Otmar Issing: The euro and the Lisbon agenda
Speech by Mr Otmar Issing, Member of the Executive Board of the ECB, at the 32nd Economics
Conference of the Austrian National Bank, 28 May 2004.
* * *
1. Introduction
When the European Council agreed on the so-called Lisbon agenda in March 2000 the EU had
witnessed a period with high real growth rates. "The Union is experiencing its best macro-economic
outlook for a generation", the Council concluded at the time. Against this background, the Lisbon
European Council set itself its well-known strategic goal1 to be reached by 2010 and defined a broad
agenda for structural reforms in labour, product and financial markets. Four years later, real GDP
growth has dropped to significantly lower levels. So far, many structural reforms have been found
difficult to implement and the Lisbon agenda's mid-term goals for 2005 are unlikely to be reached.
In the following, I would first like to draw attention to the economic benefits of structural reforms and
highlight where deficiencies in their implementation have become particularly obvious. I will then
concentrate on two aspects regarding the Lisbon agenda, which I consider as being of particular
interest from the viewpoint of the single monetary policy. First, I would like to focus on the ways in
which structural reforms change the economic environment in which the single monetary policy is
conducted. Second, I would like to highlight how in turn monetary policy can support the Lisbon
process. Third and finally, I will argue that exploiting the euro area's growth potential with the help of
structural reforms will contribute to global economic growth and is thus indispensable for reducing
existing global economic imbalances.
2. Main elements of the Lisbon agenda
Let me first briefly explain why the European countries must proceed with structural reform and why
we continuously ask euro area Member States to step up their reform efforts in this regard.
Well-designed structural reforms increase the mobility of production factors between different uses
and improve their allocation in an economy towards their most efficient use. In doing so, structural
reforms raise factor productivity, open up additional employment opportunities and allow for lower
prices of goods and services. Exploiting the opportunities of such a more efficient allocation of
production factors will eventually allow an economy to achieve a higher real income and a higher
sustainable long-run growth path.
In the last decade, euro area countries have made considerable progress with reforms in labour,
product and capital markets, varying, however, considerably across countries. Among the outcomes
were a higher level of competition in product markets due to, for example, a lower level of state aids
and regulatory reform in network industries that resulted in substantial price reductions as well as in
higher activity. For example, between 2000 and mid-2003 alone, the price decline in
telecommunication services as measured by the HICP sub-index for telecommunications led to a
cumulated downward effect on total HICP inflation of 0.33 percentage point.2 Moreover, its positive
effect on real acticity supported the creation of new jobs. At the same time, labour market reforms
undertaken during the 1990s seem to have contributed to the strong employment growth and to the
considerable decline in unemployment in many countries during the cyclical upswing between 1997
and 2000. Reform measures in this field included, for example, improvements in countries' job
mediation systems, a more intensive use of part-time work contracts as well as policies raising the
efficiency of tax and benefit systems.
With the so-called Lisbon agenda the European Council intends to reinforce these reform efforts. It
identifies various areas for further reform, summarised under employment, research and innovation,
the single market, social cohesion as well as sustainable development and the environment. I think we
all agree that stepping up structural reforms in these areas is indispensible for improving the euro
area's unsatisfactory growth potential and its ability to create employment, even more so after the EU
has been enlarged to countries that have substantially lower labour costs.
The euro area's insufficient flexibility is manifested in the high rate of unemployment, which amounted
to 8.8% in 2003. This reveals shortcomings in the implementation of structural refoms that would
improve the use of the euro area's productive forces and increase their flexibility in response to
economic shocks. It is thus crucial that the Lisbon agenda's impetus is maintained, which must
manifest itself in increased efforts to reach the agenda's 2010 targets. There is, however, still a long
way to go. For example, raising the euro area overall employment rate to 70% by 2010 can be
expected to require an additional 15.3 million jobs, although hiding significantly varying challenges for
different groups in the labour market. Whereas, for example, significant progress has been made to
raise female employment, employment growth for older workers aged 55-64 would have to
substantially exceed its annual average of 1.7% between 1996 and 2002 to achieve the employment
target for older workers of 50% by 2010.
Making the Lisbon agenda a success therefore requires particular efforts in the field of labour market
reform to open up additional employment opportunities. At the same time, further structural reforms
need to increase the prerequisites for innovation, research and development, particularly by providing
educational attainment levels adequate for labour market needs. Furthermore, a continuation of
reforms in capital markets, a removal of barriers to competition particularly in the service sector as well
as further liberalisation in electricity, postal services and transport as envisaged in the Lisbon agenda
is needed.
