Otmar Issing: Globalisation, EMU and the euro
Speech by Mr Otmar Issing, Member of the Executive Board of the European Central Bank, at the
34th Economic Conference 2006 on "Globalization: Opportunities and Challenges for the World,
Europe and Austria", Vienna, 22 May 2006.
References to the speech can be found on the website of the European Central Bank.
* * *
Introduction
Let me first extend a warm thank to the Oesterreichische Nationalbank (OeNB) for inviting me here
today to share a few thoughts on globalisation and the role played by the euro and the European and
Economic Monetary Union (EMU).
In the last decades, Austria hosted a number of distinguished economists, such as Carl Menger,
Friedrich von Wieser, Ludwig von Mises, Joseph Schumpeter, Friedrich von Hayek, who shaped the
economic thought worldwide. In the context of this conference, it is useful to mention the "creative
destruction" term, coined by Joseph Schumpeter in 1942 at Harvard after his migration to the United
States. Schumpeter argued that the process of industrial mutation, which is intrinsic to capitalism,
"revolutionizes the economic structure from within, incessantly destroying the old one, incessantly
creating a new one."1
No doubt globalisation has a big "destruction" potential. To benefit from the global changes, countries
need to be flexible and quick enough at adopting and spreading new technologies, risking in moving
into new areas with big market opportunities in the future, which then translates in new jobs and higher
economic growth.
The term "globalisation" has become one of the most fashionable buzzwords in contemporary political
and economic debate. In an economic context, globalisation is associated with the growing economic
linkages among countries through trade in goods and services, free cross-border capital flows, and
more rapid and widespread diffusion of technology.2 From a historical point of view, this is hardly a
new phenomenon,3 but over the past few decades this process has accelerated, as the time and costs
necessary to connect distinct geographical locations have been drastically reduced. Indeed,
geographical distance and national borders are much less important than previously, allowing firms to
operate easily across national and geographical barriers. Multinational corporations, for example,
typically manufacture their products in a wide variety of countries and sell to consumers around the
world. And investment in financial markets can now be carried out directly on an international basis
rather than through intermediaries, owing to economic deregulation and financial liberalisation, which
have been underpinned by rapid advances in information and communication technology.
We can therefore safely conclude that globalisation has radically transformed our economic and
financial landscapes. What I would like to do today is to discuss the inter-linkages between
globalisation, EMU and the euro.
Before looking into this challenging issue, let me briefly talk about the creation of EMU in the context of
globalisation.
The creation of EMU in the context of globalisation
EMU is the end-point of a long process towards monetary union, which started only a few years after
the end of the Second World War. Its origin is rooted in the 1957 Treaty of Rome establishing the
European Economic Community. At this point Belgium, France, Germany, Italy, Luxembourg and the
Netherlands wished to remove economic barriers among Member States, but wanted to remain within
the Bretton Woods system of stable exchange rates.
In 1969, when the Bretton Woods system appeared on the verge of collapse, the European leaders of
the time were already thinking about creating their own alternative system of stable exchange rates
among the European currencies. Three key initiatives leading towards EMU can be highlighted: the
Werner Report
in 1970, which introduced the concept of the "Snake in the Tunnel" that was later
launched before the end of the Bretton Woods system in 1973; the European Monetary System in
Delors Report
1979, involving the introduction of the European Currency Unit; and the in 1989, which
is reflected in the Maastricht treaty in 1991. The years since 1969 depict a period of repeated attempts
to establish a zone of exchange rate stability in (Western) Europe.4
These initiatives can also be seen in the context of the globalisation process. For example, the
speculative attacks at the end of 1992, which deepened the exchange rate crisis in Europe,
highlighted the increasing importance of exchange rate stability in an economic area with a single
market. The policymakers' challenge consisted of gradually creating a large economic area with
monetary stability and where capital controls were progressively relaxed with the ultimate aim of
establishing a monetary union large enough to defend itself against speculative attacks. Indeed, we
can safely conclude that based on the experience of the last 7 and half years, a viable monetary union
is a more credible commitment device than a fixed or quasi-fixed exchange rate regime. This process
is still ongoing, because the euro is not only the currency shared by the 12 euro area countries, but is
also the anchor for most of the other EU countries' currencies.
In addition to influencing the economic and political debate in Europe in preparation for EMU,
globalisation will also continue to shape the future of the global monetary system, once the Asian
currencies and in particular the Chinese renminbi take a definite stance on their respective exchange
rate regimes. The successful experience of EMU might encourage other economic areas to create
new currencies and new joint central banks. Therefore, one might expect that globalisation will also
affect the number of currencies currently circulating in the world. However, the creation of monetary
unions requires a strong political commitment and forceful policy initiatives, as revealed by the EMU
experience.
