Mr Duisenberg considers the euro, the dollar and national economic policies: what room for
manoeuvre?
Speech by Dr Willem F Duisenberg, the President of the European Central Bank, at the Euro,
J+80 Conference in Paris on 25 March 1999.
The euro made its debut on the international financial markets at the start of this year. Its
successful launch in the 11 countries which form the so-called euro area constitutes a milestone in
the process of European integration. The introduction of the euro has created a single currency
area which approximately matches the United States in terms of economic size, is the world's
largest with respect to its share in total world exports and ranks second in terms of the size of its
capital markets. Thus, the euro has had and will continue to have in the years to come a profound
impact upon both the euro area and the world economy.
The launch of the euro has raised questions concerning the relationship between the exchange
rate, the monetary policy of the ECB and the room for manoeuvre of national policy. For the
purpose of today's discussion I would propose to break down this rather complex issue into three
aspects: namely, the role of the exchange rate of the euro in the Eurosystem's monetary policy
strategy, the ECB's view of recent developments of the euro exchange rate vis-à-vis the US
dollar, and the relationship between the single currency in the euro area and the flexibility of
macroeconomic and structural policies in euro area countries.
The role of the exchange rate in the monetary policy of the Eurosystem
The introduction of the euro implies a change in the role and the importance of the exchange rate
in Europe. Considered individually, most euro area countries are exceptionally open economies.
In 1997 the sum of their exports plus imports as a share of their combined GDP was 53%. By
contrast, for the euro area as a whole, trade in goods, measured as exports and imports combined,
is around 26% of GDP and thus only somewhat higher than that of the United States and Japan.
Hence the importance of a certain movement in the euro exchange rate for domestic economic
developments has become less compared with the same movement of the exchange rate of a
national currency in the past. Nevertheless, through its effect on economic activity and prices, the
exchange rate affects the outlook for price stability and thus still undoubtedly plays an important
role in the monetary policy of the Eurosystem. Let me therefore elaborate on this role in some
more detail.
The primary objective of the single monetary policy is the maintenance of price stability.
Monetary policy will always be geared to this objective. Consequently, the monetary policy
strategy of the Eurosystem does not embody an implicit or explicit exchange rate target or
objective, since gearing monetary policy decisions to maintaining such an exchange rate target
may, at times, conflict with the goal of price stability.
Consequently, the ECB subscribes to the view that the exchange rates are primarily the outcome
of current and expected monetary, fiscal and structural policies as well as cyclical and other
economic developments, rather than an objective or target of monetary policy. Exchange rate
misalignments and excessive volatility often reflect macroeconomic imbalances and/or market
uncertainties. Accordingly, stability-oriented macroeconomic policies pursued in a transparent
manner are the best contribution that can be made by policymakers to fostering exchange rate
stability. In other words, misalignments and excessive volatility should be contained by
addressing their underlying causes. The Eurosystem's stability-oriented monetary policy strategy
ensures that the single monetary policy makes the best possible contribution in this regard. By
contrast, attempts to suppress exchange rate movements through direct targeting do not address,
by themselves, the underlying causes of misalignment. Monetary policy in particular cannot
correct misalignments caused by structural or fiscal policies. They need to be addressed via other
policy actions.
Moreover, in a world characterised by integrated and highly liquid international financial
markets, there is serious doubt as to whether pegging or targeting exchange rates is feasible. The
sophistication, depth and liquidity of today's financial markets make it increasingly difficult for a
central bank to defend an exchange rate for a prolonged period. In addition, the experience with
exchange rate coordination among the G7 countries shows that it has always been very difficult to
agree on a common objective. Obstacles to exchange rate coordination were also experienced by
some ERM member states. When during the late 1980s and early 1990s economic developments
in some member states of the ERM diverged, their bilateral exchange rates came under pressure,
and eventually the exchange rate bands had to be widened to ensure two-way risk for speculators.
