Nicholas C Garganas: The single monetary policy and the analytics of
OCAs - what has the euro area experience taught us?
Speech by Mr Nicholas C Garganas, Governor of the Bank of Greece, at a public lecture,
Athens, 30 April 2008.
* * *
It gives me great pleasure to be here today to give this public lecture on the European
experience with monetary union. The fact that the lecture is taking place at my Αlma Μater
makes this occasion a particularly special one for me, and I am grateful to Howard Davis and
Kevin Featherstone for extending me the invitation. I hope that what I have to say will provide
some food for thought. Indeed, I am hopeful that I may be able to convince some sceptics in
the audience - and I know that they are out there - that monetary union among European
countries can and does work!
The adoption of the euro by 11 EU countries in 1999 was a remarkable achievement. It
represented the culmination of a process of integration and convergence that had begun
some 50 years earlier. The creation of the euro could be viewed as the end of a process,
with Europe having finally reached full economic and monetary integration. Such a view,
however, would, at best, be incomplete. Although the introduction of the euro marked the
culmination of a long process, it also marked the beginning of another one. In particular, it
created new challenges for economic policy. I will focus on these challenges in what follows.
A natural starting point for analysis of the benefits and costs of a monetary union is the
theory of optimum currency areas, originated by Robert Mundell in the early 1960s, and an
important reason for his Nobel Prize in Economics. This literature on optimum currency areas
identifies two main costs of a country's participation in a monetary union. These costs are the
loss of an independent monetary policy and the ability to alter the nominal exchange rate in
order to mitigate the effects of asymmetric shocks. The theory also identifies the desirable
characteristics that potential members of a single currency area should have in order to
minimise these costs. The characteristics are sometimes viewed as preconditions for judging
whether a nation should join a currency union.
I will argue that this traditional way of thinking about judging optimality is incomplete.
Underlying my argument are the following two factors.
• First, the traditional approach has to be modified to take modern developments in
monetary theory and policy into account. In a world in which monetary policy is best
suited to achieve price stability, the loss of monetary policy independence may not
be very costly. In fact, for a small open economy, such as Greece, it may actually
provide net benefits.
•
Second, it can be misleading to view the optimum-currency-area characteristics as
preconditions for ensuring the success of a country's participation in a monetary
union. In particular, to view the characteristics as preconditions overlooks the fact
that the characteristics, or criteria, can themselves be endogenous. I will argue that
the creation of a monetary union can itself create conditions that are favourable to
the well-functioning of the union.
I. The loss of monetary policy independence to the ECB
Let me first turn to the matter of the loss of monetary independence. Modern monetary
theory emphasises the role of monetary policy in providing price stability. By so doing,
monetary policy can best provide a stable environment, which is a prerequisite for growth.
This view contrasts strongly with the view that monetary policy can be used for fine-tuning
the economy.
The intellectual underpinnings of the emphasis on price stability can be traced to Milton
Friedman's and Ed Phelps' critique of the Phillips curve in the late 1960s. On a brief personal
note, I was privileged to have been taught macroeconomics at LSE by A W Phillips.
Professor Phillips was an excellent teacher who made contributions in many areas of
macroeconomics. In fact, it is well known that Milton Friedman tried to recruit him to the
University of Chicago, but, fortunately for LSE, he declined. The Phillips curve expressed the
idea of a trade-off between inflation and unemployment. The Friedman-Phelps insight, which
helped earn those economists their respective Nobel prizes, was that the trade-off was, at
best, temporary. Repeated attempts to reduce unemployment by allowing inflation to rise
would result in ever-increasing inflation with unemployment returning to its natural rate.
Although the Friedman-Phelps hypothesis swept through academia in the 1970s, policy
makers were slower to catch on. As a result, the 1970s, and in some cases the 1980s,
provided a real-world laboratory for testing the Friedman-Phelps hypothesis. As we now
know, central banks that kept trying to pin down the rate of unemployment wound up with
both high inflation rates and high unemployment rates. This was a lesson that would not be
lost on subsequent generations of central bankers.