The economic impact of globalisation and the role of EMU
I would now like to turn to the main area of my paper and discuss, first, the economic impact of
globalisation on economic linkages - most notably trade and capital flows - and second, the impact of
EMU on regional financial integration and global portfolio reallocation.
Impact on trade, foreign direct investment and cross-border portfolio flows
The effects of globalisation are channelled via trade in goods and services, all of which has a tangible
impact on businesses and households. Globalisation means that transport costs have decreased,
technological innovations are more easily diffused, information is readily available at a low cost, and
consumer tastes have been converging with an increasing number of global brands. Over the last
three decades, tariffs have halved and a large number of trade agreements have entered into force
between various countries. These developments have resulted in a steady opening of markets in
Europe and around the world. In the early 1970s, for example, global exports accounted for only
onetenth of world GDP, compared with one-quarter today. The share of intermediate inputs in total trade
flows is also at a historically high level, reflecting the dramatic deepening of global economic
interlinkages in recent years. Higher global demand and increase in the use of the euro in international
trade have contributed to this new phenomenon. While intra-euro area trade has grown robustly since
the introduction of the euro, extra-euro area trade has recorded even more rapid growth.
The effects of globalisation are also channelled via foreign direct investment (FDI). The role of
multinational enterprises in the world economy has similarly grown over the years, as reflected in the
expansion of the world's FDI stock, which is almost equal to the annual GDP of the euro area. In many
countries, the operations of foreign affiliates are now extremely important for domestic growth, with
rising sales, value added, employment and exports. For the euro area, these international linkages are
highly significant, particularly because economies of scale and cross-country technological spillovers
support euro area economic growth. Euro area corporate businesses are among the most dynamic in
the world, providing more than one-third of the world's FDI stock. At the same time, almost one-third of
world FDI is invested in euro area Member States. Intra-euro area FDI stocks have also grown
robustly, increasing from almost 14% of euro area GDP in 1999 to around 24% by 2004.
Consumers clearly benefit from greater trade and FDI linkages via greater variety of goods and lower
prices. However, adjustment costs, which are often front-loaded and concentrated on specific regions
and sectors, also need to be taken into consideration. The change in the structure of the global
economy requires individual countries to make structural adjustments through the determined
implementation of structural reforms; such reforms are even more vital for countries in a monetary
union. We know that the ability of a country to benefit from globalisation very much depends on the
quality of its institutional and structural environment. All economies - including advanced ones such as
the euro area - have to adapt to the changing needs of the world economy. Structural reforms in the
labour, goods and capital markets are a key element of any long-run strategy to improve investment,
growth and employment prospects, and are essential in order to face successfully the challenges
ahead of population ageing, technological change and globalisation. The euro area has indeed
undergone and will continue to undergo substantial structural changes, all of which are necessary and
beneficial if the euro area is to secure a leading role in the global economy. Member States, therefore,
need to stick to the implementation of their agreed reform agendas.
The impact of globalisation is also apparent in the sharp increases in cross-border portfolio flows
observed since the beginning of the 1990s, a process that continues to be encouraged by the
substantial number of bilateral investment treaties, the liberalisation of capital accounts, and
technological advances in payment, settlement and trading systems as well as financial information
systems, which tend to reduce information asymmetries. Since the beginning of the 1990s, countries
have accumulated foreign portfolio assets equivalent to almost half of the annual world GDP, up from
just one-third in 1997, and a small fraction in the 1970s and 1980s. Similarly, in 2005 euro area
residents held foreign portfolio holdings with a total value of approximately 3.5 trillion euro, a figure
that is almost half of euro area's annual GDP.
Cross-border financial linkages, new financial products and the possibility of more accurate and wider
risk-sharing have however also raised the level of interrelations across national financial markets. This
implies that financial systems are more exposed to common risks, as financial disturbances may be
transmitted more easily across borders in periods of turbulence. As a result, sceptics have indeed
expressed concerns about the sustainability of global financial integration, which is regarded by some
as having the potential to destabilise the global economy. But there is also an opposing view
according to which global financial integration reduces the risks to the global economy, for which there
are convincing arguments.