I would like to conclude this part of my speech with three remarks:
First, trust in the course of structural reform as fostered by the Lisbon agenda and a better
understanding of the economic benefits structural reforms entail are conducive to raising consumer
confidence and private consumption. It is thus indispensible to maintain trust in this course, and to
keep commitments also in periods with slower growth.
Second, numeric targets seem to me currently the central measure to benchmark progress with
structural reforms. As numeric targets increase necessary pressure for underperforming countries, it
should be considered to strengthen this instrument.
Third, as we all know, the implementation of changes in long-grown relationships is always a difficult
task. When asked for their willingness for reform in general, a large part of the population would
probably signal a high degree of approval. But as soon as a concrete measure would harm the
personal status-quo, only a minority would agree. The main challenge for the Lisbon agenda's success
is thus to persuade the people of the long-term benefits of structural reform and to remove the
scepticism with respect to short-term costs. In this regard, also the ECB plays its part in its
communication on the benefits of structural reforms.
3. The impact of structural reforms on the conduct of monetary policy
Let me now turn to the discussion of the implications that the implementation of the Lisbon agenda
may have for the conduct of monetary policy in the euro area.
The ECB has always stressed the importance of a swift implementation of structural reform agendas
across the euro area. This reflects above all the firm belief that structural reforms enhance the welfare
of the European citizens.
But structural reforms also tend to facilitate monetary policy and increase its effectiveness. A more
flexible economic environment helps the labour and product markets to better adjust to economic
shocks and respond to policy actions more quickly. For example, more flexible labour markets may
imply that negative supply shocks are absorbed with a smaller short-term increase in inflationary
pressures, as second round effects are more subdued. This, in turn, allows monetary policy to react
less strongly. Such an environment will not only make it easier for monetary policy to maintain price
stability, but it will also help to keep the volatility of inflation and output lower.
But there are also challenges for the central bank, arising from the uncertainty related to the changed
economic environment in which monetary policy operates. More precisely, structural reforms may
change the rules governing the dynamic evolution of the euro area economy and the transmission
mechanism of monetary policy actions in ways that are difficult to identify in the short run. I shall try,
now, to elaborate on this more in detail.
Normally, economists think about structural reforms as having positive "supply" effects that allow firms
to increase their productivity, while at the same time fostering aggregate demand. From the point of
view of the monetary policymaker who adopts a forward looking strategy, understanding the nature of
the changes in the supply potential of the economy is crucial for assessing to what extent such shocks
have an impact on price stability. Moreover, changes in potential output growth can impact on the
determination of the "equilibrium" real interest rate, as well as on the optimal time path towards such
equilibrium real rate.
A first approach is to outline these issues under the simplifying assumption that the potential output
and the real equilibrium interest rate can be estimated with a high degree of precision. In case the
positive supply shock leads only to a one-off increase in the level of potential output, but not to a
permanently higher output growth,3 the equilibrium real rate would not change. However, when the
shock is permanent4 and leads to higher potential output growth the return on capital will increase and
the equilibrium real interest rate will follow. This implies that in the long run policy rates need to be
higher than otherwise.
Once the possibly new "equilibrium" interest rate and potential output growth are pinned down, the
central bank has to set interest rates by taking into consideration a large set of other indicators,
including the short-term interactions of aggregate demand and supply. In case of a positive supply
shock actual and potential output accelerate simultaneously only if demand and supply effects emerge
at the same time and are of the same magnitude. If this was the case, and other things being equal,
monetary policy would essentially need to align short-term rates with the higher equilibrium real
interest rate which is consistent with the permanently higher potential growth. In a different situation,
for instance when supply effects dominate in the short-run5 the increase in productivity and potential
output levels brought about by structural reforms will often tend to reduce short-term inflationary
pressures. In this case, the central bank would be in the position of eventually adjusting short-term
rates more gradually towards the higher "equilibrium" as long as potential GDP temporarily expands
more rapidly than demand and, consequently, inflationary pressures remain muted.
Everything just said, however, presumes that concepts like the precise level of the equilibrium interest
rate, the natural rate of unemployment or the potential output are observed or estimated with a
sufficient degree of confidence by the central bank. In reality this is not at all the case. Monetary policy
decisions that have to be taken in real time and without the benefit of hindsight, will always face a
particularly high degree of uncertainty when long-run trends in macroeconomic variables change, and
also the fundamental relations linking macroeconomic variables change in ways that could render
existing models of the transmission mechanism unreliable. In such a situation, monetary policy
decision-making calls for great caution and any kind of mechanistic reactions, in particular to indicators
whose developments are very difficult to interpret, should be avoided.
