Mario Draghi: A central banker's perspective on European economic
convergence
Speech by Mr Mario Draghi, President of the European Central Bank, at the Anchor 2013
Conference, organised by the Magyar Nemzeti Bank (the central bank of Hungary),
Budapest, 7 December 2012.
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Ladies and Gentlemen,
It is a great pleasure to be here in Budapest and to participate in the annual Anchor
conference. I understand that this will be the last Anchor conference for András Simor in his
position as Governor of the Magyar Nemzeti Bank. So this is an excellent opportunity for me
to pay him a sincere tribute for his work here and as a valued member of the General Council
of the European Central Bank (ECB).
In my remarks today, I would like to focus on the process of economic convergence in
Europe. As the experiences of recent years have made clear, this process does not end with
a country's adoption of the euro. Nor does participation in the single monetary policy provide
automatic delivery of convergence.
I will first talk about the challenges facing the euro area as a result of shortcomings in the
process of convergence and integration. I will then discuss the challenges of convergence for
those members of the European Union (EU) that have not yet adopted the euro.
1. Two challenges in the process of European integration
The institutional challenge
Over a period of many years, the EU has provided an unprecedented framework for
successful regional integration. The process of integration has involved not only the creation
of a common market and the harmonisation or coordination of several economic policies, but
also the conduct of some of these policies at a supranational level.
A central pillar of the EU's institutional architecture has always been the principle of
subsidiarity. This is the rule that action shall only be taken at the supranational level if the
objectives to be pursued cannot be sufficiently achieved by EU members, either at the level
of central government or at the regional and local level.
While we should continue to preserve the principle of subsidiarity, the recent challenges for
the euro area have provided us with a major institutional lesson: maximising the benefits of
the single currency requires not only a strong ECB; it also requires additional strong common
institutions.
We need strong institutions to guarantee competitiveness and to encourage sustainable
growth; to guide fiscal policies and ensure fiscal sustainability; and to supervise and stabilise
the single financial market. We also need strong institutions to engage citizens more closely
in the European project.
In other words, the future prosperity of Europe hinges on our ability to complement monetary
union with economic union, fiscal union and financial union. This more advanced institutional
architecture will in turn need to be embedded in some form of political union that engages
citizens more deeply in European decision-making. As a result, joining the euro area in the
future should imply greater sharing of sovereignty and a deeper European accountability
than it did ten years ago.
The institutional challenge is the first major challenge with which we are currently confronted.
We have already made much progress in addressing the challenge. But a great deal of work
remains to be done.
The economic challenge
The second and complementary challenge is economic. The benefits of adopting the euro
are greater the more consistent the economic structures of existing and prospective
members are. Convergence can be broadly defined as a process in which cross-country
differences in economic structures are reduced over time. The success of the convergence
process ultimately depends on the sustainability of the underlying policies.
Shortcomings in the process of convergence across euro area members have been at the
root of the challenges we have faced since 2010. But I am pleased to report that progress in
addressing those shortcomings is being made.
External imbalances and fiscal imbalances are starting to be unwound. Efforts to regain price
and non-price competitiveness are bearing early fruit. Deleveraging is generally proceeding
in an orderly way, even though credit flows to the real economy seem to be negatively
affected in parts of the euro area. Debt is being reduced in some countries, while others are
devising strategies to make debt reduction sustainable over time. And financial sector
weaknesses are being addressed along with their links to sovereign risk.
As I have said, progress is being made but much still needs to be done. The recent
experiences of some current euro area members also serve as a cautionary tale to
EU members bound by the Treaty to adopt the euro in the future. I will now turn to the
challenges facing these countries in the process of convergence.
2. The perspective of EU countries which have still to adopt the euro
The framework for convergence
With two exceptions, all EU members that are not yet in the euro area are expected to adopt
the single currency on meeting certain convergence criteria. As you know, the Treaty defines
these criteria along three dimensions.