In this respect, empirical evidence suggests that the strongest determinants of the global portfolio
reallocation over the 1997-2001 period were (1) the need to diversify the risks of holding foreign
portfolio assets across several countries, and (2) the willingness to close the gap between actual and
optimal shares of foreign investment, which suggests that rational portfolio optimisation was the
primary motivation behind investors' reallocation of their international portfolios. This has two main
implications: first, that investors do not ignore the main principles of portfolio theory; and second, that
portfolio investments might be less prone to boom and bust cycles, being driven by long-term
economic fundamentals.5
The overall effects of global financial integration on the stability of the financial sector can be expected
to be positive in the long run, because greater liquidity and the adoption of risk-sharing and
riskmitigating techniques both strengthen the overall resilience and shock-absorption capacity of the
global financial system. Cross-border capital flows not only benefit the recipient economies, but also
the countries of origin, as they facilitate international risk-sharing and participation in returns abroad.
Trade in goods and services and cross-border capital flows have clearly increased the spillovers of
macroeconomic fluctuations globally.6 However, one should welcome the recent developments in
international financial integration, because they reflect trends towards an efficient allocation of
resources and, in this way, support growth and promote welfare in the global economy.
How much further will financial globalisation deepen? In order to answer this question, we examine
developments in countries' home bias, i.e. how much investors prefer to invest in domestic assets
rather than fully diversifying their portfolio internationally.7 In a world without transaction and
information costs, all countries would hold the same portfolio and would diversify their investment in
other countries in proportion to the size of their financial markets.8 In such an ideal scenario, each
economy would be perfectly positioned to withstand economic shocks. This portfolio theory provides a
benchmark for assessing the degree of financial integration in a given country.
Over the last decade many countries have indeed been reducing their risk positions in equity markets
through this mechanism, and in several developed countries the tendency to invest in domestic equity
assets has decreased. However, the latter are still far from having a theoretically optimal portfolio, i.e.
one with a zero home bias. In 2003, equity home bias amounted to 70% in the euro area and the US,
and almost 90% in Japan (see Chart 1).9
The degree of home bias in the fixed income market is also high, and has only decreased over time in
the euro area (see Chart 2).
Chart 1. Home bias in the equity market for the Chart 2. Home bias in the debt instruments market
euro area, the US and Japan (annual data) for the euro area, the US and Japan (annual data)
Sources: IMF, Thomson Financial DataStream,
ECB calculations. Sources: BIS, IMF, ECB calculations.
Note: The home bias of the euro area is Note: The home bias of the euro area is computed
computed excluding intra-euro area asset trade excluding intra-euro area asset trade allocation.
allocation.
We can, therefore, say that the global tendency to invest in the home market has been declining,
albeit possibly more slowly than one would have expected, and only in the equity market. This is
because the tendency to invest more in international markets - as reflected in the surge in
crossborder portfolio flows - has been accompanied by the tendency of households to shift part of their
savings towards riskier domestic assets, as the sharp rise in countries' domestic market capitalisation
reveals.
What can we say about the future? We should expect that home bias will continue to decline, most
likely at a slow pace, because investors need to perceive that diversifying their global portfolio more
and more on a global scale will reduce risk; for that they need to become more familiar with the
international environment.
Impact of EMU on portfolio reallocation and financial integration
Did EMU play a role in the reallocation of capital worldwide and on financial integration? To answer
this question, we need to remind us what a monetary union implies. The elimination of the exchange
rate risk is the first obvious implication, which is also a feature of other fixed exchange rate regimes.
But the fundamental difference is that - when EMU was established - Member States committed to
irrevocable conversion rates of their currencies. A second important factor is related to the effect of
EMU on the business cycle of Member States, the consequent impact on asset returns and, as a
result, on portfolio diversification by international investors. A third crucial factor, which could have
influenced the reallocation of portfolio holdings, is the catalyst effect of the single currency arising from
the reduction/elimination of cross-border barriers, which enhanced financial integration particularly
among the Member States.
In order to assess whether EMU did play a role in the reallocation of portfolio holdings worldwide and
on financial integration, we can look at countries' home bias measures as well as the cross-border
investment in euro area portfolio assets.
While home bias for the euro area as a whole - treated as one economic entity - has decreased
somewhat, particularly in the fixed income markets, in some cases it has declined enormously for
individual euro area Member States (see Charts 3-4).
In Italy, for instance, the value of debt instruments held by residents is much lower than in 1997, when
the majority of these instruments were issued domestically thanks also to the relatively higher level of
interest rates that prevailed before EMU (see Chart 4). The decrease in home bias among individual
Member States has been more pronounced for debt instrument holdings than equity holdings. This
implies that euro area investors have reallocated their portfolio holdings within the euro area, as a
consequence of the establishment of EMU.
