Erkki Liikanen: The tenth anniversary of the euro - a time to reflect
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Professor Ragnar
Nurkse seminars, Bank of Estonia, Tallin, 10 September 2008.
* * *
It was only ten years ago, in May 1998, when European leaders decided to launch the third
stage of Economic and Monetary Union.
European Central Bank
The was founded a month later, in June 1988. Under the Maastricht
Treaty, the new monetary institution was granted full independence to conduct monetary
policy, with price stability as its primary objective. The task of defining price stability was
given to the Governing Council of the ECB, in which the Governor of the Bank of Finland
was, and is, a member.
At the same time, an informal discussion forum, the Euro Group, was created by the
Ministers of Finance and Economic Affairs in the euro area countries to discuss issues
related to EMU, such as the economic situation, coordination of economic policies, structural
reforms, enlargement of the euro area and the external representation of EMU.
Introduction of the common currency and common monetary policy had been preceded by
four years of very intensive legal, regulatory and logistical preparations. It was necessary that
the infrastructure for the common monetary policy was fully operational from the first day.
These preparations had remained largely unnoticed by the public at large.
The creation of Economic and Monetary Union was also preceded by a great number of
sceptical remarks from many commentators, including academic economists. Many experts
in international macroeconomics doubted that a single monetary policy could suit countries
whose economies diverged in many respects.
The second major milestone, and the biggest one for euro area citizens, was January 2002,
when the changeover from national notes and coins to euro notes and coins took place in 12
EU member states.
The euro area has since expanded by a further three countries, and, at the beginning of next
year, the area will welcome another new member.
Three months ago, in June, we had the tenth anniversary of the European Central Bank. The
coming New Year will mark the tenth anniversary of the common currency, the euro. Today
everybody, including the vocal critics, agree that EMU and the euro have been a great
success.
But there is no doubt that many important challenges still remain. In the rest of my talk, I will
reflect on the successes and challenges of EMU from both a European and a Finnish
perspective.
European perspective
Monetary stability
Monetary stability is the greatest achievement of EMU. By monetary stability, I mean the
absence of tensions on the money and currency markets. These tensions diminished and
practically disappeared on the road to EMU. The launch of EMU then made such tensions
impossible between the participating countries.
But EMU has also contributed to monetary stability in non-participating countries. Many of
these countries have the objective to join EMU and are therefore committed to conducting
stability-oriented policies to make participation possible at a later date.
EMU has contributed to the monetary stability of floating exchange countries as well. This is
because these countries have also conducted stability-oriented policies aiming at low
inflation and sound government finances.
Two forces have contributed to this effect. Firstly, there is a size effect. Smaller neighbours
have an incentive to conduct stability-oriented policies as long as they have a large
neighbour with predictable monetary policy aiming at low and stable inflation. Deviation from
such a policy would hurt the smaller neighbours, not the large currency area. The cost would
be higher risk premia and higher real interest rates. We only have to recall that in the 1970s
and 1980s Germany had lower real interest rates than its neighbours, which were less
successful in maintaining monetary stability.
Secondly, there is a political-economy argument. The existence of a large area of monetary
stability makes it easier, or at least less difficult, for the political leaders of smaller neighbours
to resist in situations where special interest groups are calling for more inflationary policies.
They might sometimes think that they suffer from too high interest rates or too strong an
exchange rate. The risk of time inconsistency is thereby reduced.
European history has witnessed repeated episodes of monetary instability. Typically, the
instability has been caused by an economic slowdown or recession. This was the case at the
beginning of the 1980s and the 1990s, as well as in the mid-1970s. The ultimate trigger for
instability was the different policy reactions to the shocks that occurred at these times.
Europe is now going through a challenging period. Economic activity is weakening due to
higher commodity prices, which dampen consumption and investment, and also due to the
uncertainty the recent financial market turbulence is causing for the growth outlook. Had
EMU not been a reality, we would probably now be experiencing a similar, or even worse,
monetary mess than Europe experienced at the beginning of the 1990s.