Building on the Friedman-Phelps insight, Finn Kydland and Ed Prescott showed that a
central bank engaged in discretionary policies has an incentive to promise low inflation, but
then to run an expansionary monetary policy that produces higher inflation without lowering
unemployment. In a contribution that helped earn these authors the Nobel Prize in 2004,
Kydland and Prescott showed that, to be credible, central bankers must demonstrate that
they are fully committed to a low-inflation objective. Full commitment in the Kydland-Prescott
framework, necessitates independence from political pressures to follow inflationary
monetary policies. Otherwise, once inflation expectations become entrenched, it can be very
difficult to reduce them. The costs of doing so, in terms of higher unemployment, can be
substantial. Again, the experiences of country after country which pursued expansionary
monetary policies in the 1970s and 1980s provided the laboratory.
These insights, and the subsequent literature built around them, contributed to the now
widely-held view that central banks should have independence from the political process with
a mandate to achieve price stability. In this way the monetary authorities can make the best
possible contribution to supporting sustained economic growth and employment creation.
The monetary policy strategy of the ECB can be seen in this light. It involves three key
elements. First, there is the objective of price stability which the ECB defines as a
year-onyear increase in consumer prices for the euro area of "below, but close to, 2 per cent". The
"close to" was added in 2003 to establish a safety margin above zero inflation to guard
against deflationary risks. Price stability is a medium-term goal reflecting the long lags
involved in the transmission of monetary policy.
Second, the "two pillars" of economic and monetary analyses have been formulated so as to
enable the ECB to attain its objective.
•
In the economic analysis, an assessment of current economic and financial
developments from the perspective of the interplay between supply and demand in
the product and factor markets is made. This provides short- to medium-term
indications of inflation.
•
As a cross-check to the economic analysis, the monetary analysis focuses on
money and credit developments in recognition of empirical evidence suggesting that
monetary growth and inflation tend to be related in the medium to long run.
The final element is central bank independence. The Maastricht Treaty grants full political
independence to the ECB in its pursuit of price stability. In a democratic society, however,
central bank independence needs to be counterbalanced by accountability, that is, an
obligation on the part of the central bank to explain its decisions to the public and its elected
representatives, including, in the case of the ECB, those in the European Parliament. In turn,
accountability requires transparency with respect both to objectives and decision-making. To
this end, monetary policy decisions taken by the ECB are explained "in real time" at a press
conference immediately after each rate-setting Governing Council meeting.
The success of the ECB's monetary strategy is borne out by its record. Since the inception of
the euro area, average inflation in the euro area has been 2.08%, a shade higher than the
ECB's definition of price stability. Inflation expectations have also remained firmly anchored
around the ECB's definition of price stability, attesting to the ECB's credibility. Long-term
interest rates have been at historically low levels.
For countries such as Greece, with histories of high inflation, the gains from joining the euro
area have been very substantial. For years, Greece suffered from double-digit inflation.
Growth was anaemic and unemployment rose in spite of periods of fairly loose monetary
policy. Nominal interest rates were high, reaching close to 30 per cent at times during the
1980s. In contrast, the low levels of nominal interest rates experienced in the euro area,
reflecting the low levels of inflation expectations, have created conditions for an improved
business climate, higher investment and, ultimately, higher growth.
In sum, the loss of monetary policy independence, identified in the earlier
optimum-currencyarea literature as one of the two main costs of joining a monetary union, is not necessarily a
cost after all. That earlier literature was formulated in the context of Keynesian
demandmanagement policies that were popular in the 1960s. Since that time, however, both
economic theory and the experience of high unemployment coupled with high inflation have
taught us the importance of a credible monetary policy aimed at providing price stability.
Moreover, I have argued that for countries with histories of high inflation and political
interference in policy formation, a credible monetary policy can be attained by joining a
monetary union with an independent central bank. I also mentioned, however, that the earlier
literature on optimum currency areas identified a second cost of joining a monetary union -
the loss of the exchange-rate instrument. After all, monetary policy can be focused on price
stability, but, in the face of an asymmetric shock, the nominal exchange rate may change so
that adjustment is facilitated. How important, then, is the exchange-rate instrument in dealing
with asymmetries among the countries participating in the euro area?
