Jean-Claude Trichet: A stability-oriented monetary policy as a necessary
condition for long term growth
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the UNICE
Competitiveness Day, Brussels, 9 December 2004.
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Ladies and gentlemen,
It is a pleasure for me today to address such a distinguished audience, which best represents the
European entrepreneurial capacity and dynamism. Today I would like to discuss first the general role
of policy institutions in a developed market economy. I shall then dwell more specifically on how the
conduct of monetary and fiscal policy in the euro area contributes to foster high and sustainable output
growth and job creation. Finally, I shall stress the importance of structural reforms in labour and
product markets in ensuring that our economy is endowed with the degree of flexibility that is needed
for firms and workers to be able to withstand successfully the challenges that the contemporaneous,
highly interrelated world economy poses to us.
The determinants of sustainable long term growth
The determination of the factors that increase the individuals' standard of living is the main issue that
scholars have analysed since economics was born as a modern science more than 250 years ago.
The evolution of the economic theory has greatly furthered and deepened our understanding of this
issue. Nevertheless, one core conclusion remains today as important as it was in the late eighteenth
century: the amount of goods and services produced in any given economy grows at its highest
possible rate when the rules of market economies are applied.
We have learned that this prescription cannot possibly be translated into a pure laissez-faire doctrine,
because when the production and the exchange of goods and services is carried out without a proper
legal and institutional framework the potential of the economy would not be fully exploited. For this
reason, societies need to equip themselves with the right framework, which enhances the collective
welfare by clearly defining and ensuring property rights and ensuring the efficient supply of public
goods. This means in particular that economic policy must ensure that individuals have the necessary
incentive to earn their income by working and producing goods and services which other individuals
need. It also means that enterprises must take their decisions on the basis of market signals without
relying on subsidies or being protected from competition. This will foster the accumulation of human
and physical capital and a high level of employment, which are the determinants of long term growth.
To fulfil this objective, economic policy must create and maintain a "stable" macroeconomic
environment, ensure an appropriate level of flexibility of the economic system and provide incentives
to work and invest in both physical and human capital in order to maximise employment and output
growth.
In Europe and more particularly in the euro area, the stability of the macroeconomic framework and
the flexibility of the economic structures are two guiding principles of economic policy that are
enshrined into the Treaty and the Lisbon Agenda, respectively. How can these principles be best
applied in practice?
The role of a stability oriented monetary policy
Let me start by illustrating the role that the ECB's monetary policy plays in fostering long term output
growth in the euro area. The EU Treaty establishes the maintenance of price stability as the primary
objective of the ECB. This objective refers to the general price level in the euro area and the ECB has
made it clear that it aims at keeping inflation (as measured by the Harmonised Index of Consumer
Prices) below and close to 2% over the medium term. The ECB does all what is necessary to be
credible in the delivery of price stability - in line with its definition - over time, including in the medium
and long term. By credibly maintaining price stability, the ECB brings about a decisive contribution to
long run output growth, and it does this through several channels.
First, price stability ensures the transparency of the relative price mechanism, thus enhancing the
efficiency of resources allocation. In an environment of price stability economic agents can more easily
discern the change in the relative value of each single good and service produced as well as that of
labour and capital. In a situation of increasing inflation, instead, resources could be wrongly allocated
to the production of goods and services whose relative demand has not increased. Furthermore,
households may have difficulties in discerning the relative price of goods and services thus choosing a
consumption bundle that turns out to be suboptimal.
Preserving price stability also contributes to fostering private consumption. Lower inflation supports
private consumption via its positive impact on the real value of households' income and wealth.
Another important channel through which price stability fosters economic growth consists in the
reduction of borrowing costs for individuals and firms. As we all know, inflation erodes the purchasing
power of the nominal return on long term loan contracts or bonds. In case of high and uncertain
inflation, savers or those who lend their liquid funds would then require a higher rate of return from
borrowers, in order to compensate for the higher risks related to the uncertainty about future inflation.
This inflation risk premium implies that in an economy with high inflation, less investment projects with
a rather high rate of return will be profitable. In such circumstances, capital accumulation will be lower
than it could have been in a situation of price stability and the output growth rate is consequently
reduced.