It seems plausible that in such an environment of high uncertainty, monetary policy is more efficient by
assigning a more prominent role to indicators that can be more precisely measured or estimated rather
than concepts that can only be estimated with a high degree of uncertainty. This is one of the reasons
why typically, central banks do not rely on "output gap" estimates. Furthermore, when cross-checking
all the available information, the central bank must carefully take into consideration the possibility of
structural breaks in historical relationships as well as the signals sent by different models in the
context of various types of approaches. In the end, when assessing the appropriateness of its
monetary policy stance against the prospects of achieving its medium term objective the central bank
has to make sure to incorporate all the information embedded in the economic and monetary analysis.
The ECB's monetary policy strategy was designed precisely with the aim of ensuring that in the
assessment of risks to price stability no relevant information would be lost and that appropriate
attention would be paid to different analytical perspectives. Its two-pillar approach is a way of
conveying to the public the notion of a diversified analysis and of ensuring robust decision-making in
an environment characterised by high uncertainty.
This approach also allows the ECB to assess the impact of structural reforms on both the cyclical and
the more long-term components of the inflation process in the euro area. As noted before, in case
reforms increase potential output growth in the euro area, the ECB will take into consideration the
short-term relative developments in aggregate demand and supply. Furthermore, it will have to assess
its assumptions for the desirable medium term evolution of monetary aggregates if potential growth
were to change.
Let me give you an example that goes back to 2001, when in the context of the well known debate
about the emergence of a possibly "new economy" the Governing Council decided to assess potential
changes in trend productivity growth in the euro area and its implications for the reference value for
monetary growth. The conclusion in December 2001 was that there is no decisive evidence of
measurable and lasting increases in productivity growth in the euro area that would warrant an upward
revision to trend potential growth.6 The Governing Council therefore opted in favour of a rather
cautious attitude and, with the benefit of hindsight, was correct to do so - thus avoiding a possible
policy mistake.
4. Price stability and the Lisbon agenda
I would now like to outline what the ECB can contribute to supporting the implementation of the Lisbon
agenda. In short, it can contribute by maintaining price stability and by helping to safeguard financial
stability as contributions to a stable macroeconomic environment. In such a stable macroeconomic
environment, structural reforms will be easier to implement. Let me explain this relationship by looking
at some aspects of price stability.
• First, price stability preserves and bolsters consumers' purchasing power, thus supporting
consumption.
•
Second, price stability enhances the efficiency of the market system at allocating resources,
by making it easier for people to recognise changes in relative prices.
•
Third, price stability avoids additional menu costs, i.e. production costs occurring when
printed prices have to be changed.
•
Fourth, price stability is associated with lower uncertainty and risk premia in financial
markets, facilitating financial actions and ultimately implying lower medium and long-term
interest rates, fostering investment.
• Fifth, price stability provides markets with an indispensable nominal anchor for adjusting
changes in wages consistently with productivity growth.
•
Sixth, price stability prevents the considerable and arbitrary redistribution of wealth and
income that arises in inflationary as well as in deflationary environments.
In this regard, price stability is a vital element of fostering sustainable growth as well as of supporting
employment and social cohesion, thus supporting the Lisbon process in achieving its objectives.
Moreover, as price stability helps to guide economic agents in their decisions to move production
factors towards more efficient uses it should help structural reforms to exploit their welfare-enhancing
benefits. As an additional aspect, within an environment of stable prices, a decline in relative prices in
some sectors resulting from structural reforms would become more visible, supporting acceptance of
such reforms. Price stability is thus the most important contribution of monetary policy to the Lisbon
process.
Empirical estimations show that even rather low rates of inflation can lead to welfare losses that might
be larger than usually thought. A study for the US, for example, indicates that a permanent increase in
the inflation rate from 0% to 4% can lead to permanent output losses ranging from 0.4-1.1%.7 There
are, however, several arguments that support basing a definition of price stability on positive but low
inflation rates. The ECB has thus provided a quantitative definition of price stability, namely a
year-on-year increase in the HICP for the euro area as a whole of below 2% to be maintained over the
medium term. Looking back, over the last five years, despite significant exogenous shocks the ECB's
stability-oriented monetary policy following this definition has resulted over the medium term in low and
stable inflation. And it has ensured that medium and long-run inflation expectations have been well
anchored. Monetary policy has thus delivered its necessary contribution to a stable macroeconomic
environment supporting the implementation of structural reforms.