Price stability
Monetary stability and price stability are inseparable. We cannot have monetary stability
without price stability. Price stability, in turn, is a precondition for sustainable growth. It
reduces uncertainty, which is reflected in lower real interest rates, thus supporting
investment. It also promotes competition, which accelerates productivity growth. Productivity
growth, in turn, has always been, and will continue to be, the primary source of increasing
prosperity.
Average Inflation in the euro area in the period 1999 to 2007 has been slightly above 2%.
This is low compared with 4% in the early 1990s and 8% in the 1980s, not to mention the
double digit inflation of the 1970s.
It is not true that lower inflation would imply higher real interest rates, as some people today
still seem to think. On the contrary, inflation risk premia diminish as inflation uncertainty
diminishes, and nominal interest rates decline as low inflation becomes firmly anchored in
expectations. This is illustrated by the fact that the real long-term interest rate in the euro
area countries (EMU12) has been 2.4% since 1999, compared with 4.7% in the period 1989
to 1998.
Inflation and inflation volatility by decade
EU12
% p.a.
Long-term real
interest rate
Average inflation
1989-98 4.7%
1999-08 2.4%
Standard
deviation
Source: European Commission, EMU@10 (2008)
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The ECB's definition of price stability is the rate of increase in the Harmonised Index of
Consumer Prices being close to but below 2% in the medium term. Against this benchmark,
the inflation performance of the euro area has not been entirely satisfactory. But the
deviation is understandable, given the repeated upward shocks in the relative price of oil.
Monetary policy and inflation in the euro area
%
6
5
Monetary policy rate
4
3
2
Inflation
1
0
1999 2001 2003 2005 2007
Sources: European Central Bank and Eurostat.
20058
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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
The recent resurgence of inflation, however, is a far more serious concern than the small
deviation of the inflation outcome from the price stability objective. The latest figures on euro
area inflation now stand at a level which is almost twice as high as the ECB's definition of
price stability.
Admittedly, much of this acceleration in inflation is, once again, attributable to relative price
shocks, that is, to increased commodity prices. The central bank cannot (and should not
attempt to) affect relative prices. There is a risk, however, that relative price shocks of this
kind can raise longer-term inflation expectations and affect price and wage-setting behaviour,
creating a price-wage cycle and finally disanchoring inflation expectations.
The euro area is not the only region which has been able to enjoy low inflation for an
extended period of time. Most OECD countries had similar experience of disinflation in the
1980s, and they achieved a similar degree of price stability as the euro area by the end of
the 1990s. Average inflation in Sweden, for example, has since 1999 been half a percentage
point lower, and in the US half a percentage point higher, than in the euro area on average.
10,0
Low inflation - a global 9,0
Euro area
8,0
7,0
achievement
6,0
5,0
4,0
♦
Low inflation and low
3,0
2,0
inflation volatility achieved
1,0
0,0
in most developed
1960s 1970s 1980s 1990s 2000s
10,0
countries
9,0
Average
8,0 Sweden
inflation
♦ 7,0
Institutions matter:
6,0
5,0
- central bank independence
4,0
3,0
- well-defined target for
2,0
1,0
monetary policy
0,0
1960s 1970s 1980s 1990s 2000s
- transparency and
10,0
Standard
9,0
accountability
deviation
8,0 USA
7,0
♦
Monetary stability in the 6,0
5,0
4,0
euro area has made it
3,0
2,0
easier for neighbours to
1,0
0,0
maintain stability
1960s 1970s 1980s 1990s 2000s
Source: European Commission, EMU@10 (2008)
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 4
The role of institutions
Why this similarity?
Globalisation has no doubt increased competition and lowered the prices of manufactured
goods worldwide. Globalisation and the enlargement of the EU have contributed to wage
moderation, because of the threat of competition coming from low-wage countries.
