Jens Thomsen: How does the individual member state design an appropriate
stabilisation policy in a monetary union?
Panel statement by Mr Jens Thomsen, Member of the Board of Governors of the National Bank of
Denmark, at the 3rd ECB Central Banking Conference, Frankfurt, 22 October 2004.
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Having pursued a fixed-exchange-rate policy for many years, Denmark has gained extensive
experience in this area. The present central rate was fixed in January 1987. Some of this experience is
also relevant in relation to the new EU member states' participation in ERM II. In my contribution, I will
focus not only on ERM II, but also on the broader question: how does the individual member state
design an appropriate stabilisation policy in a monetary union? This means that the conclusions drawn
will be applicable to both new and old EU member states.
In EMU, there is obviously no national monetary policy. The national stabilisation policy must therefore
be based on alternative instruments.
ERM II is an integral part of the EMU process. For as long as the broad fluctuation band is utilised,
monetary policy may still form part of a country's stabilisation policy. However, it cannot stand alone.
As I will describe, its impact will diminish as the date of EMU entry approaches. All new EU member
states have stated that they want to be in ERM II for as short a period as possible.
This means that fiscal and structural policies - the only national policy instruments in EMU - should
already be appropriately designed within ERM II. This will ensure, among other things, that the terms
of the Stability and Growth Pact are met or are, at least, immediately in sight. This is a simple but
important point to always keep in mind.
Denmark has decided to stabilise its exchange rate close to the central rate. On account of the high
degree of convergence, the stability of the Danish krone in the market, and the sustained
stabilityoriented economic policy, Denmark participates in ERM II with a narrow fluctuation band of
+/-2.25 per cent. This band is, however, far from utilised. In other words, fiscal and structural policies
are the only stabilisation-policy instruments available to Denmark - as will also be the case in EMU.
This means that the exchange rate - and the exchange rate alone - determines the interest-rate
spread. Intervention in the foreign-exchange market is also an option, for brief periods of time, to
counter adverse exchange-rate movements. Intervention cannot stand alone, however.
Organisationally, this also implies that we must be able to adjust our interest rates when required,
without being tied down by the meeting schedule of a monetary-policy committee. This is a well-known
fact in the market and thus highly transparent. Alternatively, one could say that our monetary-policy
committee convenes every day and as required.
Central bank independence is a prerequisite in this respect. Without it, the implementation of
necessary measures can be endangered.
We have a clear division of work regarding intra-marginal interventions. The Board of Governors, in
collaboration with Market Operations, establishes a strategy based on current market conditions. The
Board of Governors has access to real-time information on any interventions, but is not consulted in
advance. Interventions within one day are never capped, but subject to ongoing assessment in order
to establish whether strategy adjustments are called for. The ECB is kept informed on an ongoing
basis.
In principle, one might ask whether the design of our stabilisation policy is appropriate?
Theoretically, there are two arguments for acting as we do.
Firstly, the institutions are designed to be in compliance with EMU participation and thus also with the
provisions of the Treaty. At some future point in time we expect Denmark to enter EMU, and when it
does, we will not have to alter our fiscal policy, since it is already based on government finances in
surplus or close to balance. There is strong political support for this rule-bound division of labour in
economic policy. The awarding of this year's Nobel Prize in Economic Science demonstrates that the
design of institutions is also considered to be of great theoretical importance.
Secondly, we know from the "impossible trinity" that in a world of free capital movements, it is not
possible to set interest and exchange rates independently of one other. The central bank has one
instrument, and one instrument only, at its disposal: the short-term rate. Any attempts to stabilise the
exchange rate while at the same time meeting other targets, are thus futile in theory. In practice, they
spawn a number of problems which are aggravated the closer one seeks to stabilise the exchange
rate.
A number of central banks, including several from new EU member states, currently base their
monetary policy on inflation targeting. In principle, the central bank seeks to approximately meet not
only one, but two targets, an inflation target and an output-gap target, using just one instrument: the
short-term rate. The reason that this is viable is that usually the targets work together. The problem in
supplementing these targets with an exchange-rate target is that the need for internal stabilisation may
easily conflict with the exchange-rate target.
Spain formally continued its inflation targeting up to its EMU entry. This was, however, also a period in
which the interest-rate spread to Germany progressively narrowed, and never widened, while fiscal
policy was put in place. Meeting the convergence criteria was the central aim of the overall economic
policy - irrespective of how monetary policy was classified.
Theoretically, inflation targeting in ERM II presents an additional complication in that the impact of the
national interest rate diminishes relative to domestic activity and future inflation rates as the date of
EMU accession approaches.
If the country is expected to enter EMU in, say, one year, the national interest rate will exist for only
one year. The closer the date of entry, the greater the interest-rate changes needed to influence
activity.
If the inflation-targeting country is expected to enter EMU with a specific exchange rate, there is, on
the other hand, a risk of wide exchange-rate movements in the run up. With a known entry rate, the
spot rate has to move in order to fulfil the interest-rate parity.
This issue, trivial as it may seem, is rarely mentioned in the literature.
This means that, in practice, new EMU members need to abandon inflation targeting well before EMU
entry and rely on fiscal and structural policies.
In Denmark's experience, this is no hindrance to appropriate economic performance.
Monetary policy is reserved for keeping the exchange rate stable and close to the central rate within
ERM II. In conjunction with sound public finances, this has ensured an anchoring of inflationary
expectations in line with the ECB's definition of price stability.
We have used structural improvements and symmetric fiscal policy, in compliance with the
requirements of the Stability and Growth Pact, to achieve sound public finances. Our clear
mediumterm objective is to reduce the government debt.
The fiscal policy stance is determined annually in connection with the Finance Bill for the coming year
and allowing for the expected cyclical development. Discretionary fiscal policy measures are rarely
used in the course of the year and have typically included structural improvements.
In the long term, the structural policy is most important. As the world keeps turning, structural reforms
in principle never end. The most appropriate speed and sequence of reforms e.g. depend on whether
the output gap is positive or negative. This makes it difficult to draw a clear distinction between
structural and fiscal policy.
In international terms, including countries that apply best practice inflation targeting, Denmark has
seen very moderate volatility in inflation as well as output in recent years. We attribute this, in large
measure, to the use of stabilisation policy as described above. In the 1970s and early 1980s, a very
activist fiscal policy was pursued, as opposed to the current situation. Our government debt rose
steeply and the exchange-rate policy was anything but consistent. In those years, Danish volatility was
high by international standards.
Danish experience thus speaks against fiscal as well as monetary fine-tuning of the economy. Efforts
to stabilise the economy often end up rocking the boat. Our experience, in the main, corroborates the
focus on structural economic factors theoretically established by Kydland and Prescott.
I want to make one final point:
It is appropriate that drivers practise and qualify for a driver's licence before getting behind the wheel.
Similarly, it is appropriate that a country documents that it is ready for EMU prior to entry. Part of this
documentation is ERM II membership