Perhaps less well-known but also important is the ECB's and the ESCB's contribution to a stable
macroeconomic environment by promoting financial stability. This task is crucial as a well-developed
and stable financial system improves the efficiency of financing decisions, favours a better allocation
of investment in and among economies and thus supports economic growth. This was also recognised
by the Lisbon Council when it called for accelerating the completion of the internal market for financial
services and to "exploit the potential of the euro" in achieving this aim. The tasks of the ESCB in this
regard consist of systematically monitoring financial stability conditions in EU and euro area countries.
This monitoring particularly aims at identifying potential sources of vulnerability in the financial system
of the euro area and the EU and to assess its resilience to shocks.
To sum up, maintaining price stability is a vital contribution to fostering non-inflationary sustainable
growth and, together with financial stability, supports a stable macroeconomic environment, within
which structural reforms can fully exploit their welfare enhancing effects. Maintaining price stability and
promoting financial stability is thus the assistance monetary policy can render to the Lisbon agenda's
reform efforts.
5. Global aspects
Increasing the euro area's insufficient growth potential and its ability to adjust more flexibly to changes
in economic variables becomes particularly important against the background of globalisation. This is
even more the case as over the last years the international trade in goods, capital and services has
witnessed imbalances. These imbalances are signalled by, for example, the persistent US current
account deficit, which amounts to around 5% of GDP. This is connected with an increase in US net
liabilities vis-à-vis the rest of the world from 5% in the early 1990s to roughly 23% of GDP at the end of
2002.
These imbalances will finally have to be corrected. An adjustment can, however, be brought about in
several ways: First, the deficit country's growth rate could decline relative to growth rates in the rest of
the world. This would, among others, reduce this country's demand for foreign goods and services,
potentially hampering real growth because of reduced exports elsewhere in the world. Second, the
global imbalance could be diminished by an acceleration of growth in the rest of the world as this
would lead to an increased demand for the deficit country's exports. The more flexible the adjustment
to declining global imbalances is, the more orderly the necessary adjustment can be brought about,
meaning with less and less sudden disruptions in key economic variables.
One may conjecture that, with its net outflows of goods and capital, part of the adjustment will also fall
upon the euro area. In the US a view seems to prevail, which one could paraphrase with a previous
statement by the then US Treasury Secretary Connolly with respect to the US currency: "It may be our
deficit, but it is your problem". One characteristic of this "problem" is the large outflow of investment
capital from the EU and the euro area towards other regions in the world and the US market in
particular. One reason for the large flow of capital towards US markets in the second half of the 1990s
were surely overly optimistic expectations with regard to the "new economy". Considering only
investment since 1997, rough estimates indicate that EU investors have incurred tremendous losses,
ranging from EUR 200 billion to EUR 540 billion until mid-2002. However, the large aggregate outflow
of capital from Europe should be taken as a sign for its insufficient attractiveness for internationally
mobile capital.
Having said this, the euro area can support the reduction of global imbalances by a much stronger
contribution to global growth. This requires that the euro area exploits its growth potential and
becomes a more attractive place to invest. Again, this calls for improving the functioning of labour,
product and capital markets, as their partly insufficient flexibility has been found to act as impediment
to investing in several euro area economies. Raising the rate of investment with the help of structural
reforms is therefore not only a crucial measure to increase the euro area's ability to adjust to declining
global imbalances. By allowing them to achieve higher sustainable growth rates structural reforms also
indirectly contribute to global growth and thus to reducing global imbalances.8
6. Conclusion
The Lisbon agenda presses EU countries to make their homework in the field of structural reform.
However, whereas some progress has been made, deficiencies remain, particularly in the labour and
service markets. Reforms in labour markets have, however, been found hardest to implement and are
most of the times accompanied by tensions. I hope Olivier Blanchard will be right in the end with his
assessment that these tensions "are a symptom of change, not of immobility".9
The Lisbon agenda has been crucial for raising Europe's attention to the necessity for further structural
reforms. Countries now have to implement well-designed policies that remedy the root causes of their
particular problems in labour, product and financial markets. These structural reforms will improve the
environment, in which the stability-oriented monetary policy is conducted. In turn, this process of
reform can best be implemented within a stable macroeconomic environment in which microeconomic
policies can fully develop their welfare-enhancing effects. The single monetary policy will continue to
play its part in this respect by maintaining price stability and by promoting financial stability.