Globalisation in itself, however, cannot be the cause of low inflation. But it has made it easier
for central banks to maintain low inflation at comparatively low interest rates. This, in turn,
may have contributed to (sometimes excessive) asset price inflation in different parts of the
world.
A more fundamental factor contributing to low inflation worldwide was the institutional reform
that profoundly changed the role of the central bank in most countries. The innovations of the
early 1990s were central bank independence, price stability (or low inflation) as the primary
objective of the central bank, and an emphasis on the accountability of central banks.
These cornerstones were written into the blueprint for EMU, the report of the Delors
Committee. The Maastricht Treaty made the institutional reform obligatory for all EU central
banks. Many other countries outside the EU, and outside the European continent, have
implemented similar institutional reforms. This proves that such a reform has been judged to
serve the national interest in a wide variety of countries. The central banks of those countries
have in most cases been successful in meeting their inflation targets, which has contributed
to monetary stability worldwide.
Central bank independence and accountability alone are not a sufficient guarantee of the
happy coexistence of price stability and sustainable growth. In addition, we need fiscal
restraint to prevent a widening of public deficits so that they put upward pressure on real
long-term interest rates and crowd out private spending. In the worst case, they could
ultimately lead to the removal of central bank independence, with central banks being forced
to rescue governments. That would signal the end of monetary and price stability.
Economic performance
While inflation performance since the start of EMU has been satisfactory - excluding recent
months - we have no reason to be happy with growth performance.
Economic growth in the euro area since the launch of the euro has averaged 2.1%,
compared with 2.6% growth in the United States and 2.7% on average in the three
nonparticipating member states: Denmark, Sweden and the UK. Labour productivity growth has
been very modest, at 0.8%, which is only half the average productivity growth in the
abovementioned benchmark countries.
Growth performance
Employment growth
GDP growth
Productivity growth
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But we must admit that employment growth in the euro area has been impressive. Since the
launch of the euro, 16 million new jobs have been created in the area, compared with 13
million new jobs in the United States in the same period. Unemployment has come down
from a peak of 11% in the mid-1990s to 7% today.
This strong labour market performance tells us that labour market reforms - where such
reforms have been introduced - have brought about the desired results. These reforms have
contributed to a rise in employment among less-skilled workers, which partly explains the
slow rate of labour productivity growth.
Despite the improvement, the situation on the labour market is far from satisfactory.
Employment rates are low compared with the US or, for example, the Nordic countries.
These observations could, however, be turned into a more positive story. A low employment
ratio tells us there is a lot of potential for growth in the labour force. International
comparisons have shown that the euro area lags behind the US in the use of ICT in services.
More investment in ICT, and especially in reorganisation of the work which ICT enables,
would help to close the productivity gap and would raise per capita GDP closer to the US
level.
This can be seen as a promise for the future: There is plenty of room for improvement with
better use of existing resources and better utilization of existing technologies. On top of this,
there is plenty of room for innovation and upgrading our human capital.
Employment rates would increase and the productivity gap would close, albeit gradually, if
there were proper incentives in place. These incentives can be created by implementing
structural reforms in product and labour markets.
Structural reforms typically increase competition in both these markets. Competition
increases entry and exit of firms, a phenomenon which is sometimes called "creative
destruction". This requires greater adaptability and mobility than many people are willing to
accept, which explains why it is so often politically difficult to introduce structural reforms. To
reduce the resistance to change, social safety nets and positive adjustment support may be
necessary.
Model calculations show that increased competition may bring about significant positive
effects. A study by Bayomi, Laxton and Pesenti from 2004 suggests that increasing
competition in the euro area to the US level could boost output by no less than 12%.
A Bank of Finland study from 2006 examined the effects on the Finnish economy of a
general increase in competition both in product markets and in labour markets. The increase
in competition is defined as a reduction of excess rents in these markets by just a fifth - in
other words, monopoly profits in the economy are reduced by 20%.