Some currencies were even forced to abandon the ERM. These experiences are now reflected in
ERM II. ERM II has relatively wide standard fluctuation bands and the ECB has the possibility of
suspending intervention and financing if these could impinge on its primary objective of
maintaining price stability. ERM II is explicitly designed to foster convergence to the euro area of
countries that have not yet adopted the euro.
For all these reasons, stable exchange rates of the euro are best served by stability-oriented
policies that are consistent with economic fundamentals. In particular, exchange rate targets or
objectives would be neither a substitute for a credible and stability-oriented macroeconomic
policy stance nor a surrogate for a flexible response on the part of domestic markets.
Nevertheless, exchange rates affect the maintenance of price stability as they influence import
prices and activity, and thereby consumer prices, in the euro area. Moreover, they reflect market
expectations about future economic developments and policies. Furthermore, due consideration
has to be given to the exchange rate of the euro against the background of the importance of the
euro area in the international monetary and financial system.
Therefore, the ECB monitors exchange rate movements on an ongoing basis within its broadly
based assessment of the outlook for price developments. The euro exchange rate is an integral
part of the broad range of variables used by the Eurosystem to take its monetary policy decisions.
The exchange rate is also monitored as it may be a channel for monetary policy transmission.
Clear exchange rate misalignments, although difficult to identify, would be a cause of concern for
the Eurosystem. If prolonged, they might affect inflation expectations and distort economic
activity as well as hamper the efficient allocation of financial resources. Although in the euro area
these negative effects will be mitigated, as a result of the low degree of openness of the economy,
they cannot be ignored altogether.
According to the Maastricht Treaty, the ECOFIN Council may formulate so-called general
orientations for exchange rate policy. These orientations - and this is consistent with the above -
shall be without prejudice to the primary objective of the Eurosystem of maintaining price
stability. Therefore, the EU finance ministers, who are ultimately responsible for the exchange
rate policy of the euro, agreed in December 1997 that they would only issue these general
orientations for the euro exchange rate in exceptional circumstances, such as in the case of clear
and persistent misalignments of the euro. Successful and credible stability-oriented policies
should help prevent the emergence of misalignments in the future.
The ECB's view on the dollar exchange rate
Let me now share with you our views on the exchange rate of the euro against the dollar. The
weakening of the euro vis-à-vis the dollar during January and February was mainly attributable to
a series of economic data releases over this period, which were mostly relatively favourable as far
as the US economy was concerned. The US economy surprised commentators with very positive
data on employment and output. Over the same period data releases for the euro area were more
muted.
It appears, therefore, that the recent developments of the euro exchange rate primarily reflect the
previously unexpected strength of the US economy.
Therefore, the recent fluctuations of the euro exchange rate should not be considered overly
dramatic. The exchange rate of the euro against the dollar is now comparable with the level at
which the so-called synthetic euro was quoted against the dollar prior to September 1998.
Moreover, long-term government bond yields of euro area member states continue to be lower
than in the United States, also suggesting that investors believe in the stability of the euro.
The current euro exchange rate, therefore, does not hint at a misalignment or at a structural
weakness of the euro. Moreover, there is no indication that financial markets doubt the credibility
of the monetary policy of the Eurosystem. Nevertheless, we should keep in mind that the
credibility of a currency is a precious but likewise fragile asset. The possibility cannot be
excluded that increased uncertainty about the political support for a stability-oriented monetary
and fiscal policy has contributed to the weakening of the euro. Through pursuing a
stabilityoriented monetary policy, the Eurosystem underscores the confidence that the world has in this
young currency, the euro.
What flexibility is left to national governments?
I now turn to the final part of my talk. It is clear that euro area governments will continue to need
flexibility in national policies to address country-specific developments. For example, they will
need to be able to respond to asymmetric shocks, that by their nature do not affect all euro area
countries equally, and to more deep-seated economic problems related to the structure of their
economies. Clearly, following the introduction of the euro, the instruments of monetary policy
and the exchange rate are no longer available to national governments for addressing
countryspecific developments. Therefore the need for flexibility in other policies at the national level is
even more apparent than before. Such national flexibility will be necessary both to address
shortterm imbalances in demand and to deepen structural reform efforts with a view to improving the
supply-side conditions of the individual euro area economies. National governments retain the
principal ability to address both objectives as they retain control of fiscal policy and the capacity
to undertake structural reform.
