Gertrude Tumpel-Gugerell: Challenges for the Euro at ten
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the conference "The Euro at ten: Governing the Eurozone in a globalised
world economy", Berlin, 8 December 2008.
* * *
Dear Ladies and Gentlemen,1
It is for me a great honour, and a pleasure, to have been invited here today to speak about
the current state of the euro area, and the challenges it faces. In little more than three weeks,
we will celebrate the tenth anniversary of the creation of the Euro. The decision to establish
European Monetary Union was - as you know - not uncontroversial. During the years
leading up to EMU, indeed, several commentators offered gloomy projections on the viability
of the common currency, with the range of predictions going from the swift break-up of the
monetary union in the face of the first breeze, to the possibility that EMU might even lead to
conflicts among member states. The experience of the last ten years - and especially the
dramatic events of the last several months - have clearly shown the full extent to which such
predictions were misguided.
First, since January 1999 the Euro has guaranteed to hundreds of millions of people the
same extent of price stability which had traditionally been associated with the strongest
among its constituent currencies. Second, the common currency has effectively protected
euro area countries from both the inflationary impulses originating on world food and energy
markets, and, since August 2007, the worst financial storm since the end of the 1920s. The
success of the Euro along this second dimension is testified by the simplest, and most telling
indicator of all: as widely reported in the financial press, in several European countries which
had not previously contemplated joining EMU, the financial crisis has led to significant shifts
in public opinion in favor of Euro adoption. It is during tough economic times such as those
we are currently going through that both the benefits of belonging to a strong and stable
currency area, and the dangers of "going it alone" in an economic environment which is
prone to sudden and violent swings, become fully apparent. The Euro is only ten years old,
but with the current crisis it is truly coming of age.
Today I will discuss the main accomplishments of European Monetary Union, and I will then
elaborate on the challenges faced by the euro area, both within the current conjuncture, and
from a longer-term perspective.
1. Key accomplishments of European Monetary Union
Figure 1 provides a clear illustration of a key accomplishment of EMU showing aggregate
euro area HICP inflation since the collapse of Bretton Woods in August 1971. It also shows
individual inflation rates for the 15 countries which, as of today, belong to the monetary
union; and the evolution of the cross-sectional standard deviation of inflation rates among
these countries2 as a simple measure of heterogeneity of their inflationary experiences.
As apparent from the chart, after showing some signs of instability during the years leading
up to the collapse of Bretton Woods, inflation increased dramatically after 1971, reaching, at
the euro area-wide level, a peak of 13.6 per cent in the fourth quarter of 1974. Moreover,
cross-sectional dispersion of inflation rates reached a peak in excess of 9 per cent in the
second half of the 1970s.
Starting from the first half of the 1980s, the disinflation process was characterized by a
decrease in both individual countries' inflation rates, and the extent of their cross-sectional
dispersion. Under EMU, euro area inflation has been equal, on average, to slightly more than
2 per cent, and has been, by historical standards, remarkably stable.
This inflation stabilisation under EMU has been accompanied by two further key
developments: first, the disappearance of inflation persistence, defined as the tendency for
inflation to deviate from the central bank's price stability objective following a shock, rather
than quickly reverting to it; and second, the stabilisation of inflation expectations, with the
disappearance of an impact of actual inflation outcomes on agents' expectations, which is a
clear indication of the credibility of our price stability objective. I briefly elaborate on both
issues.
Recent ECB research3 has shown that, after January 1999, inflation persistence has
disappeared both at the aggregate, euro area-wide level, and within its three largest
countries (Germany, France, and Italy). Further, similar changes have affected inflation
dynamics in several inflation-targeting countries and in Switzerland under the "new monetary
policy concept", whereas they have been largely absent in the United States and Japan, two
countries characterised by a committment to price stability but lacking a clearly-defined
nominal anchor. As a result, in the euro area, Switzerland, and inflation-targeting countries,
inflation dynamics is - as of today - essentially purely forward-looking, whereas in countries
such as the United States and Japan it still retains a significant backward-looking
component.
