an economic area is also a relevant factor as regards theinternational role of its currency. In this respect the euro area is more openthan the United States or Japan, with a percentage of external trade of around25.8% of GDP, compared with 19.6% for the United States and 17.9% in the caseof Japan (data from Eurostat for 1997). However, a euro area consisting of the15 countries of the European Union would be more closed, by the mere arithmeticfact that the transactions with the present pre-ins would become domestictransactions, resulting in a coefficient of openness of 19.4%, similar to thatof the United States. Clearly, the size and the degree of openness areparameters that move in opposite directions: the larger the euro area, thesmaller its degree of openness to other countries.
Thefinancial dimension of the euro
Thesize or habitat of an economy does not only depend on demographic or economicfactors; it also has to do with the financial base or dimension of the area. Inconsidering the financial dimension of the euro area, the first relevantfeature to observe is the low level of capitalisation of the stock markets incomparison with the United States and Japan. Compared with a stock marketcapitalisation of EUR 3,655 billion in the euro area in 1998, the United Statespresents a figure almost four times this amount (EUR 13,025 billion). Japanranks third, with EUR 2,091 billion. There would be a marked difference if onewere to include all 15 countries of the European Union, since the stockexchange capitalisation would increase to EUR 6,081 billion.
Althoughthese figures could give the impression that the euro area has a relativelysmall financial dimension relative to its economic dimension, this is not thecase. The lower degree of development of the capital markets is offset by ahigher degree of banking assets. This means that the financial base of realeconomic activity in Europe is founded on bank intermediation, which is also afeature of the Japanese economy. For example, private domestic credit in theeuro area amounts to 92.4% of GDP, while in the United States it is only 68.9%.Conversely, fixed domestic income represents 34.2% of GDP in the euro areacompared with 66.1% of GDP in the United States (statistics from theInternational Monetary Fund and the Bank for International Settlements as atthe end of 1997, taken from the Monthly Bulletin of the European Central Bank).We therefore have two distinct models of private financing which clearly haveto be taken into account when assessing Europe's financial dimension comparedwith the United States or Japan.
THE ROLE OF THE EURO AND THEEUROSYSTEM IN THE PROCESS OF
EUROPEAN INTEGRATION
Theeuro as a catalyst for European integration
Theeuro, the Eurosystem's monetary policy and, in general, the activity of the ECBand the Eurosystem will play a key role in the integration of Europeanfinancial markets and all markets in general. We can say that the euro will actas a catalyst for European economic integration.
Monetaryand financial integration
Theintegration of the European money markets relies, of course, on the existenceof a single system for refinancing the banks in the euro area, that is to sayon the common monetary policy. However, it also relies technically on a systemof instantaneous data transfer and on the new common payment system, TARGET,enabling real-time gross settlement. Thanks to the smooth operation of theinformation, communication and payment systems, a common monetary policy isrealistic and the integration of the markets can take place. Such integrationwill, in turn, involve greater liquidity and further development of thefinancial markets.
Aspecific channel through which the monetary policy of the ECB and the TARGET systemcan have a direct impact on the development of the financial markets of theeuro area is the requirement to have guarantees or collateral for operationswith the ECB. This requirement for adequate collateral can stimulate theprocess of loan securitisation, especially in the case of the bankinginstitutions of certain financial systems. The underlying assets can be usedacross borders, which means that a banking institution in a country belongingto the European System of Central Banks (ESCB) can receive funds from itsnational central bank by pledging assets located in other countries, which isalso relevant from the perspective of the integration of the financial marketsof the area.
Thetrend towards further integration of the European financial markets,accompanied by increased use of the euro as a vehicle for internationalinvestment, should logically follow a process which would start in theshort-term money market, subsequently be expanded into the longer-term moneymarket and finally extend to the public and private bond and equity markets. Inthe short term there must be a tendency for the differentials in money marketinterest rates to be eliminated, as the functioning of the market improves,while in the long-term securities markets — both public and private, of course- interest rates will always include a risk premium linked to the degree ofsolvency of the country (deficit and public debt, commitments on pensions), orto the credit risk of the private issuer, and to the liquidity of the securities.
Economicintegration Monetary and financial integration stemming from the euro and theactivity of the Eurosystem will affect the operation of the European singlemarket in a positive way. The European market, with a single currency, willtend to be more transparent, more competitive, more efficient and will functionmore smoothly. This is the reason why joining the European Union, as a generalrule, leads to joining the euro area, once certain economic conditions (theso-called convergence criteria) are fulfilled.
Thecase of Denmark, as you will know better than I, constitutes an acceptedexception to the general rule, formalised in Protocol No. 8 on Denmark of theTreaty on European Union signed in Maastricht on 7 February 1992, and in the so-called«Decision concerning certain problems raised by Denmark on the Treaty onEuropean Union» of 11 and 12 December 1992, which contains thenotification from Denmark that it would not participate in the third stage ofthe European Economic and Monetary Union.
However,the Danish krone was in fact pegged to the Deutsche Mark from 1982 until theend of 1998. Furthermore, since 1 January 1999 it has been participating in ERMII with a rather narrow fluctuation band of ±2.25%, and effectively has had analmost fixed exchange rate vis-а-vis the euro. Therefore, the Danish monetarypolicy, through this exchange rate strategy, is the monetary policy of theEurosystem. In other words, Denmark follows «the rules of the game»almost entirely, or as the Governor of Danmarks Nationalbank, Ms Bodil NyboeAndersen, often says, «The Danish krone shadows the euro».
Inthis connection, and before the question and answer session begins, let meconclude by addressing the following key questions to you, on the understandingthat this is a rhetorical way to express my ideas and that I do not necessarilyexpect any of you to answer them.
IfDenmark already is following «the rules of the game», why, then,should you not make use of the advantages of belonging to the Eurosystem? Why,then, should you not participate in the decisions concerning the monetarypolicy which, in actual fact, applies to Denmark?
______________________
(1)For a more detailed analysis, see the article entitled «The internationalrole of the euro», in the August 1999 edition of the ECB's MonthlyBulletin, pp. 31-35.
***
European Economic andMonetary Union — principles and
perspectives
Summary of a presentationby Ms Sirkka Hдmдlдinen,
Member of the ExecutiveBoard of the European Central Bank,
The Tore Browaldh lecture1999,
School of Economics andCommercial Law, Gцteborg University,
Gothenburg, 25 February1999
TheEuropean integration process started shortly after the Second World War andwas, at the time, strongly motivated by political factors. The aim was toeliminate the risk that wars and crises would once more plague the continent.The first concrete result was the establishment, in 1952, of the European Coaland Steel Community between six countries (Belgium, France, Germany, Italy,Luxembourg and the Netherlands). This was followed by the adoption of theTreaty of Rome in 1957, laying the foundations for the European EconomicCommunity.
Thefirst concrete proposal for a Monetary Union was presented in the so-calledWerner Report in 1970. The Report was intended to pave the way for theestablishment of a Monetary Union in the early 1980s. However, the proposals ofthe Werner Report were never implemented — being overtaken by world events.After the break-up of the Bretton Woods system and the shock of the first oilcrisis in 1973, most western European economies were contaminated by theeconomic sickness popularly labelled «Eurosclerosis», characterisedby high inflation and persisting unemployment. At that time, the Europeaneconomies were protected by regulations and financial markets were still poorlydeveloped. In this environment, it was concluded that a Monetary Union wouldnot be possible and the project was postponed.
Theidea of establishing Monetary Union was revived only in 1988 and a detailedproposal was presented the following year in the Delors Report, after thelaunch (in 1985) of the Single Market programme on the free movement of goods,services, capital and labour. Because of the single market, the Report could bemore explicit and credible with regard to how best to achieve closer economicties between the EU economies before the introduction of a single currency.Moreover, the Report was supported by a detailed description of aninstitutional set-up geared towards ensuring stability-oriented economicpolicies.
Notwithstandingthe thorough work invested in the Delors Report, almost 10 years of convergenceand technical preparations were required in order to ensure the successfulimplementation of the euro on 1 January 1999. And the project is still notover: the euro coins and banknotes will be introduced only in 2002 — 13 yearsafter the presentation of the Delors Report and 32 years after the presentationof the Werner Report.
Achievinga credible currency
Today,almost two months after the introduction of the euro, we can say that thetechnical changeover to the euro was successful. Now, the Eurosystem (i.e. theECB and the 11 national central banks of the participating Member States) mustfocus on ensuring the long-term success of the new currency. The credibility ofa currency is built up by several factors, the basis of which is the centralbank's commitment to price stability. Here, the Eurosystem is in the fortunateposition of being assigned, through the Maastricht Treaty, the unambiguousprimary objective of maintaining price stability in the euro area. Anotherfundamental building block of credibility is ensuring that monetary policydecisions are independent of political pressures. This building block was alsolaid down in the Maastricht Treaty, which ensures that the ECB and theparticipating national central banks enjoy a very high degree of independence,possibly more than any other central bank in the world.
Thecredibility of a currency also relies on the preparedness of governments topursue stability-oriented policies of fiscal discipline and to undertakenecessary structural reforms. On this point, the Stability and Growth Pactadopted by the EU countries provides a basic framework for fiscal disciplineand should enhance the governments' incentive to proceed with structuralreforms.
Inorder to enhance credibility, it is also important that the central bank'sstrategy for achieving the primary objective is clear and that the link betweenthe strategy and the central bank's policy actions is easily understood by thepublic. By following a transparent approach, the central bank can directlyimprove the efficiency of monetary policy. This contributes to achieving stableprices with the lowest possible interest rates.
Strivingtowards increased transparency led the Governing Council of the ECB (composedof the Governors of the 11 national central banks and the six members of theECB's Executive Board) to establish a precise definition of price stability inorder to bring about absolute clarity as regards the primary objective; pricestability was defined as a year-on-year increase of the Harmonised Index ofConsumer Prices (HICP) for the euro area of below 2%. This is a medium-termobjective. In the short run, many factors beyond the scope of monetary policyalso affect the price movements.
Theadoption of the Eurosystem's monetary policy strategy also aimed at enhancingtransparency in the implementation of monetary policy. The strategy is based ontwo key elements: First, money has been assigned a prominent role in the formof a reference value for the growth of the euro area wide monetary aggregateM3. Second, the Eurosystem carries out a broadly based assessment of theoutlook for price developments and the risks to price stability in the euroarea on the basis of a wide range of economic and financial indicators.
Inorder to explain to the public the Eurosystem's policy actions against thebackground of the adopted monetary policy strategy, the Eurosystem uses severalchannels: the ECB's Monthly Bulletin; the issuance of a detailed press releaseafter each Governing Council meeting, in which the decisions are explained; theorganisation of a monthly press conference at the ECB; the appearances of thePresident at the European Parliament; and, finally, the numerous speeches andarticles by the members of the Governing Council. Taken as a whole, theEurosystem is probably among the more active central banks when it comes toexplaining its policies to the public.
Afurther important building block in order to establish credibility is thepromotion of an efficient implementation of the monetary policy decisions. TheEurosystem has aimed to set up an operational framework which is consistentwith market principles and which ensures equal treatment of counterparties andfinancial systems across the euro area. The Eurosystem's operational frameworkis based on the principle of decentralisation in order to take advantage of theestablished links between the national central banks and their counterparties.The monetary policy operations will therefore be conducted by the nationalcentral banks, while decisions are taken centrally in the ECB's decision-makingbodies.
Theconsequences of a single currency: perspectives for the future
Themost important effects of the single currency relate to the possibility ofimproving macroeconomic stability and credibility for the policies pursued;these effects are particularly important for the smaller European economies.Moreover, important benefits can be derived from microeconomic factors, such aslower transaction costs, wider and deeper financial markets, improved pricetransparency and increased competition.
Startingwith the macroeconomic factors, Monetary Union makes it possible for theparticipating countries to combine their credibility. In this way, smallcountries can, to a certain extent, «borrow» credibility from some ofthe large countries which have pursued stability-oriented policies for a longtime. Under credible conditions, the financial markets are no longer underpressure from speculative attacks by large institutional investors. Price andinterest rate developments are stabilised, and the investment climate forcompanies is secured. In the microeconomic field, the most obvious consequencesrelate to lower transaction costs and increased price transparency acrossnational borders. These factors are likely to contribute to increasedcompetition and downward price pressure on many products.
Onevery important consequence is that the use of a single currency will give riseto larger and more competitive financial markets in the euro area. In mostEuropean countries, the financial markets have, by tradition, been rathershallow, with few participants and a rather narrow set of financial instrumentson offer. A high degree of segmentation and a lack of cross-border competitionhave implied relatively low trading volumes, high transaction costs and areluctance to implement innovative financial instruments.
Onthe introduction of the euro, the foreign exchange risk of trading in thedifferent national markets in the euro area fully disappeared. This hastriggered increasing cross-border competition and has provided an incentive forthe harmonisation of market practices. In fact, the trading of money marketpaper and euro area government bonds can already be considered to be largelyintegrated. The markets for private bonds are still segmented owing to thediffering institutional and regulatory conditions across Member States, butthey, too, will gradually integrate and provide an incentive for increasing theissuance volumes of private bonds. This will contribute to reducing thefinancing costs for private companies, and it will provide improvedopportunities for investors.
MonetaryUnion provides much needed assurance of exchange rate stability for exporters,importers and investors. This is particularly important for small and openeconomies. In fact, most countries in Europe are to be considered small in thecurrent global perspective. The active use of the exchange rate as a tool ofeconomic policy could be an alternative for a large reserve-currency country.For a small country, experience has shown that large changes in the exchangerate tend to give rise to higher costs rather than benefits, due to the harmfuleffects on expectations and higher interest rates.
Someof the economic effects of the Monetary Union may partially benefit also thecountries remaining outside Monetary Union. Nevertheless, it is important forthe «out» countries, to assess whether they find that the benefits ofmaintaining a national monetary policy «autonomy» — if there is anysuch autonomy in an integrated and globalised market situation — outweigh thepossible drawbacks of not being able to fully draw on the credibility of theeuro area, the integration of the euro area financial markets, lowertransaction costs, improved price transparency and increased competition.
Theeuro and the Nordic countries
TheNordic countries have chosen to organise their monetary policy ties to the euroarea in very different ways: Finland is the only Nordic country taking part inMonetary Union as from the start of Stage Three; Denmark negotiated an opt-outfrom Monetary Union but follows a fixed exchange rate policy vis-а-vis the eurowithin the new Exchange Rate Mechanism (ERM II); Sweden decided not toparticipate in Monetary Union from the start of Stage Three, without having aformal opt-out and the Swedish krona still floats freely against the euro; andNorway and Iceland remain outside the EU altogether.
Thedivergent approaches taken by the Nordic countries as regards one of the mostimportant economic and political projects in Europe in modern times aresomewhat strange in view of their traditionally close cultural, historical,political and economic ties. Nordic co-operation has always been very importantand close. I note with satisfaction that the public opinions in Denmark andSweden now seem to be swinging in a more favourable direction with regard tofuture membership. Maybe the successful implementation of the euro has made thepublic understand that Monetary Union is aimed at ensuring long-term stabilityin Europe. In this context, the recent signals from the Government of theUnited Kingdom in favour of membership in the Monetary Union are also veryencouraging.
Personally,I think that it would be beneficial to all Nordic countries — and the UnitedKingdom — to join Monetary Union within the not too distant future. I hope thatSweden and Denmark can become members already before the introduction of theeuro banknotes and coins in 2002.
Itis important for these countries to also assess the political aspects ofremaining outside Monetary Union. Experience has shown that EU Member Stateswhich have taken initiatives and worked constructively towards Europeanintegration have been generally more successful in gaining influence than thoseless committed to the project. In this respect, it should be noted that the aimof the Maastricht Treaty is clearly to establish a Monetary Union comprisingall EU Member States.
Personally,I also think that the Nordic countries could provide a fruitful jointcontribution to the long-term success of Monetary Union. There is no need tooveremphasise the role of small countries in this process, but it is clear thatco-ordinated views by a group of small countries would have a larger influencethan the views of individual countries. One of the benefits of the Nordiccountries — and small countries in general — is that they are seldom bound totheir old traditional system. In contrast, they typically fight for efficientsolutions which would be in the interest of the whole of the euro area.
Concludingremarks
Theproject to establish European Economic and Monetary Union was carefullyprepared and based on very strong political commitment. It has contributed tothe co-ordination of economic policies — even in a wider sense — in anenvironment of deregulated financial markets and the free flow of capital. Thestability arguments behind the introduction of the euro have been so wellaccepted that we are already seeing serious and visible efforts aimed at thenext step towards a global «single currency» through theestablishment of exchange rate co-ordination between the euro, the US dollarand the Japanese yen. In order for any such world-wide currency co-ordinationto become successful, there would be a need for political commitment toglobally harmonising fiscal, monetary and structural policies. In this context,I would advise realism, caution and a gradual approach in spite of thelonger-term ideal goal of global stability. There are still many challenges andadjustments ahead within the euro area before any world-wide steps should beconsidered. Our first priority is to ensure long-term stability in the euroarea economies under the single monetary policy and on the hope that the euroarea will soon cover all EU countries.
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Eurosystem: new challengesfor old missions
Inaugural Lecture byTommaso Padoa-Schioppa,
Member of the ExecutiveBoard of the European Central Bank,
on the occasion of hisappointment as
honorary Professor ofJohann Wolfgang Goethe-Universitдt,
Frankfurt am Main, 15 April1999
Table of contents
1. Introduction
2. Policy missions
3. New challenges
4. Making the eurosystem acentral bank
5. Dealing with theEuropean unemployment
6. Managing financialtransformations
7. Coping with a lack ofpolitical union
8. Conclusion
1.INTRODUCTION
Iparticipate in this Dies Academicus, at the University that carries the name ofGoethe, in the town of Frankfurt, in the first year of the euro, with thoughtsand emotions that are hard to conceal.
Inmy early youth, at the time of the decisions that determine one's life, thedearest of my Gymnasium teachers told me: «You have to resolve, in orderto decide your future, the dilemma of what interests you most: whether tounderstand or to change the world.» My choice has been Economics. And, thesubject of economics being human action, I early discounted that the call foraction would prevail, in my motivations, over the enquiring spirit. I did notexpect how strongly that dilemma would continue to accompany my life. Moreimportantly, I did not understand, at the time, how much acting and enquiring arecomplementary ways of being in the world and searching for truth, as Goethe'swork and life so profoundly witness. Science changes reality; practicalactivity not supported by reflection and analysis is ineffective and evenharmful.
IfI now live in Frankfurt and am here today it is because most of my professionallife was spent in an institution — the Banca d'Italia — where eminent personslike Guido Carli, Paolo Baffi and Carlo Azeglio Ciampi allowed the dilemma ofmy early years being kept somewhat unresolved and favoured independent analysisas a complement of practical activity. They also shared and encouraged thecombination of enquiry and action that helped the euro to become a reality. Tothem I therefore dedicate this lecture.
Academiais the place where teaching and enquiring reinforce each other by going hand inhand. It originates from Socrates' precept that «the wisest recognisesthat he is in truth of no account in respect to wisdom». Teaching isassertive, enquiring interrogative. One is based on the presumption that wehave answers to transmit; the other is based on the modesty imposed byunresolved questions.
Themode of the following remarks will be the interrogative, rather than theassertive one. Not only because presumption is certainly not my йtat d'esprittoday, but, more importantly, because the theme of this lecture — the newchallenges posed by the advent of the euro — has a distinctly intellectualdimension, not only a practical one. The success of EMU will largely depend onthe ability to identify new problems at an early stage and to analyse themwithout prejudice. While the mission entrusted to central bankers is not new,the challenges in the years to come may indeed differ from those of the lastfew decades. They may be «new» either because they have not beenexperienced before, or because they have acquired a new dimension.
Inreviewing what I consider to be, for the Eurosystem, the most important of suchchallenges, I shall use the academic privilege of taking a free and forward-lookingperspective. My point of view will, therefore, not necessarily coincide withthat of my institution. Moreover, I shall not be objective, because I shallmainly draw on the intellectual and practical experiences that have constitutedmy professional life.
2.POLICY MISSIONS
Policymissions have not been altered by the start of the euro. They correspond toaspects of the public interest that were not redefined, and did not need aredefinition, because of the euro.
Inthe field of central banking the public interest is to provide economicactivity with a medium of exchange that preserves its value over time. In thebroader field of economic policy — of which monetary policy is part — thepublic interest is, to use words from the Maastricht Treaty that can besimilarly found in most national constitutions and legislation, «topromote economic and social progress which is balanced and sustainable»(Article B). In the field of European integration, the mission is that of«creating an ever closer union among the people of Europe, in whichdecisions are taken as closely as possible to the citizen» (Article A).Finally, in the field of international relations the public interest is to«maintain international peace and security» (UN Charter Article 1.1)as well as to «contribute to the promotion and maintenance of high levelof employment and real income» (Articles of Agreement of the IMF, Article1.ii).
Theformulation of these policy missions has taken shape over the course of thiscentury, or even earlier, on the basis of experience, scholarly investigation,political debate and action. There would be no consensus about the primarymission of the central bank if countries had not experienced firsthyperinflation and then successful monetary management by a stability-orientedand independent central bank. Social progress and economic growth would not beon the agenda of governments without the labour movement and the GreatDepression. We would not have the EU Treaties and the Charter of the UN withoutthe tragedy of two World Wars.
Economistshave explored the scope for economic policy action, and the limits thereof, inthe monetary, fiscal and regulatory fields. Without thirty years of academicdebate about the role of monetary policy, the EMU Treaty and the Statute of theESCB/ECB would not have been written the way they were. The subordination ofeconomic policies to the principle of «an open market economy with freecompetition» would not have been explicitly inserted in the MaastrichtTreaty (Article 3A) had those principles not gained recognition in thecommunity of scholars.
Centralbankers (most notably in the Delors Committee) have prepared the blueprint forthe single currency. International and constitutional lawyers have elaboratedthe legal concepts and studied the procedures to carry out the policy missions.They have built that legal monument that is the Rome/Maastricht Treaty.Citizens and politicians have discussed, promoted and implemented the wholeprocess.
Differentpolicies carry different degrees of compulsion and effectiveness. In general,instruments are more strongly framed when they are entrusted to institutionswhose area of jurisdiction coincides with that of the nation state. Stronglyframed instruments, however, do not necessarily produce strong results. Toughregulation against air pollution adopted only by a small country is lesseffective, for that same country, than softer regulation adopted by a largergroup of countries. The economic literature about externalities, or that aboutoptimal currency areas, are seminal examples of the contribution economicresearch can make in this respect.
Inthe following I shall focus on the mission of the central banker, because thisis the function assigned to me. I am convinced, however, that the missions Imentioned are fundamentally complementary. Different assignments are part of anorderly division of labour. In a democratic and market-oriented environment notonly citizens, but also officials, can consider the aims of the various policybodies and charters — national and international — to which they refer asforming a consistent configuration. I regard this as a special privilege of thetime and space in which I have lived so far.