Responding to short-term imbalances in demand
Let us first consider the role that national governments continue to play in responding to
shortterm imbalances in patterns of demand. It is sometimes argued that the requirements of the
Stability and Growth Pact will prevent national governments from using fiscal policy to address
these imbalances. However, if implemented correctly and without undue delay, the contrary is
true, as compliance with the Stability and Growth Pact provisions will allow sufficient room for
manoeuvre. The centrepiece of the budgetary provisions to be respected by member states is the
medium-term objective of a budgetary position close to balance or in surplus. Sound government
finances are important to strengthen the conditions for price stability and for the strong and
sustainable growth necessary to support employment growth. Moreover, if governments achieve
balanced budgets in normal periods of the cycle, they create a safety margin, sufficient to allow
the operation of automatic stabilisers in the event of a slowdown, or in the face of unexpected
shocks, without risking excessive deficits.
The problem at the moment is that in the euro area as a whole we are still far from reaching the
target of balanced budgets in normal cyclical conditions. Substantial structural imbalances
continue to restrict the flexibility of public sector budgets. In a number of countries,
deficit-toGDP ratios remain close to the 3% value set in the Treaty as a reference for excessive deficits,
rather than the medium-term balanced or surplus position envisaged in the Stability and Growth
Pact. Recent fiscal consolidation has been rather disappointing. A significant increase in overall
deficits, for instance as a response to a decline in real GDP growth rates, could reverse the
progress we have seen in recent years in reducing deficit-to-GDP ratios across the euro area.
Moreover, in the case of a prolonged growth slowdown, it is quite possible that deficits will
quickly reach excessive levels.
So it is clear that it is of the utmost importance that governments make structural improvements
to their fiscal positions, as this would allow them to regain sufficient flexibility in their budgets
and, most importantly, could effectively contribute to supporting stability and growth in the euro
area. However, despite the desirability of achieving this room for manoeuvre swiftly, only
moderate fiscal consolidation is currently envisaged for the medium term. A number of stability
programmes are aimed at attaining the necessary flexibility only at a relatively late date, and this
is on the assumption of sustained economic growth and low interest rates. It is important that we
see a commitment from policymakers to ensuring the swift achievement of this aim or to going
beyond the aims envisaged in these programmes once economic growth has picked up.
The role of longer-term structural reforms
The most important area where there is national flexibility is in relation to structural policies.
Indeed it is arguable that many of the important challenges which face euro area countries can
only be addressed through national policies in this area. As the March 1998 Convergence Report
of the European Monetary Institute already identified, there is an urgent need for lasting policy
adjustments arising from:
• high and persistent unemployment which is largely of a structural nature;
• demographic trends which are expected to place a heavy burden on future public
expenditure; and
• the high levels of public debt, which will weigh on the current budgets of many member
states until debt levels are reduced.
To start with the first long-term economic issue, I now turn my attention to the contribution that
structural reforms to euro area labour markets can make to reducing the very high level of
European unemployment. As I have done in my comparison of the euro with the dollar, let us
again contrast the developments in Europe with those of the United States. In 1970
unemployment in the United States, at around 4%, was actually significantly higher than in most
European economies. Since then, although there has been a marked variation in the US
unemployment rate during the course of each economic cycle, there has been no apparent
longterm trend, as the unemployment rate stood at 4.4% in January 1999. In contrast, average
European unemployment has been on a steadily rising path. The unemployment rates in the
United States and Europe appeared to have broadly converged by the early 1980s, and since that
time the unemployment rate in the United States has been below the EU average. Even though the
euro area unemployment rate fell last year, the January 1999 figure of 10.6% was more than
double the corresponding US rate.