This assumed reduction in rents is rather modest, and the model does not assume the
increased competition to have any effects on the rate of technological change, so the total
impact on output is not huge, at only about 3%. But more interestingly, real wages, which
initially fall, as wages are brought closer to the labour market equilibrium, soon rise again,
and end up also 3% above their initial level. Moreover, employment increases by almost 2%.
Much of the early debate on structural reforms in Europe focused on the labour market. The
product market has been in the focus more recently. There are obvious interconnections
between the two markets. If the product market is characterised by full competition, there are
no rents (extra profits) on the distribution of which the workers could negotiate. There is
simply no room for any wage mark-ups.
Frictions in the capital market are a less debated area. Yet they play an important role not
only in financing the investments of existing firms, but also in the reallocation of capital from
less productive to more productive uses. This is a part of the "creative destruction" by which
the economy adapts to changes in the environment and raises its total factor productivity.
There has been a lot of debate and analysis of financial integration. We know the euro has
catalysed substantial integration in markets closely linked to monetary policy. In particular,
the interbank markets are well integrated - or at least they were, and hopefully will be again,
once the turmoil passes - as are the government bond markets and, increasingly, also the
corporate bond markets.
However, much still remains to be done in other areas. The infrastructure supporting the
bond and equity markets is fragmented and hinders competition. Retail banking continues to
be mainly national, except in our two countries and some others.
We know from experience that protected sectors seldom develop, because they lack
incentives. And so it is also in financial services: it is the pressure of cross-border
competition that will motivate innovation and productivity improvement within the financial
sector. The best way to guarantee a high level of financial services for EU citizens is to
remove the remaining obstacles to competition.
Financial development goes hand in hand with financial integration. Financial development
is, in turn, an important determinant of competition, innovation and, thereby, productivity in
the whole economy.
Without well-functioning financial markets, economic power would be in the hands of those
who have liquid wealth, collateral and connections, not in the hands of those who have ideas.
That would be a recipe for stagnation.
Financial markets create the opportunities for newcomers to dislodge the incumbent, to
leapfrog them by innovating. Competition increases, monopoly rents fall and productivity
rises.
The Finnish perspective
Finland's road to EMU
Finland was among the first group of countries that moved to the third stage of EMU at the
beginning of 1999. Finland had been a member of the EU for three and a half years at that
time. The currency had been part of ERM2 for less than two years.
At the time of Finland's accession to the European Union in 1995 it was not yet certain that
EMU would become a reality. The likelihood that Finland would be in the first group of
countries was even lower, as could be read from poll results and from the financial market
data.
Like most other countries, Finland did not meet the EMU entry criteria in 1995. The general
government deficit was not projected to reach 3% any time soon. At that time, the Finnish
markka was not participating in the ERM.
The floating exchange rate (since September 1992) and inflation targeting (since February
1993) had served the country well. In the course of 1994, short-term interest rates came
down rapidly, the currency appreciated, and the foreign exchange reserves of the Bank of
Finland were restored.
The inflation target of 2%, which was to be achieved by1995, was met one year in advance.
The financial market's confidence in the Finnish economy started to return in spring 1995,
and this was reflected in a sharp drop in the long-term interest rate differential vis-à-vis
Germany.
Finland's road to EMU: Inflation and long-term
interest rate differential
Long-term interest rate differential, FIM-DEM, 10 y govt. bonds
Underlying inflation
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The decision to participate in the ERM was taken in October 1996. In January 1997, there
was short-lived speculation about a revaluation of the markka, and the Bank of Finland had
to intervene heavily. Otherwise, the currency markets remained tranquil. The government
finances improved more rapidly than anticipated, with the deficit having disappeared entirely
by 1998.
Effects of EMU on the Finnish economy
A frequently asked question is: How much has Finland's participation in EMU affected the
performance of the Finnish economy?
There is no obvious answer to this question. Furthermore, any answer would be impossible
to verify empirically, simply because we cannot repeat history with Finland remaining outside
monetary union.