The first dimension is the degree of nominal convergence with the euro area. This implies
achieving price stability; ensuring the sustainability of the government's financial position;
realising sustainable convergence of long-term nominal interest rates; and maintaining a
stable exchange rate between the national currency and the euro.
The Treaty also requires that nominal convergence is sustainable. This is not possible
without it being underpinned by a high degree of real convergence. According to this second
dimension, adopting the euro makes sense only if the economic structure of a prospective
member has converged sufficiently towards the prevailing structures in the euro area.
The success of the real convergence process in turn depends on the sustainability of the
relevant policies. The challenges that we have faced since 2010 highlight the dangers that
large and persistent macroeconomic imbalances pose, not only for the stability of domestic
economies, but also for the smooth functioning of the euro area as a whole. We all know the
dire implications of prolonged losses of competitiveness, excessive indebtedness and
housing market bubbles.
Recognising this fact, EU members have moved towards stronger surveillance of domestic
Macroeconomic Imbalance
policies. Let me remind you of two examples. One is the new
Procedure, which aims to prevent the build-up of new macroeconomic imbalances and
enforce the correction of existing imbalances. The other is the "fiscal compact", which was
signed by all EU members except the UK and the Czech Republic in March this year and
which strengthens the sustainability and credibility of fiscal policies.
The third dimension of convergence is institutional. The relevant national legislation,
including the statute of the national central bank, needs to be compatible with the
EU Treaties and the Statute of the European System of Central Banks (ESCB).
More generally, a lesson we have learned the hard way is that the strength of the institutional
environment is crucial for the sustainability of economic integration and convergence.
Improvements in the institutional environment entail, among other things, better regulations,
better governance, better quality of statistics and a more business-friendly environment.
Removing impediments to the efficient use of factors of production helps to enhance the
growth potential of each country.
How to achieve a high degree of sustainable convergence?
So how can countries best prepare their economies to reap the benefits of closer European
integration? There are four building blocks: monetary policy, structural policy, fiscal policy
and financial policy. Let me reflect briefly on each of these.
Monetary policy
First, monetary policy, which, before the euro is adopted, remains a national responsibility.
But a number of Treaty obligations already apply at this stage. In particular, the main
objective of monetary policy should be price stability, and exchange rate policy should be
treated as a matter of common interest.
Monetary policy best contributes to growth through the delivery of price stability. Overall price
stability creates a predictable environment that fosters the efficient adjustment of relative
prices and bolsters investor and consumer confidence. It also protects the purchasing power
of the most vulnerable members of the population.
Different monetary policy frameworks have been devised to deliver price stability. Some
EU members outside the euro area have fixed the exchange rate of their domestic currencies
to the euro, which has a very good track record of low inflation. A different approach - which
has been adopted by Hungary - has combined exchange rate flexibility with a regime of
inflation targeting.
I understand that Governor Simor will focus his remarks on the past and future of inflation
targeting in Hungary. So I will limit my comments to the importance of central bank credibility
for the success of inflation targeting.
The ultimate success of a central bank in maintaining price stability depends on its credibility.
Credibility anchors inflation expectations in line with the definition of price stability adopted by
the central bank. Well-anchored inflation expectations in turn align the choices relevant for
wage and price setting.
A key prerequisite for a credible monetary policy is the independence of the central bank.
This principle is enshrined in the Treaty and the Statute of the ESCB. Each central bank in
the EU should have institutional, personal, functional, and financial independence.

Institutional and personal independence protect the central bank and members of its
decision-making bodies from direct or indirect influences of third parties in the performance
of their tasks. Functional independence requires that the central bank has the necessary
means and instruments for achieving its objective independently of any other authority. And
financial independence guarantees that the central bank has access to and control over
sufficient financial and human resources to fulfil its mandate.
Credible inflation targeting in small open economies also depends on central banks'
recognition of the impact of their monetary policy decisions on the exchange rate.