3.NEW CHALLENGES
Inthe last thirty years central bankers have fought for two objectives: therecognition of the primacy of price stability for monetary policy, and theindependence of the central bank. This has been the period in which thecombination of political democracy and fiduciary currency made the governanceof money particularly difficult in many countries.
Theintellectual recognition, then the political acceptance and finally the actualimplementation of a monetary constitution based on price stability and centralbank independence have required a long process. The academic profession hascontributed to it in a powerful way, from Irving Fisher to Don Patinkin toRobert Lucas. Even those who have denied the need of having a central bank,like Milton Friedman and Friedrich A. von Hayek, have in the end contributed toclarify its role and function. No less persuasive have been the arguments ofexperience. In a positive sense, the economic success of the country — Germany- where the two elements had been introduced at an early stage. In a negativesense, the social evil of high and prolonged inflation suffered by many othercountries, including my own.
Inlegal and institutional terms, the result of this long fight has been engravedin the Treaty of Maastricht. The Treaty represents the strongest monetaryconstitution ever written, not only because of its substance, but also becausethe procedure to amend it is more difficult than that required for the charterof any existing central bank. Largely induced by Maastricht and EMU is also theindependent status of national central banks in the European Union. We shouldindeed not forget that, until recently, key decisions in the field of monetarypolicy were still in the hands of the Treasury in such countries as the UnitedKingdom, France, Italy and Spain. The Maastricht process has been the catalystfor monetary reforms central bankers had advocated for years.
Partly,but not exclusively, because of this process, the conditions under which thesingle currency has come to life differ from those prevailing in the pastyears.
Priceshave for some time now shown the highest degree of stability seen for more thanthirty years. Most countries have made significant progress towards fiscalconsolidation. The consensus on sound principles of budgetary and monetarymanagement is broader and stronger, among both politicians and ordinary people,than in any other period the present generation can remember. Few dispute in anopen way the now widely used expression «culture of stability».
However,when in 1981 it was decided to save the last specimen of the smallpox virus ina laboratory for the sake of documentation, health had not ceased to be indanger. Similarly, none of these achievements can be considered as permanentand central bankers should primarily strive to preserve them. To this end,detecting new challenges at an early stage is essential. The question is: wheredo the problems come from? What are the circumstances under which the «oldmission» will have to be accomplished in the coming years? What threatensour health besides smallpox?
4.MAKING THE EUROSYSTEM A CENTRAL BANK
Thefirst challenge consists in making the Eurosystem a central bank. It may seemsimple, but is not. Let me start my explanation from the two key words of thisproposition.
Eurosystemis the word chosen by the ECB to indicate the «ECB+11 participatingnational central banks», i.e. the central bank of the euro. The Treaty hasno name for this key entity, while it refers extensively to the ESCB (EuropeanSystem of Central Banks) formed by the ECB and the 15 European national centralbanks). However, as long as there are «out» countries, the ESCB inits full composition will remain a scarcely relevant entity because it neitherrefers to a single currency area nor has any policy competence. Instead, theword Eurosystem indicates clearly the articulated entity which is for the eurowhat the Federal Reserve System is for the dollar.
Centralbank is the institution in charge of the public interests associated with thecurrency. It originates from fundamental changes in the technology of payments:the adoption of banknotes, cheques and giros, and their final disconnectionfrom gold. These changes have shaped the two other functions that most centralbanks have derived from the original payment system function: monetary policyand banking supervision. Man-made money made monetary policy possible.Commercial bank money made banking supervision necessary.
Thesethree functions have most often been entrusted to the same institution becausethey are inextricably linked. Just as money has the interrelated roles of meansof payment, unit of account and store of value, so central banking has atriadic function that refers to the three roles of money. Operating andsupervising the payment system refers to money as a means of payment; ensuringprice stability refers to money as a unit of account and a store of value;pursuing the stability of banks refers to money as a means of payment and astore of value. The function remains triadic (albeit, in my view, in a lesssatisfactory way) even where prudential control is entrusted to a separateagency. I am referring to the special «supervision» any central bankhas over its banking community, necessitated by the fact that banks are theprimary creators of money, providers of payment services, managers of the stockof savings and counterparties of central bank operations.
Inperforming its triadic function the central bank exerts operational andregulatory powers, interacts with other public authorities and the financialcommunity, entertains relations with other central banks, participates ininternational debates and negotiations about monetary and financial matters. Inall these activities it pursues and represents the public interest of a soundcurrency; all are instrumental to that interest. From the point of view of theperceptions of people and markets all such activities refer to that same publicgood that we call confidence.
Forthe Eurosystem the challenge is to rise to a full central banking role as justdefined. It is necessary because of the links that bind the various functionsof money. The Eurosystem would find it hard to play effectively its mostdelicate role — the pursuit of a stable currency or, as the German Constitutionputs it, «die Wдhrung zu sichern» — if it appeared as an inexplicableexception to the classic paradigm of a central bank. The public, the markets,the international institutions and fora would not understand.
Butit is also difficult, because the steps to take are multiple and complex fromboth a conceptual and a practical point of view. Moreover, they cannot all betaken at once. Let me briefly explain.
Inthe articulation of any federal constitution (Bund, Land and local, to use theGerman terminology) the central bank undoubtedly belongs to the level of the«federation», or Bund. The fact that important activities areconducted by «local» components of the system (Landeszentralbanken,or Federal Reserve District Banks) is an organisational feature that does notimpinge upon the constitutional position of the central bank. The same happenswithin Monetary Union. The Eurosystem is the central bank of the euro area,even though operations are carried out — to the extent possible and appropriate- through its component parts, the NCBs. Indeed, the constitutional and theorganisational profile of the institution are not in contradiction.
Althougha federal and decentralised central bank is not a novelty, the Eurosystem is aspecial case. It is the central bank of an economy that has a much deepernational segmentation than any other currency area. Its components have formany generations (and until few weeks ago) performed the full range of centralbanking functions under their own responsibility and in a national context.They have been accountable to, and sometimes dependent on, nationalinstitutions. Public opinion has perceived, and still perceives, them asnational entities. The notion of the public interest they were referring to wasthe notion of a national interest. Significant differences existed, and partlyremain, in their tasks, organisations, statutes and cultures.
Inthis situation, making the Eurosystem a central bank requires drawing theappropriate distinction between being national in the organisational sense andbeing euro area-wide in the definition of the public interest pursued. This isa difficult distinction to draw in conceptual terms, not only in practicalterms or from the point of view of personal attitudes.
Inthe preparatory discussions and negotiations that led to the Maastricht Treaty,central banks took the view that monetary functions are indivisible and that,contrary to the fiscal field, subsidiarity cannot apply to the monetary field.Their traditional and strongly held position has been that the public interestassigned to central bank is a whole which cannot easily be decomposed. Indeed,while there is a fairly well developed theory of fiscal federalism, there is noequivalent for the monetary field.
AsI said, I do think that the functions of a central bank constitute a whole thatcannot be split. This does not exclude that the Eurosystem should avoid seekingmore uniformity than necessary and that some diversity is a positive factor andhas always been valued as an aspect of the richness of Europe. Perhaps even alimited degree of internal competition may be used as an incentive to goodperformance. But can the Eurosystem depart from the two historical models ofthe Federal Reserve System and the Bundesbank? What are, in conceptual terms,the criteria of what I just called the «appropriate distinction»?What should be the touchstone?
Itwould be an illusion, I think, to expect or pretend to have a full andsatisfactory answer solely from legal interpretation. And it would beunfortunate if the Eurosystem were to fall into the trap of the narrowlylegalistic approach that paralyses international organisations. The Eurosystemis not an international organisation, its model is not the Articles ofAgreement of the IMF. Of course, the answer will have to comply with theTreaty, which provides useful guidance. However, the system is entrusted todecision-making bodies that are composed not of lawyers, but of centralbankers. They carry the primary responsibility to manage the euro and areaccountable for that responsibility. They have known for years what a centralbank is and how vague the wordings of central bank statutes have historicallybeen. Their touchstone can only be, in the end, the effectiveness in theaccomplishment of the basic mission embodied in the triadic paradigm of centralbanking functions.
5.DEALING WITH EUROPEAN UNEMPLOYMENT
Thesecond challenge comes from the high level of unemployment in Europe.
Everyeconomist, observer or policy-maker would probably agree that the most seriousproblem for the European economy, today and in the years to come, is highunemployment. In large parts of continental Europe the economic system justseems to have lost the ability to create new jobs.
Alsoon the nature and causes of European unemployment there is a large degree ofagreement, as there was agreement on the nature and causes of Europeaninflation well before price stability was finally restored in the 1990s. Thekey words describing such agreement are structural factors and flexibility.There is agreement that perverse incentives, direct and indirect taxation oflabour, unsustainable pension schemes, overly tight employment rules andrigidities throughout the economy are the main obstacles to the creation of newjobs. There is agreement that the typically European welfare state systemshould be profoundly corrected, but not suppressed. Many also think that ratherthan following a «Thatcherian» policy of cracking down on the tradeunions, it would be preferable to work with, rather than against, the labourorganisations, although reform entails occasional confrontations.
Aswith inflation in the 1970s and 1980s, so unemployment in the 1990s — whilebeing a European disease — is quite diversified across European countries andregions, due to differences in both policies and economic situations. It isover or around 20 per cent in the Mezzogiorno and Sachsen-Anhalt, but below 7per cent in Lombardy and Baden-Wьrttemberg; over 18 per cent in Spain, but lessthan 4 in the Netherlands.
Notwithstandingthe intergovernmental debates at a European level and the stated intention toundertake common initiatives, the instruments of employment policy remain innational hands, although only partly in the hands of governments. I regard thisas appropriate because competition should not be suppressed from the labourmarket.
Adoptingthe appropriate policies of structural reform has proved extremely difficult inmany key European countries, including my own and this one. Other countries,such as the Netherlands and the United Kingdom, have been more successful. Eventhe most successful experiences, however, have shown that reducing unemploymentis a long and gradual process. Although some countries started labour market reformsin the early 1980s, they only reaped the benefits in the 1990s.
Unemploymentwill thus remain with us in the years to come and I am convinced that it shouldbe regarded as the greatest policy challenge not only by governments and labourorganisations, but by the Eurosystem as well. Let me explain why.
Aneconomy in which unemployment drags above 10 per cent for years is a sickeconomy, just like one in which public finances or inflation are chronicallydestroying savings. To operate in a sick economy is always a risk for thecentral bank and for the successful fulfilment of its primary mission. In thecase of prolonged unemployment, the risk arises both on a functional and aninstitutional ground.
Ona functional ground, i.e. from the point of view of the relationship betweeneconomic variables that models usually consider, a chronically weak economy isone in which expectations deteriorate, investments stagnate, consumptiondeclines. Structural unemployment may increase the risk of a deflationary spiralbecause a longer expected duration of unemployment may imply that householdsrespond more conservatively (in terms of increasing savings) in the face of adeflationary shock. Today, we see no signs of deflation. Markets and observerswho pay attention to communications by the Eurosystem know that the monetarypolicy strategy of the euro area is symmetrical, equally attentive to inflationand deflation. Thus, they know that if that risk became reality, the Eurosystemwould have to act, and would act. But we know that monetary policy is much lesseffective in countering deflation than it is in countering inflation.
Amore insidious threat, however, may arise on the institutional ground. It comesfrom a chain of causation involving social attitudes, economic theory andpolicy, actual economic developments and institutional arrangements. Attitudesof society respond to economic situations and policies, which in turn depend onthe state of development of economics. Institutions, on their part, are influencedby attitudes of society. Both the course of economic thought and the practiceof policy were lastingly altered by the Great Depression. The epitome of thishistorical event was the Keynesian revolution. In many countries the strongconsensus about the primacy of price stability and the independence of thecentral bank was the outcome of the prolonged inflation suffered in the 1970sand 1980s. Here in Germany, it is rooted in the experience of hyperinflation.Would such a consensus survive if high unemployment remained a chronic featureof key European economies for many more years? And how would the position ofthe central bank change if that consensus faltered?
Ascentral bankers primarily concerned with price stability, what can we do tocope with this challenge and to reduce the risks? My answer may seemdisappointingly partial, as I do not think there is a miraculous medicine thatmonetary policy can provide. I would phrase it as follows.
Firstly,the central banker should be aware of the danger. He should know that in thefuture his principal objective may not receive, from the public, governmentsand parliaments the same strong support which has been the outcome of the twodecades of high inflation. Since unemployment is what concerns the voters andthe youngsters most, it may be increasingly necessary for him to play aneducational role in explaining the benefits of a stable currency to those whohave not directly experienced the costs of inflation. This is very much likethe case of the post-war generations in Europe which, being fortunate enoughnot to experience the horror of World War II, need now to be reminded about thehuman costs of that terrible conflict.
Secondly,the central banker should avoid mistakes. It may seem obvious, but he shouldnever forget that independence does not mean infallibility and that the likelynew environment will offer no forgiveness for mistakes. A mistake would be theattempt to provide a substitute for the lack of structural policies byproviding unnecessary monetary stimulus: it is not because the right medicineis neither supplied by the pharmacist nor demanded by the patient that thewrong medicine becomes effective. Another mistake would be to give theimpression that the central bank has a ceiling in mind for growth, rather thanfor inflation. On the contrary, the central bank should make it clear that anyrate of non-inflationary growth is welcomed and would be accommodated, thehigher the better.
Technically,this will not be an easy task. The analytical uncertainty surrounding estimatesof potential output and its growth rate might lead the central banker torespond quite cautiously to evidence of shifts in the rate of non-inflationarygrowth. While such caution is certainly optimal from an inflation stabilisationpoint of view, it might be wrongly interpreted as a systematic deflationarybias by the public and the politicians. This is a clear case in which anyprogress made by scholars in refining the analytical tools of the economicprofession will greatly help the central banker to achieve his goals withoutimposing unnecessary costs on society at large.
Onthe whole, however, it is part of the central banker's role to make theday-by-day decisions that, in the end, constitute monetary policy. This responsibilitycan be neither transferred to, nor challenged by, policy makers responsible forother areas. Last week, the Eurosystem has made, for the first time in itslife, an affirmative monetary policy decision by lowering its official rates.In this way, the Eurosystem has acted in line with its monetary policy strategyand made a significant contribution towards an economic environment in whichthe considerable growth potential of the euro area can be exploited in full. Itis now the responsibility of other sectors of economic policy making to dotheir part by strictly adhering to the Stability and Growth Pact andimplementing decisive structural reforms.
6.MANAGING FINANCIAL TRANSFORMATIONS
Thethird challenge consists in accompanying and surveying the rapid changes theEuropean financial institutions and markets are undergoing, and will continueto undergo over the coming years, partly — but not exclusively — as aconsequence of the euro.
Itis sufficient to observe the US Federal Reserve System to understand the rolethe Eurosystem should play in the coming years: attention in monitoring changesin the financial system, active participation in the policy debate caused bysuch change, intense dialogue with both the Administration and Congress,influence exerted on opinions and decisions.
Toa large extent the factors of change are technology determined, henceindependent of the euro and even not specifically European. Technology is thedriving force of the transformation in banking and finance that modifies thetraditional deposit loan structure of banks. Technology also reshapesdramatically the back office and the communication with customers, thusproducing massive over-branching and over-staffing in traditional banks. Alsothe globalisation of finance comes primarily from the combination of dataprocessing and telecommunications.
Otherchanges are specifically European. Since universal banking has historicallyprevailed in continental Europe, the change from an institution-based to a market-basedfinancial system is particularly significant in this part of the world.Similarly, the development of financial conglomerates is more pronounced inEurope than in the United States or Japan. Typical of continental Europe arealso the labour market rigidities that make the restructuring of banks sodifficult and slow.
Finally,there are changes induced by the euro. The removal of currency specificity as acause of national segmentation of the financial industry is causing aconvulsive shake-up of both institutions and markets. Since the beginning ofthis year, about ten banks ranking near the top of their respective nationallists have concluded or started merger operations in France, Spain, Italy, theNetherlands, Belgium and Norway. In most European countries stock exchanges andother organised markets, which were legally and structurally organised asproviders of a public service, have been transformed into profit-driven privateinstitutions and are now in a process of rapid concentration. In the coming twoor three years the number of banks will shrink, the largest banks will becomemuch larger, few financial centres and market networks will replace the presentone-country one-centre configuration.
Inany national system the central bank would actively monitor and even guide thecourse of such a transformation. It would do so along with the various agenciesresponsible for financial supervision and competition policy, and with aninvolvement of the executive power itself. Although largely determined bybusiness decisions, these developments indeed involve the public interest invarious ways.
Surveyingand accompanying a profound transformation of the financial industry would be adifficult task for any central bank. For the Eurosystem it will represent adaunting challenge because it will put to the test an unprecedentedarticulation of the policy functions that are called for. Let me brieflyexplain this assertion.
Theinstitutional setting of the euro area establishes a double separation betweencentral banking and other public functions. Firstly, a functional separation,whereby banking supervision is now assigned to institutions that — even whenthey are national central banks — no longer exert independent monetary policyfunctions. Of this separation we have many previous examples (Germany, Japan,Sweden, now the UK, etc.). Much newer is a second, geographical, separation,whereby — with only the partial exception of competition policy — the area ofjurisdiction of central banking does not coincide with the area of jurisdictionof the other public functions involved (banking supervision, regulation of thesecurities market, etc.).
Experts,including academic people, have so far focused attention onlender-of-last-resort functions and suggested that the new setting would not beable to act effectively in a crisis. I have argued elsewhere why this criticismseems unjustified. Here, I would like to suggest that the real challenge couldcome, in my opinion, from tensions between the national and the euro areainterest in the process of financial transformation.
Theprocess of industry transformation will inevitably involve aspects that havetraditionally been considered as sensitive by public authorities: suppressionof jobs, location of facilities and headquarters. Financial transformation willalso produce a hardening of competition and competition will be, to aconsiderable extent, one between national financial centers and industries, notonly between individual banks or institutions. The propensity to defendnational champions may prevail over the pursuit of efficiency. The risk for theEurosystem to fall in the trap of an improper interplay between the EU and thenational dimension of the public interest may become high. Like any central bank,the Eurosystem should be both active and neutral in the great transformation of«its» financial industry. The word «system» that is part ofits own name refers, and should apply in practice, to the whole euro area.
7.COPING WITH A LACK OF POLITICAL UNION
Thefourth challenge consists in coping with the lack of a political union. Therelationship between monetary and political union and whether the latter shouldbe a precondition for the former has been a central issue in the Europeandebate well before the establishment of the Delors Committee in 1988. While Ido think that there is a lack of political union and that this lack constitutesa serious challenge for the Eurosystem, I also think that the expression«lack of political union» is often used in an unclear way that blursthe issue. Let me thus first consider two meanings of this expression withwhich I do not concur.
First,I do not concur with the idea that there is no political union in Europe today.It is not because the content and the competence of the European Union aremainly economic, that its nature and historical role are not political. Evenbefore the single currency, EU competence extended over virtually the wholeCorpus Iuris of economic activity, from the establishment of «the freemovement of goods, persons, services and capital» (the four freedomsproclaimed by Article 3 of the Treaty) to external economic relationships. Tounderstand how very political these issues are, it should suffice to thinkabout the place they take in the US political debate today, or have taken inthe politics of our countries before the creation of the European Community.Moreover, the institutional architecture of the European Union is entirely thatof a political system, not that of an international organisation based onintergovernmental co-operation: a legislative capacity that prevails over thatof Member States, a judicial power, a directly elected Parliament.
Second,I do not concur with the idea that Monetary Union has developed outside the politicalprocess. Quite the contrary is true. The establishment of a single currency inthe European Union has been achieved because of the strong politicaldetermination of elected governments over a full decade, from June 1988 to May1998. It is significant that during that long period continuity has not beenbroken by repeated changes of political majority in virtually all countriesexcept Germany. Technocrats, i.e. central bankers, have «only» playedtheir role, crucial as it may be. They have provided expertise, from thedrafting of the blueprint to the preparatory work for the actual start of thesystem. And, no less important, they have loyally accepted the limits of theirrole and recognised that the ultimate decisions have belonged to elected politicians.This is the meaning of the two statements of July 1988 and March 1998 withwhich the Bundesbank has defined its position at the beginning and the end ofthe crucial decade. «In der Beschrдnkung zeigt sich der Meister».
Theestablishment of a single currency is a strongly political event in its genesisand a profound social and cultural change in its nature. As economists andcentral bankers we pay limited attention to notes and coins because they are aminor and endogenous component of the money stock. For many politicians,however, Monetary Union meant little else than a common banknote. They saw,better than us, that for the people money has to do with the perception of thesociety to which they belong and, ultimately, with their culture. As such,money goes well beyond the economic sphere of human action. Indeed, the actwhereby we accept to provide goods or services to an unknown person in exchangefor pieces of paper that have no intrinsic value is perhaps the mostsignificant and widespread testimony of the social contract that binds people.This is why coinage and money printing have always been a prerogative of theState.
Yet,for two main reasons it remains true that Europe has a lack of political union.First, the European Union is still not the ultimate provider of internal andexternal security, the two key functions that constitute the raison d'кtre ofthe modern State. Second, EU institutions still fail to comply with the keyconstitutional principles that constitute the heritage of western democracies:foundation of the legislative and executive functions on the popular vote,majority principle, equilibrium of powers.
Whydoes the lack of political union constitute a challenge for the Eurosystem? Iwould answer as follows.
Ina period of less than thirty years money has abandoned both the anchors it hashad since the earliest times: metal and the sovereign. It is true that centralbanks have struggled for years to free the printing press from the influence ofthe modern sovereign, as they struggled in the past to free it from theinfluence of private interests. It is equally true that the present status ofthe Eurosystem in the constellation of public powers is exceptionallyfavourable. However, only a superficial thinker could confuse independence withsolitude and take the view that the lack of political union strengthens theposition of the central bank and makes it freer to fulfil its mission.
Thesecurity on which a sound currency assesses its role cannot be providedexclusively by the central bank. It derives from a number of elements that onlythe State or, more broadly, a political union as previously defined, canprovide. When we say that a currency is a «safe haven» we refer notonly to the quality and credibility of its central bank, but to the solidity ofthe whole social, political and economic structure to which it belongs. Andhistorical experience shows that when that structure appears to weaken, thecurrency weakens, irrespective of the actions of the central bank. A strongcurrency requires a strong economy and a strong polity, not only a competentcentral bank. The central bank is, and should remain, an institution with toolimited a mission to replace the lack of a political union.