Chart 3. Home bias in the equity market among Chart 4. Home bias in the debt instrument market
euro area countries (annual data) among euro area countries (annual data)
Sources: IMF, Thomson Financial DataStream,
Sources: BIS, IMF, ECB calculations.
ECB calculations.
Note: The home bias of the euro area is computed
Note: The home bias of the euro area is computed
excluding intra-euro area asset trade allocation.
excluding intra-euro area asset trade allocation.
Indeed, a simple inspection of the data reveals that European countries increased their holdings of
euro area international assets (as a share of their total international portfolio) between 1997 and 2003
(see Charts 5-6).10 Over this period, the share of intra-euro area allocation increased markedly by 10
percentage points for equity portfolios and by almost 25 percentage points for fixed income portfolios.
Moreover, global financial integration was accompanied by a large shift in holdings towards the euro
area countries, thereby favouring international risk-sharing vis-à-vis the euro area, particularly with
regard to other European countries and, to a lower extent, with respect to emerging markets in equity
portfolios (see Charts 5 and 6).11
Chart 5. International allocation of euro area equity Chart 6. International allocation of euro area debt
assets relative to total equity holdings by region instrument assets relative to total debt instrument
(percentage) holdings by region (percentage)
Sources: IMF, Thomson Financial DataStream,
Sources: BIS, IMF, ECB calculations.
ECB calculations.
Note: Country groupings are listed in footnote 10.
Note: Country groupings are listed in footnote 10.
12 EMU countries = Share of intra euro area
12 EMU countries = Share of intra euro area
nondomestic assets in total euro area holdings.
nondomestic assets in total euro area holdings.
Other country groupings = Share of euro area
Other country groupings = Share of euro area
assets held by non-euro area residents in total
assets held by non-euro area residents in total
non-euro area residents' holdings
non-euro area residents' holdings
One important conclusion can be drawn from this analysis. By reducing the barriers for cross-border
portfolio allocation, EMU has had an impact on regional financial integration not only among euro area
member states, but also vis-à-vis other European countries, which is particularly sizeable in the fixed
income market.
This brings me on to one of the key achievements since the creation of EMU: namely, the fostering of
European financial integration, which goes well beyond the mere elimination of the exchange rate
risk.12 By providing a higher degree of financial integration, EMU has enhanced risk-sharing among
participating Member States and contributed to a smooth and effective implementation of monetary
policy in the euro area.13
To sum up, from a global perspective, the establishment of EMU in January 1999 represents a
fundamental institutional change in the world economy, and could in part help explain the large
reallocation of capital that has taken place worldwide.
The euro area - a zone of stability
Before concluding, let me emphasise that since 1999 we have experienced a number of important
shocks to the global economy, such as the Y2K problem at the turn of the millennium, substantial oil
price increases, the fall and the rise of the euro exchange rate, the boom and burst of the equity
market bubble, global imbalances and the clouds of war and terrorism. Amidst all of this, the ECB has
guided inflation expectations consistent with price stability and thus provided a reliable anchor for the
euro area economy, while the euro has sheltered euro area financial markets against those shocks.
Indeed, long-term forward break-even inflation rates - which measure inflation expectations and the
corresponding inflation risk premium over a horizon in the more distant future - have remained
remarkably stable in recent years in the euro area, at a level only moderately above 2% and thus only
slightly above comparable survey expectations (see Chart 7). This indicates that the ECB has been
very successful in firmly anchoring long-term inflation expectations at a level consistent with its
definition of price stability that is below 2% over the medium term.
Chart 7: Implied forward break-even inflation Chart 8: Correlation of weekly changes in 10-year
rates and comparable Consensus Economics nominal and index-linked government bond yields
inflation expectations and break-even inflation rates between the euro
area and the US
(% p.a.; five-day moving averages of daily data
(BEIRs): Jan. 2005 to Apr. 2006) (12-week moving averages: Jul. 2002 to Apr. 2006)
Sources: Reuters, Consensus Economics, ECB
Sources: Reuters, ECB calculations.
calculations.
As pointed out by Malcom Knight, extracting "clean" information about domestic economic
developments from financial market indicators in a more globalised world has undoubtedly become
much more arduous.
However, the break-even inflation rate (i.e. the yield differential between conventional nominal and
inflation-linked bonds) predominantly reflects market expectations of domestic inflationary trends.