Financial market developments during the past few years are indeed a testimony to the success of the
ECB's stability oriented monetary policy in securing low and stable long-term inflation expectations
and thereby low interest rates in the euro area. Over the period between 1995 and 1999, the latter is
the year when the euro replaced the national currencies of eleven EU member states and the ECB
started to run a single monetary policy, long-term inflation expectations, as measured by Consensus
Economic Forecasts, swiftly converged towards the "below 2 per cent level", which is the ECB's
definition of price stability, from levels much higher still in the mid-1990s. Such a high degree of
credibility was reflected in the developments of euro area long term interest rates, which by the
beginning of 1999 had declined to around 4%, which was the level prevailing for the most credible and
stable currencies, thus resulting for a number of countries and economies in a decline of around
9 percentage points since the beginning of 1995.
Since 1999 the ECB's stability-oriented monetary policy and, overall, the ECB credibility in delivering
price stability has been remarkably successful and has contributed to maintain financing costs - from
the short term to the long term up to 30 years - at historically low levels. Inflation expectations have
remained at low levels and have not been significantly affected by short-term developments in actual
euro area headline inflation. Furthermore, in the period since the start of the single monetary policy,
the fluctuation of key macroeconomic variables has declined significantly. In comparison with the
average level of the first half of the nineties, the volatility of long-term inflation expectations (as
measured by the Consensus Economic Forecast) has declined by more than one half. From a longer
term perspective, when compared with the average levels recorded in the 1980s and the first half of
the nineties the observed volatility of inflation and long term interest rates declined by around three
quarters. Furthermore, over this latter period the decline in the volatility of both real GDP and
employment figures by more than one quarter should also be associated with the contribution of
successful stability-oriented macro-economic policies in the euro area.
The ECB manages monetary policy in a systematic and transparent manner so that private agents are
in the best possible conditions to gauge the likely evolution of interest rates in response to economic
developments. First of all, the ECB is very clear about its monetary policy strategy. In addition, the
ECB informs the public through the monthly press conference held just after the first Governing
Council meeting of the month where the economic and monetary diagnosis of the ECB and the
decisions taken by the Governing Council are displayed and explained almost in real time. The ECB
has been a pioneer in this domain and has been followed by other central banks keen on increasing
the transparency of their actions and decisions. This transparency is one further element contributing
to macroeconomic stability and long-term growth. In an environment where the predictability of interest
rates movements and their likely relation with key macroeconomic developments is relatively high,
firms can better manage their balance sheets. This reduces both their vulnerability to economic shocks
and their risk management costs and creates the condition for better decisions as regards domestic
and foreign investment.
Finally, I would like to stress the importance of maintaining price stability in enhancing the functioning
of the labour market and contributing to sound nominal wage developments and competitive unit
labour costs, which fosters firms' competitiveness, growth and job creation. In a credible regime of low
inflation workers do not ask for extra-wage increases to compensate for inflation risk and firms and
trade unions know ex-ante that firms will not be able to pass higher wages on to consumer prices. This
helps to avoid excessive nominal increases, thus enhancing the ability of firms to efficiently manage
their production costs and create new jobs. At the current juncture, it is important that there are no
second round effects on wage and price settings arising from the recent increase in oil prices. Such
effects have not been observed till now. All economic agents know without any doubt that we are very
vigilant in this respect; and we trust that it is this vigilance and our credibility that are decisively
contributing to prevent second round effects.
The role of a stability oriented fiscal policy
Of great importance for the maintenance of macroeconomic stability and long term growth are sound
public finances. The Stability and Growth Pact, which complements and further specifies the
EU Treaty, provides a set of rules for the national fiscal authorities with the aim to ensuring fiscal
soundness, by avoiding excessive deficits and safeguarding government finances, as defined by the
attainment in the medium-term of budgetary positions "close to balance or in surplus". Far from being
a straightjacket on national policymakers, these rules derive from the experience accumulated in past
decades showing that increased debt ratios - as well as the implicit debt associated with social
security systems in ageing societies - cast a permanent shadow over long term output growth and
constantly limit the scope for fiscal policy to act as a stabilising instrument.