There are, however, at least two ways to approach this question. One is to compare actual
experience since 1999 with the expectations that prevailed before monetary union became a
reality. The second is to compare Finland's experience with that of a comparable country
which decided not to participate.
Expectations and outcome
One area where the expectations have been fulfilled, or even exceeded, is monetary and
price stability. For Finland's citizens this has meant historically low and stable interest rates
and low (or no) inflation for most of the time.
Since 2002 until very recently consumer price inflation in Finland was the lowest or one of
the lowest in the whole euro area. With short-term interest rates being equal across the euro
area, this implied higher real short-term interest rates in Finland than in the rest of the euro
area. Apparently this did in no way affect consumer sentiment in a negative direction. Rather,
on the contrary, consumers' confidence in their own economic situation has remained high
throughout the period.
In the late 1990s, there was a lot of debate about the possibility of asymmetric shocks. In
Sweden they had a similar debate. The fears of adverse asymmetric shocks never
materialised.
It is ironic that the first asymmetric shock turned out to be a positive one. The worldwide ICT
boom in 1999-2000 had a disproportionately large impact on Finland given the importance
the sector had gained in the 1990s.
This favourable asymmetric shock would have been expected to cause a real appreciation of
the currency. Outside EMU and under floating exchange rates and inflation targeting, the
currency would most likely have appreciated in nominal terms, hurting non-ICT industries.
Employment development would have been weakened.
With a less than fully credible fixed exchange rate (as in the 1980s) the likely outcome would
have been higher inflation and increased exchange rate uncertainty and higher interest rates
later on.
In reality, inflation did accelerate somewhat in 1999-2000, but inflation expectations
remained constant. Participation in EMU had a stabilising effect in the face of a positive
asymmetric shock.
The expectation in the mid-1990s was that accession to the EU and eventual participation in
EMU would enhance competition, with a favourable impact on productivity growth. There is
no doubt that competition has increased in many areas. EU membership was particularly
important because it opened the borders for imported food to flow in, as a result of which
retail food prices declined by about 10% in 1995-6.
In other areas, the effects of EU membership or EMU participation are difficult to separate
from other influences, such as the "creative destruction" process sparked by the deep
recession and the rapid rise of the ICT sector. There is anecdotal evidence that EMU had an
anticipatory effect on productivity: once the option to devalue is taken away permanently, it is
better to adjust early and pay attention to productivity.
Comparison: Finland and Sweden
The macroeconomic performance of Finland has been rather favourable since 1999: that is,
the period of Finnish participation in monetary union. Annual economic growth has been
[above 3%] on average, which is high by European standards. Consumer price inflation has
been below 2% on average, one of the lowest in Europe. Employment has been growing and
the unemployment rate has declined steadily during all these years. Government finances
have shown surpluses in each year, and the general government debt ratio has declined
rapidly and is currently one of the lowest in the euro area.
GDP growth: Finland and euro area
Finland
Euro area
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Inflation (HICP): Finland and euro area
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A frequently asked question is: How much did Finland's participation in EMU contribute to
this favourable development?
Again there is no simple answer to this question. Membership of EMU by itself cannot
explain the above-average economic growth. Above-average performance must be
attributable to something that is country-specific.
Participation in EMU has no doubt contributed a lot to the favourable macroeconomic
performance by boosting competition and productivity and lowering transaction costs. But
that is not a sufficient explanation on its own. The causes must be found elsewhere. A
comparison with a structurally similar country outside EMU might help to identify these
essential conditions. Sweden is an obvious candidate for such a comparison.
Sweden joined the EU at the same time as Finland, but decided not to link its currency to the
ERM and thus did not fulfil one of the entry criteria for EMU. Sweden has conducted an
independent monetary policy based on a floating exchange rate and a numerical inflation
target of 2%, with a tolerance range of +/- 1%.