Correlation analysis suggests that, while short-term fluctuations in nominal as well as index-linked
bond yields tend to be quite closely synchronised between the euro area and the US, the relationship
between euro area and US break-even inflation rates tends to be very weak (see Chart 8). Only in
times when inflation expectations react to common global inflationary shocks, for example to strong
increases in oil prices, can a closer synchronisation of movements in break-even inflation rates be
observed.
How would the European economy have developed had the euro not been introduced? We can only
speculate, but past experience can be quite instructive. We must not forget that, as a consequence of
the collapse of the Bretton Woods system and the world's first major oil crisis, the 1970s were a period
of monetary disintegration in Europe. Nor should we forget the devaluation of the Italian lira by almost
30% against the Deutsche Mark after the 1992 ERM crises. The exchange rate risk premium, which is
believed to have been a major determinant of interest rates before the introduction of the euro, would
have increased the spreads on government bond yields across Member States with adverse effects on
countries with large debt ratios.14 In all likelihood, therefore, a currency crisis in Europe may well have
arisen, with speculative attacks on weaker currencies leading to large devaluations. Most likely, the
existence of the European single market would also have been challenged in such a situation, given
the sequence of abrupt shifts in competitiveness between EU Member States.
Globalisation, by contrast, has promoted diversification and allowed risks to be spread across regions.
Regional and global financial integration as well as internal stability have shielded the euro area
against potential speculative attacks on the euro with all their negative consequences.
But the euro is far from a universal panacea. Countries must make flexible adjustments to their
product and labour markets in order to increase the potential output of the euro area and to reduce the
still intolerably high unemployment rate. Establishing competitive, efficient and well-functioning
markets is essential in order to enhance medium to long-term economic growth, to facilitate the
adjustment process, and to increase the resilience of the euro area to economic shocks.
In this respect, the globalisation process itself should induce policymakers to take unpopular decisions
while ensuring fiscal discipline. For a monetary union to work, sound fiscal policies are a prerequisite.
Therefore, Member States must adhere to the criteria set out in the Growth and Stability Pact.
But is it possible, as some have argued, to promote growth and structural reform at the same time as
encouraging further fiscal consolidation? My answer is a clear yes. There is no evidence for such a
trade-off. On the contrary, countries that have in the past undertaken consolidation measures as part
of a comprehensive reform agenda have fared best both in terms of boosting growth and sound public
finances. These countries (e.g. Ireland in the late 1980s and Spain and some others in the mid-1990s)
have benefited from strong supply-side effects on growth and - rather quickly - from the confidence
effects of reform, which mitigated the adverse demand effects of fiscal consolidation.15
So, given this evidence, if euro area countries are to benefit fully from the globalisation process,
attaining sound public finances is a prerequisite.
Concluding remarks
Let me now conclude, in what is going to be my last public speech as a member of the Executive
Board of the European Central Bank. By coincidence, - on 8 May 1998 -, just before the beginning of
my mandate at the ECB , I gave a speech in Vienna at that year conference organised by the OeNB
(title of the speech: Welche geldpolitische Strategie für die EZB?). I am again back in Vienna at the
end of my mandate.
Distinguished economists have often criticised the very concept of European Monetary Union, mainly
because the Member States in question did not fulfil optimum currency area criteria, having for
example a low degree of labour mobility, inflexible real wages as well as sharp differences in
commodity prices and segmented financial markets. At this point, I have to confess that I too was
sceptical for similar reasons, also because I have always argued that unsound government fiscal
policies would ultimately discredit the efforts of monetary policymakers to fight inflation. However, at
the same time, I also believed that, if all countries did their homework and the Maastricht Treaty
criteria were met, I could envisage a successful monetary union - although, to be honest, in the first
half of the 1990s I did not think it would be possible for 11 European countries to achieve price stability
at the start of Monetary Union.
In 1998, at my hearing in front of the European Parliament, I said:
"The introduction of the euro will reshape the face of Europe. It is the most significant event in the
international monetary and financial world since the end of the Second World War. But the euro will
only be able to play its intended role if it becomes a stable currency. To achieve this, the Maastricht
Treaty has given the European Central Bank (ECB) clear priority for the objective of price stability and
has granted its decision-makers independence so as to be able to take the necessary decisions."
I believe that we have fulfilled our mandate. By pursuing price stability in the euro area, we have also
made a positive contribution to stability worldwide. The euro is not only a very stable currency, but has
also become the world's second international currency, after the US dollar. Moreover, EMU has
affected global capital reallocation, attracting FDI as well as portfolio investment, and has enhanced
regional financial integration among euro area Member States.
Let me therefore underline my firm belief that the euro is an undoubted financial and monetary
success because the people who use it around the world believe in its stability.