Looking at the latest unemployment rates around the euro area - which range from 2.8% in
Luxembourg (January 1999) and 3.6% in the Netherlands (December 1998) to 17.8% in Spain
(January 1999) - suggests that policies must be developed at the national level. What is needed
appears to be national structural reforms to make sustainable reductions in unemployment rather
than a boost to euro area aggregate demand. Moreover, making labour markets more flexible can
also make it easier to cope with short-term imbalances in demand.
However, the situation in euro area labour markets is not uniformly bad. Some countries,
particularly those with more flexible labour markets, more moderate wage increases and less
discouraging tax and social security policies, have managed to avoid the trend of ever-rising
unemployment. For example, the Netherlands, Ireland, Portugal, Austria and Luxembourg all
currently show unemployment rates well below the euro area average. There are also examples of
other countries with higher unemployment rates, such as Spain, that have begun to take steps to
reform their labour markets and are now beginning to see tangible results. We can also look at
some of the non-participating member states, such as Denmark and the United Kingdom, to see
that high unemployment can be reduced through structural reforms.
The need for structural reform is widely recognised, for instance in the OECD Jobs Study and at
the November 1997 Luxembourg European Council meeting, and some progress with new policy
measures is already being made. First, there are 'active labour market measures' to provide
education, training and work experience - particularly targeted at the long-term unemployed.
Second, there are reforms to ensure that tax and social security systems make people significantly
better off in work than out of it. Third, there are measures to ensure that low-productivity workers
are not forced out of the labour market. These include reducing the burden of taxes and non-wage
labour costs and making sure that minimum wage schemes and collectively bargained wage
agreements take account of the need to preserve such jobs. I would also wish to add that, contrary
to some suggestions, such policies do not amount to 'competitive devaluations', and structural
reforms and wage moderation are no 'zero sum game'. They can help generate net increases in
average employment and should not be criticised as 'wage or social dumping'.
The second long-term economic issue I should like to address today is the need to prepare for the
substantial financial consequences of the ageing of European populations. On the basis of current
trends in birth rates and life expectancy, unfunded public pension and healthcare schemes
generate very high implicit government liabilities in most euro area countries. Indeed, in many
cases these implicit liabilities appear to be of such magnitude that they dwarf even the large
official government debt levels. Unless action is taken quickly, these financial burdens will fall
on future generations of taxpayers and may also threaten the soundness of government finances.
Therefore, to prepare for the ageing of the population, substantial savings need to be made.
The third key issue is the need to make progress in reducing the high government debt-to-GDP
ratios that have substantially increased over the past two decades. Whilst there was some
improvement in the run-up to the start of EMU, the recent progress has been disappointing as the
average debt-to-GDP ratio for the euro area fell only slightly to 73.8% in 1998, compared with
74.6% in 1997. Such imbalances are undesirable and can also have wider implications for the
conduct of monetary policy. If there are any doubts about the soundness of fiscal policies, this can
influence the effectiveness of monetary policy instruments, and undermine the credibility of
monetary policy.
In addition to the long-term economic issues mentioned so far, I should also like to emphasise
that the structural reform agenda available to national governments to promote economic
development extends well beyond the reform of labour markets and public finances. For example,
national governments can take steps to promote entrepreneurship and make it easier for people to
The introduction of the euro and a common monetary policy has certainly not rendered
national governments impotent. With the ability to vary fiscal policy and undertake structural
reforms, national governments retain the key powers to address the real needs of their
economies. If the terms of the Stability and Growth Pact are adhered to, then there is sufficient
flexibility to allow automatic stabilisers to work in the event of a slowdown. Structural
reforms provide the only means of achieving lasting reductions in unemployment, preparing
for the ageing of the population and reducing the burden of government debt. National
governments would be well advised to press ahead with such reforms. Apart from having their
own merits, such policies would also support the ECB in maintaining price stability in the
euro area.