Theproblems posed by the coexistence of a single currency with a still unachievedpolitical union will influence both practical and intellectual activity in thecoming years. They will have implications for the central banker, thepolitician and, more generally, the citizen. For the politician the implicationis that his political decision to move ahead with Monetary Union in advance ofpolitical union contains an implicit commitment to work for the completion ofpolitical union. The central banker should be aware of the special difficultiesand responsibilities deriving from this anomalous condition. On the one hand hewill have to cope with this situation and adapt his attitudes to a composite — EU and national — institutional architecture, one that lacks the simplicity hewas used to and in which the Eurosystem now represents the most advancedsupranational component. On the other he should be prepared for the furtherevolution of that same architecture. Finally, from the citizens that we allare, it will require a deeper reflection about the multiple «socialcontracts» he is part of, and the loyalties they entail.
8.CONCLUSION
Ihave been fortunate to operate in an environment in which no conflict hasarisen between the central banking profession I have exercised for more thanthirty years and the European conviction that, like many persons of mygeneration, I matured in my youth. Since the early '80s I have also beenconvinced that monetary union, i.e. a confluence of the two motives, wasdesirable and possible. At the same time, the challenges for the Eurosystemoriginate precisely from that confluence.
Thechallenges are not solely economic in their nature, nor can their features becaptured by the functional relationships economists are most familiar with.Although partly related to economic factors, their features are in fact tied tothe special institutional environment to which the Eurosystem now belongs. Theyderive from the tension between the completion of the union in the monetaryfield and the incompleteness of the overall construction. It is a tensionbecause in that environment the notion of the public interest is no longer assimply and statically defined as it was when the Nation-State was anall-pervasive reality and the jurisdiction of the central bank coincided withits jurisdiction. Inevitably, this tension runs through the institutions of theEuropean Union, the Eurosystem itself, and even our minds.
Achallenge is a call to a difficult task; it entails the two notions ofnecessity and difficulty. The problems I have tried to describe are a challengenot only for practitioners, but also for the academic profession, because theirsolutions can hardly be found in a textbook and will only be invented if thecreativity of practitioners will be supplemented with that of scholars.
***
Monetary policy in EMU
Prof. Otmar Issing
Member of the executiveboard of the European Central Bank
Washington, D.C.
6 October 1998
1.Introduction
On1 January 1999, the curtain will rise on a world premiиre. For the first timein history, sovereign states will abandon their own currencies in favour of acommon currency, and transfer their monetary policy sovereignty to a newlycreated supranational institution. This process is all the more unusual from ahistorical perspective because the national currencies involved are not beingabolished because of their weakness. On the contrary, proof of a large measureof monetary stability is demanded as a precondition for participation.
Thedecision has been taken. The Euro will start on time. It must not — and it willnot — fail. The European System of Central Banks (ESCB) will devote its bestendeavours to making European Monetary Union (EMU) a success.
TheFrench president recently called this unique project a «great collectiveadventure». As a central banker I am generally not in favour of«adventures» — but who would deny that there are risks anduncertainties in this enterprise? You should be reassured that at the EuropeanCentral Bank (ECB), we have the necessary independence, instruments and toolsto deal with these risks and uncertainties in a successful way. I will discusssome of these in a moment.
Moreover,when considering the uncertainties implied by the transition to Stage Three ofEMU, we should not forget that Monetary Union will also reduce, or eveneliminate, a number of risks. This has already been demonstrated, even beforethe actual introduction of the euro. Recent turmoil in international financialmarkets did not cause any significant disruption to exchange rates amongcurrencies of the designated participants in Stage Three. This is a cleardemonstration of the success of the EMU process.
Today,I will address the role of monetary policy in EMU.
First,I will make reference to the final goal of monetary policy — the maintenance ofprice stability.
Second,I will discuss some important issues relating to the design and implementationof the monetary policy strategy at the outset of Stage Three of Monetary Union;and
Finally,I will describe some features of the operational framework of the ESCB thathave recently been finalised.
Letme begin by discussing the over-riding priority we attach to the maintenance ofprice stability.
2.The priority of price stability
TheTreaty on European Union — the Maastricht Treaty — stipulates that the«primary objective of the ESCB shall be to maintain price stability».It was left to the ESCB to provide a quantitative definition of this primaryobjective. At the ECB's precursor, the European Monetary Institute (EMI), itwas agreed that, in the interests of transparency and accountability, theESCB's chosen operational definition of price stability should be announcedpublicly. This announcement would form an important element of the overallmonetary policy strategy. Simply defining price stability leaves open thequestion of why price stability is desirable. As a central banker, the benefitsof price stability appear self-evident. Any single argument in favour of pricestability cannot comprehensively describe the benefits that it brings.
Forinstance, concerning the United States, Martin Feldstein has recently shownthat, in combination with taxes and social contributions, even quite modestrates of inflation can cause considerable real economic losses. Research at theBundesbank has produced similar results for Germany.
Butelimination of the losses caused by this channel is only one illustrativeexample among the many benefits of price stability. The greatest contributionthat the ESCB can make to the euro area's output and employment performance isto achieve and maintain the stability of prices. Stable prices are at the coreof the 'stability culture' we are trying to create in Europe, a culture that isthe foundation of sustainable and strong growth in the standard of living forEurope's citizens.
Atthe same time, the ESCB does not operate in a vacuum. Monetary policy needs tobe supported by an appropriate fiscal policy and necessary structural reformsimplemented at the national level if this 'stability culture' is to be built onsolid and sustainable foundations. The private sector also has its part toplay, notably by exercising wage moderation, given the high levels ofstructural unemployment in the euro area. Progress on all these dimensions isnot only desirable, but also absolutely necessary. Monetary policy alone cannotensure strong, non-inflationary growth and improved employment prospectsthroughout the euro area. However, only a monetary policy focussed closely onthe achievement of price stability can lay the basis for these conditions.
Ofcourse, that is not to say that the ESCB can, or should, ignore broadermacroeconomic considerations. For instance, the threats posed by deflation incombination with nominal rigidities to the real economy have to be taken intoaccount. In order to prevent any misunderstanding, let me be very clear: mydiscussion of deflation has to be seen in the context of the formulation of anoptimal definition of price stability for the ESCB that takes into accountdeflationary dangers. These dangers certainly cannot be ruled out and ourdefinition of price stability should reflect them. However, simply recallingthe current rate of inflation in the euro area — 1.2% — shows that deflation isnot an immediate concern for policy-makers.
Whileperiodic and transitory falls in the price level may be normal, and should notgive rise to major concerns, a prolonged deflation is clearly inconsistent withany meaningful definition of price stability. Moreover, since nominal interestrates cannot fall below zero, a prolonged deflation may render the interestrate policy of the central bank rather ineffective. What remains is out-rightpurchases of assets — both foreign and domestic.
Similarly,the ESCB cannot ignore the implications of nominal rigidities in wages andprices for the transmission mechanism of monetary policy. If we were to livelong enough under a regime of stable prices, I would not exclude thepossibility that wage and price setting behaviour would adapt, and nominalrigidities would finally disappear. This would reduce some of the potentialoutput costs of fighting inflation, and thus increase the net long-run benefitsof price stability. However, for the time being we may have to live with theserigidities and take their effects into account when deciding on our monetarypolicy strategy.
Inthis respect, the present situation is not easy for the ESCB. Unemployment inthe euro area is currently very high.
However,in contrast to these persistently high levels of unemployment — which arelargely structural in origin — the prospects for maintaining price stabilityare currently very encouraging. Inflation expectations and long-term interestrates in the euro area are at close to historical lows. Actual area-wideinflation is also very subdued.
Thecurrent low 'headline' rate of inflation has been moderated somewhat by recentfalls in oil and commodity prices, themselves stemming, in part, from theeconomic and financial crises in Asia and, more recently, in Russia. However,this effect on inflation has been largely off-set by the impact of indirect taxrises in a number of participating countries, which have raised consumer pricesfor certain goods. All in all, the changed external environment contributes toan overall outlook of very subdued inflationary pressures.
Indefining price stability, one might ideally refer to a conceptual measure of'core' inflation that tries to isolate monetary effects on the price level — for which the ESCB is properly responsible — from such terms of trade orindirect tax shocks, over which it has little immediate control.
Inour month-to-month communication with the public, 'core' measures of inflationmay prove useful. But, in its preparatory work for Monetary Union, the EMIrecognised that any sensible definition of price stability for the euro areawould have to be based on a comprehensive and harmonised price measure. 'Core'measures of inflation typically exclude some items. They are unlikely to becomprehensive enough to satisfy the requirements of an index suitable for asensible public definition. These considerations point to using the 'headline'measure of the harmonised index of consumer prices (or HICP) for the euro areain the definition of price stability.
Finally,the ESCB needs to build on the success of its constituent national centralbanks (NCBs) in reducing inflation and achieving price stability during theconvergence process in Stage Two of EMU. Given the current generally benigninflation outlook in the euro area that is the product of theseaccomplishments, there is an understandable desire to 'lock-in' the currentsuccess in achieving price stability as well as the apparent credibility ofmonetary policy, and ensure continuity with existing central bank practice.
3.The importance of the monetary strategy for a successful start of Europeanmonetary policy
Whenprice stability is defined using the principles just outlined, how should theESCB proceed to maintain it? In achieving and maintaining price stability — theprimary objective of the Treaty — the choice of monetary policy strategy isvital.
Withinthe ECB, a considerable amount of work on the monetary policy strategy hasalready been completed, building to a large extent on the substantial earlierpreparatory work of the EMI. A high degree of consensus has been reached amongthe NCBs and within the ECB about the main outlines of the strategy — I willaddress some of these areas of agreement in a moment. The final decision hasnot yet been made. But you should be reassured that progress is being made at agood pace. I have no doubt that we will be in a position to announce thedetails of the ESCB's monetary policy strategy in good time, prior to the startof Stage Three.
Beinga new institution, the European Central bank must be prepared to come underintense scrutiny right from the start. In particular, the internationalfinancial markets will monitor its every decision like hawks. Facing thisenvironment in the run-up to Monetary Union, the ESCB must ensure thateverything possible is done to make the launch of Stage Three as tension-freeas is possible. Choosing and announcing an appropriate monetary strategy iscrucial.
Themonetary policy strategy is, in the first place, important for the internaldecision-making process of the ESCB — how the Governing Council will decide onthe appropriate monetary policy stance, given the economic environment. Aboveall, the ESCB strategy must lead to good — that is to say, timely andforward-looking — monetary policy decisions.
Butthe strategy is also of the utmost significance in communicating with audiencesoutside the ESCB. It should stabilise inflation expectations. The more thestrategy helps to promote credibility and confidence in the ESCB's monetarypolicy at the outset of EMU, the more effective that policy will be — and theeasier the ESCB's task of maintaining price stability will become.
Indeciding upon the appropriate monetary policy strategy, the following aspectsmust be seen as essential requirements. The strategy must:
*reinforce the ESCB's commitment to price stability, the
primaryand over-riding task stipulated by the Treaty;
*it must clearly signal the anti-inflationary objectives of
theESCB, and serve as a consistent benchmark for the
monetarypolicy stance; and,
*it must be transparent and explained clearly to the general
public- only then can the strategy serve as a basis for the
ESCB'saccountability to the public at large.
Therealisation that achievement of an optimal, non-inflationary macroeconomicoutcome may founder on the private sector's distrust has been central to themonetary policy debate of the nineteen-eighties and 'nineties. The search foranswers to the questions raised by this debate has spawned an enormous economicliterature. The keywords «time inconsistency» and«credibility» draw forth an almost unmanageable flood of publicationsthat have appeared in the wake of the pioneering contributions of Kydland / Prescottand Barro / Gordon.
Theneed to establish a credible and consistent monetary strategy in the face ofthe well-known time inconsistency problem faced by policy makers — the dilemmahighlighted by this economic literature — is especially important for the ESCBat the outset of Monetary Union. As a brand new institution, the ESCB will haveno track record of its own.
Buildingits reputation, and the associated credibility of monetary policy, is vital.But the process of doing so is complicated by the relatively high level ofuncertainty surrounding the transition to Monetary Union itself. The transitionto Stage Three is a unique event, and will create unique opportunities for many- but it will also create some unique problems for monetary policy makers. Atthe ECB, we are addressing these problems and are confident that the risks canbe managed successfully. Many of the difficulties we face will be overcomethrough our own efforts over the coming months.
Amongthese problems are the difficulties involved in creating a comprehensive andaccurate database of euro area-wide statistics. Running a single monetarypolicy for the euro area requires timely, reliable and accurate euro area data.In some cases, the euro area statistics simply did not exist until quiterecently. In others, the statistics are based on new concepts, and theproperties of the data series are not yet well known. The long runs of highquality back-data required for empirical economic analysis may be unavailable.Those that do exist are likely to have been constructed using some degree ofestimation and judgement, possibly rendering the econometric results producedwith them questionable.
Furthermore,the regime shift associated with the adoption of the single monetary policy maychange the way expectations are formed in the euro area, and thereby alterforward-looking economic behaviour. Monetary policy's effects on consumption,investment, and wage bargaining — and therefore the whole transmissionmechanism of monetary policy to developments in the price level — would beamong the important economic relationships to be affected in this way.
Thismay be no bad thing. Indeed, using the regime shift implied by the transitionto Stage Three to change both public and private sector behaviour in favourabledirections may be one of the largest gains that the euro area can extract fromMonetary Union. Nevertheless, these changes are likely to complicate theimplementation of certain important elements of a monetary strategy, at leastin the short term, as past relationships between macroeconomic variables maybreak down. What is good for the euro area economy as a whole may create somepractical problems for the ESCB.
Oneexample of this so-called 'Lucas critique' phenomenon is the impact of current,very low rates of inflation on private behaviour. For many countriesparticipating in Monetary Union, there is simply no — or only very recent — experience of how the private sector will behave in an environment of sustainedand credible low inflation. Instability in past relationships may result,should behaviour change in this new, low inflation environment. I have alreadyargued that these structural changes will benefit Europe's citizens — pricestability will allow markets to work more efficiently, thereby raising growth,and improving employment prospects. But these changes may also complicate theESCB's assessment of economic and financial conditions.
Theseuncertainties — arising directly from the transition to Stage Three itself — are both compounded by, and inter-related with, the broader economic context inwhich Monetary Union will be established. The increasing internationalisationof the global economy, and the current rapid pace of technological change, haveaffected all sectors of the economy, and the banking and financial systems inparticular. For example, at present there are many, inter-related innovationsin the payments system, such as:
*the introduction of TARGET (directly related to EMU itself);
*greater technological sophistication of payments mechanisms,
asuse of computers and information technology becomes more
widespreadand advanced;
*the additional incentive for cash-less payments that may
arisefrom the fact that for some time to come -
approximatelythree years — the new euro-denominated notes
andcoin will not come into circulation. In particular,
narrowmonetary aggregates might be affected by this
development;and,
*increased competition among banks and settlements systems,
arisingfrom globalisation and the breakdown of barriers
betweenpreviously segmented national markets, which may
drivedown the margins and fees charged to customers.
Atthe ESCB we will need to keep abreast of these developments, both for theirimmediate impact on one of our «basic tasks» — promoting the smoothoperation of the payments system — and because of their broader implicationsfor the euro area economy. Reducing transactions costs in the way I justdescribed will benefit European consumers and producers — but it may alsochange the indicator properties of monetary, financial and economic variablesthat national central banks have looked to as guides for monetary policy in thepast.
Finally,in Monetary Union there will be some heterogeneity across countries within theeuro area. Europe's diversity is one of its greatest assets. But this diversityis greater than is typically the case between different regions in the samecountry using a single currency. Nevertheless, the ECB Governing Council willhave to concentrate on monetary and economic developments in the euro area as awhole when discussing and taking monetary policy decisions.
Howshould a monetary policy strategy be selected in this — for monetary policymakers, at least — potentially difficult environment? The EMI outlined a numberof 'guiding principles' for the selection of a monetary strategy by the ESCB.Foremost amongst these was the principle of 'effectiveness'. The best monetarypolicy strategy for the ESCB is the one which best signals a credible andrealistic commitment to, and ensures achievement of, the primary objective ofprice stability.
Formany commentators, this criterion points unambiguously in the direction ofso-called 'direct inflation targeting'. If monetary strategies are to be judgedaccording to how well they achieve price stability, defined as a low rate ofmeasured inflation, then advocates of inflation targets argue an optimalstrategy would surely target this low inflation rate directly. Thesecommentators would place explicit quantitative targets for inflation itself atthe centre of the ESCB's monetary policy strategy. Their approach has beenstrongly endorsed in some academic and central banking circles.
But,in the current circumstances, a pure 'direct inflation targeting' strategy istoo simplistic for the ESCB, and possibly even mis-conceived. The ESCB wellunderstands the primacy of price developments and price stability for monetarypolicy making. Indeed, the Treaty's mandate is unambiguous in this respect. Wewill signal our intentions on this dimension very clearly by making atransparent public announcement of our definition of price stability. Thecurrent low level of long-term nominal interest rates in the euro area suggeststhat the financial markets, at least, understand and believe the over-ridingpriority that we attach to achieving price stability.
Regardingstrategy, our choice therefore need not be governed solely by a desire tosignal our intent to maintain price stability. This has already been well-established- by the Treaty, and by the success of the convergence process in reducinginflation in Europe to its current low level. Rather than signalling ourintent, the strategy must constitute a practical guide that ensures monetarypolicy is effective in achieving the goal we have been set.
Inthis respect, there are considerable problems with using inflation itself asthe direct target within the ESCB's overall strategy. Because of the well-knownlags in the transmission mechanism of monetary policy to the economy ingeneral, and the price level in particular, it is impossible for a central bankto control inflation directly. Therefore, 'inflation targeting' in practicemeans 'inflation forecast targeting' where central banks set monetary policy tokeep their best forecast of inflation at the target level deemed consistentwith price stability.
Butrecognition of this need for forecasts in an inflation targeting strategyimmediately raises practical difficulties. In the uncertain environment likelyto exist at the outset of Monetary Union, forecasting inflation will be verydifficult, not least for the conceptual, empirical and practical reasons Ioutlined a moment ago. Forecasting models estimated using historic data may notoffer a reliable guide to the behaviour of the euro area economy under MonetaryUnion. Forecast uncertainty is likely to be relatively large, possiblyrendering the whole inflation targeting strategy ineffective.
Toaddress these uncertainties, a large element of judgement would have to beintroduced into the forecasting process, in order to allow for the regimeshifts and structural and institutional changes that are a seemingly inevitableconsequence of EMU. Simply relying on historic relationships to forecast futuredevelopments is unlikely to prove accurate or effective. While introducingjudgmental adjustments into forecasts in these circumstances would be bothappropriate and necessary, such adjustments are likely to compromise thetransparency of the inflation forecasts and, thus, of any inflation targetingstrategy. Using judgement may prevent outside observers from readily assessingthe reliability and robustness of the inflation forecasting procedures used bythe ESCB.
Isee a distinct bias in the academic discussion of the comparative advantages ofinflation targeting and monetary targeting. With good reason, many argumentsare presented against the ESCB adopting a monetary target. But proponents ofinflation targeting seem to forget that, in the current context, most of thesearguments could also be used against inflation targeting. Above all, I have notseen any attempt thus far — even if only a tentative one — to explain how theESCB should deal with the specific difficulties involved in making an inflationforecast at the outset of Monetary Union that could be used as the centrepieceof an inflation targeting strategy.
Inmany respects, a strategy giving a prominent role to monetary aggregates hasconsiderable advantages over direct inflation targeting. Monetary aggregatesare published. They are clearly not subject to various kinds of 'judgmentalmanipulation' by policy makers or central bank staff that might be possiblewith inflation forecasts. To the extent that policy makers wish to depart fromthe signals offered by monetary growth because of 'special factors' or'distortions' to the data — including those distortions arising from thetransition to Monetary Union itself — they will have to do so in a public,clear and transparent manner.
Moreover,a strategy that assigns a prominent role to the monetary aggregates emphasisesthe responsibility of the ESCB for the monetary impulses to inflation, which acentral bank can control more readily than inflation itself. These monetaryimpulses are the most important determinants of inflation in the medium term,while various other factors, such as terms of trade or indirect tax shocks, mayinfluence the price level over shorter horizons.
Inthe light of these considerations, it was agreed at the EMI that, regardless ofthe final choice of the monetary policy strategy, monetary aggregates would beaccorded a prominent role in the overall monetary framework adopted by theESCB.
However,the EMI also noted that certain technical pre-conditions would have to be metbefore this 'prominent role' could be translated into an explicit, publiclyannounced monetary target, guideline, benchmark or monitoring range.Specifically, such targets or ranges would only be meaningful guides tomonetary policy if the relationship between money and prices — as encapsulatedin a 'demand for money' equation — was expected to remain sufficiently stable.
Inthis regard, several existing empirical studies point towards the stability ofthe demand for euro area-wide monetary aggregates. However, these studies arenecessarily only preliminary. The reliability of these results in the face ofthe uncertainties raised by the transition to Stage Three is unknown. Futureshifts in the velocity of money are certainly possible — perhaps even likely.They cannot be predicted with certainty. Moreover, it is not clear whetherthose aggregates that have the best results in terms of stability aresufficiently controllable in the short-term with the policy instrumentsavailable to the ESCB. In these circumstances, relying on a pure strategy ofstrict monetary targeting is simply too risky.
Againstthis background, the ESCB will have to design a monetary policy strategy of itsown. The chosen strategy will show as much as possible continuity with thesuccessful strategies that participating NCBs conducted in the Stage Two. Atthe same time the ESCB's strategy will take into account to the extent neededthe unique situation created by the introduction of the euro.
4.The new monetary policy instruments and procedures for the euro area
Havinga well-designed monetary strategy is vital. But we must also be able toimplement it successfully at an operational level. What instruments areavailable to implement this strategy?
TheECB will have a complete set of monetary policy instruments at its disposal.These instruments have been selected on the basis of their efficiency fortransmitting monetary policy and their neutrality across market participants.
Threetypes of instruments are available to the ESCB: open market operations,standing facilities and a minimum reserve system. I will briefly present theseinstruments in the remainder of my speech.
4.1Open market operations
Openmarket operations include, first, a weekly main refinancing operation, which willtake the form of a reverse repurchase transaction with a maturity of two weeks.The main refinancing operation will be based on a tender procedure. The tendermay be a fixed rate tender, with counterparties bidding amounts, or a floatingrate tender, where counterparties propose bids including both amounts andinterest rates.
Second,there is the monthly longer term refinancing operation, which has a maturity ofthree months and will always take the form of an interest rate tender. This isbecause the ECB will avoid signalling its monetary policy stance through theseparticular operations.
TheECB will also conduct fine-tuning operations, through the national centralbanks of the euro area or, in exceptional circumstances, on its own account.Fine tuning operations will be conducted whenever liquidity or money marketconditions warrant. Fine tuning operations may take the form of reverserepurchase transactions (that is, the same type of transaction as that used inthe main refinancing and the longer term refinancing operations, but with nopre-set start date nor a pre-set maturity), foreign exchange swaps or thetaking of fixed-term deposits. Fine tuning operations in the form of reverserepurchase operations may be executed either through quick tenders orbilaterally. In both cases, these operations will involve a limited set ofeligible counterparties that have an appropriate track record of activity inthe money market. The other types of fine tuning operations will also beexecuted with a limited number of eligible counterparties, which will beselected ex ante by the ECB. In some countries, there will be a rotationscheme, which will aim at giving the opportunity to all eligible fine tuningcounterparties to participate in fine tuning operations.
