Jürgen Stark: Economic adjustment in a monetary union
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the Bank of Latvia annual conference "Global Challenges and Local Opportunities:
Achievements and Prospects in the Baltic States", Riga, 12 October 2011.
* * *
Exactly three years ago, in October 2008, the global financial crisis started to hit the Latvian
economy. A strong policy reaction was unavoidable to stabilise the situation and correct past
excesses. Latvia embarked on a remarkable economic adjustment process, laying the
foundations of a renewed upturn. Although there is still a long way to go, strong policies,
supported by international financial assistance, have resulted in a significant reduction of
Latvia's macroeconomic imbalances.
Right now, some euro area countries are facing similar challenges to those facing Latvia
during the past three years. Although the magnitudes and some other features may differ,
the broad characteristics are the same. In both cases, there is a need for adjustment as a
result of macroeconomic imbalances, losses in competitiveness and unsustainable economic
policies. For both Latvia and euro area countries, the challenge is to implement an economic
adjustment without using the nominal exchange rate as an instrument. In Latvia, the
authorities chose not to use that option, whereas in the euro area that option is no longer
available.
Adjusting without the nominal exchange rate is the topic of my speech today. The loss of the
exchange rate as a policy instrument has important implications for economic policies,
especially in a world where countries are faced with economic shocks that require
adjustment. After discussing some conceptual issues, I will draw some lessons from the
crisis for the euro area. Those lessons very clearly highlight that, in order to reap the benefits
of a common currency, participating countries need to satisfy certain economic conditions.
Finally, I will also reflect on Latvia's experience.
Conceptual considerations: economic adjustment in a monetary union
How do countries in a monetary union adjust to asymmetric macroeconomic shocks? In the
absence of nominal exchange rate flexibility vis-à-vis the other countries participating in a
monetary union, adjustment has to occur via other channels. Many years ago, Mundell
argued that if a group of countries wanted to adopt a common currency, the shocks that they
were exposed to had better be similar. If that were not the case, they would need to have
strong alternative adjustment mechanisms.1
Mundell and others identified key conditions for such alternative adjustment mechanisms:
price flexibility, factor mobility and fiscal transfers. Price flexibility is important in order to let
countries affected by adverse economic shocks recover by adjusting wages and reducing
relative prices in order to rebuild competitiveness. The second adjustment mechanism,
cross-border factor mobility, or in particular labour mobility, helps to adjust to adverse shocks
as people move out of the depressed economy until it regains competitiveness and the
labour market in the country finds a new equilibrium. A third adjustment mechanism identified
in the literature is fiscal transfers, flowing from the stronger countries or regions to the
weaker parts of the monetary union.
Although these adjustment mechanisms are often referred to as being substitutes, they are in
fact not. While the first two are important to solve the problem facing a country affected by an
adverse shock, the third, fiscal transfers, only hides the problem. Temporary transfers can
play a stabilising role and may be needed - subject to strict conditionality - if a country is
affected by a very serious adverse shock. Open-ended transfers, however, are not a mode of
adjustment. In fact, they are the opposite. They finance non-adjustment.
Therefore, the key adjustment mechanism in a monetary union is price and wage flexibility,
assuming that cross-border labour mobility is limited. Wages and prices are essential for
country adjustments, as they directly impact on the real exchange rate, and thus on a
country's competitiveness. In fact, wages and prices are, by definition, the only remaining
component of the real exchange rate that can be adjusted in the absence of nominal
exchange rate flexibility.
It is also important in this regard to distinguish between temporary and permanent adverse
shocks. Options that are attractive in the face of temporary shocks may be less so if the
shock is permanent or highly persistent and vice versa. In the case of a permanent adverse
shock, the country in question faces an adjustment to a permanently lower standard of living.
Economic flexibility can be promoted by removing the institutional barriers to flexible wage
and price-setting mechanisms. If wages and prices are flexible enough and able to adjust to
changes in economic conditions, then this will not only speed up the adjustment, but it will
also help to avoid unwelcome fluctuations in output and unemployment. In a monetary union,
most of the adjustment has to take place through national labour markets. Therefore, wage
setting should appropriately reflect the different situations of sectors, of firms and of overall
labour market conditions.
Lessons from the crisis
Let me move from conceptual issues to the actual situation in the euro area. What are the
causes of imbalances in EMU that need to be adjusted now? What are the implications of
these developments for the functioning of the monetary union? What lessons can we draw
from this experience for economic adjustment in EMU?
The key point I want to make here is that macroeconomic imbalances and unsustainable
fiscal policies are the root cause of the sovereign debt crisis in the euro area. The existing
economic governance framework has not been able to prevent the emergence of excessive
macroeconomic imbalances. Moreover, fiscal policy coordination in the euro area turned out
to be completely insufficient.
Before I discuss what needs to be done to improve EMU's institutional framework, let me first
say something on the causes of the macroeconomic imbalances in euro area countries.