Although its implementation has been far from satisfactory, we should see that the Stability and
Growth Pact brought about significant improvements in the fiscal performance of the EU over the
years. In other major economies outside Europe fiscal deficits reached very high levels in the recent
economic slowdown, and the ratio of debt to GDP in these countries is now on a very worrisome path.
In contrast, the euro area public finances weathered the economy cyclical downturn with aggregate
deficit to GDP ratios remaining between 2% and 3% and with debt to GDP ratios only moderately
rising. While this is less than what the ECB - as well as the Council and the Commission - had hoped
for, it is a significant achievement for Europe where in the early 1990s average deficit to GDP ratios of
above 5% were still recorded. The euro area is now in a better starting position, in terms of
macro-economic policies, compared to a number of major economies to emerge from the phase of
economic slowdown. These achievements are from time to time forgotten in the ongoing debate on the
Stability and Growth Pact, and they demonstrate how important it is for Europe not to weaken this
Pact.
As the ECB has repeatedly clarified on several occasions, it is important that the Stability and the
Growth Pact and the excessive deficit procedure remain key cornerstones of the Economic Union. Let
us never forget that we cannot have a Monetary Union (MU) without and Economic Union (EU), to
make a coherent and economically rational EMU. This implies that both the Pact and the excessive
deficit procedure are respected in their current form. Their implementation could be improved, in
particular as regards the preventive arm of the Pact, ie the implementation of those rules aiming at
avoiding that excessive deficits arise in the first place.
Experience shows that if financial markets are uncertain about the future soundness of fiscal policy, at
some stage long term interest rates are likely to increase. This tends to exert a negative impact on
private investment and physical capital formation. Ultimately, unsound fiscal policies reduce
production, output suffers a permanent loss and consumption possibilities are diminished in the long
run. To be sure, being in a monetary union, like the euro area, does not shield countries that are
expected to follow an unsustainable fiscal course from sooner or later being forced to pay higher credit
risk premia on their government bonds relative to more disciplined countries in the union. The Treaty
explicitly prohibits that individual governments, which run policies that are not sustainable, can be
bailed-out by other governments or by the ECB.
In recent years budgetary developments in the euro area have not been fully satisfactory and there is
growing concern among market participants and observers that consensus on the importance of fiscal
discipline is weakening in the euro area. While fiscal accounts in the euro area have been affected by
the sluggish economic growth experienced in the past two or three years, it is undeniable that, in
general, the resilience of fiscal deficits in the euro area is mainly due to high - and, sometimes, very
high - structural public expenditure, which, by definition, are not dependent of the cyclical
developments.
It is of crucial importance that euro area member states take advantage of the ongoing recovery and
focus on the pursuit of balanced budgets or surpluses in the medium term. Such a policy would
contribute to ensuring that the conditions for long-term growth in the euro area are strengthened and
to meeting the challenges arising from an ageing population. Empirical evidence supports the
conclusion that comprehensive fiscal consolidation programmes, if appropriately designed and
credible, can have favourable effects on confidence, investment conditions and thereby on output
growth even in the short term. Notably, if fiscal reform is based on the consolidation of public
expenditure rather than on an increase in taxation, the adjustment in fiscal accounts would tend to
support both private consumption and investment - because the current and expected after tax
disposable income of household and firms increases.
Comprehensive and credible expenditure-based fiscal stabilisation programmes would in particular
have positive supply effects as well. A number of empirical studies suggest that there are two main
reasons why this can be the case. First, lower expected deficits reduce long term market interest
rates, which creates more opportunities to invest and increase the productive potential of the
economy. Second, following the reduction in labour taxation that is possible when public expenditure
is reduced, the expectation of higher after-tax income induces higher labour supply and mitigates
wage increases, thus boosting the country's international competitiveness and job creation.
The role of structural reforms
A stability oriented macroeconomic policy framework is not sufficient to ensure that high long-term
growth is achieved. When private agents take their decisions over consumption, saving and
investment, they should also not have impediments in the form of unnecessary and excessive
regulations. A sound monetary and fiscal policy framework has to be complemented by structural
policies that make the economy more flexible and dynamic.