The macroeconomic performance of Sweden has been very similar to that of Finland over
the past ten years. Economic growth has been about the same as in Finland and clearly
above the euro area average. Inflation has been below 2% most of the time. Employment
has developed favourably. Open unemployment has been somewhat lower than in Finland.
Government finances have shown surpluses [in each year]. The general government debt
ratio is, along with Finland, one of the lowest in the euro area.
GDP growth differentials vis-à-vis the euro area
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Inflation differentials vis-à-vis the euro area
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Thus, a quick comparison of macroeconomic performance does not provide an answer to the
question of whether participation in EMU has been beneficial for Finland.
that
The fact that Finland's macroeconomic performance has been favourable proves only
participation in EMU has not been harmful to Finland. It does not prove that participation has
contributed to this favourable performance.
The fact that Sweden's macroeconomic performance has been favourable proves only that
Sweden has not suffered from non-participation in EMU. But it does not prove that the
nonparticipation has contributed to this favourable performance.
The popularity of monetary union was not particularly high in Finland on the eve of EMU.
According to a Eurobarometer survey conducted in autumn 1997, only one third of Finnish
citizens supported the idea that EMU with one single currency would be "a good thing".
Finland was clearly an EMU-sceptic country at that time, together with the UK, Denmark and
Sweden.
Moreover, the support of Finnish citizens for membership of the EU was surprisingly low in
1997. Less than 40% regarded membership as "a good thing". The Swedes were equally
sceptical, while the Danes were much more favourable, with 55% of citizens regarding
membership of the EU as "a good thing".
By 2005, Finns' support for the EU was still low, but support for EMU had surged and was
the fourth highest in the EU with a score of 80%. Swedish perceptions had changed much
less, but still favourably.
The final question then is: What explains the favourable macroeconomic performance of
Finland and Sweden?
The answer might be: Both countries have sound public finances. Inflation expectations have
been well anchored in both countries (at least until recently). Both have comparatively
flexible product and labour markets. Both countries are open economies and they are in
favour of free trade.
To put this briefly: both countries have had modern economic policies.
Popularity of EU and the euro
The EU is a good thing
Finns have remained
sceptical on the EU
The euro is a good thing
The Finns were
eurosceptical in 1997, but
now are one of the most
pro-euro in Europe!
1997
2005
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Conclusions: Nurkse would not disagree
Ragnar Nurkse had great experience of a broad range of economic issues such as monetary
instability and financial disorder as well as trade wars and competitive devaluations - and,
finally, of macroeconomic and political instability culminating in military conflicts and
ultimately war.
Nurkse was more than an observer; he was a top-ranking scholar in international monetary
economics. He was also a policy adviser with an ambition to design rules to improve
international coordination as well as better coordination of domestic economic policies. He
prepared a study for the League of Nations entitled International Currency Experience
(1944). This report was distributed to delegates at the United Nations Monetary and Financial
Conference at Bretton Woods in July 1944. His study contained many of the seeds of the
Bretton Woods Agreement, although he was not among its architects.
Ragnar Nurkse was in favour of fixed but adjustable exchange rates. He understood that a
precondition for such an arrangement is an agreement with the major powers on the
coordination of economic policies. For it to function smoothly, the major powers would have
to pursue disciplined monetary and fiscal policies with the objective of price stability.
Interestingly, price stability was not among the objectives of the Bretton Woods Agreement.
Many modern elements were present in the thinking of the economists at the League of
Nations. Nurkse was one of those modernists. Endres and Fleming (1998) mention that
Nurkse's colleagues at the League of Nations had recommended rules-based monetary
policy and central bank independence already before him (Nurkse joined the League in
1934).
Disciplined monetary and fiscal policies in major countries continue to be a prerequisite for
international monetary stability. Nurkse would not disagree.
Central bank independence, a monetary policy strategy based on the objective of price
stability, central bank transparency which makes monetary policy predictable, and the
elimination of excessive deficits are the cornerstones of macroeconomic policies in Europe
today. Nurkse would not disagree.