Some countries have built up significant internal and external economic imbalances during
the past decade, and recorded inflation rates persistently above the euro area average
(see Slide 2, HICP inflation). The ECB repeatedly warned against emerging imbalances.
Increases in labour compensation in some countries, driven in most cases by high public
sector wage increases, exceeded productivity gains by a significant margin, leading to
increases in unit labour costs in excess of the euro area average and a gradual erosion of
competitiveness (see Slide 3, ULC indices). At the same time, growth in the unregulated
financial sector and unsustainably strong domestic demand growth, coupled in some cases
with excessive credit growth and large and sustained increases in real estate prices, resulted
in large current account deficits (see Slide 4, CA deficits) and high levels of public and
private debt (see Slide 5, public debt ratios).
Many factors contributed to these developments, including unrealistically optimistic
expectations about future income developments and the underestimation of credit risks by
financial institutions. A key factor was that wage and income policies were not sufficiently
geared towards preserving competitiveness in a monetary union. Governments failed to
address structural rigidities in the euro area economies - relating to, among other things,
wage-setting institutions, including wage indexation, and to labour and product market
regulation.
An institutional framework focusing on the early identification and correction of
macroeconomic imbalances would have helped to prevent these problems. But the ongoing
crisis is also a symptom of policy failures and deficiencies in the existing institutional
framework governing economic policies in EMU. The Broad Economic Policy Guidelines, the
central link in coordination of the Member States' economic policies, did not work. The
instruments and procedures were available. But they were either not implemented or
ignored, or they were watered down. Peer pressure among the Member States - potentially
a strong tool of mutual fiscal surveillance - fell short of what was needed as countries did not
attach sufficient importance to their joint responsibility for the stability of the euro area.
Several proposals have been made on how to overcome the flaws in the EMU governance
framework and I will only say a few words on the changes we need here.2 Addressing EMU's
difficulties requires a major strengthening of the rules and organisations that govern fiscal and
other economic policies. The identification of the necessary reforms has to begin with the
ultimate objective: institutional arrangements that provide credible incentives for sound policies.
Euro area countries and countries preparing for euro adoption should be aware that this
requires the transfer of sovereignty to a central institution with much stronger powers. It also
requires stricter rules on the preparation and implementation of budgets at the national level.
The recent agreement reached by the European Parliament and the Council on the
economic governance package is a step in the right direction. But it falls short of the
"quantum leap" in economic governance that the ECB has long advocated for the euro area.3
I particularly regret that one of the key aspects of such a quantum leap - greater automaticity
in decision-making through the use of reverse qualified majority voting to the maximum
extent possible - has only partly been achieved. I therefore believe that, in the medium term,
the review clause included in the package should be used to enable further enhancements to
euro area economic governance that will contribute to a smoother functioning of EMU.
Reaping the benefits from the euro
The experience of the crisis has shown that participation in a monetary union places
important demands on national economic policies. What economic conditions need to be
satisfied for a country to fully reap the benefits from adopting the euro? I believe that the
fundamental logic of the Treaty, and the convergence framework embedded in the Treaty,
remains correct: countries have to make sure that they pursue sound macroeconomic
policies. They should first and foremost focus on establishing sound fiscal and sustainable
macroeconomic developments in their own country and complement this with the necessary
structural reforms. By doing so, they will actually kill two birds with one stone, as they then
also follow the best possible strategy for ensuring smooth integration into the euro area in a
lasting manner.
Reaping the benefits of the euro is thus in the hands of the national authorities themselves.
Not only can they improve market flexibility, but they can also conduct a well-designed fiscal
policy. As I have stressed on many occasions, the best contribution fiscal policy can make to
the proper functioning of the euro area is by being sustainable and medium-term oriented.
Moreover fiscal policy can and should also help mitigate 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.
Let me stress that governments and social partners share responsibility for ensuring that
wage determination sufficiently takes into account labour market conditions and does not
jeopardise competitiveness and employment. Governments should also be aware that wage
setting in the public sector can serve as a role model for the private sector. And social
partners need to take into account the different conditions at the firm and sectoral level,
internalising the repercussions of wage settlements on competitiveness and thus
employment at their company and in their industry, sector or region. Sufficient wage
differentiation would improve employment opportunities for less skilled workers and in
regions or sectors with high unemployment. In this respect, excessive regulations - both in
labour and product 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.
The Latvian experience
Let me turn from the euro area to Latvia. Following years of excessive demand growth and
serious overheating, Latvia recorded severe losses in output, particularly in 2009 (see
Slide 6, GDP levels). This contraction was triggered by a major adverse shock, the global
financial crisis, but would have occurred sooner or later anyway, as the macroeconomic
imbalances that had been built up were unsustainable. The crisis that started in 2008 marked
the beginning of a painful but remarkable adjustment process. Thanks to strong domestic
policies combined with international support, this adjustment has laid the foundations for an
economic recovery, underpinned by healthier balance sheets and improvements in
competitiveness.