Since March 2000, when the European Council launched the Lisbon agenda, European national
governments, parliaments and social partners have become increasingly aware of the importance of
implementing a substantial, courageous and far-reaching agenda of structural reforms. The ECB, from
its side, fully endorses the Lisbon agenda and shares its objectives. We also agree with the main
conclusion of the High Level Group chaired by Wim Kok that - in preparation of the mid-term review of
the Lisbon Strategy - has stressed the advantages of sharpening the focus on the key issues in order
to revamp the structural reform process in Europe.
Indeed, in the last decade, euro area countries have made some tangible progress with their structural
reform programs. Competition in product markets due to, for example, a lower level of state aid and
de-regulatory measures has increased, especially in network industries. This resulted in significant
downward price effects in some sectors like telecommunication.
The ECB is supporting strongly governments that are courageously embarking on reforms and does
not underestimate the difficulty to implement them. In particular it has proven to be more difficult than
previously expected for European governments and social partners to implement labour market
reforms that could strengthen the positive employment trends recorded in the EU in the second half of
the 1990s.
Breaking the reform deadlock is of the utmost importance, also in light of growing role played by new
economies in the international market place that exposes European firms to new and challenging
competitive pressures. It is not my intention today to provide suggestions to government, parliaments
and social partners about specific policy actions, but it is clear to me that in the area of labour market
reform, increasing flexibility and suppleness with a view to maximize job creation and to augment the
capacity of outsiders, like unskilled youth, to enter the job market is of the essence.
In another domain there is a number of countries where the lengthening of retirement age, allowing
workers to work longer hours per week and the reduction of non-wage costs of labour - like labour
income taxation and social security contributions - are necessary to increase labour supply and
demand, thus raising the productive capacity of the economy. Recent events involving a number of
important euro area companies demonstrate that social partners are aware of the collective benefits
induced by a better management of resource utilisation, as workers and employers could agree on
measures that would preserve competitiveness and consolidate jobs.
Moreover, other measures facilitating workers reallocation, reducing both employment traps - due to
generous unemployment subsidies and high marginal income taxes - and costs related to adjustments
in the labour force are often useful to increase the resilience of the economy to unforeseen shocks. A
more flexible economy will make it easier for the corporate sector to maintain competitiveness without
large cuts in employment.
Finally, a more flexible cost structure will increase the expected rate of return from private investment
in both physical capital and research and education of the labour force. Hence, both the productivity
and the quality of the labour force employed will increase, thereby setting the stage for virtuous
dynamics that lead to higher output growth.
Conclusion
All policymakers are called to play their role in making the euro area a more dynamic economy. By
maintaining price stability, and by being credible in delivering it over the medium and long term, the
ECB makes its own indispensable contribution to foster growth in the euro area. The rate of potential
economic growth very much depends also on the other policy actors. It requires fiscal policy to be
sound and sustainable, and it requires reforms ensuring that the structure of the economy is flexible
and supple enough to augment the growth potential of Europe and to allow economic agents to
respond smoothly to economic shocks.
In a very rapidly changing environment, where new technological advances, not only in the IT area,
are extremely powerful and seem to be comparable only with the start of the industrial revolution,
where creativity and conceptual innovations are flourishing in all economic sectors, particularly in the
global financial system, and where economic globalisation is rapidly transforming the very structure of
the world economy, the euro area and its 306 million fellow citizens are called to adapt in order to take
advantage of the opportunities offered by this new world and to respond to new challenges.
A lot has been done in Europe over the last 20 years: the combination of the bold single market
endeavour starting in the mid eighties and of the single currency starting at the end of the nineties are
perhaps the most striking historical set of structural reforms at the level of a continent in peace time.
We have proved we were able to move and to restructure. We still have a lot to do as Wim Kok is
wisely and strongly recommending.
In this respect, permit me a last remark: at the moment I am speaking most of the reforms that are
necessary at the level of our continent have been implemented with success in some European
economies, generally on the basis of a bi-partisan consensus and with a large accord of the
entrepreneurs and of the unions. Benchmarking in each particular domain of structural reforms the
entire euro area and the European Union on the best European performers might well be the most
powerful tool to make the necessary progress. Let's just do it!
I thank you for your attention.