Finally,open market operations may also be conducted whenever structural reasons, suchas the longer-term evolution of liquidity profiles, warrant it. These so-calledstructural operations may take the form of outright purchases or sales ofsecurities or the issuance of debt certificates by the ECB.
4.2Standing facilities
TheECB will operate two overnight standing facilities, which will be available toall credit institutions at national central banks of the euro area, providedthat, when using the marginal lending facility, they have sufficientcollateral. The rate of the marginal lending facility will constitute the upperbound of collateralised overnight money market rates. The deposit facility willbe remunerated at a rate that will constitute the lower bound of overnightmoney market rates.
Whenusing the marginal lending facility, or, for that matter, when entering inliquidity-providing open market operations in the form of reverse transactions,counterparties have to post assets with their national central bank (or the ECBin the exceptional case when the ECB conducts fine tuning operations on its ownaccount). These assets are meant to act as guarantees for credits received fromthe European System of Central Banks. A list of eligible assets has been drawnup for this purpose. The list comprises a wide variety of assets and has twosub-sets. First, the so-called tier one assets, which are selected by the ECBaccording to uniform criteria relating to their credit standing in the wholeeuro area. Second, the so-called tier two assets, which have been selected bythe ECB because they are of particular importance for certain national bankingsystems of the euro area, in order to promote a certain degree of continuity atthe start of the Stage Three of EMU. Two principles of equal treatment areapplied, however. First, the credit standing of tier two assets is as high asthat of tier one assets. Second, both tier one and tier two assets may be usedby any credit institution in the euro area, irrespective of its location.
Inaddition, a set of risk control measures has been elaborated to ensure that,for any counterparty, the amount of assets provided is always sufficient. Riskcontrol measures cover the assets' price and credit risks, taking account ofthe asset type, its characteristics and the maturity of the transaction. TheECB's risk control measures have been elaborated with careful attention to thebest market practices in this area. They include the deduction of haircuts fromthe assets and the imposition of initial margins to the credit amount. Anotherfeature of the risk control framework is the regular revaluations of theassets, which will, in most cases, take place daily and may trigger margincalls, most often to be settled through delivery of additional assets.
4.3Minimum reserve system
TheECB will also apply a minimum reserve system to credit institutions of the euroarea. Two main monetary policy objectives have been assigned to the minimumreserve system. The first objective is to stabilise money market interest ratesthrough the averaging mechanism, whereby the fulfilment of minimum reserverequirements is based on average reserve holdings over monthly periods of time.During the maintenance period, this allows the banking system to absorbliquidity shocks. The reduced volatility of money market rates will reduce theneed for frequent fine tuning operations, which will mean that markets are lessdistorted by central bank interventions than they would otherwise be. The secondobjective of the minimum reserve system is to enlarge the demand for centralbank money, so as to enlarge the liquidity deficit of the banking systemvis-а-vis the ESCB. This will safeguard the role of the European System ofCentral Banks as a provider of liquidity to the banking system.
Reserverequirements will be calculated by applying a reserve ratio of 1.5% to 2.5% tothe deposits, debt securities and money market paper issued by creditinstitutions, except for residual maturities above two years. Althoughrepurchase agreements are included in the reserve base, they will be subject toa zero reserve ratio. Inter-bank liabilities and liabilities vis-а-vis the ESCBwill not be subject to reserve requirements. An allowance of the order of E100,000 will be deducted from reserve requirements, so that credit institutionswith a small reserve base will not have to hold minimum reserves.
Reserveholdings will be remunerated up to the required reserve level, at the rate ofthe main refinancing operation (as averaged over a month). It may be arguedthat a less than full remuneration of minimum reserves would increase theinterest rate elasticity of central bank money demand. This notwithstanding,the ECB has decided in favour of a full remuneration of minimum reserves inview of the distortion to efficient markets that a less than full remunerationwould have implied. As a result of the full remuneration of minimum reserves,the European Central Bank has also decided not to exempt any credit institutionfrom the minimum reserve system.
4.4Procedures
TheECB will have many counterparties and be subject to close public scrutiny. Ithas therefore set up procedures for informing its counterparties and the publicabout its monetary policy instruments in a robust and transparent manner.
TheECB will inform its counterparties and the public through a document detailing itsmonetary policy instruments and procedures and through the regular publicationof various materials on its Internet site.
GeneralDocumentation
TheECB has produced a document describing its monetary policy instruments andprocedures in detail. This is called «General Documentation on ESCBMonetary Policy Instruments and Procedures». A revised version of thisdocument was published recently. This revised version includes all the newlyspecified elements of the monetary policy framework of the ECB, including forinstance the minimum reserve system. This document also includes a calendar forthe standard tender operations in 1999 (both main refinancing and longer termrefinancing operations). Calendars of standard tender operations will bepublished by the ECB every year.
Publicationson the ECB's Internet site
Thelist of assets that are eligible as guarantees for liquidity providingoperations will be made public on the Internet site of the ECB. The list willbe updated on a weekly basis and users will be able to subscribe to ane-mailing facility for receiving certain designated parts of the list on aregular basis. Users will also be able to query the list, which will contain alarge number of assets.
Thelist of institutions subject to minimum reserves, that is, credit institutionsestablished in the euro area, will also be available on the Internet site ofthe ECB, together with the list of all monetary and financial institutions inthe European Union.
5.Concluding remarks
Weare less than three months away from the moment when monetary policysovereignty is transferred from the NCBs to the ESCB. The bulk of thepreparatory work has already been completed, but major decisions — above all,the choice of a monetary policy strategy — still have to be made. The publiccan be certain that we will always inform them, regularly and comprehensively,about our considerations and deliberations. We will make all our decisionstransparent. I have no doubt that we will be well prepared for the moment atwhich we take over responsibility for monetary policy in the euro area.
The euro as aninternational currency
Speech delivered by EugenioDomingo Solans,
Member of the GoverningCouncil and the Executive Board of the
European Central Bank,
at The Athens Summit '99,
in Athens on 18 September1999
Thank you for inviting me to theAthens Summit '99 and for giving me the opportunity to speak to you atthis important event.
I should like to share with youmy views, and the ECB's views, on the importance of the euro as aninternational currency. I understand that this issue may be of interest toexperts from Greece, a «pre-in» country which intends to jointhe euro area, and to many participants from countries outside the euroarea and the European Union, some of which currently have exchangerate regimes related to the euro.
Nowadays the euro is the secondmost widely used currency in the world economy, behind the US dollar andahead of the Japanese yen. As we all know, any currency fulfils threebasic functions: it is a store of value, a medium of exchange and a unitof account. As a store of value the use of the euro as an investment and financing currency is rapidly increasing, as investors understand theadvisability of diversifying their portfolio currencies among those whichare more stable and more internationally used. The euro is developing at aslower pace as a medium of exchange or payment currency in theinternational exchange of goods and services. This fact can easily beexplained by the combined and reinforcing effects of networkexternalities and economies of scale in the use of a predominantinternational currency as a medium of exchange, as is the case with theUS dollar. The use of the euro as a unit of account is linked to its use as a store of value and a medium of exchange. The value stored in euroor the payments made in euro will tend to be counted in euro.
There are good reasons to expectan increase in international public use of the euro as a reserve,intervention and pegging currency, inasmuch as the public authoritiesunderstand that it is worthwhile to allocate their foreign reserves amongthe main international currencies and to give the euro a relevant sharein accordance with its internal and external stability and the economic and financial importance of the euro area.
In connection with the use of theeuro as a pegging currency, approximately 30 countries outside the euroarea currently have exchange rate regimes involving the euro to a greateror lesser extent. These exchange rate regimes are currency boards (Bosnia-Herzegovina, Bulgaria, Estonia); currencies pegged to the euro(Cyprus, the Former Yugoslav Republic of Macedonia and 14 Africancountries in which the CFA franc is the legal tender); currencies peggedto a basket of currencies including the euro, in some cases with afluctuation band (Hungary, Iceland, Poland, Turkey, etc.); systems ofmanaged floating in which the euro is used informally as the referencecurrency (Czech Republic, Slovak Republic and Slovenia); and, last but notleast, European Union currencies pegged to the euro through a co-operativearrangement, namely ERM II. As you well know, Denmark and Greece joinedERM II on 1 January 1999 with a ±2.25% fluctuation band for theDanish krone and a ±15% fluctuation band for the Greek drachma.Although the euro remains in second position after the US dollar interms of its official use, the role of the euro will increase in the future, without a doubt, especially after the year 2002 when the eurobanknotes and coins will begin to circulate.
Taking the current situation as astarting point, the Eurosystem's position concerning the futureinternational role of the euro is crystal clear: we shall not adopt abelligerent stance in order to force the use of the euro upon theworld economy. We are convinced that the use of the euro as an international currency will come about anyway. It will happen spontaneously, slowly but inexorably, without any impulses other thanthose based on free will and the decisions of market participants, withoutany logic other than that of the market. In other words, theinternationalisation of the euro is not a policy objective of theEurosystem; it will neither be fostered nor hindered by us. Thedevelopment of the euro as an international currency will be amarket-driven process, a free process.
The euro fulfils the necessaryconditions to be a leading international currency with the US dollar andnot against it. There is enough room for both currencies in the worldeconomy. The necessary conditions for a currency to become an international currency are based on two broad factors: low risk and largesize. The low risk factor is related to the confidence inspired by thecurrency and its central bank, which in turn mainly depends on theinternal and external stability of the currency. The low risk factor tendsto lead to diversification among international currencies, sincediversification is a means to reduce the overall risk; it acts, so tospeak, as a centrifugal force. By contrast, the large size factor relatesto the relative demographic economic and financial importance of the area which supports the currency; in other words, the «habitat» of the currency. The large size factor, which concerns the demographic,economic and financial dimension, generally tends to lead tocentralisation around one or a few key international currencies. It can beseen as a centripetal force, as a virtuous circle, which will tend to leadto an increasing use of the euro as an international currency. Let usconsider these two factors in more detail.
The first factor concerns lowrisk, credibility and stability. The stability of the euro is a priorityfor the ECB. Compared with the idea of stability, the strength of the eurois of lesser importance. This does not mean that the exchange rate of theeuro does not constitute an element to be considered in the second pillar of the monetary policy strategy of the ECB, which consists of abroadly based assessment of the outlook for price developments and risksto stability obtained from a wide range of economic indicators, the euroexchange rate being one of them. However, the basic factor that willdetermine the importance of the euro as a widely used currency in theworld economy, in addition to the demographic, economic and financialdimensions of the euro area, is, without a doubt, the stability of thenew currency, understood as a means to maintain the purchasing power of savings.
Stability is the basicrequirement for a good currency. It is what we at the ECB want for theeuro. We want a stable euro and we are convinced that, in the long term,the euro will derive strength from its stability.
The stability of the euro is thebasis for the confidence in and the credibility of the ECB, without whicha large international role for the euro would be unthinkable. Stability isthe proof of the effectiveness of the institution. Yet in order to becredible it is not sufficient for the ECB to maintain stability. Other parametersof its action must be considered: accountability, transparency andcommunication, a Europe-wide perspective, etc.
These parameters or conditionsfor the credibility of the euro are certainly demanding. However, theachievement of these conditions is the aim of all those of us whohave responsibilities with regard to the functioning of the Eurosystem.
The second factor, which we havecalled the large size factor or the habitat of the euro, is important becausewithout a certain critical mass, a currency cannot have internationalrelevance, however high its degree of stability.
The figures relating to thepopulation and the GDP of the euro area illustrate this. With 292 millioninhabitants, its population exceeds that of the United States (270million) and that of Japan (127 million). The GDP of the euro area is, onthe other hand, equal to 76% of the GDP of the United States (EUR5,774 billion compared with EUR 7,592 billion), though it is higher thanthat of Japan (EUR 3,327 billion). The source of this information, whichrefers to 1998, is Eurostat.
However, even more important thanthe current figures is the potential for the future development of theeuro area, in terms of population and GDP, if and when the so-called«pre-ins» (Denmark, Greece, Sweden and the United Kingdom) jointhe Eurosystem.
The entry of these countrieswould result in a monetary area of 376 million inhabitants, 39% largerthan the United States and almost triple the size of Japan, with a GDP ofEUR 7,495 billion, only slightly less than that of the United States and125% higher than that of Japan.
All these facts and figures whichdemonstrate the demographic and economic importance of the European Unionwould be further strengthened by enlargement to eastern Europe. Ourcontinent has a historical, cultural and geographical identity — fromthe Iberian peninsula to the Urals, with certain additional external territories — which, in the future, may also come to form an economicunit. However that is, for the moment, a distant prospect.
The size or habitat of an economydoes not only depend on demographic or economic factors; it also has to dowith the financial base or dimension of the area. In considering the financial dimension of the euro area, the first relevant feature toobserve is the low level of capitalisation of the stock markets incomparison with the United States and Japan.
Although this feature could givethe impression that the euro area has a relatively small financialdimension relative to its economic dimension, this is not the case. Thelower degree of development of the capital markets is offset by a higherdegree of banking assets. This means that the financial base of real economic activity in Europe is founded on bank intermediation, which isalso a feature of the Japanese economy. For example, private domesticcredit in the euro area amounts to 92.4% of GDP, while in the UnitedStates it is only 68.9%. Conversely, fixed domestic income represents34.2% of GDP in the euro area compared with 66.1% of GDP in the UnitedStates (statistics from the International Monetary Fund and the Bank forInternational Settlements as at the end of 1997, taken from theMonthly Bulletin of the European Central Bank). We, therefore, havetwo distinct models of private financing which clearly have to be taken into account when assessing Europe's financial dimension comparedwith the United States or Japan.
The euro, the Eurosystem'smonetary policy and, in general, the activity of the ECB and theEurosystem play a key role in the integration of European financialmarkets and all markets in general. The euro is acting as a catalyst forEuropean economic integration. And more integration will lead to a greatereconomic and financial dimension.
Monetary and financialintegration stemming from the euro and the activity of the Eurosystem willaffect the operation of the single European market in a positive way. TheEuropean market, with a single currency, will tend to be more transparent,more competitive, more efficient and will function more smoothly.This is the reason why joining the European Union, as a general rule, will lead to joining the euro area, once certain economic conditions (theso-called convergence criteria) have been fulfilled.
Monetary union is always apolitical operation, irrespective of its technical and economicimplications. Currency is one of the most genuine expressions of sovereignty,because the power to issue money is one of the greatest powers inexistence. The Treaty on European Union led, first, to thedepoliticisation of monetary power in Europe, by means of grantingindependence to the central banks and prohibiting the monetising ofpublic deficits, and afterwards to denationalisation or supranationalisation (via the creation of the Eurosystem). The Eurosystemwas not only created for the purpose of improving the operation of the SingleMarket, but also in order to make progress on the building of the Europeanpolitical structure.
The euro should not only beseen as a catalyst for European economic integration, it should also beseen as a main beam necessary to construct the European politicalstructure. The relationship between political power and monetary power isan interesting subject which is open to investigation and discussion,but that would certainly go beyond the scope of this speech. I merely wishto point out that, in the case of Europe, it is clear that following theachievement of a single currency, the door remains open to politicalunion, which would represent a crucial step in the process of integration.In conclusion, it would seem clear that the implications of the euro go«beyond supply and demand» (to use the title of the work ofWilhelm Rцpke). We are now fully immersed in «meta-economy»,which means it is time to end my speech.
Keynote address to bedelivered by
Dr. Willem F. Duisenberg
President of the EuropeanCentral Bank
on
The European System ofCentral Banks
Current position and futureprospects
At a Conference organisedby the Royal Institute of International
Affairs on
European economic andMonetary Union
Markets and Politics underthe Euro
London 27 november 1998
1.Introduction
Ladiesand Gentlemen, I should like to express my appreciation at being invited todeliver a speech at this conference organised by the Royal Institute ofInternational Affairs. It is a great pleasure for me to be here, in London,today.
Thetopic I am going to address relates to the current position and the futureprospects of the European System of Central Banks. I feel that this topicprovides me with an opportunity to deal with the objective of the ESCB and itscontribution to the other policies in the Community. I will also briefly touchupon the decision-making in the ESCB, recall the main features of our monetarypolicy strategy and talk about our regard for openness and transparency. Thefinal part of my talk will cover the views of the ESCB on recent economicdevelopments and the future outlook for price stability in the euro area.
2.Independence, transparency and accountability
Inthe Maastricht Treaty the ESCB has been given an independent status. The reasonis that politicians all over the world have come round to the view thatmonetary policy decisions taken with too close a political involvement tend totake too short a time horizon into consideration. The consequence is that inthe longer term such decisions do not support sustainable gains in employmentand income, but only lead to higher inflation. This view is confirmed by a hostof economic research.
Independence,however, requires a clear mandate. The ESCB has such a mandate. Its primaryobjective is to maintain price stability. Without prejudice to the objective ofprice stability the ESCB shall support the general economic policies in theCommunity. Price stability is not an end in itself: it creates the conditionsin which other, higher-order, objectives can be reached. In particular, I sharethe deep concerns about the unacceptably high level of unemployment in Europe.The ESCB will do what it can to contribute to the solution of this problem. Bymaintaining price stability inflation expectations and interest rates can bekept at a low level. This creates a stability-oriented environment whichfosters sustainable growth, a high level of employment, a fair society and betterliving standards. Moreover, in specific circumstances, if production, inflationand employment all move in the same direction, monetary policy can play somerole in stabilising output and employment growth without endangering pricestability. However, the contribution from monetary policy can generally be onlylimited. Given the structural nature of the unemployment problems the solutionis to be found, above all, in structural reforms aimed at well-functioninglabour and product markets.
Anindependent central bank does not only need a clear mandate. It has also to bean open and transparent institution, for at least three reasons. First,transparency enhances the effectiveness of monetary policy by creating thecorrect expectations on the part of economic agents. A predictable monetarypolicy contributes to achieving stable prices without significant adjustmentcosts and with the lowest interest rate possible. The second reason is that ina democratic society the central bank has to account for its policies. Finally,transparency towards the outside world can also structure and discipline theinternal debate inside the central bank.
Letme now turn to the ways and means of achieving transparency. As a first elementthe ESCB has defined a quantitative objective for price stability. It reads asfollows: price stability is a year-on-year increase in the Harmonised Index ofConsumer Prices (HICP) for the euro area of below 2%. Although I do notconsider deflation to be likely in the current environment, I may add that asituation of falling prices would not be consistent with price stability.
TheGoverning Council has made it clear that «Price stability is to bemaintained over the medium term». The ESCB cannot be held accountable forshort-run deviations from price stability, for example due to shocks in importprices or specific fiscal measures. A monetary policy reaction to short-runfluctuations in the price level would provide the wrong signals to the marketand cause unnecessary interest rate volatility. In summary, the ESCB will reactin an appropriate, measured and, when necessary, gradualist manner to economicdisturbances that threaten price stability in the medium term, rather than inan abrupt way, in order to avoid unnecessary disruptions of the process ofeconomic growth. That said, the ESCB will, whenever necessary, openly discussand explain the sources of possible deviations from the quantitative definitionof price stability.
Inaddition, let me remind you that by focusing on the HICP for the euro area, theESCB makes it clear that it will base its decisions on monetary, economic andfinancial developments in the euro area as a whole. The single monetary policyhas to take a euro area-wide perspective: it will not react to specific regionalor national developments.
Theinstitutional implication is that the ESCB should develop into a strong unity,with a strong centre and strong national central banks. It should become atruly European institution, with a truly European outlook. Of course, it maytake some time to arrive where we ultimately want to be. We have to get used tothinking in euro area-wide terms. In the ECB Governing Council we are already«practising» that approach and are making progress. I am confidentthat the ESCB will indeed act as a unity.
Transparencyand openness will be apparent from the way in which the ESCB communicates withthe public. The ESCB will regularly present its assessment of the monetary,economic and financial situation in the euro area and provide information abouteach specific monetary policy decision, be it a move in interest rates or anabsence of change. This will notably be done by way of press releases, pressconferences, publications and speeches. Press releases are made availableimmediately after the fortnightly meetings of the Governing Council and, as youmay know, they always include a precise list of the decisions taken togetherwith background information.
Therewill be a monthly press conference. Such a press conference will start with a detailedintroductory statement, as has been the case so far, and these introductorystatements will also be published immediately, without delay. In this statementthe Vice-President and I will present the Governing Council's view of theeconomic situation and the underlying arguments for its monetary policydecisions, followed by a question and answer session.
Thepublications of the ESCB will include, in particular, an ECB Bulletin eachmonth as well as an Annual Report. As from 1999, a detailed analysis of theeconomic situation in the euro area will be presented in the monthly Bulletin.Thematic articles in this Bulletin will include in-depth analyses by the ECB onmatters regarding the monetary policy of the ESCB and the economy of the euroarea. Further, you may also recall that, as required by its Statute, the ESCBwill publish its consolidated balance sheet on a weekly basis.
Mycolleagues on the Executive Board of the ECB and I intend to be very active ingiving speeches dealing with all issues of relevance for the conduct ofmonetary policy. I am convinced that the Governors of the national centralbanks will also play their role in this respect.
SinceI am talking about the communication and external relations of the ESCB, Iwould like to underline that I am prepared to accept invitations to appearbefore the European Parliament at least four times a year to present theactivities of the ESCB and the ECB's Annual Report. Finally, it should be notedthat the ESCB will have a regular exchange of information and views with theECOFIN. Representatives of the ECB will be invited to ECOFIN meetings wheneverissues of concern to monetary policy are discussed. A similar relationship willnaturally also exist with the EURO-11, whose meetings will generally beattended by the President of the ECB, whenever matters relevant to the ESCB areon the agenda.
3.Monetary policy strategy of the ESCB
Weare now approaching the start of the Third Stage of EMU. The decision-makingbodies of the ECB have made a certain number of important decisions since theESCB was established. As part of these decisions, the monetary policy strategyof the ESCB was recently announced and explained to the public. The selectedstability-oriented strategy promotes as much continuity as possible with theexisting strategies of national central banks in the EU. At the same time, itsdesign is adapted to the unique situation of introducing a single currency ineleven countries, which may to a certain extent change economic behaviour.Therefore as much continuity as possible and as much change as required is thethrust of our strategy.