II. Asymmetric shocks and the loss of the exchange rate as a policy instrument:
the preconditions for monetary union reassessed
The early literature on optimum currency areas included a search for mechanisms that could
replace the exchange rate or compensate for its absence. This search led to the identification
of a number of criteria on which the optimality of a potential currency area could be
assessed. These criteria effectively became preconditions for forming a single currency area.
I will argue that this traditional view is static in nature. It assumes that a country's
characteristics are immutable. In fact, the experience of the euro area suggests that
participation in a monetary union can, in itself, induce changes in economic structure and
performance that make the currency area optimum. Much academic research, based on the
experience of European monetary union, indicates that the creation of a monetary union can
itself create conditions favourable to the well-functioning of the union, either through
endogenous changes in the way the economies of the union operate or through policy
changes induced by the existence of the union. Let me illustrate by discussing some of the
so-called preconditions enumerated in the early literature and looking at their evolution within
the euro area.
Mundell, in 1961, identified high mobility of the factors of production (both capital and labour)
as a precondition for giving up the use of the national exchange-rate. While labour mobility is
still low within the euro area, reflecting, in part, linguistic and cultural differences, the mobility
of capital has been increasing as evidenced by the positive effect that the euro has had on
intra-euro area FDI. Between 1999 and 2006 (the latest data available), the stock of euro
area FDI more than doubled, from around 14 per cent of euro area GDP to over 30 percent.
The importance of the mobility of financial capital was highlighted not only by Mundell (1961),
but also by James Ingram who, in 1962, emphasised the role that financial market integration
could play in reducing the costs of monetary union. Deeper financial market integration can
help in a number of ways. First, it can cause the transmission mechanism of monetary
impulses to become more similar throughout the countries of the union. Second, it can help
reduce the impact of asymmetric shocks by causing equilibrating movements in capital flows.
Finally, it can allow members of the union to insure against the impact of asymmetric shocks
since it provides opportunities for diversification of income sources. If members of the
monetary union hold claims on other countries within the union, then the income effect of any
asymmetric shocks would be mitigated.
The introduction of the euro has helped make euro area financial markets more integrated.
The money market has been almost perfectly integrated since the formation of monetary
union. The significant growth of the euro corporate bond market also provides evidence of
integration and widens the range of potential investors to which firms have access. National
bonds and equity market returns exhibit closer co-movements than they did prior to the
introduction of the euro. The main area where financial integration has lagged is that of retail
banking where, in spite of an increase in cross-border mergers and acquisitions in recent
years, cross-border activity remains relatively limited.
Forces for further integration will continue, as market participants increasingly exploit the new
environment of monetary union. In addition, a number of initiatives, supported by the
Eurosystem and/or the Commission, are further encouraging integration. An example is
TARGET2, the new payment platform for the financial system, which began operating in
November 2007. As integration proceeds, we can expect that monetary transmission
mechanisms across the euro area will continue to converge, helping the implementation of
the single monetary policy and bringing the euro area closer to an optimum currency area.
Ronald McKinnon, in 1963, added the criterion of openness. The more open the economies
of a monetary union, the less effective nominal exchange rate changes will be in facilitating
adjustment because the changes are more likely to feed onto domestic prices and wages,
offsetting the competitiveness gains.
Recent empirical evidence, however, has shown that a common currency (as opposed to
separate currencies tied together with fixed exchange rates) can promote openness, or trade
integration. The basic intuition underlying this view is that a set of national currencies is a
significant barrier to trade. In addition to removing the costs of currency conversion, a single
currency and a common monetary policy preclude future competitive devaluations, and
facilitate foreign direct investment and the building of long-term relationships. These
outcomes, in turn, can promote (over-and-above what may have been attained on the basis
of the elimination of exchange-rate uncertainty among separate currencies) reciprocal trade,
economic and financial integration, and the accumulation of knowledge. Greater trade
integration can increase growth by increasing allocative efficiency and accelerating the
transfer of knowledge.