What explains these findings? The simplest and most logical explanation is that credible and
clearly defined nominal anchors, by providing a "focal point" for agents' inflation expectations,
have rescinded the link between such expectations and past inflation outcomes, which was
instead inevitable during historical periods in which such anchors either were absent or were
not regarded as credible. This conjecture is indeed compatible with the stylised fact
previously mentioned: the stabilisation of inflation expectations under EMU.
Several recent studies4 suggest that the introduction of explicit numerical targets for inflation
has anchored inflation expectations, that means making them essentially unresponsive to
actual macroeconomic developments - in particular, to past inflation outcomes. Beechey,
Johannsen, and Levin (2007), for example, show that long-run inflation expectations are
more firmly anchored in the euro area than in the United States. They show that
macroeconomic news have significant effects on U.S. forward inflation compensation - even
at long horizons - whereas they only influence euro area inflation compensation at short
horizons.
Low and stable inflation, and the firm anchoring of inflation expectations, have automatically
led to another fundamental achievement of European Monetary Union: historically low
interest rates, with all the accompanying benefits for both consumers and firms, in terms of
lower borrowing costs. [See Figure 2]
Overall, European Monetary Union has been associated with a remarkable stabilisation of
the nominal side of the economy, with low and stable inflation, well-anchored inflation
expectations, and historically low and stable nominal interest rates. A question that naturally
arises is: "Did the stabilisation of the nominal side of the economy come at the expense of
developments on the real side?" As I will now discuss, empirical evidence clearly rejects
such a notion along several dimensions.
Figure 3 shows a scatterplot of the standard deviations of annual CPI inflation and real GDP
growth for the euro area, the United States, and 47 other countries since the beginning of
European Monetary Union.5 As the figure makes clear, the performance of the euro area has
been remarkable. First, the standard deviation of euro area inflation, equal to 0.5 per cent,
has been the lowest of the sample, with only Switzerland and Japan close, but slightly
higher. Second, the volatility of output growth, at 1.1 per cent, has been the second lowest of
the sample after the United Kingdom, which has however exhibited a markedly higher
volatility of inflation, equal to 0.9 per cent. Third, the comparison with the United States -
which, being a monetary Union of roughly similar economic size, provides the most natural
benchmark - is uniformly positive, with the U.S. volatilities of inflation and output growth
equal to 0.9 and 1.2, respectively. The evidence reported in Figure 3 therefore suggests that
the stabilisation of the nominal side of the euro area economy has not been achieved at the
expense of the real side. Rather, the opposite appears to be true, with both the real and the
nominal side exhibiting an excellent performance from an international perspective.
Indeed, macroeconomic stabilisation has been accompanied by a remarkable performance in
terms of job creation. First, from January 1999 until the end of 2007, the number of people
employed in the euro area has increased by 15.7 million, compared with an increase by only
about 5 million during the previous nine years; second, under EMU the unemployment rate
has fallen to its lowest level since the early 1980s. The improvement in euro area labour
market's performance reflects corporate restructuring, wage moderation in most countries,
and - crucially - the progress made on structural reforms associated with the Lisbon
process. As I will come to in a moment, a lot of progress in this dimension is - of course -
still possible and needed.
A further benefit of the introduction of the Euro has been the strengthening of trade and
financial linkages across euro area countries. First, the sum of intra-euro area exports and
imports increased from around 31% of GDP in 1998 to about 40% in 2007. Second, the Euro
has been fostering a gradual portfolio reallocation away from holdings of domestic financial
instruments, and towards holdings of financial instruments issued elsewhere within the euro
area. Euro area cross-border holdings of long-term debt securities, for example, have
markedly increased from about 10% of the overall stock at the end of the 1990s to nearly
60% in 2006. Notably, euro area residents have also almost doubled the amount of
crossborder holdings of equity issued within the area, from 15% in 1997 to 29% in 2006.
Wellintegrated euro area financial markets, and well-diversified asset portfolios, decrease the
extent to which the saving and spending decisions of firms and households depend on
economic and financial developments in a specific country, region or sector. As a
consequence, credit and risk-sharing channels are increasingly contributing to attenuate the
impact of shocks within a specific euro area country or sector.
Summing up, nearly ten years after the start of European Monetary Union, the common
currency has to be regarded as an unqualified success, guaranteeing macroeconomic
stability to hundreds of millions of European citizens, and shielding them from the direst
consequences of the macroeconomic shocks which - especially in recent months - have
been affecting the world economy. Many challenges however remain. I will devote the next
part of my speech to long-term challenges, and I will then turn to current issues.