Ourstrategy consists of two pillars. The first is an important role for money andthe second is a broad-based assessment of the outlook for price developments inthe euro area. The main reason for assigning a prominent role to money is theempirically well-founded view that inflation, at least in the long run, is amonetary phenomenon. This simple and obvious observation led the GoverningCouncil to announce a quantitative reference value for the growth of a broadmeasure of money. This choice will create a «nominal anchor» formonetary policy and therefore help stabilise private inflation expectations atlonger horizons. The reference value will be derived in a manner that isclearly consistent with — and serves the achievement of — price stability. Itwill be constructed such that, in the absence of special factors or otherdistortions, deviations of monetary growth from the reference value will signalrisks to price stability.
However,it has to be clear that the reference value is different from an intermediatemonetary target, as the ESCB has not made any commitment to correct deviationsof actual monetary growth from the reference value over the short term. Inparticular, it has been realistically recognised that the move to a singlecurrency and ongoing financial innovations may generate fluctuations in theselected monetary aggregate which are not necessarily associated withinflationary or deflationary pressures. For this reason, it is important tocontinuously monitor the relevance of temporary factors or even structuralchanges in order to avoid a mechanistic policy reaction to deviations of thechosen monetary aggregate from the reference value. The results of thisanalysis and its impact on the ESCB's monetary policy decisions will beexplained to the public.
Letme turn now to the second key element of the monetary policy strategy, thebroad-based assessment of the risks to price stability. The informationcontained in monetary aggregates, while of the utmost importance, will by nomeans constitute the whole of the «information set» in the hands ofthe ESCB. In parallel with the analysis of money growth, a wide range ofeconomic and financial variables will be used to formulate an assessment of theoutlook for price developments. The envisaged strategy will enable the ESCB toperform a cross-check between the information coming from the evolution ofmonetary aggregates and those from other economic and financial indicators.
4.Recent economic developments and prospects
Letme turn to the current economic situation. The euro area experienced astrengthening of economic growth in 1997, to 2.5%, and a further accelerationhas been anticipated for this year. The global environment has, of course,deteriorated in the meantime, but this has not so far had an observable impacton growth which has, in any event, been increasingly led by domestic demand.Inflation has remained subdued and even fallen somewhat over the past year,partly as a result of the impact of weaker global demand on oil and commodityprices. However, the favourable pattern of inflation has also been supported bydomestic factors, such as a very moderate development in unit labour costs andindustrial producer prices.
Concerningrecent price developments, HICP inflation for the euro area fell to 1.0% inSeptember, due to a strong impact from food prices, but I would not want toread too much into this latest decline as some price components can berelatively volatile over short periods. More significantly, preliminary datasuggest that various broad monetary aggregates for the euro area are increasingat between 3 and 5%, and thus do not appear to signal any strong incipient inflationaryor deflationary pressures. We are in line with the consensus view thatinflation in the euro area will rise moderately in 1999, but remain below 2%. Ido not consider deflation to be a serious risk for price stability at present.
Sofar, despite the worsening of the global environment, euro area-wide activityhas continued to expand at a fairly stable rate. At around 3%, annual real GDPgrowth was broadly unchanged in the first half of 1998 from the solid growthseen in the second half of 1997. Industrial production growth has slowedsomewhat since the spring. More recent evidence, particularly that of thearea-wide survey data, may also suggest a moderation in the pace of growth andfurther developments in these indicators will continue to be monitored closely.Area-wide growth should, however, be supported by a number of domestic factors.One factor supporting continued growth, particularly in private consumption, isthe gradual improvement in labour market conditions. Moreover, the lowest short-terminterest rates in the euro area currently stand at 3.3%, and several countrieshave cut interest rates towards this level recently as part of the processtowards interest rate convergence. The process of convergence towards thislevel has been gradual, but should imply a reduction in the average short-terminterest rate in the euro area of about 0.5 percentage point since July.Long-term rates also stand at low levels. And, there has been a marked degreeof exchange rate stability among countries participating in the euro. This isundoubtedly a welcome development from the standpoint of encouraging trade andinvestment. Thus, our assessment is similar to that of other internationalorganisations, that — unless the international environment deterioratesfurther, which is not currently expected — growth will be somewhat weaker in1999. Growth should, however, remain high enough to support continuedemployment creation and, assuming a recovery in the international environment,there should be a pick-up in growth in the year 2000. At the meetings inDecember the ECB Governing Council will again assess the outlook for economicand price developments.
Althoughthe economic outlook may be less favourable than expected — let us say — half ayear ago, I believe that the conditions for a successful launch of the euro arein place. You can be sure that the ESCB will do its utmost to make the euro astable currency.
The euro: pushing theboundaries
Presentation by Ms SirkkaHдmдlдinen,
Member of the Executive Boardof the European Central Bank,
at the symposium arrangedby the European Private Equity and
Venture Capital Association
on 11 June 1999 in Prague
Itis a great honour for me to be invited here today to this symposium arranged bythe European Private Equity and Venture Capital Association to speak about thenew European currency — the euro. Indeed, the theme of this symposium — «Pushing the boundaries» — is very appropriate when speaking aboutthe euro. To my mind, the establishment of Economic and Monetary Union can becharacterised as pushing the boundaries in several ways, such as:
*pushing the boundaries in the process of European
integration;
*pushing the boundaries of stability-oriented policies in
Europe;and
*pushing the boundaries of market integration in Europe.
Intoday's presentation, I shall give an overview of these three aspects ofEconomic and Monetary Union. Thereafter, I shall discuss more thoroughly theimplications of the single currency for the development of the Europeanfinancial markets, focusing on the capital markets. Finally, I shall reflectbriefly on the importance of equity prices, and other asset prices, in theformulation of monetary policy.
1.Pushing the boundaries of the process of European integration
Ishall start with a few comments on the role of the euro in the overall Europeanintegration process: I think there is little doubt that in future books onEuropean history the start of the third stage of European Economic and MonetaryUnion on 1 January 1999 will be marked as a significant and unique event in thelong process of European integration. On that day, the national currencies of11 EU countries became denominations of the euro. At the same time, the«Eurosystem» (which is composed of the European Central Bank (ECB)and the 11 national central banks (NCBs) of the participating Member States)assumed responsibility for the monetary policy of the euro area.
Inorder to put this event into a historical context, I should like to note thatthe establishment of an Economic and Monetary Union in Europe was, in fact,originally motivated more by general political arguments than by economicarguments. In the current debate, these overall political arguments have almostdisappeared. Instead, the media and economic analysts are increasingly focusingtheir assessment of the new currency on the recent short-term economic andfinancial developments in the euro area.
Theprocess of European integration started shortly after the end of the SecondWorld War and gained momentum in the 1950s. At the time, the striving forintegration was mainly driven by the aim of eliminating the risk that wars andcrises would once more plague the continent. Through the establishment ofcommon institutions, political conflicts could be avoided or at least resolvedthrough discussion and compromise.
Theidea of establishing a monetary union and a common monetary policy was raisedat an early stage of this process. It was argued that the full economic effectsfrom integration in Europe could only be gained if the transaction costs ofexchanging different currencies were eliminated. Other benefits of a monetaryunion in Europe were emphasised less in the early stages of the discussion,partly due to the fact that at that time the Bretton Woods system was alreadyproviding a high degree of exchange rate stability.
Thefirst concrete proposal for an economic and monetary union in Europe waspresented in 1970 in the so-called Werner Report, named after the then PrimeMinister of Luxembourg, Pierre Werner. However, this proposal was neverimplemented. In the aftermath of the break-up of the Bretton Woods system andthe shock of the first oil crisis in 1973, the European economies entered aperiod of stagnation with high inflation, persisting unemployment andinstability in exchange rates and interest rates. The European countriesapplied very different policy responses to the unfavourable economicdevelopments, and policy co-ordination deteriorated. In this environment, itwas not realistic to establish a monetary union.
Theexperience of this volatile period showed that large exchange rate fluctuationsbetween the European currencies led to a disruption of trade flows and anunfavourable investment climate, thereby hampering the aims of achievinggrowth, employment, economic stability and enhanced integration. Therefore, thebenefits of eliminating intra-EU exchange rate volatility became anincreasingly powerful argument when the issue of establishing an economic andmonetary union was revisited in the so-called Delors Report in 1989.
TheDelors Report contained a detailed plan for the establishment of Economic andMonetary Union and eventually became the basis for the drafting of theMaastricht Treaty. This time, the time schedule for establishing the Economicand Monetary Union took into account the need to first achieve a high degree ofnominal convergence for the participating countries.
Thefact that the plan for the introduction of the single currency was then pursuedand implemented in such a determined and consistent manner implied, in itself,a boost for the overall process of integration. The momentum of the process ofintegration is no longer crucially dependent on political decisions. Bycontrast, the integration of the European economies has become an irreversibleand self-sustained process, which is proceeding automatically in all areas ofpolitical, economic, social and cultural life. The euro can thus be seen as acatalyst for further co-ordination and integration in other policy areas. Thisis one way in which the introduction of the euro has definitely helped to pushthe boundaries in the process of European integration.
Anotherway to push the boundaries in the European integration process relates to thegeographical extent of the euro area and the European Union. Here, I sincerelyhope that the four EU countries which have not yet adopted the euro will soonbe able to join the Monetary Union. At the same time, I hope the process toenlarge the European Union with the applicant countries will progresssuccessfully. An enlargement of the euro area and of the European Union wouldfurther strengthen the role of Europe in a global perspective and should be forthe benefit of all participating countries. However, it is clear that countriesaiming to join the Economic Monetary Union would have to fulfil the same degreeof nominal convergence as was required from the participating countries whenthe Economic and Monetary Union was established. This is essential in order toavoid tensions to emerge in the euro area, which could eventually compromisemacro-economic stability.
2.Pushing the boundaries of stability-oriented economic policies
Economicand Monetary Union in Europe also provides an opportunity to push the boundariesin areas of economic policy. The convergence process prior to the establishmentof Economic and Monetary Union was helpful in order to achieve a broadconsensus among policy makers on the virtues of stability-oriented policies,i.e. policies directed towards price stability, fiscal discipline andstructural reform geared at promoting growth and employment. The convergenceprocess also helped policy makers to focus their efforts on the formulation ofstability-oriented economic policies in the participating countries and it alsofacilitated the acceptance of these policies among the general public.
Inthe new environment of Economic and Monetary Union, monetary policy can nolonger be applied as a means of accommodating economic developments in an individualMember State. Such nation-specific developments would have to be countered byfiscal and structural policies, while the best way in which the single monetarypolicy can contribute to improved conditions for growth and employment is byensuring price stability in the euro area as a whole. In this respect, theformulation of the Maastricht Treaty is instrumental, since it guarantees theEurosystem's firm commitment to price stability; it clearly specifies thatprice stability is the primary objective of the single monetary policy.
TheEurosystem has put a lot of effort into establishing a monetary policyframework that will ensure that it can fulfil its primary objective of pricestability as efficiently as possible. There are several aspects to thisframework.
First,the Eurosystem has adopted a quantitative definition of the primary objective — the Governing Council of the ECB has defined price stability as a year-on-yearincrease of the Harmonised Index of Consumer Prices (HICP) for the euro area ofbelow 2%. This is a medium-term objective. In the short run, many factorsbeyond the scope of monetary policy also affect price movements.
Second,the Eurosystem has made public the strategy to be used for the implementationof the single monetary policy. This strategy is based on two key elements,whereby money has been assigned a prominent role, as signalled by theannouncement of a reference rate of 4Ѕ% for the 12-month growth of the euroarea monetary aggregate M3. The other element consists of a broadly basedassessment of the outlook for price developments and the risks to pricestability in the euro area on the basis of a wide range of economic andfinancial indicators.
Third,the Eurosystem puts significant emphasis on the need to carefully explain itspolicy actions in terms of its monetary policy strategy. Therefore, theEurosystem has established various channels for the communication with marketparticipants and the general public. The most important communication channelsare the ECB's Monthly Bulletin, its press releases and the press conferencesfollowing the meetings of the Governing Council, the President's appearances inthe European Parliament and the speeches given by the members of the GoverningCouncil.
Fourth,the Eurosystem's monetary policy is implemented in a marketed-oriented manner.The Eurosystem's key policy instrument is its weekly tender for two-week repooperations, the so-called main refinancing operations. The features of themonetary policy operations are decided by the decision-making bodies of theECB, but the operations are conducted in a decentralised manner by the NCBs.
Theexperience gained from the first five months of operations has shown that theEurosystem's procedures for decision-making and operational implementationworks very well. There are therefore no operational reasons to call intoquestion the ability of the Eurosystem to fulfil its mandate to ensure pricestability in the euro area. However, stable macroeconomic policies cannot beachieved by monetary policy alone. It is also necessary for governments topursue fiscal and structural policies consistent with such macroeconomic stability.
Inorder to ensure fiscal discipline in the participating countries, the EUCouncil agreed in June 1997 to establish the so-called Stability and GrowthPact. This Pact sets an upper limit of 3% of GDP for the fiscal deficits of thecountries participating in the euro area. Furthermore, the Pact specifies as anobjective that Member States are to bring government budgets close to balanceor even into surplus in the medium term. Only if this objective is met willsufficient room for manoeuvre be created to enable fiscal policy to react tocyclical developments without risking a loss of credibility.
Asregards structural policies, the policy framework is, so far, less welldeveloped. This is worrying given that the need for structural reform is urgentin many areas in order to be able to effectively promote greater growthpotential and higher employment. I appreciate that these problems are generallyacknowledged, and some action has been taken in recent years. For example, itis encouraging that the European Employment Pact adopted at the EU Summit inCologne last weekend explicitly recognises the need to pursue comprehensivestructural labour market reform.
Nevertheless,experience from several countries shows that it usually takes a long time for thefull effects of structural reforms to be seen. Therefore, it is worrisome thatstructural reforms, in particular as regards labour markets as well as those tolimit expenditure on social security and pension systems, are long overdue inseveral Member States.
Clearly,the establishment of Economic and Monetary Union does not mean that the effortsundertaken during the convergence process can be relaxed. On the contrary, theneed for policy co-ordination among the participating countries is now even morepressing. We have already seen examples of negative market reactions to anyperceived slippage in fiscal discipline or postponement of structural reform.Personally, I think that these swift market reactions, although sometimesexaggerated, may be helpful in promoting a continued stability-oriented policythinking in Europe. Any move towards less responsible policies would come upagainst intense peer pressure from other countries.
Inthis context, I would once more like to underline how important it is that aconsensus has emerged among European policy-makers on the virtues of pricestability, fiscal discipline and market-oriented structural reform. In thisway, we have already pushed the boundary significantly towards a macroeconomicenvironment conducive to growth and employment, although much still needs to bedone in the years to come.
4.Pushing the boundaries in the development of financial markets
However,the success of the euro is not only in the hands of central bankers andpolicy-makers. An important area in which the private sector has aninstrumental role in meeting the challenge of pushing the boundaries is in thedevelopment of the European financial markets. In order for the euro to be asuccess, it is important for the euro area financial markets to become wider,deeper and more diversified. The introduction of the euro has provided furtherinput into this process; the elimination of exchange rate risks has removed oneof the main barriers to financial market integration in Europe.
Inmost European countries, the financial markets have, traditionally, been rathershallow, with few participants and a narrow range of financial instruments onoffer. A high degree of segmentation and a lack of cross-border competitionhave implied relatively low trading volumes, high transaction costs and areluctance to implement innovative financial instruments. This segmentation hasbeen a function of exchange rate borders, tradition, differing practices and,of course, national regulations and tax regimes.
Followingthe elimination of the barriers implied by different currencies, it is now upto the European Commission and the relevant national authorities to further theintegration process in the areas of regulation and taxation. Meanwhile, it is upto market participants to take advantage of the business opportunities impliedby the increased scope for market integration.
Theintroduction of the euro brought about an almost immediate integration of thenational money markets into a euro area-wide money market. This was madepossible thanks to the establishment of pan-European payment systems, such asthe TARGET system set up by the Eurosystem, which enables banks to accessliquidity throughout the euro area in real time.
Thecross-border integration of bond markets in the euro area is progressing at aslower pace, as is also true of equities and derivatives markets. Thisnotwithstanding, we are also experiencing important developments in thesesegments of the financial markets. These developments are partly due to thegeneral trends towards globalisation and technological refinement and partlyrelated to the introduction of the euro. As a result of the introduction of theeuro, market participants increasingly perceive similar instruments traded inthe different national markets to be close substitutes. This holds true, inparticular, for bonds issued by the euro area governments, where theestablishment of common benchmarks, the narrowing of yield spreads andincreased market liquidity seem to indicate that a high degree of cross-bordersubstitutability has already been achieved.
Thefact that euro area financial instruments are increasingly considered to beclose substitutes increases the competitive pressures on national markets toattract issuers and investors wishing to benefit from increased cross-bordercompetition and lower transaction costs. In this context, we have recentlyexperienced several initiatives aimed at creating capital markets acrossnational borders, such as the plans to establish common trading platformslinking the European stock exchanges. Similar initiatives have also been takento establish links between national securities settlement systems, which wouldfacilitate the cross-border mobilisation of securities. In the longer run, suchdevelopments will make it possible for investors to manage their investmentportfolios more efficiently.
TheEurosystem welcomes such initiatives aimed at improving the cross-borderintegration of financial markets in the euro area, and globally, since they mayresult in a wider range of financial instruments on offer, and at a lower cost,than is currently the case in the national markets. This could lead to avirtuous circle in which the increased issuance of instruments denominated ineuro will draw the attention of international investors to the euro areacapital markets, in turn making the euro an increasingly attractive currencyfor private as well as public issuers.
Infact, the experience of the first few months of the life of the euro seems toindicate that such a positive development may already be under way. In thefirst quarter of 1999, bonds denominated in euro accounted for around 50% ofthe bonds issued internationally. This share is considerably higher than thetraditional aggregate share for bonds denominated in the constituentcurrencies, which had been in the range of 20% to 30% in recent years. We havealso seen a considerable increase in the average size of bond issuesdenominated in euro, as compared with those of bonds denominated in the formercurrencies, which may indicate that the trade in euro-denominated issues islikely to become increasingly liquid.
Despitethe recent developments in the euro area capital markets, euro area companiesare still mainly dependent on financing through the banking system. Hence,there is still plenty of scope for further development in the area of corporatefinancing. For example, the amount of private bonds traded in the euro area isstill very low compared with the United States. The market capitalisation ofequities is considerably lower in most euro area countries as compared with theUnited States and the United Kingdom. Likewise, the venture capital business inthe euro area is still in its infancy compared with the relatively matureventure capital markets in the United States and the United Kingdom.Personally, I am convinced that the introduction of the euro will also behelpful to the development of these segments of the financial markets.
Inthis context, I should like to say a few words on how the introduction of theeuro may underpin the reshaping of the European banking sector. The increasedscope for securitisation will put pressure on the European banking sector tomove away from traditional retail banking activities in favour of more advancedfinancial services. The European banking industry is still segmented intorelatively small national markets. The introduction of the euro is likely toadd momentum to cross-border integration in the European banking sector. Althougha considerable consolidation of the European banking sector has taken placeover the last decade, this consolidation has so far been almost exclusivelybased on mergers and acquisitions within national borders. It is only recentlythat we have also started to see such deals taking place across nationalborders.
Iwelcome this trend towards an expansion beyond national borders with open arms,since the establishment of truly pan-European — and global — banking groupswill be instrumental in efforts to enhance competition in the provision offinancial services.
5.The Eurosystem and the equity markets
Ishould like to conclude my presentation today by briefly discussing about theeuro area equity markets as seen from the perspective of the Eurosystem. It isclear that the Eurosystem has no direct control or influence over thedevelopment of equity markets. However, the Eurosystem acknowledges theimportance of well-functioning and efficient equity markets for the economy asa means of mobilising savings into productive investment. Hence, efficientequity markets with transparent price formation, high market liquidity and lowtransaction costs are of great value in the capital formation process.
Theexistence of efficient equity markets should also reduce the risk of theemergence of asset price bubbles, which is desirable from a monetary policyperspective. Prior to the emergence of asset price bubbles in someindustrialised countries in the early 1990s, few central banks paid muchattention to the development of prices of equities or other assets in theirmonetary policy formulation.
However,the effects of the bubble economies in the early 1990s, notably in Japan, theUnited Kingdom and Scandinavia, led to an intense debate among economists onhow monetary policy could have responded better to the situation. Some researchwas carried out in order to establish price indexes that would incorporateasset prices and which could be used as target variables or indicators withinthe monetary policy framework. However, no central bank is explicitly makinguse of such asset price-weighted indexes in monetary policy formulation.Nevertheless, this development in the early 1990s made most central banks awareof the fact that large swings in asset prices can have important effects theprice formation in the economy through its implications on real economicdevelopments and, in particular, financial market stability.
However,in practice it is not easy to let monetary policy actions respond to assetprice developments. Central banks have only one tool for the implementation ofmonetary policy — the short-term interest rate. They can therefore noteffectively try to achieve several objectives at the same time. It is alsodifficult to judge how developments in asset prices actually feed into consumerprices, thereby making it tricky to assess the need for the appropriatemonetary policy response to their changes. This difficulty is exacerbated bythe rather high volatility of certain asset prices, such as equities, whichcould result in frequent changes in policy interest rates if the central bankwere to incorporate them mechanistically into its reaction function.
Inthis respect, the present situation in the United States, as well as in severalEuropean countries, is interesting: equity prices have risen rapidly for anextended period but consumer prices remain very subdued and there are, so far,no signs that there is going to be a spill-over from asset price developmentsinto consumer price inflation.
Againstthe background of the rather unclear relationship between asset pricedevelopments and consumer price inflation, the development of equity pricesdoes not have a prominent role in the formulation of the Eurosystem's monetarypolicy. This notwithstanding, the Eurosystem closely monitors the prices ofequities and other assets within its broadly based assessment of economicdevelopments in the euro area, which forms the second pillar of its monetarypolicy strategy. The Eurosystem will therefore remain vigilant in order todetect any influence from asset prices, through their impact on real economicdevelopments and financial market stability, on the formation of consumerprices.
***
THE MONETARY POLICY OF THEEUROPEAN CENTRAL BANK
Speech by Eugenio DomingoSolans
Member of the ExecutiveBoard of the European Central Bank
during the «WorkingBreakfast» at the Permanent Seminar
on 4 December 1998 inMadrid
Introduction
Itwas with immense pleasure that I accepted the invitation to take part in thisevent, organised by Euroforum. In view of the prestigious nature of Euroforum,the professional standing of its President, Eduardo Bueno, Professor at theUniversidad Autуnoma de Madrid and consultant to the Banco de Espaсa (there isa great deal of similarity between our respective professional histories) and,above all, the value I have attached to his friendship over the past thirtyyears, there was no question as to whether to agree to join you for thisworking breakfast.
Ihave been asked to keep my presentation brief in order to allow as much time aspossible for discussion. Therefore I will try to put forward a few ideas on themonetary policy of the European Central Bank (ECB) which I can develop duringsubsequent discussions. During the discussion period please feel free to raiseany questions on other aspects of the ECB's operations.