The euro area's experience indicates that the euro has indeed acted as a catalyst for trade
integration. Intra-euro area trade in goods increased from 26% of euro area GDP in 1998 to
33% in 2006. Intra-area trade in services has also risen. Recent empirical work has shown
that similar increases in trade have not taken place among European countries which did not
adopt the euro.
Kenen (1969) emphasised product diversification, the idea being that countries which were
more diversified or less specialised in production would be less likely to face asymmetric
shocks. Indeed, before the formation of European monetary union, there was considerable
worry that monetary union would cause national economies to become more specialised as
production became concentrated to reap the benefits of scale and agglomeration economies.
Whilst there is perhaps little evidence that the advent of monetary union has caused
economies to become even more diversified, there is no evidence that they have become
more specialised, thus allaying these early fears.
Another contribution to optimum-currency area literature, again made by Peter Kenen in
1969, brought out the importance of establishing a fiscal transfer mechanism at the
supranational level in order to help stabilise economies hit by asymmetric shocks. While such
a centralised fiscal mechanism is extremely limited in Europe, the Stability and Growth Pact
with its emphasis on budgets being either in balance or surplus over the economic cycle is
designed to ensure that national budget have the flexibility to react to adverse asymmetric
shocks.
In sum, the creation of the euro may itself be contributing to the very conditions that make
the use of nominal exchange-rate adjustments among the members of the euro area less
necessary than was the case before they joined the euro area. Nevertheless, it can be
argued that a country surely must give up something if it no longer has the exchange-rate
tool. My reaction to this argument is that adjustment of the nominal exchange-rate is not a
magic bullet. One should not expect an economy with competitiveness problems, running,
say, current account deficits equal to 6 per cent of GDP, to depreciate the nominal exchange
rate and become competitive for-ever-after. We tried this policy in Greece in the 1980s; and
wound up with higher inflation, undiminished current-account deficits, and a currency that
became prone to speculative attacks.
By its very nature, the current account is the result of intertemporal decisions with respect to
savings and investment by the private sector and government. It should not be surprising,
then, that the nominal exchange rate cannot be relied upon to bring about lasting adjustment.
Such adjustment requires changes in an economy's structure, and, as I have argued,
membership in a monetary union can encourage those changes.
III. Conclusions
I have argued that ways of thinking about monetary union have evolved considerably from
the early days of the literature on optimum currency areas. Developments in modern
macroeconomics recast the goals of monetary policy. The focus nowadays on price stability
and the creation of the conditions necessary to support growth and employment changes the
balance of the arguments about the cost of giving up an independent monetary policy.
Provided that the monetary policy framework at the union level delivers price stability, there
is little to be lost from transferring monetary policy to the union level.
The success of the euro area has demonstrated that one size can fit all. Let me briefly
mention three pieces of evidence which support this. First, inflation dispersion has declined
and has been around 1 percentage point since the second half of 1999. This compares
favourable with inflation dispersion across a monetary union of similar size, the US. Second,
the decline in inflation dispersion has not been at the expense of higher growth dispersion.
Growth dispersion has remained close to its historical average of around 2 percentage points
and, if any trend is discernable, it is a downward one. Finally, business cycles appear to have
become more correlated.
The evidence from almost 10 years of monetary union in Europe points to a euro area which
is endogenously adapting itself to become an optimum currency area. The euro area
provides clear evidence that the criteria identified in the earlier literature do not need to be
exogenously in place prior to monetary union. I do not want to leave you with the impression,
however, that euro area policy-makers can sit back and relax because all the necessary work
has been done. After all, I began this lecture by remarking that the adoption of the euro
created new challenges for economic policy. The adoption of the euro was neither the
beginning nor the end of an optimum currency area among European countries. The process
is ongoing, and much more needs to be done, especially in regard to structural policies, to
ensure that the euro area becomes a more dynamic force for growth in the global economy.
It is my view that the experience of the euro area to date only serves to highlight the fact that
a currency union requires flexibility and competition in factor and product markets. These are
the characteristics that will make monetary union work more effectively.
Thank you for your attention.
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