2. Long-term challenges
The long-term success of European Monetary Union crucially depends on four key issues:
first, increasing the long-term growth potential of the euro area; second, making the euro
area economy more flexible and more competitive; third, pursuing sound fiscal policies; and
fourth, the completion of the single market. I will discuss these issues in turn.
Although the euro area economy's stability under EMU has been remarkable, its
performance in terms of average growth rates has been less impressive. Since the beginning
of the 1990s, euro area real GDP growth has been equal, on average, to 2.1 per cent,
compared with 2.8 per cent in the United States. Since the beginning of EMU, the annual
growth rate for the euro area has averaged 2.2 per cent per year, compared with 2.7% in the
US. A key reason for the euro area's moderate performance is the comparatively low trend
growth in labour productivity. Whereas in the 1980s, the average annual growth rate of
labour productivity was equal to 2.3 per cent, in the 1990s it declined to 1.8 per cent, and
between 1999 and 2007 it further decreased to 1.2 per cent. By contrast, over the same
periods average U.S. hourly labour productivity growth accelerated from 1.2 to 1.6, and then
to 2.1 per cent. What lies at the origin of these differences in labour productivity
developments in the two areas? Specific policies targeted at increasing employment - in
particularly for the unskilled segment of the labour market - certainly contributed to the
decrease in labour productivity growth in the euro area. Labour supply developments,
however, can only explain a minor fraction of the overall deceleration in labour productivity
growth, with the dominant portion being instead due to a significant slowdown in total factor
productivity growth (or TFP growth), which is generally taken as a measure of technological
progress, and of improvements in the organisation and overall efficiency of all the factors of
production. Average TFP growth in the euro area, indeed, was equal to 1.6 per cent in the
1980s, and it declined to 1.1 per cent in the 1990s and to 0.7 per cent between 1999 and
2007.
What explains such difference between the United States and the euro area in terms of
average TFP growth? The consensus among economists points towards a clear edge, on the
part of the United States, in exploiting advances in information and communication
technology (ICT), due largely to a favourable regulatory environment, a superior ability to
redesign management and organisational systems, the relative ease of reallocating,
retraining, and shedding workers, and continued investment in research and development
(R&D). In 2006, the fraction of R&D investment relative to GDP in the euro area was only 1.9
per cent, compared with 2.7 per cent in the United States. This is a first dimension along
which improvements ought to be made. It is also necessary to intensify cooperation between
industry, universities, and public sector research institutes, in order to raise the efficiency of
public R&D spending. As for investment in human capital, in several euro area countries its
rate of accumulation is still insufficient, in particular when compared with the needs of
contemporary, knowledge-intensive economies. The effectiveness of the accumulation of
human capital should be enhanced at all stages of the education process, by improving the
quality and efficiency of our schools and universities, and should be continued through
lifelong training and learning.
A further step ought to be increasing competition in both labour and product markets, thus
providing strongest incentives to invest and innovate, and to ultimately boost productivity.
More generally, it is necessary to support a more innovative and entrepreneur-friendly
economic environment. Europe needs to create an environment which is more apt at
fostering new and dynamic firms willing to reap the benefits of opening markets and to
pursue creative or innovative ventures. Finally, a key requirement is for firms to be able to
access relatively easily the finance they need. From this point of view, the euro area
significantly lags behind the United States, with its venture capital financing, expressed as a
fraction of overall GDP, being equal to a fraction of what it is in the U.S.
Turning more specifically to the labour market, the comparative rate of growth of working-age
population is one of the key factors explaining differences in real GDP growth between the
euro area and the fastest growing industrial economies. Over the last two decades, for
example, the average contribution to real GDP growth from growth of the working-age
population has been approximately 0.8 percentage point higher in the United States than in
the euro area. Looking ahead, the euro area faces the prospect of an ageing population, so
that the labour force could become an important constraint on trend growth.