Thethree fundamental principles underlying the monetary policy
Asin the case of any other central bank, the ECB's monetary policy is based onthree fundamental principles: setting the objectives to be achieved,establishing the most appropriate strategy for accomplishing these objectivesand, finally, selecting the best instruments for implementing its chosenstrategy.
Whilethe Governing Council of the ECB is responsible for formulating its monetarypolicy, both the Executive Board of the ECB and the national central banks areinvolved in its application and therefore this constitutes one of the tasksallotted to the European System of Central Banks (ESCB) as a whole.
Objectives,strategies and instruments therefore form the three main elements which enableus to establish the precise point within the range of monetary policypossibilities which should constitute the ECB's policy: its precise altitude,longitude and depth.
TheECB's monetary policy objectives
Wedid not have to think long and hard to define the ECB's monetary policyobjectives and, generally speaking, those of the ESCB. This had been done forus by the Treaty on European Union in which, under Article 105, it is statedthat «the primary objective of the ESCB shall be to maintain price stability»which, on a more practical level, the ECB has defined as a year-on-yearincrease in the harmonised index of consumer prices (HICP) for the euro area ofbelow 2%, which it seeks to maintain in the medium term. «Withoutprejudice to the objective of price stability», continues theaforementioned Article 105 of the Treaty, «the ESCB shall support thegeneral economic policies in the Community with a view to contributing to theachievement of the objectives of the Community as laid down in Article 2».
Ifyou refer to the aforementioned Article 2 of the so-called Treaty ofMaastricht, you will find that sustainable and non-inflationary growth,together with a high level of employment and social protection, are among itsaims.
TheECB, then, must prioritise those of its activities which promote the objectiveof stability and, without prejudice to this approach, it will contribute,indirectly and to the extent possible, to economic growth and increasedemployment.
Isthis approach in any way contradictory? Absolutely not. The best contributionthe ECB can make to promoting investment and thus to generating economic growthand increased employment is precisely by providing a framework for pricestabilisation. The worst path that the ECB could follow would be to implement alax economic policy which claimed to be directly creating jobs.
Infact, in the medium term price stability will encourage efficient investment,sustainable growth and employment. This is because stability prevents pricedistortions, that is to say any distortion of the mechanism which guidesdecision-makers in the markets, and thus favours an improved allocation ofresources. When stability is achieved, prices are more transparent, whichpromotes competition and therefore efficiency.
Moreover,if economic agents have positive expectations with regard to stability, therisk premium element of long-term of interest rates will fall, promotinginvestment and lasting consumption. In this respect, it should be rememberedthat one of the clearest inflation forecast indicators is an increasingly steepmaturity-related asset yield curve.
Finally,stability promotes growth and employment insofar as it allows resources to bechannelled into productive activity. Inflation, on the other hand, merelyencourages speculative investment with the aim of safeguarding funds againstmonetary deterioration.
Aswe saw earlier, the aims set out in Article 2 of the Maastricht Treaty alsoinclude social safeguards. In this context, therefore, it can be said thatinflation is the most unjust of all taxes, because it attacks personal incomeand assets while distorting certain public redistribution mechanisms such as,for instance, progressive taxation scales.
Inother words, stability is not just important for economic efficiency but alsofor social justice, since it provides economic conditions which benefit theweakest and most vulnerable members of society.
Anappropriate ECB monetary policy is a necessary condition but will not, initself, enable us to achieve stability. National taxation policies geared tosatisfying the objectives of the Stability and Growth Pact, together withseveral supply-side policies leaning towards liberalisation and flexibility,are also necessary to enable us to avoid the persistent need for measures tocombat inflation.
Wemust avoid the temptation to reinterpret the Stability and Growth Pact byintroducing «golden rules» of dubious legality, based on the falsetheoretical foundations of the so-called «ultra-rationalityhypothesis» which, in the past, claimed to justify increased taxationpressure and which now calls for increased public spending in terms ofinvestment. Let's not beat about the bush: taxation policy has only one goldenrule, which consists in maintaining a long-term budgetary balance on theeconomic horizon.
Inconnection with the ECB's objectives, it should also be noted that it isdifficult or even impossible to meet two separate targets simultaneously usingonly a single monetary policy. This applies when dealing with the concept offixing fluctuation bands for the rate of exchange between the euro and the USdollar. In this case, the exchange rate objective could conflict with the pricestability concept and the ECB would then fail in its primary objective. We mustnot forget, with regard to this issue, that combining linked exchange rates,the free circulation of capital and monetary autonomy is not, to be quiteblunt, sustainable. It is precisely this which is the raison d'кtre of the ECBas the single monetary authority in an economic area which has irrevocablyfixed exchange rates (a single currency) and freely circulating capital (asingle market).
Toconclude this section, let me stress that it is essential for the ECB to makeit absolutely clear that its main objective is stability. If, as some wouldsuggest (for instance in the Modigliani manifesto), the ECB were to directlytarget employment, this would adversely affect the credibility of its monetarypolicy and thus have an impact not only on inflation but also, paradoxically,on employment. The direct targeting of employment objectives by a central bankis counterproductive.
TheECB's monetary policy strategy
Astrategy is a combination of criteria and procedures which allow decisions tobe taken in order to achieve a monetary policy objective. This decision-makingprocess can be based on inflation forecasts which depend on the behaviour of arelevant monetary variable or, more simply, on the «pegging» ofexchange rates to a stable currency. This last strategy is ideal for more openeconomies, encompassed by a specific monetary zone, such as, for instance, theNetherlands and Germany. However, this would not be suitable for a much largerbut relatively closed economic space such as the euro area.
Ibelieve that it is a mistake to try to exaggerate the polarity of the inflationstrategy and the monetary strategy. These are quite clearly separate strategiesbut they are not in any way opposed, incompatible or irreconcilable. Certainly,some aspects of each of these strategies should be combined, resulting inanother, completely separate and valid strategy. This is what the ECB has doneand it now needs to give the end product a name which does not merely describethe desired objective («the stability-orientated monetary policystrategy»).
Thereare two components to the ECB's monetary policy strategy. The first, morepractical and visible component consists in a quantitative reference to thegrowth of the money supply as defined by the broad M3 aggregate. Taking intoaccount the quantitative definition of stability, economic growth and realistichypotheses on money circulation rates, this monetary reference has initiallybeen set at 4 1/2%.
Thesecond component of the ECB's monetary strategy, a more general and envelopingone, is the estimation of inflation forecasts and risks for price stability inview of changes in a group of significant variables, all of which are relatedto the euro area as a whole. Some examples of these significant variables are credit,long-term interest rates, prices of raw materials, import prices, wages andpublic spending deficits.
Inflationis a monetary phenomenon. When the rate at which the money supply grows isgreater than the nominal potential rate of growth of an economy, in the mediumterm this will generate inflation. In other words, the medium-term inflationrate is indicative of excessive monetary expansion in relation to economicgrowth. Growth in the money supply therefore provides the best early warning ofinflation and monetary control is the best monetary policy strategy. Thevirtues of the first component of the ECB monetary strategy are, when all issaid and done, well known. If it worked, this alone would be sufficient.
Inpractice, however, things are never so simple. Inflation forecasting andcontrol cannot rely solely on a monetary aggregate because of doubts as towhether or not this monetary aggregate can be controlled and is stable andmeaningful. If a narrow definition of money, such as M1, is adopted,controllability can be achieved in that, through the monetary policyinstrument, it is possible to have a greater impact on its evolution, but thisis offset by the loss of stability and significance. If it is decided to optfor a broad monetary aggregate, such as M3 or M4, the money demand functionbecomes more stable and clearly more significant, in that a greater correlationcan be achieved between exchange rates, providing a better explanation ofchanges in nominal costs and inflation, in return for some loss of control.Despite this, doubts persist. In practice, these will, of course, increase whennational currencies are replaced with the euro; then the need for the secondpart of the monetary policy strategy will become obvious.
TheESCB monetary policy tool
Thewide range of instruments available to the ESCB for the implementation of theeuro area monetary policy has been established with reference to twofundamental criteria: efficiency and neutrality. These instruments can beseparated into three categories, related to open market operations, standingfacilities and minimum reserves.
TheESCB's instruments and procedures do not differ significantly from thosetraditionally used by the Banco de Espaсa and with which you are all familiar.This means that I only need to highlight a few differences. In addition, Ishould add that over recent weeks the Banco de Espaсa has introduced changesaimed at facilitating a smooth transition.
Withregard to open market operations, the frequency and maturity of the mainre-financing operation has become that of a weekly auction of loans with amaturity of two weeks, and an interest rate which is either announced inadvance (fixed rate auction) or announced later as the result of offersreceived (variable rate auction). There will also be monthly auctions forthree-month loans which will always be of the variable rate type in order toavoid sending signals to the market. Fine-tuning will be carried out inexceptional circumstances between two regular auctions and, finally, thestructural liquidity demand can be influenced by means of open markettransactions which consist in the direct purchase and sale of securities or theissuance of debt certificates.
Standingcredit and deposit facilities will supply or absorb overnight liquidity,without the imposition of any other restrictions on their use by institutionsother than the provision of guarantees or collateral. Both types of interest onstanding facilities constitute a strip or corridor which will contain short-termmarket interest rate swings and provide a structure for monetary policy trends.This means that they will play an important role in terms of providing signals,a role also fulfilled by the Banco de Espaсa but in a less predetermined andformalised manner.
Asfar as guarantees for all these transactions are concerned, it should be statedthat acceptable collateral may take the form of either a public instrument or aprivate instrument, provided that these are of a suitable nature, according tothe neutrality principle applied to the public sector and to the privatesector.
Theminimum reserves will be equal to 2% of book liabilities calculated on thebasis of a monthly average, will be subject to a minimum exempt level of EUR100,000 and — this being the most important point underlining the maindifference compared with the current position in Spain — will be remunerated inline with market rates. The averaging provision will allow us to absorbliquidity shocks without recourse to standing facilities. Such a minimumreserves will constitute a useful tool for restricting the volatile nature ofmonetary market interests rates, for reducing the need for fine-tuning and fortightening up the system's liquidity, thereby enhancing the effectiveness of themonetary policy. Its remuneration in line with the market will not only reducemoney demand elasticity with regard to interest rates but also offer neutralityto euro area banks as compared with those in other countries which do not usesuch a tool.
Conclusion
Althoughinevitably in a simplified form, I hope that this statement on the aims,strategy and instruments of the euro area monetary policy has provided somebasic information on the central core of the ECB's operations and that it canbe used as a starting-point for our discussions.
Thankyou for listening; during the discussion period, I shall be pleased toelaborate on the issues raised or examine any others which you think may be ofinterest.
The monetary policy of theEurosystem
Main remarks of the speechdelivered by Eugenio Domingo Solans
Member of the GoverningCouncil and the Executive Board of the
European Central Bank
at the SOCIETAT CATALANAD'ECONOMIA
(Institut d'EstudisCatalans)
Barcelona, 2 July 1999
The text will be available in Catalanat a later stage.
* The primary objective of theEurosystem and, therefore, the touchstone to measure its success is theachievement of price stability. In the medium term the best contribution thatthe Eurosystem can make in favour of sustained growth is, precisely, to createan environment of stability. There is clearly no greater fertiliser foreconomic growth than price stability, and nothing is more refractory toeconomic growth than inflation. Provided that stability is achieved and thatthere is no risk for stability in the future, the Eurosystem has to create thebest monetary conditions for exploiting the considerable growth potential ofthe euro area. This should be done in a passive way, without any activism: likethe air we breathe, not like the air from an oxygen tank.
* The 5.2% increase in the three-monthmoving average of the 12-month growth rates of M3 covering the period fromMarch to May 1999 is in line with the 4 Ѕ reference value for money growth,which is the basis of the first pillar of the ECB's monetary policy. Neitherthe slight increase in the moving average compared to its value last month(5.1%) nor the non-substantial and almost constant difference from thereference value signal a risk for price stability.
* The results of the broadly basedassessment of the outlook for price developments, which constitutes the secondpillar of the ECB's strategy, confirm that there is no risk to price stabilityin the euro area.
* The second pillar of the ECB'smonetary policy strategy includes, among other indicators, the exchange ratedevelopments of the euro. The ECB's assessment on the evolution of the exchangerate of the euro should, therefore, be linked to the risk for price stabilityof a depreciation of the euro. Taking into account that the euro area economyis a rather closed one, no significant inflationary impact should be expectedfrom the recent exchange rate developments of the euro.
* One main feature of the instrumentsand procedures of the Eurosystem's monetary policy is their high level offlexibility, in the sense that without discretionary changes the instrumentscan accommodate a wide range of different market situations. On the other hand,there is flexibility in the sense that the Eurosystem has at its disposal awide set of monetary policy instruments and has, therefore, the possibility tomove from one to the other if and when it is deemed appropriate, taking intoaccount their advantages and disadvantages. In the first stage of the ECB'smonetary policy, the fixed rate tender with a discretionary allotment is thebest choice for the main refinancing operation owing to its advantages in termsof signalling effects and controlling both the liquidity allotted and thevolatility of overnight rates. On the contrary, in the case of longer-termrefinancing operations, the Eurosystem as a rule does not intend to sendsignals to the market and the effects on the liquidity and on the overnightrates are weaker. Therefore, for longer-term refinancing operations, themarket-oriented variable rate tender has a clear advantage.
* The activities and the monetarypolicy decisions of the ECB should be interpreted from a euro area perspectiveas a whole. To interpret them from a national standpoint would be a mistake.
***
THE ROLE OF THE CENTRALBANK IN THE UNITED EUROPE
Speech by Dr. Willem F.Duisenberg,
President of the EuropeanCentral Bank,
National Bank of Poland,
Warsaw, Poland on 4 May1999
1.Introduction
Firstand foremost, I should like to congratulate the National Bank of Poland (theNBP) on its 75th anniversary. The age of the NBP already suggests that as thePresident of the European Central Bank (ECB), an institution that is even lessthan one year old and has only been conducting monetary policy since Januarythis year, I should be modest. I am aware that the role of the NBP has not beenconstant over these 75 years and that in the past decade, in particular, theNBP has gone through a remarkable restructuring process. My previous centralbank, de Nederlandsche Bank, has, together with the International Monetary Fundand many national central banks, been involved in assisting the NBP in itsefforts to adapt to the role of a central bank in a market economy. Of course,the real work had to be done by you yourselves and I believe you can be proudof what has been achieved over the past decade.
Todayin my speech I should like to focus on the role of the ECB, as a truly Europeaninstitution. First of all, I shall explain the background against which theintroduction of the euro and the establishment of the ECB should be considered.Thereafter, I shall discuss the main features of the institutional structurethat determines monetary policy-making. I shall then turn to our monetarypolicy strategy and the role of accountability and transparency in thisstrategy. I shall conclude by briefly addressing the issue of EU enlargement.
2.The process of European integration
On1 January of this year the euro was introduced in 11 countries with a combinedpopulation of almost 300 million. The ECB started to conduct a single monetarypolicy for the so-called euro area. Former national currencies, such as theFrench franc and the German Mark are no longer autonomous currencies, butsubdivisions of the euro. Euro banknotes and coins will only be introduced in2002.
Thevoluntary transfer of monetary sovereignty from the national to the Europeanlevel is unique in history. However, it should not be seen as a single,isolated event. The introduction of the euro is part of the process of Europeanintegration. This process started shortly after the second World War and hasnow been under way for more than half a century. The aims of Europeanintegration are not only, or even primarily, economic. Indeed, this process hasbeen driven and continues to be driven by the political conviction that anintegrated Europe will be safer, more stable and more prosperous than afragmented Europe. It is true that economic integration has been the mainengine of this process and that, although it has had its ups and downs,integration has delivered important economic benefits. On balance it has been successful.
Theintroduction of the euro and the establishment of the ECB are important newsteps in this process of European integration. They are not the completion ofthis process, for at least two reasons. First, the launch of the euro can becompared to the launch of a rocket. A good launch is crucial, but only thebeginning of the mission. The euro has been launched successfully. Thechallenge now is to make it a success. This will not happen automatically, butwill require effort on the part of many authorities, institutions and people.Second, four EU Member States have not (yet) introduced the euro. I hope thatthis will happen in the future. Moreover, as you are aware, the EU itself islikely to increase its membership over time, also to include Poland.Ultimately, this is bound to extend the euro area. This process, too, isalready requiring and will continue to require great efforts: no pain, no gain,as is often the case.
3.The institutional framework of the single monetary policy
Letme now turn to the institutional framework for the conduct of the singlemonetary policy. This was laid down in the Treaty establishing the EuropeanCommunity, the so-called Maastricht Treaty, and the Statute of the ESCB, whichis an integral part of this Treaty. According to the Treaty the ECB has theprimary objective of maintaining price stability. Without prejudice to thisobjective, it is to support the general economic policies in the Community,with objectives such as economic growth and high employment.
Decisionson monetary policy are made by the Governing Council of the ECB. This bodycomprises the six executive directors of the ECB and the 11 governors of thenational central banks (NCBs) of the Member States which have introduced theeuro. These 17 people meet every fortnight at the ECB, in Frankfurt am Main.Decision-making on monetary policy is fully centralised. All members of theGoverning Council have one vote, whether they come from Germany or Luxembourg.This is because of an important principle. They are not representing theircountry, but are obliged to take decisions on the basis of euro area-wideconsiderations. Regional or national monetary policy does not and cannot existin the euro area. There is only one, single monetary policy for the euro areaas a whole. Therefore, the ECB should develop into a truly Europeaninstitution. This is a process that will inevitably take some time, but myfeeling is that we are already making good progress.
Theexecution of monetary policy is to a great extent decentralised. It is in largepart carried out by the NCBs. The ECB and the 11 NCBs together are referred toas the Eurosystem. If we refer to the ECB and the 15 NCBs of all EU MemberStates, we speak of the European System of Central Banks (ESCB). The GeneralCouncil of the ECB meets quarterly and comprises the President andVice-President of the ECB and the 15 governors of the NCBs of all the EU MemberStates. This body does not make decisions on monetary policy, but discussesissues concerning the relationship between the «ins» and thecountries I prefer to call «pre-ins», such as exchange rate issues.The third decision-making body of the ECB is the Executive Board of the ECB,comprising the six executive directors of the ECB. The Executive Board isresponsible for current business and the implementation of monetary policy asdecided by the Governing Council. The staff of the ECB will, in the course ofthis year, reach a level of between 750 and 800 and is likely to grow furtherin the years ahead.
TheECB is one of the most, if not the most, independent central bank in the world.Its independence and that of the participating national central banks arefirmly enshrined in the Maastricht Treaty. Members of the Governing Council arenot allowed to take or seek instructions from anybody, politicians included.Politicians are not allowed to give such instructions. Members of the GoverningCouncil have a term of office of at least five years. The ECB is financiallyindependent.
Theindependent status of the ECB fits into the recent world-wide trend of grantingindependence to central banks. This tendency is evidenced by both practicalexperience and academic research. By shielding monetary policy decisions frompolitical interference, price stability can be maintained without having togive up economic growth. Indeed, in that sense having an independent centralbank is a good thing for all concerned. The reason for central bankindependence is that monetary policy-making under the influence of politicianstends to focus too much on short-term considerations. This can easily lead totemporary, non-sustainable increases in growth, but inevitably results inlasting increases in inflation with no lasting gains in growth and employmentat all. Politicians all over the world have come to realise this and havedecided to remove the temptation to pursue short-term gains and to make theircentral bank independent. It should be underlined that granting thisindependence is, as it should be, a political decision. An independent centralbank needs a clear legal mandate.
4.The monetary policy strategy
TheECB has, as I mentioned earlier, such a mandate. However, the Treaty does notspecify how the ECB should pursue its primary objective of maintaining price stability;in other words: it is silent on what is called the monetary policy strategy.The ECB therefore formulated its strategy in the second half of last year. Thatwas no easy task. The introduction of the euro constitutes a structural break,which may change the behaviour of firms and individuals and make it lesspredictable. To a certain extent it is comparable to what Poland experiencedwhen it embarked on its reform process. The rules of the game change and thismakes policy-making more complicated. Our monetary policy strategy has takenthese specific circumstances into account. It is tailored to this unique periodof the introduction of the euro, although it has elements of both monetarytargeting and inflation targeting.
Inthe context of this strategy the ECB has provided a quantitative definition ofprice stability. Price stability is defined as a year-on-year increase in theharmonised index of consumer prices (HICP) of below 2% for the euro area as awhole. Price stability is to be maintained in the medium term.
Thestrategy consists of two pillars. The first pillar is a prominent role formoney. Ultimately, inflation is a monetary phenomenon. It is in the end resultof too much money chasing too few goods. Therefore, we have formulated a referencevalue for the growth of a broad monetary aggregate, M3, of 4 Ѕ% on an annualbasis. Growth of the money stock at this pace would provide the economy withsufficient liquidity for growth in activity in line with trend growth, withoutinflation. At the end of this year this figure will be reviewed. It should beemphasised that we did not define a target for money growth. The reason forthis is the structural break that the introduction of the euro creates. Bycalling this a reference value, it is made clear that money is one variablewhich we look at very carefully in order to examine whether inflationary ordeflationary pressures are tending to emerge. We do not, however, reactmechanistically to changes in money growth.
Theformulation of the second pillar is also prompted by the potential changes ineconomic behaviour on account of the introduction of the euro. It is a broadlybased assessment of the outlook for price developments on the basis of ananalysis of monetary, financial and economic developments. In this contextinterest rates, the yield curve, wage developments, public finance, the outputgap, surveys of economic sentiment and many other indicators are analysed. Useis also made of forecasts produced by other bodies and internally for inflationand other economic variables.
Thisbrings me to the role of the exchange rate of the euro in our strategy. Sinceour primary objective is price stability and since the euro area as a whole isa relatively closed economy with an export share of 14% of gross domesticproduct, we do not have a target for the exchange rate of the euro, forexample, against the US dollar. This does not mean, and it is good to underlinethis once more, that the ECB is indifferent to the external value of the euroor even neglects it. The external value of the euro is one of the indicators welook at in the broadly based assessment of the outlook for price developments.Within that framework, we constantly monitor exchange rate developments,analyse them and shall act on them, if and when this becomes necessary.However, such action will never be mechanistic, nor will it be isolated. Theexternal value of the euro and its development are analysed and considered inthe context of other indicators of future price developments. The ECB alsotries to assess international confidence in the still very young euro. Ofcourse, the level of international confidence in the euro is not the onlyfactor determining its external value, nor is the exchange rate the onlyindicator of confidence in the euro. It is, for instance, encouraging to seehow the euro has been received on the international money and capital markets.I am sure that an internally stable euro will also strongly underpininternational confidence in this currency, as it has for other currencies inthe past.