I believe that Latvia's experience harbours important lessons for countries inside the euro
area that have to undergo a similar adjustment. The adjustment process in Latvia during the
past few years shows that it is possible to reduce large macroeconomic imbalances without
adjusting the nominal exchange rate. Such an adjustment benefits from a high degree of
flexibility of the economy and needs to rely on a determined and strong policy response to
rebalance the economy, regain competitiveness and lay the foundations for sustainable
output growth. A sizeable fiscal adjustment was essential for strengthening fiscal
sustainability and critical in regaining market confidence. Cuts in wage costs and prices were
necessary to regain competitiveness that had been lost during the boom years. Exactly three
years after the crisis hit, Latvia now seems close to concluding its international financial
assistance programme.
What were the specific elements that underpinned this adjustment? I want to mention four
elements in this regard. First, in the absence of nominal exchange rate flexibility, any real
exchange rate adjustment had to be delivered via cuts in wage costs and prices combined
with enhancements in labour productivity. The adjustment in wages was both market-driven,
owing to a sharp decline in the demand for labour, and supported by policies aimed at cutting
public sector wage costs. The labour market adjustment was not only achieved through wage
cuts, but also through employment cuts, reductions in hours worked and a restructuring of
production processes. As a result, unit labour costs declined significantly, partly offsetting
their previous excessive gains (see Slide 7, ULC levels).
Second, sizeable fiscal consolidation was targeted at bringing Latvia's fiscal position back to
a sustainable path, lowering sovereign funding needs and regaining market confidence.
Efforts also focused on strengthening the budgetary framework and procedures. Following a
sharp increase in fiscal deficits, Latvia's fiscal position has started to improve, but the deficit
remains at a very high level (see Slide 8, fiscal balances).
A third element of the adjustment strategy comprised structural reforms to enhance market
flexibility and medium-term growth. Measures focused on both labour and product markets,
such as revisions to labour market legislation to strengthen labour market flexibility,
improving the business climate by streamlining start-up procedures and tax administration,
supporting exporting firms and combating the informal economy. Although clear progress has
been made, I believe that the structural reform agenda remains unfinished.
Fourth and finally, the adjustment strategy comprised measures to strengthen financial
stability and reduce private sector debt burdens. The authorities initially focused on securing
liquidity in banks. Subsequently, adequate capitalisation became increasingly important,
given the deterioration in the quality of banks' loan portfolios in the wake of the economic
downturn. As a result, financial stability was maintained, although more time is still needed to
repair private sector balance sheets.
Despite Latvia's adjustment so far, ensuring the continued success of the strategy will
demand resolute implementation of further reforms on several fronts. Key challenges remain
to ensure fiscal sustainability, strengthen the economic structure and improve the ability for
the economy to grow without generating inflationary pressures. Latvia still has a low GDP per
capita relative to many other EU countries (see Slide 9, GDP per capita), implying that it has
an important potential to catch up vis-à-vis the rest of the EU. This catching-up process is
likely to have a bearing on inflation in the medium term. Given the tightly pegged exchange
rate and the limitations of alternative counter-cyclical policy instruments, it may be difficult to
prevent macroeconomic imbalances from building up again. Moreover, the severe economic
downturn in Latvia has left its legacies in the form of a destruction of supply capacity and a
very large decline in employment (see Slide 10, employment). It is essential for Latvia to
strengthen the fundamental drivers of sustainable and balanced growth by enhancing the
quality and quantity of labour supply and improving the quality of the business environment,
which is hampered by, among other things, a large informal economy.
As regards euro adoption, the challenges that some euro area countries are currently facing
illustrates very clearly the importance of sustainable convergence. Very careful preparation is
required to make sure that convergence continues after euro adoption. Measures to reduce
inflation temporarily or easily-reversible measures to lower the fiscal deficit do not represent
sustainable convergence. The decision to adopt the euro is a very fundamental one and
should not be taken lightly.
Concluding remarks
Let me conclude. Economic shocks are a fact of life and countries should be prepared to
deal with them. This is all the more the case in a monetary union, where the nominal
exchange rate is no longer available as an instrument of adjustment. The challenges that
some euro area countries currently face underline the critical importance of strong
adjustment mechanisms and the need to avoid macroeconomic imbalances and
unsustainable fiscal policies. This all underlines the responsibility of national economic
policy-makers. Stability begins at home. Strong economic adjustment mechanisms not only
help to absorb adverse shocks, but they are also essential to reap the benefits of the euro.
The Latvian experience shows that adjusting to major adverse shocks and reducing large
macroeconomic imbalances is not impossible. Using a combination of fiscal and nominal
wage adjustment, structural reforms and measures to preserve financial stability, as well as
international support, Latvia has been able to lay the foundations for its economy to stabilise
and recover, although important challenges remain and the policy agenda remains
unfinished. What matters is a broad political consensus, and a broad consensus in society,
about the need for adjustment and the correction of past behaviour. I wish Latvia all the best
in its efforts in this regard.
Thank you for your attention.