Turning to labour utilisation, in spite of subdued growth in working-age population, over the
last ten years there has been a significant increase in the total number of hours worked in the
euro area. This stands in contrast to developments in the United States, where a small
deceleration has taken place. A significant portion of the acceleration in the euro area can be
explained by an increase in labour utilisation, and in particular by improvements in both
participation and employment rates. Despite this progress, however, there is still room for
improvements in the workings of European labour markets. First, the employment rate in the
euro area is still low by international standards. Second, the rate of unemployment in the
euro area is still high, in particular in some individual countries. In particular, whereas the
employment rate for prime-age males in the euro area is comparable to that in the United
States, significant disparities between the two areas remain concerning the youth, female
and older segments of the labour force. For example, in 2007 the female employment rate
was 58 per cent in the euro area, compared with 66 per cent in the United States, whereas
the employment rates for older workers were 43.3 and 61.7 per cent, respectively. Finally the
youth employment rates in the two areas were 38 and 54.2, respectively.
In spite of significant achievements in job creation over the most recent years, both the still
comparatively high unemployment rates in the euro area, and the low participation rates in
some countries, point towards the need to stimulate both the supply and the demand sides of
the labour market. Concerning labour supply, further reforms in income tax and benefit
systems would contribute to increase incentives to work, especially for those segments of the
labour force characterised by a weaker attachment to the labour market, such as women and
older workers. Concerning labour demand, it is necessary to reduce labour market rigidities,
in particular those restricting wage differentiation and wage flexibility, which negatively
impact upon the hiring especially of younger and older workers. Under this respect, in
several euro area countries progress towards greater contractual flexibility has been
comparatively slow, and employment protection legislation - especially for permanent
contracts - remains quite rigid.
Beyond increasing flexibility, another key challenge for the euro area is improving its
competitiveness. In this respect, a key issue is keeping the dynamics of unit labour costs
firmly under control to prevent or correct abnormal deviations. In situations in which such
deviations appear, it is of paramount importance that social partners and national
governments take swift action in order to address wage developments that go beyond
productivity increases, so that unit labour costs in those economies increase less rapidly than
the euro area average.
The third key long-term challenge is the commitment to sound fiscal policies and, thereby, to
implement the Stability and Growth Pact. There are several reasons why sound fiscal
policies are a crucial prerequisite for the monetary union's long-term success. First and
foremost, they are needed in order to minimise the risk of fiscal policy spillover, both into
monetary policy and, more generally, across countries. Further, they are needed to increase
the flexibility and adaptability of the economy. Sound fiscal policies, for example, are a
necessary condition for flexibility, thus dampening business-cycle fluctuations through the
workings of automatic stabilisers.
The final challenge pertains to the full completion of the Single Market, which will not only
increase competition and efficiency, but also improve adjustment mechanisms in the face of
adverse shocks. Under this respect, in spite of the fact that the single market was already a
goal of the founding fathers of the European Union - as set out in the Treaty of Rome - there
is still significant progress to be made. According to the OECD, for example, product market
regulation is still high in several euro area countries, and the extent of regulation in the euro
area considered as a whole is still significantly higher than in the United States.
Let me now turn to a key challenge that we are currently facing, namely how EMU deals with
the current developments in financial markets.
3. Current challenges
The world economy is currently going through the most dramatic crisis since the 1930s. The
factors leading up to the current turmoil were excessive growth in global credit, and
historically high leverage in the financial system as well as in the non-financial sectors of
some countries. Excessive credit growth and inordinately high levels of leverage, however,
are not a product of nature: rather, they were the product of a specific time and of specific
regulatory frameworks. In fact, the developments since August 2007 were also the outcome
of minimal, or "light touch" regulation - or even the circumvention of regulation at all - which
in the views of some went so far as to maintain that markets could essentially "self-regulate".
Therefore, I believe - and this will be an important challenge for the coming years - that the
current episode will ultimately lead to a new intellectual consensus on the proper boundaries
between governments and markets, first and foremost concerning the most appropriate
regulation of financial markets.
Working within such a system in flux, policymakers around the globe are now battling the
consequences on the real economy of the strongest recessionary winds since the financial
market collapse of the end of the 1920s. The situation is made especially complex by a
combination of several different problems which - even taken in isolation, by themselves -
would be sufficient to create significant challenges for policymakers. Let me briefly discuss
the most important among them.