For example, in the presence of heavily indebted private and public sectors with large open
foreign exchange positions, central banks have little space for manoeuvre when faced with a
flagging economy. This is especially true when inflation is already high and there is not yet a
critical mass of structural and institutional reforms capable of reducing the country risk
premium to sustainable levels.
In these circumstances, lowering the policy rate to stimulate the economy may risk sparking
depreciation pressures on the domestic currency at some point in time. Depreciation of the
currency may in turn further fuel inflation and offset the impact of economic stimuli through
negative balance sheet effects on consumption and investment.
Structural policies
The second building block is structural policy. The sustainability of nominal convergence is to
a large extent conditional on a sufficient degree of structural, or real, convergence. A broad
indicator of the degree of real convergence with the euro area is the catching-up of per capita
incomes and price levels of new members with those of the euro area.
Convergence in real per capita GDP levels has to be fostered by far-reaching structural and
institutional changes aimed at enhancing the growth potential of the economy. Such reforms
typically aim at strengthening the flexibility of adjustment mechanisms in the economy and
improving the business environment.
When goods and labour markets are rigid, inflation and inflation expectations may remain
high even in the presence of monetary regimes committed to the achievement of price
stability. Both governments and social partners share responsibility for ensuring that wage
determination takes sufficient account of labour market conditions and does not jeopardise
competitiveness and employment. Active labour market policies should tackle persistent
bottlenecks, such as skill mismatches.
Finally, protection of vested interests in the product markets and lack of mobility and
adaptability in the labour markets undermine job creation, in particular for young and less
qualified workers, as well as for all those who face problems entering the labour market.
Lowering barriers to entry will increase competition, particularly in those domestic service
sectors that are sheltered from international competition, and thus support price stability.
Economic growth led by the private sector needs to be fostered by a stable and
business-friendly policy environment. In this respect, governments should strive for
transparency and predictability of the policy regime, a low compliance burden, and effective
governance in applying the rule of law.
Fiscal policy
It is also crucial that the achievement of price stability is supported by sound fiscal positions,
the third building block of convergence. Irresponsible fiscal policies can jeopardise credibility,
as higher inflation becomes desirable to reduce the real value of government debt.
Fiscal policies should be sustainable and oriented to the medium term. They should further
aim at mitigating undesirable trend growth differentials through "high quality" expenditure and
tax policies. In particular, high and inefficient public expenditure can put a brake on economic
activity by imposing a high tax burden on the economy and channelling resources into
unproductive uses.
Financial policies
The fourth building block is financial policy. A sound banking sector, liquid and
well-functioning capital markets are important for the sustainability of nominal convergence.
On the one hand, well-functioning banking sectors and capital markets ensure efficient
financing of capital accumulation in the economy, thus supporting potential output growth. On
the other hand, they sustain the smooth functioning of the monetary policy transmission
channels, such as the interest rate and bank lending channels. In this regard, financial sector
vulnerabilities pose great challenges for the conduct of monetary policy.
Conclusions
Let me draw to a close. The experiences of the past few years have shown that participation
in a monetary union places important demands on national economic policies.
Euro area governments are hard at work responding to those demands. They are correcting
macroeconomic imbalances. They are establishing a stronger framework of governance to
keep countries on the path of sustainable convergence. And they are improving the
institutional set-up underpinning monetary union.
For those EU members that have not yet adopted the euro, the challenge is to achieve a high
degree of sustainable convergence with the euro area. This requires credible commitment on
the part of their central banks to achieve price stability and treatment of exchange rate
policies as a matter of common interest.
For the members of the euro area, the challenge is to achieve full compatibility of their
economies with participation in monetary union. Product and labour markets must possess
sufficient adjustment capacity to buffer shocks while maintaining high output and
employment. It is in this area that progress is most needed.
As I have indicated, much work remains to be done - in both the current and prospective
members of the euro area, and both individually in each EU member, and jointly across
Europe. But I have no doubt that this opportunity to continue progress will be seized and that
together we will reap the benefits of sustainable economic convergence and lasting regional
integration.
Thank you for your attention.