Asthe currency of a very large area, the issue of the international role of theeuro naturally arises. The ECB takes a neutral stance regarding this role. Itwill neither be stimulated, nor hindered. On the one hand, an internationalcurrency has advantages for citizens in the euro area, on the other, it maysometimes complicate the conduct of monetary policy when a large amount of eurois circulating outside the euro area. We shall leave the development of theinternational role of the euro to market participants and market forces. Ifhistory is a guide as to what will happen, there will be a gradual processwhereby the euro will have an increasingly international role. Such a gradualdevelopment would also be a welcome development, if only to prevent the eurofrom becoming too strong externally at some point in time. It is likely andunderstandable that interest in the euro is already considerable in thosecountries aspiring to join the EU, including Poland. I shall elaborate on thisissue at the end of my speech.
Comingback to our monetary policy strategy, I should like to point out that it isimportant to make clear what monetary policy can and cannot do. Monetary policycan maintain price stability, but only in the medium term. In the short termprices are also influenced by non-monetary developments. Moreover, monetarypolicy measures only have an impact on prices with long, variable and notentirely predictable time-lags of between 1.5 and 2 years. Therefore, monetarypolicy-making should have a forward-looking character. Today's inflation is theresult of past policy measures, and current policy measures only affect futureinflation. The uncertainty of the economic process in a market economy isanother reason for policy-makers to be modest. The ECB does not pursue anactivist policy. Precise steering of the business cycle or acyclically-oriented monetary policy are not feasible and are likely todestabilise rather than stabilise the economy. Some commentators haveinterpreted our recent interest rate reduction as a change to a morecyclically-oriented monetary policy strategy. This is not true. Our strategywas, is and shall remain medium term-oriented and firmly focused on maintainingthe price stability which currently prevails in the euro area.
Monetarypolicy should be supported by sound budgetary policies and wage developments inline with productivity growth and taking into account the objective of pricestability. Otherwise, price stability can only be maintained at a high cost interms of lost output and employment. This also explains why independence shouldnot mean isolation. It is important to have a regular exchange of informationand views with other policy-makers. The Maastricht Treaty stipulates that thePresident of the ECB is invited to meetings of the EU Council meeting in thecomposition of the Ministers of Economy and Finance whenever there are issueson the agenda which are relevant to the ECB's tasks. The President of theCouncil of Ministers and a member of the European Commission may attendmeetings of the Governing Council, although they do not have the right to vote.The President of the Council of Ministers may submit motions for deliberation.Apart from these formal contacts, there are many informal contacts, for examplein the context of the so-called Euro-11 group of finance ministers from theeuro area countries. I regularly attend meetings of this group.
Monetarypolicy cannot be used to solve structural problems, such as the unacceptablyhigh level of unemployment in the euro area. Structural problems call forstructural solutions, in this case measures targeted at making labour andproduct markets work more flexibly. The best contribution the ECB's monetarypolicy can make in this context is to maintain price stability. In this way oneof the conditions for sustainable growth in incomes and employment is created.As important as this is, it should be realised that jobs are created by firmswhich are confident about the future and not by central banks.
5.Accountability and transparency
Accountabilityfor policies is the logical complement to independence in a democratic society.The Maastricht Treaty includes a number of provisions in this respect. First,there is the mandate to pursue price stability. This provides a qualitativemeasure against which the ECB's performance can be measured. As I have alreadymentioned, we have decided to enhance this by providing a quantitativedefinition of price stability. One of the aims of publishing our monetarypolicy strategy is to make our policy decisions transparent.
TheECB has to publish an annual report in which, inter alia, the monetary policyof the previous and current year are discussed. I present this Annual Report tothe EU Council and to the European Parliament, which may hold a general debateon the basis of it. The President and other members of the Executive Board ofthe ECB may be heard by the competent committees of the European Parliament. Ihave agreed to appear before the European Parliament at least four times ayear. The ECB has to report on its activities at least quarterly. It has beendecided to go beyond this requirement and to publish a monthly bulletin.
Itis my view that the main way to achieve accountability is through beingtransparent and open. In passing, I should like to note that transparency alsoenhances the effectiveness of a central bank. The better it is understood, themore successful a central bank is. Apart from the activities I have alreadymentioned, transparency is achieved in several ways. Every month, after thefirst meeting of the Governing Council, the Vice-President and I give a pressconference. I start the conference with a comprehensive introductory statement,in which I explain the decisions taken by the Governing Council and theunderlying analysis and arguments for and against. This introductory statementis published immediately on the ECB's Internet Web site. This is followed by aquestion and answer session attended by several hundred journalists. Thequestions and answers are also published on the Internet shortly afterwards.All the members of the Governing Council frequently make speeches, giveinterviews and contribute to journals and books. Thousands of people visit theECB and the national central banks each year and, for our part, we and ourstaff attend many conferences and other public events.
6.EU enlargement
TheEuropean integration process continues. The euro should be made a success. Ihave already explained how we have started the process of doing that. Someobservers have criticised the EU for its «obsession with its own internaldynamics», in particular in the context of European Economic and MonetaryUnion (EMU). With all energies focused on meeting the convergence criteria andthe preparation for the launch of the euro, Europeans outside the EU havewondered whether EMU and enlargement are not mutually exclusive objectives.
Letme briefly comment on this issue. After the historic decision to complete theEuropean Single Market in the 1980s, it was felt that economic integrationshould not stop at that point. To fully reap the rewards of economicintegration within the Community, a single currency was felt necessary; a logicpointedly encapsulated in the title of one report: «One market, onemoney».
Hence,the underlying idea of EMU was to advance European integration and to ensurethat full use would be made of the economic potential of the Single Market.This idea continues to be the focus of European policy-makers, as evidenced bythe association agreements and the ongoing accession negotiations with a numberof European countries, Poland among them. Good and mutually beneficial economicrelations with third countries in Europe and further afield are a pillar of EUpolicy orientation. Recognising this, the principles of an open market economywith free competition are enshrined in the Treaty on European Union. EMU willnot weaken this commitment, but rather reinforce it. Closer co-operation inEurope and the respect of common principles in the political, economic andsocial fields are likely to form the basis for further integration. The ECBshall contribute to this process within the scope of its responsibility.
Countrieswishing to deepen their monetary co-operation to the ultimate extent possibleby forming a monetary union will have to adapt their economic and legal systemsto the standards required by the Treaty and aim at a sufficient degree ofeconomic convergence. In the absence of these conditions, adjustment costs forboth current and new participants could be high. Any premature decision on theadoption of the euro could have severe repercussions on a country'scompetitiveness and trigger painful economic adjustments. Therefore,implementation of the necessary institutional reforms and of a sufficientdegree of convergence should not be considered as an obstacle preventingfurther integration in Europe, but rather as an essential means of ensuring thelasting success of EMU, for existing and new participants alike. Looking at theimpressive progress made in a relatively short time in this country, there isno reason to be pessimistic about Poland's chances of meeting these standardsand convergence criteria. I shall not venture, however, to predict when thiswill be the case.
Evenat the current juncture, though, EMU in one part of Europe is already having animpact on the whole region. Let me briefly mention two aspects:
*If the euro emerges, as I believe it will, as a strong and
stablecurrency, it will provide the countries in the region
withan important reference currency, an anchor towards
which,should the intention arise, monetary policy could
crediblybe oriented.
*Furthermore, EMU is set to bring about the development of a
trulyunified European financial market, close to that of
theUnited States in depth and sophistication. The
competitivepressures of this euro area financial market
willcreate more favourable financing conditions for
borrowers.A number of central and eastern European
countrieshave already successfully tapped this market.
Inview of these effects, it is altogether natural that the ECB has started tofollow with great interest economic and financial developments in the widerEurope, particularly in those countries which have applied for EU membership.Moreover, the ECB monitors closely the exchange rate developments with thosecountries which have established some form of exchange rate link to the euro.
Theeuro has the potential to become more than just a new currency for almost 300million people in 11 countries. It may also become a unifying symbol, standingfor all that the peoples of Europe have in common. Consequently, the publicperception of the euro could endow the single currency with a role in the Europeanintegration process reaching beyond monetary policy in the strict sense. Maythe euro contribute to the establishment of what the preamble to the TreatyEstablishing the European Community calls: «an ever closer union among thepeoples of Europe».
***
The single Europeanmonetary policy
Speech by Willem F.Duisenberg
President of the EuropeanCentral Bank
at the University ofHohenheim
on 9 February 1999, inHohenheim, Germany
Ladiesand gentlemen, The single European monetary policy has been a reality for alittle more than five weeks. After years of intensive preparatory work andsuccessful economic convergence, monetary policy is now jointly determined fora large part of Europe by the Governing Council of the European Central Bank.The monetary policy is implemented by the Eurosystem, the name given to the ECBand the 11 central banks of the EU Member States participating in MonetaryUnion.
Thesingle currency is quoted on the international financial markets and is used innon-cash payments. However, the euro will not appear as yet in tangible form asbanknotes and coins. Nonetheless there is no doubt that this currency, whichwas only brought into existence on 1 January 1999, will play an important roleboth within the euro area and beyond.
Thereis good reason for this confidence, ladies and gentlemen. Overall the first fewweeks went smoothly for the single currency and the monetary policy of theEurosystem. The start did not pass by entirely without a hitch — which was notto be expected in any case, given the significance and scale of this project — but there were no major complications.
MonetaryUnion is a unique and outstanding achievement. It provides the greatopportunity to achieve the goal of lasting price stability throughout Europe.Price stability is the best contribution that monetary policy can make tolasting economic and employment growth in Europe. The national governments andall those involved in collective wage bargaining are being called on to removethe structural causes of the excessively high unemployment. We can only hopethat the introduction of the euro will spur the implementation of structuralreforms.
Thestability-oriented monetary policy strategy of the Eurosystem
TheTreaty establishing the European Community assigns the European System ofCentral Banks (ESCB) — and thereby the Eurosystem — the primary objective ofmaintaining price stability. The Governing Council will do its utmost to fulfilthis task and to explain its monetary policy so as to be comprehensible to thegeneral public. For this reason we have developed a stability-oriented monetarypolicy which essentially consists of three main elements.
TheGoverning Council has published a quantitative definition of its primaryobjective, price stability. This gives clear guidance for expectations inrelation to future price developments. Price stability is defined as anincrease in the Harmonised Index of Consumer Prices of the euro area of lessthan 2% compared with the previous year. The publication of this definitionprovides the public and the European Parliament with a clear benchmark againstwhich to measure the success of the single monetary policy, and therebyprovides for the transparency and accountability of the Eurosystem and itspolicy.
Thewording «less than 2%» clearly defines the upper limit for themeasured inflation rate which is compatible with price stability. I do notthink I need emphasise that deflation — or a sustained fall in prices — wouldbe incompatible with price stability. The latest available data for the annualrate of inflation according to the Harmonised Index of Consumer Prices for theeuro area as a whole fall within the definition of price stability. Thisoutcome is clearly the result, above all, of the successful monetary policy ofthe national central banks in the years before the start of Monetary Union.
TheECB has only been responsible for monetary policy for a little more than onemonth. It will only be possible to judge the success of its current policy inone to two years'time. This reflects the fact that the transmission of monetarypolicy impulses is subject to relatively long and variable time lags. TheGoverning Council has therefore emphasised that price stability must bemaintained in the medium term. This statement underlines not only the need fora forward-looking approach to monetary policy, but also takes intoconsideration the short-term volatility of prices in response to non-monetaryshocks which are beyond the control of monetary policy.
Inorder to achieve the goal of price stability, our strategy rests, inparticular, on two «pillars». Before I explain this in more detail, Ishould like to emphasise that traditional and previously established macroeconomicrelationships could change as a consequence of the introduction of the euro.This was one key reason why neither a monetary targeting nor a direct inflationtargeting strategy could be applied. Our strategy is also more than just asimple combination of these two approaches. Rather, it is precisely tailored tothe needs of the ECB.
Thefirst pillar of the monetary policy strategy is a prominent role for money.Since inflation is ultimately a monetary phenomenon in the medium term, themoney supply provides a natural «nominal anchor» for a monetarypolicy geared to safe-guarding price stability. To emphasise this prominentrole, the Governing Council has published a quantitative reference value forgrowth in the money supply. The first reference value decided upon by theGoverning Council for growth in M3 was 4.5% per annum and was published on 1December. This value is based on the above-mentioned definition of pricestability and assumes a trend growth in real gross domestic product of 2-2.5%per annum, as well as a medium-term reduction in the velocity of circulation ofM3 of around 0.5-1% per annum.
Weshall not, however, respond mechanistically to deviations from the referencevalue for money supply growth, but shall first analyse them carefully forsignals relating to future price developments. Larger or sustained deviationsnormally signal risks to price stability.
Thesecond pillar of the monetary policy strategy consists in a broadly basedassessment of the outlook for price developments in the entire euro area. Thisassessment will be based on a broad range of monetary policy indicators. Inparticular, those variables which could contain information on future pricedevelopments will be analysed in depth. This analysis should not only provideinformation on the risks for price development, but should also help toidentify the causes of unexpected changes in important economic variables.
Somecommentators reduced this comprehensive analysis to an inflation forecast. Atthe same time, there were demands for the ECB to have to publish theseforecasts in order to satisfy the need for transparency and accountability.Therefore allow me to make this clear: our strategy includes a comprehensiveanalysis of numerous indicators and several forecasts. To focus on a singleofficial inflation forecast of the Eurosystem for a specific point in timewould in no way accurately reflect our internal analytical and decision-makingprocess. It would impinge upon the transparency and clarity of the explanationof our policy. The publication of an official inflation forecast would also beinappropriate with regard to the accountability of the ECB, all the more so ifthis forecast were based on the assumption of no change in the monetary policy.The success of the monetary policy of the ECB should primarily be measured interms of the maintenance of price stability, not the accuracy of itsconditional forecasts.
Thestability-oriented monetary policy strategy of the Eurosystem, which I havejust outlined, constitutes a new and clear strategy. It emphasises the primacyof the goal of price stability. It takes into account the inevitableuncertainties concerning economic relationships inherent in the transition toMonetary Union and the associated systemic changes and guarantees a high degreeof transparency.
Ladiesand gentlemen, allow me to comment on certain suggestions on the orientation ofmonetary policy which have recently appeared in the press. Some of these ideasgive the impression that monetary policy should concentrate upon objectivesother than price stability, since stable prices have already been achieved.Inter alia, it has been suggested that the ECB should react more or lessmechanistically to exchange rate developments or other variables such as, forinstance, unit labour costs. Furthermore, there were calls for monetary policy,by means of reductions in interest rates, to be used to combat unemployment.Against this background there is a need to set out clearly the possibilitiesand limitations of monetary policy.
Boththe reasoning in the Maastricht Treaty and many economic analyses show that thebest contribution the single monetary policy can make to employment growth isto concentrate on price stability. Without such a clear approach there is adanger that the public may question the commitment of the Eurosystem to thegoal of maintaining price stability. Inflation expectations, risk premia andthus long-term rates would rise. This would increase the cost of the investmentwhich is necessary for a sustained and lasting rise in the standard of living.
Evenunder the best possible circumstances, though — i.e. if it proves to bepossible to assure lasting price stability — monetary policy alone cannot solvethe major economic problems of unemployment and future problems in socialsecurity systems.
TheGoverning Council regards the current high level of unemployment in the euroarea as a matter of great concern. This problem is, however, predominantly astructural one. It is mainly the result of the rigidities in the labour andgoods markets in the euro area which have arisen partly through an excessiveand disproportionate degree of regulation. Structural economic reforms, whichtarget the reduction of rigidities, are the appropriate solution. In those euroarea countries in which such reforms have been implemented unemployment figureshave declined markedly. In addition, I should like to emphasise that moderatewage developments and a reduction in the burden of tax and social securitycontributions would generally help to reduce unemployment. This would be thecase even if the country concerned did not trade heavily with its neighbouringcountries. The positive influence of low taxes and wages on employment clearlyhas overall benefits from an international perspective. Such a policy shouldnot be denounced as «wage dumping».
Turningto the role of exchange rates between the euro and other important currenciesoutside the EU, in particular the US dollar, the Eurosystem has, in formulatingits monetary policy strategy, made an unambiguous choice. This strategy clearlyrules out explicit or implicit objectives or target zones for the euro exchangerate. The pursuit of an exchange rate objective could easily jeopardise themaintenance of the objective of price stability and could thereby also bedetrimental to real economic development. Target zones for exchange ratescould, for example, lead to the ECB having to raise interest rates in arecession, despite increasing downward pressure on prices. I am sure you willagree that such a mechanistic response to a change in the euro exchange ratewould not be optimal. Furthermore, it is important to remember that we areliving in a world with high capital mobility. Exchange rate agreements, whichmight have been possible to implement until recently, are no longer feasible.
Thelack of an exchange rate target does not mean that the ECB is totallyindifferent to or takes no account of the euro exchange rate. On the contrary,the exchange rate will be observed and analysed as a potentially importantmonetary policy indicator in the context of the broadly based assessment of theoutlook for price developments. A stability-oriented monetary and fiscalpolicy, as stipulated by the Maastricht Treaty and the Stability and GrowthPact, is an essential pre-condition for a stable euro exchange rate. Of course,there is no guarantee of lasting exchange rate stability, not even in a fixedexchange rate regime. Exchange rate fluctuations are often caused by structuralor fiscal policy, asymmetric real shocks or conjunctural differences. Monetarypolicy would clearly be overburdened if it had to prevent such movements in theexchange rate.
Wecannot and shall not gear our monetary policy towards a single variable,whether a money supply aggregate, an index, the exchange rate or an inflationforecast for a particular point in time. Nor can we be involved in any ex anteco-ordination which would entail an obligation to react to particularcommitments or plans. The ECB will always carefully analyse all relevantindicators. In this context, it is particularly important that the economiccauses of potential risks to price stability in the euro area are understood asfully as possible. Appropriate monetary policy decisions also depend upon thecauses of unexpected changes in important economic variables. The GoverningCouncil must, for example, take a view on whether changes in importantindicators are of a temporary or permanent nature, and whether a demand orsupply shock is involved. In our deliberations we also attempt to take intoaccount how the financial markets, consumers and firms are expected to react tomonetary policy decisions. I believe few would contest that such a complexanalysis cannot meaningfully be reduced to a more or less mechanistic reactionto a few variables or a single official forecast.
Inaddition, concern was often expressed that the Eurosystem would not acttransparently enough. In this context, it was said that a transparent monetarypolicy also necessitated the publication of the minutes of the meetings of theGoverning Council and disclosure of the voting behaviour of the individualmembers of the Council.
Forsound reasons the Governing Council decided not to adopt this approach. Thepublication of individual positions could easily lead to national influencebeing exerted over the individual Council members. The members of the GoverningCouncil must not, however, be seen as national representatives. They decidetogether on the monetary policy for the euro area as a whole. The GoverningCouncil has committed itself to go beyond the reporting and explanatoryrequirements laid down in the Treaty, which are among the most comprehensiverequirements by international standards.
Onthe basis of our strategy, after every first meeting in the month I deliver tothe press a detailed explanation of our assessment of the overall economicsituation and, in particular, the outlook for price stability. The content ofthis so-called «introductory statement» is very close to what othercentral banks refer to as minutes. In this way, the public receivescomprehensive information immediately following the meetings of the GoverningCouncil. In addition, each month we shall publish a detailed report on theeconomic situation and monetary policy throughout the euro area in ourBulletin. Such rapid information on the results of the meetings of theGoverning Council and the current economic analysis of the ECB without doubtdemonstrates a high degree of openness and transparency.
Themost recent monetary policy decisions and operations
Co-operationbetween the European central banks was always very close. In the last fewmonths of 1998 the countries participating in the third stage of Monetary Unionco-operated more and more closely. The co-ordinated reduction in leading ratesat the beginning of December 1998 clearly showed that the currency union hadbegun de facto before the start of Stage Three. This co-ordinated measurecontributed substantially — as we now know — to the stabilisation of marketexpectations.
Formore than five weeks the ECB has been conducting monetary policy operations,mainly in the form of reverse open market operations. The main operation willbe carried out at a weekly frequency with a maturity of two weeks. So far, fivesuch operations have been conducted successfully, at a fixed interest rate of3%.
Besidesthe reverse transactions which constitute the main instrument for liquiditycontrol and targeting interest rates, the Eurosystem offers two«standing» facilities: the marginal lending facility and the depositfacility. These can be accessed by credit institutions via the national centralbanks. The marginal lending facility is primarily a safety valve for short-termliquidity shortages in the banking system and thereby limits upward movementsin money market rates. To some extent, its counterpart is the short-termdeposit facility, which is used to absorb short-term liquidity surpluses. Thisforms the lower limit for money market rates. For the start of Monetary Unionthe interest rate on the deposit facility was set at 2% and the rate on themarginal lending facility was set at 4.5%.
Asa transitional measure, the Governing Council decided to establish a narrowcorridor of 2.75-3.25% between the rates on the marginal lending facility andthe deposit facility from 4 to 21 January 1999. The intention was to facilitatethe necessary adjustment to the new institutional environment brought about bythe transition to Stage Three. As already announced, on 21 January 1999 it wasdecided to return to the rates on the two «standing» facilities thatwere set for the start of the single monetary policy. Since 22 January 1999,therefore, the rate on the deposit facility has been 2% and the rate on themarginal lending facility has been 4.5%.
Acritical factor in this decision was the behaviour of the money market for theeuro area as a whole since the beginning of the year. The Governing Councilestablished that over time there had been a marked reduction in thedifficulties experienced by some market participants with the introduction ofthe integrated money market and, in particular, with cross-border liquidityflows. All in all, the integration of the money market in the euro area reacheda satisfactory stage only three weeks after its implementation. In analysingthe money market it should be noted that, inter alia, there can be a markeddifference between ECB interest rates and short-term market rates. On the onehand, market rates may include credit risk premia, and on the other,expectations may lead to differences between the two rates.
Atits meeting last Thursday the Governing Council confirmed its earlierassessment of the outlook for price stability. Therefore it was decided toleave the conditions for the next main refinancing operations, on 10 and 17February 1999, unchanged. They will be carried out as volume tenders at a fixedrate of 3%, the same conditions as the last such monetary policy operations.
Inaddition, in recent weeks the first longer-term open market operations werealso conducted, in the form of reverse transactions. These were carried out on14 January 1999 in three parallel tender procedures with maturities of one, twoand three months. The fixed rate tender procedure was used. By contrast withthe regular main refinancing operations, the Eurosystem does not use theselonger-term operations to send signals to the market and therefore usually actsas a price-taker. The ECB thus gives advance indication of the planned allocation.The interest rates which arise from these monetary policy operations shouldtherefore be seen as indicators of prevailing market conditions.
Regularassessment of the monetary, financial and economic situation
Toconclude, I should like briefly to report on the Governing Council’s currentassessment of the monetary, financial and economic situation. On the basis ofthese assessments the Governing Council decided last Tuesday to leave interestrates unchanged.