First of all, there is the painful realisation, on the part of consumers in several countries, that
the economic strength that they had come to regard as "natural" over the last several years
seems not sustainable. To a significant extent, such strength was largely based on
borrowing: borrowing against houses whose prices has been artificially inflated by bubbles
and borrowing by accumulating credit card debts. Today, household in several countries
have found themselves burdened by staggering amounts of debts, which prevent them from
consuming precisely at a time when their consumption would be most needed to cushion the
economy from the winds of recession.
Within such an environment of retrenching consumption expenditure, having well-functioning
financial markets, and a strong banking system, would be of paramount importance in order
to smooth out the impact on the economy. But since early August 2007 the financial sector
has been engulfed by an even more serious crisis, which has required policymakers to
intervene to a previously unthinkable extent. The crisis has shown the benefits of belonging
to a strong and stable currency area. As a consequence, the current crisis has led to a
radical reassessment of the desirability of joining the Euro on the part of policymakers,
financial market participants, and citizens in several countries outside the euro area.
The recent crisis has clearly shown the fundamental role played by central banks in crisis
management, through the provision and management of liquidity in the money markets and -
in some exceptional cases - by providing emergency liquidity to individual institutions. In this
respect, the ECB's money market operations have consistently been based on the
fundamental principle of separation of the monetary policy stance from liquidity management.
The former is determined in the light of the primary objective of maintaining price stability
over the medium term. The latter's goal, on the other hand, is minimising financial stability
risks, and ensuring the orderly functioning of money markets. The provision of unlimited
liquidity to the euro area banking system on the part of the ECB, against an expanded array
of eligible collateral since mid-October, should effectively eliminate concerns about liquidity
risk, and should therefore further reduce pressures in the money markets. Central banks'
actions, however, can only go so far, as they cannot tackle some of the underlying causes of
tensions on the money markets, first and foremost concerns about counterparty credit risk,
and the continuing uncertainty on banks' other funding sources and capital positions. In this
respect, the measures taken by the governments and shareholders are, therefore of
paramount importance, and should address these problems over time. Moreover, it is key to
ensure that there is access to financing for all sectors of the economy, especially for small
and medium sized enterprises, which cannot access the capital market so easily.
4. Concluding remarks
I would like to conclude by recalling some important points which ought to be kept in mind in
order to reinforce the strength and resilience of the euro area economy, thus contributing to
preserve and consolidate the remarkable success of the Euro. First and foremost is the need
to proceed along the path of structural reforms, with the firm implementation of the Lisbon
strategy, as refocused and reinforced by the EU Council. This is crucial to increase the euro
area's growth potential, foster job creation, and increase the resilience of the economy in the
face of shocks. A second key issue is the need to regularly monitor developments in unit
labour costs across euro area countries. In particular, in those countries which have
witnessed sizeable cumulative increases in unit labour costs above and beyond the euro
area average, with the resulting loss in competitiveness, it is essential that all social partners
fully understand the importance of cost and price moderation within the context of the
Monetary Union. Third, it is of crucial importance - especially within the current uncertain
environment - to preserve the public's trust in the soundness and long-term sustainability of
fiscal policies. And fourth, it is important to get the regulatory response right. Market
participants cannot go back to the business models of the 60s and 70s. However, the
regulatory and institutional framework for the financial sector as well as business models, risk
taking and corporate governance should be reviewed with and open mind in the interest of
long term prosperity and stability.
Let me close with a positive note by emphasizing that it is important to remember the
benefits the Euro has brought to hundreds of millions of people: low inflation and low interest
rates, macroeconomic stability, and - at the current juncture - has given protection against
some of the potential consequences of the worst financial storm since the end of the 1920s.
Let me re-assure you that ECB will stand up to the challenges we are facing to continue
achieving our main goal of maintaining price stability in the euro area as part of the European
policy agenda to preserve and reinforce the success of the euro.
Thank you very much for your attention.
References
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Figure 1 Inflation, and cross-sectional standard deviation of inflation rates in the euro
area (source: Benati and Goodhart, 2008)
Figure 2 Short-term nominal rates in the euro area
Figure 3 Standard deviations of annual CPI inflation and output growth since January
1999 (source: Benati and Goodhart, 2008)