Takinginto account the latest monetary data for December 1998, the three-month movingaverage of the 12-month growth rate of the monetary aggregate M3 (for theperiod from October to December 1998) remained more or less stable at 4.7%.This value is very close to the reference value set by the Governing Council.According to our analysis, the evolution of the money supply shows no risks toprice stability. Credit to the private sector also grew strongly in Decemberlast year. Although at present we do not perceive any inflationary signals,further developments will be very carefully monitored.
Withregard to the broadly based assessment of the outlook for price developmentsand the risks to price stability in the euro area, monetary and financialdevelopments can be seen to indicate a favourable assessment of the latestmonetary policy decisions of the Eurosystem. They indicate that marketparticipants expect a continuation of the environment of price stability.Long-term rates fell to new historical lows at the beginning of 1999 and therewas an overall downward shift in the yield curve. Therefore, financingconditions for investment are currently exceptionally favourable.
Atpresent the growth prospects for the euro area are, however, still marked bythe uncertainties relating to the development of the world economy in 1999.These uncertainties have had a negative impact on indicators of the economicclimate in the euro area. There are widespread expectations of an economicslowdown in the near future. This deterioration in the external economicenvironment can be linked, above all, to the financial crises in Asia, Russiaand Latin America. However, there is a mixed picture. While the growth rate forindustrial production fell up to November 1998, retail sales figures andconsumer confidence have recently shown positive trends. Furthermore, growth inreal gross domestic product in the euro area was relatively robust in the thirdquarter of 1998. In the United States real growth in the fourth quarteractually turned out higher than expected. Measured against the Harmonised Indexof Consumer Prices, the HICP, consumer prices in the euro area rose by 0.8% inDecember 1998. This is a tenth of a percentage point lower than in November.This development is in line with earlier trends. It can be linked, inparticular, to a further decline in energy prices and a weakening in priceincreases in industrial goods.
Allin all, the above-mentioned economic development and the available forecastsfor 1999 do not indicate any noticeable upward or downward pressure on prices.Potential upward risks could arise from a change in the external globaleconomic situation and any associated effects on the euro area, via import andproducer prices. These developments must be carefully monitored. There is concernthat inflationary pressure might develop in the event of a strong increase inwage prices and an easing of fiscal policy. Developments in the exchange ratewill also be closely monitored in view of their significance for pricedevelopments.
Finally,let me emphasise that the current level of real interest rates is exceptionallylow. If real interest rates are taken simply as the difference between nominalrates and the current increase in consumer prices (HICP), short-term realinterest rates in January 1999 stood at 2.3%, i.e. around 80 basis points lowerthan one year ago. Long-term real rates have fallen even more, by 110 basispoints, and stood at 3% in January. These levels are very low, both comparedwith other countries and with historical data. In line with the safe-guardingof price stability, the current monetary and financial conditions thus clearlysupport future economic growth. Monetary policy can do no more than thiswithout jeopardising the great overall economic advantages of price stabilityand its own credibility.
Realstructural reforms which increase the flexibility of the labour markets, aswell as a continuation of the moderate increase in wage prices, would not onlyease the burden on monetary policy but would also support employment growth.This will be all the more true if the deterioration in the economic situationthis year is worse than expected owing to the negative aspects of the externaleconomic environment.
The statisticalrequirements of the ESCB
Speech delivered by EugenioDomingo Solans,
Member of the ExecutiveBoard of the European Central Bank
on the occasion of a visitto the Banque Centrale du Luxembourg
Luxembourg, 25 March 1999
Thebooklet introducing statistical requirements for Stage Three, which the EMI publishedin July 1996, began with the bold statement: «Nothing is more importantfor the conduct of monetary policy than good statistics.» Thesechallenging words show the importance which the EMI attached to this area ofpreparations for Monetary Union, and I must say this has been fully justifiedby our experience in the first few weeks of the life of the euro.
Thestatement of requirements
Butlet me start back in 1996. Because of the time it takes to implementstatistical changes in reporting institutions and central banks, a statement ofprospective statistical requirements could be delayed no longer. But thatstatement had to be made with very imperfect knowledge. Nobody knew at thatstage (for example) what definitions of monetary aggregates would be chosen forthe single currency area, or what their role would be. Given the differences infinancial structures in our countries, it was not clear how to identify thefinancial institutions from whose liabilities the money stock would becompiled. It was decided to define them in functional terms, and in such a waythat money-market funds as well as banks of the traditional type would beincluded. It was not clear at that stage whether minimum reserves would beapplied, and, if they were, what form they would take — although it had beendecided that the banking statistics data would provide the basis for any suchsystem. Implementation had to start quickly for the statistics to be ready intime for a Monetary Union starting in 1999, but no one knew which Member Stateswould adopt the single currency — though it was clear that the distinctionbetween business inside and outside the euro area, would be of criticalimportance for monetary and balance of payments statistics, and would have tobe planned for in statistical systems.
Inmentioning monetary and balance of payments statistics, I do not want tosuggest that the statistical requirements set out in 1996 were confined tothese areas. On the contrary, they covered a wide range of financial andeconomic data, including financial accounts, prices and costs — relatingdirectly to the ESCB's main responsibility under the Treaty, namely to maintainprice stability — government finance data, national accounts, labour marketstatistics, production and trade data and other conjunctural statistics, andmore besides. These areas are, or course, under Eurostat's responsibility.
Thefocus on the euro area as a whole
Informulating and implementing statistical requirements, it was important torealise that the ESCB's attention would have to focus on the euro area as awhole. Monetary policy cannot discriminate among different areas of theMonetary Union — although in practice it may have different effects because ofdifferent national economic and financial structures. Focus on the area as awhole has important implications. The data must be sufficiently comparable forsensible aggregation; they must also be available to a comparable timelinessand to the same frequency. In some cases (monetary and balance of paymentsstatistics) they had to be available in a form permitting appropriateconsolidation. In short, with a few exceptions, it was realised that addingtogether existing national data would not be adequate. Important initiativeswere already under way, such as the adoption of a new European System ofAccounts [ESA95] and the implementation at national level of a new IMF Balanceof Payments Manual. However, wide-ranging statistical preparations would benecessary for the ECB to have the sort of statistical information that thenational central banks have traditionally used in conducting monetary policy.
Howfar the provision meets the current need
Iarrived at the ECB about 2 years after these requirements had been released and7 months before the start of Monetary Union. I must confess that I doubted manytimes in those early weeks whether statistics could be ready in time to sustainmonetary policy decisions. There were anxious moments too in the late stages offinalising the monetary policy strategy: would the requirements set out in 1996correspond to the need perceived in autumn 1998?
Iam now sure that the decisions made in 1996 were correct. In practice, onechoice in autumn 1998 was almost automatic: thanks to the work of Eurostat andthe national statistical offices in the context of the convergence criteria(with active involvement of the EMI), there was no plausible rival to theHarmonised Index of Consumer Prices (HICP) for the purpose of defining pricestability. I am aware that national consumer price indices are sometimescriticised for overstating inflation, because they take insufficient account ofquality improvements and use outdated weights. While further development of theHICP is to come, and at present there is no satisfactory treatment ofexpenditure on housing, I believe that every effort has been made to apply thelessons from experience with national consumer price measures. The otherchoices for statistical elements in the strategy were less obvious. In fact thebanking statistics reporting structure announced in 1996 proved able to providethe monetary aggregates and the counterpart analysis required, and — with alittle fine-tuning — to meet the needs of a statistical basis for reserverequirements, details of which were also finalised in the autumn. We were thusable to begin publishing monetary statistics only a few days after the finaldecisions were taken (at the Council meeting on 1 December), and were able topublish with some estimation last month back data on the three monetaryaggregates monthly to 1980, and a note urging caution on users of the earlierdata.
However,the monetary strategy avoids putting too much weight on one area or type ofinformation. This is only partly for statistical reasons. The formation of theeuro area is a substantial structural change, which may in time affect monetaryand financial relationships. So the ECB also examines a range of economic datafor the light they shed on the assessment of the economic situation and, inparticular, prospects for inflation. The editorial and economic developmentssections of the Monetary Bulletin show the way the ECB draws on thisinformation; the statistical information itself is set out in tables in thestatistical section. Thus, in addition to money and credit and the HICP, theeditorial typically touches on GDP, industrial output, capacity utilisation,orders, the labour market, business and consumer confidence, costs and pricesother than the HICP, earnings and wage settlements, fiscal positions — naturallyplacing the emphasis on what are judged to be the most important developmentsat the time. All these areas were covered by the statement of requirements madein 1996.
Ido not need to say that, at present, an accurate assessment of the economicsituation in the euro area is of vital importance. The editorial section of theMarch Bulletin concludes that the overall outlook for price stability remainsfavourable, with no major risk that HICP inflation will exceed 2% in the nearfuture, but there is nevertheless a balance of conflicting influences. To reachthis judgement, the Bulletin assesses the latest GDP data (slower growth in theprovisional Eurostat figures for GDP in the 4th quarter of 1998; decliningmanufacturing output), the labour market (unemployment falling slightly; somesigns of rising pay settlements), and confidence indicated by opinion surveys(business confidence weak; the consumer mood rather optimistic). The economicdevelopments section supports the overall conclusion, and analyses in moredetail price and cost developments and of output, demand and the labour market.It concludes with analysis of the fiscal position in the euro area in 1998, anda preview based on fiscal plans for 1999. I am drawing your attention to thisto show the variety of material supporting the ECB's assessment of the economicand financial position and prospects. Although we pay particular attention tocertain items — the monetary statistics, with an emphasis this time oninfluences contributing to recent faster growth, and to the rather rapid growthof credit, and the HICP — we draw on a wide range of information in acontinuous monitoring exercise. The establishment of an institution responsiblefor monetary policy in the euro area has caused a fundamental change in the useof macroeconomic statistics at European level, very much as anticipated by theImplementation Package nearly 3 years ago.
Prioritiesfor further improvement of statistics
Iwould like to take this opportunity to thank Eurostat for their efforts toimprove the quality and comparability of economic statistics relating to theeuro area, and to deliver them to the ECB on a timely manner. They have giventhis high priority and much progress has been made in the last year or so.Further improvement will come with the introduction of the new European Systemof Accounts [ESA95] starting next month (although we must expect some temporaryconfusion following the introduction of a new system). Experience suggests thatsubstantial statistical changes initially bring classification problems.Although, of course, provision has been made for back data to be available onthe closest possible approximation to the new basis, we must also expect somediscontinuity in important series. Implementation of last year's short-termStatistics Regulation will bring improvements across a wide range ofconjunctural statistics not covered by ESA95. There are also initiatives toimprove labour market statistics. With Eurostat, who are responsible for allthese areas of statistics at European level, we do our best in the ECB topromote better data. Perhaps I should underline our support here for thepriorities established last year by a working group of the Monetary Committee(the current Economic and Financial Committee), in which Yves Franchet and twoof my ECB colleagues participated (Peter Bull and Gert Jan Hogeweg): inaddition to quarterly GDP and short-term conjunctural statistics, these weregovernment finance statistics, data relating to the labour market (includinglabour costs), and the balance of payments. At present the lack of comparablenational statistics during the course of the year makes it difficult to monitorthe fiscal stance in the area as a whole, and so to assess the balance offiscal and monetary policy. Better labour market statistics are important, notonly for the ECB's assessment of possible inflationary pressure, but also toimprove understanding of the structure of labour markets in our countries, andthe rigidities which impede the achievement of fuller employment. Balance ofpayments statistics — a shared responsibility of the ECB and Eurostat atEuropean level — require a new approach in compiling data for the euro area asa whole. We intend to publish the first monthly data for the euro areafollowing the new methodology next month, and to begin joint publication of aquarterly euro-area balance of payments with Eurostat in the summer. But thereare deeper questions about future needs for balance of payments statistics inthe new circumstances which are currently being addressed. Principally, thequestion arises of the usefulness for policy purposes of national balance ofpayments statistics for Member States participating in Monetary Union. There isno question, of course, that certain data in this area are needed within theESA95 framework of national and financial accounts.
Theorganisational, legal and technical infrastructure
Ihave talked mainly about statistical requirements and their provision, but thisis only part of the story. The Treaty (specifically in Article 5 of the Statuteof the ESCB and the ECB) clearly envisaged that the ECB would performstatistical functions, assisted by and in co-operation with national centralbanks, other national authorities, the Commission (meaning in this context inparticular Eurostat), and international organisations. A large part of thepreparatory work carried out by the EMI consisted of sorting out who would dowhat, avoiding so far as possible duplication, wasted effort and conflictingdata, and keeping the whole development consistent with internationalstatistical conventions. Much of this had to be framed in legal instruments,which would complete the statutory framework provided by the Treaty and theESCB/ECB Statute. Although work on an EU Council Regulation concerning ECBstatistics began as early as 1996, the Regulation could not be finalised untillast autumn and the ECB could not adopt legal instruments on statistics inadvance of that event — much work in this area therefore had to be done at thelast minute.
InformationTechnology is another of my responsibilities at the ECB. I am glad to say thatessential elements of our data transfer and statistical processing systems werein place when I arrived, or brought into operation soon afterwards. But here,too, there is room for further improvement — the EMI and the ECB in these earlymonths have had so much to do in relation to the resources available that,broadly speaking, only the essentials have been provided so far.
Conclusion
«Nothingis more important for monetary policy than good statistics.» The formationof Monetary Union has shifted the focus of interest on to data covering theeuro area as a whole. This has required substantial changes to statistics,which need time to settle down and are some way short of completion. At thesame time, the adoption of the single currency is itself a massive structuralchange. This will surely affect economic and financial relationships and makeany data harder to interpret, although these deeper effects may occur over aperiod and take some time to become apparent. What is clear, however, is thatthe ECB must take policy decisions and explain them publicly in terms of thedata available relating to its policy responsibility. What we continue tostrive to do, through our own efforts and with the help of Eurostat, is toimprove the quality of the data underlying policy decisions, which are soimportant in gaining public understanding and acceptance for them.
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The tasks and limitationsof monetary policy
Speech delivered byChristian Noyer
Vice-President of theEuropean Central Bank,
at the VolkswirtschaftlicheTagung of the Oesterreichische
Nationalbank,
on 10 June 1999 in Vienna
Ladiesand Gentlemen,
Itis a pleasure for me to be here in Vienna today and I should like to start bythanking the conference organisers for giving me the opportunity to elaborateon the tasks and limitations of monetary policy.
Thistopic is extremely important. Looking back over the history of economicthought, it is clear that the perception of what monetary policy can do andwhat it cannot or should not do has changed. This has clearly shaped the roleof monetary policy in economic policy. In the 1960s economic theories suggesteda long-run trade-off between inflation and output. These theories provided theintellectual basis for policy-makers to pursue monetary policies biased towardshigher inflation. The high inflation experience of the 1970s together with newtheoretical findings, especially on the role of expectations, led policy-makersto move towards lowering and stabilising inflation.
Theoreticalconsiderations as well as empirical evidence over several decades suggest thathigh rates of inflation are clearly unhelpful — indeed detrimental — to growthand employment in the long term. A large number of economic arguments point tothe benefits of price stability for economic growth and employment prospects.Stable prices eliminate economic costs such as those arising from unnecessaryuncertainty about the outcome of investment decisions, the distortionaryeffects on the tax system, rising risk premia in long-term interest rates andthe reduced allocative effectiveness of the price and market systems. To quoteAlan Greenspan, chairman of the United States Federal Reserve, «Pricestability is achieved when the public no longer takes account of actual orprospective inflation in its decision-making.» Monetary policy must takeinto account the fact that the horizon for decisions by economic agents israther long-term in nature. By guaranteeing price stability, monetary policysupports the efficient functioning of the price mechanism, which is conduciveto the allocation of scarce resources. Price stability is a means of promotingsustainable economic growth and employment creation and of improvingproductivity levels and living standards.
Againstthis background, the predominant view has emerged that the best and mostlasting contribution that monetary policy can make to long-term economicwelfare in the broader sense is that of safeguarding price stability. Centralbanks throughout the world have been moving towards adopting long-term pricestability as their primary goal.
Inorder to achieve this goal most successfully, independence from politicalinterference and a clear legal mandate for price stability are of the utmostimportance. A lack of central bank independence and an ambiguous mandate caneasily force central banks to focus on the short term and, thus, fail to adoptthe forward-looking, medium-term orientation that is crucial for a successfulmonetary strategy.
Allthese issues were taken into consideration by policy-makers when drafting theTreaty establishing the European Community and designing the blueprint for theEuropean Central Bank. Both central bank independence and an unequivocalcommitment to price stability are therefore tenets of the monetary policyframework enshrined in the Treaty. There can be no doubt that the EuropeanCentral Bank (ECB) is determined and well-equipped to tackle its main task,namely, that of maintaining price stability in the euro area over the mediumterm. It will thereby make a significant contribution to the achievement ofother Community objectives such as high employment and sustainablenon-inflationary growth. In this connection, the pursuit of sound macroeconomicpolicies by the EU Member States would considerably facilitate the task of theECB. The room for manoeuvre in monetary policy and the degree of success interms of maintaining price stability are crucially dependent on the support ofsound fiscal policies and responsible wage settlements in the euro area.
TheTreaty establishing the European Community states that the primary objective ofthe European System of Central Banks (ESCB) is to maintain price stability.Without prejudice to this objective, the ESCB shall support the generaleconomic policies in the European Community. It shall operate in a manner thatis consistent with the establishment of free and competitive markets. TheTreaty states explicitly how the ESCB shall set its priorities. Price stabilityis the first goal of the monetary policy of the Eurosystem, and a contributionto the achievement of the other objectives of the European Community can onlybe made if this primary objective is not compromised. However, there isultimately no incompatibility between maintaining price stability and pursuingthese other objectives. By maintaining price stability, the ECB will alsocontribute to the achievement of other Community objectives.
Ofcourse, the ECB is concerned about the intolerably high level of unemploymentin Europe, but we should realise that the role of monetary policy in reducingunemployment in Europe can only be very limited. Many empirical studies showthat the high unemployment rate is mostly the consequence of structuralrigidities within the European labour and product markets. The Europeanunemployment rate has, indeed, been high and stable over the business cycles inthe past decade. Only structural reforms, preferably of a comprehensive nature,can therefore tackle the underlying impediments to employment growth.
Themonetary policy of the Eurosystem is geared towards the euro area as a wholeand, thus, cannot take into account purely national and regional developments.The cyclical positions of participating countries have not yet completelyconverged, although, with the single currency in place, some nationaldifferences may disappear over time. This requires national policies and labourand goods markets to be increasingly flexible in order to be able to respondeffectively to economic shocks. Well-functioning labour and product markets aretherefore needed to allow adjustments to wages and prices to be made if local economicconditions change.
Budgetarypolicies play a major role in conditioning monetary policy. National fiscalauthorities have to demonstrate their commitment to the maintenance of pricestability in the euro area over the medium term. In this context, the Stabilityand Growth Pact is a crucial element. Its aim is to encourage the pursuit ofdisciplined and sustainable fiscal policies by the participating EU MemberStates and the prospective members. Sound public finances, with lower publicdebt and tax burdens, contribute to a lowering of long-term interest rates,reduce uncertainty and increase private capital formation. They not onlyfacilitate the task of monetary policy with regard to the maintenance of pricestability, but also strengthen the conditions for sustainable growth conduciveto employment creation. Conversely, unsound fiscal policies tend to increaseinflation expectations and force monetary policy to keep short-term rateshigher than would otherwise be necessary.
Thesingle monetary policy has to be conducted independently of the short-termpolitical considerations of national governments. In this context, the ECBcannot commit itself to move its interest rates in a certain way in response tospecific actions or plans of other policy-makers. Monetary policy has to takeinto account the overall economic situation to assess the risks to pricestability. Direct ex ante co-ordination with fiscal authorities might endangermeeting the primary objective and would set the wrong incentives for theconduct of sound macroeconomic policies. This does not, of course, exclude aconstructive dialogue between the Eurosystem and government authorities whichclearly respects the independence of the ECB.
Whendealing with one of the major world currencies and with the currency of one ofthe two main world economies, it is inconceivable that price stability might bemaintained by setting an exchange rate target as an intermediate objective.However, external developments including the exchange rate are taken intoaccount in accordance with our strategy, as they may have an impact on domesticeconomic developments and thereby on price stability. Referring to recentexchange rate developments in this context, it is appropriate for me to quotethe President of the ECB, Dr. W. F. Duisenberg, who recently said that«the euro is a currency firmly based on internal price stability, andtherefore has a clear potential for a stronger external value».
Theabsence of exchange rate targets for the euro vis-а-vis other major currenciesshould not be misunderstood. For smaller, very open economies, fixed exchangerates may be a very reasonable choice. The Austrian example is one of the mostprominent in this respect. By pegging the Austrian schilling to the Deutsche markfor over twenty years, it proved possible to import credibility and pricestability. The increasingly close pegging of the Austrian currency to thecurrency of its main trading partner was, among other features of the Austrianpolicy mix, the driving force behind the economic convergence process in therun-up to Stage Three of Economic and Monetary Union (EMU). The credibility ofthe Austrian exchange rate target was also underpinned by an income policyaiming at relatively high real wage flexibility and a fiscal policy gearedtowards consolidation. All in all, the Austrian model, which set out toguarantee stability in nominal and real terms, has turned out to be verysuccessful.
Theexample given by past Austrian experience is, I believe, very valuable. Itshows that the achievement of sustainable convergence with the euro area can beassisted by means of an exchange rate target. The new Exchange Rate Mechanismof the European Union, ERM II, may play a similar role for those current andprospective EU Member States which have not yet joined Stage Three of EMU.
Theachievement of price stability is also of high importance for the stability ofthe financial system. The financial system of the euro area showed a highdegree of stability during last year's period of financial turbulence as wellas during the rather dramatic structural shift connected to the changeover tothe euro. At the ECB, we play our part in the evolution of the euro areafinancial system by providing it with stable monetary conditions. By creatingan environment of price stability, we allow private sector agents to focustheir attention on the questions that are most relevant to their activities andto take advantage of benefits of this stable environment, such as thelengthening of their planning horizons. There is a lot of empirical evidencethat safeguarding price stability is the optimal contribution that a centralbank can make to the maintenance of financial stability and that those twogoals are actually complementary.
Ishould like to conclude by saying that the main contribution of the singlemonetary policy to the welfare of the people in the euro area will be themaintenance of price stability in the medium term. The ECB is determined totackle this task and is well-equipped to do so. Our conviction is that theeconomic performance of the euro area will benefit significantly from pricestability. This will ultimately facilitate the achievement of those objectives,which underlie the general economic policies of the European Community and theindividual governments at the national level. However, the economic problems inthe euro area cannot be tackled by monetary policy alone. We have to berealistic about the goals which can be achieved by monetary policy. Neglectingthe limitations of monetary policy and promising too much could, in the longterm, be detrimental to the establishment of a stability culture in Europe, andcould also lead to delays in implementing the economic reforms that are crucialto achieving high growth and employment.
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