Jean-Claude Trichet: Further integrating euro area economies - some
reflections
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
57. Jahresversammlung des Ifo Instituts für Wirtschaftsforschung an der Universität München, Munich,
29 June 2006.
* * *
Ladies and Gentlemen,
Sehr geehrte Damen und Herren,
Herzlichen Dank für die Einladung nach München. Es ist mir eine grosse Ehre und Freude heute zu
Ihnen zu sprechen. Viele von Ihnen leisten einen direkten und eminent wichtigen Beitrag dazu, Europa
zu verändern und zu modernisieren. Lassen Sie mich zu diesem wichtigen Thema mit einigen
Überlegungen über die weitere Integration der Eurozone beitragen.
We at the ECB pay very close attention to your work. And it is certainly not only the well-known ifo
business climate index that we carefully read each month. We have a deep interest in the original
and rich economic research done here at the ifo institute, or that is catalysed by the CESifo Research
Network, for which the institute has been praised again recently. The profound restructuring and
reorganisation that you have conducted in recent years is really paying off. Furthermore, one only
needs to have a cursory look at bookshops and libraries and it becomes evident that your work, dear
Mr. Sinn, on many topics is appreciated well beyond German borders
In your recent book, but also in other papers you wrote, you put forward a thesis aimed at reconciling
what you call the "German puzzle:" i.e., the contemporaneous high merchandise export and slow
growth. Your analysis is relevant and interesting, but also very thought provoking. You point to high
wages that lead to outsourcing as some of the explanations of the puzzle. Independently from the
position that one has vis-à-vis your analysis, and agreeing with it or not, you have launched a valuable
debate.
Last but not least, I would like to mention how much we appreciate the efforts of Ifo toward the
"European Economic Advisory Group" which serves as a role model for European integration.
Consisting of a team of eight distinguished economists from eight European countries, it produces, on
an annual basis, a valuable report on the European Economy.
We also share a challenge: the need to monitor and analyse current developments while
simultaneously understanding how the underlying economic structures are changing. Today I would
like to share with you some reflections on these changes and their implications.
A preamble. As you are aware, the creation of an economic area with a single market and 12 national
economies now sharing a single currency - the euro - has been a unique endeavour in economic
history. Other countries will follow in adopting the euro in the future. This has set in motion several
new developments to which we need to pay close attention.
But we should also not forget that the euro was introduced only in 1999 (with banknotes and coins
following three years later). As such, its full effects may take some more time to unfold. Experience
also shows that in such a rapidly changing world, where the progress of science and technology, the
globalisation process and the very profound structural and institutional changes in Europe are taking
place simultaneously, we have to be humble before facts and figures and be ready to take them on
board.
My reflections are organised along five main lines. First, I will list some reasons why the euro is setting
in motion some developments that were not there before. Second, I will argue that actually the euro is
already fostering such developments and integration in many areas. Third, I will highlight some of the
main benefits and consequences of European economic and monetary integration. Fourth, I will
provide some snapshots of the diversity of euro area national economies, a natural phenomenon in a
wide currency area. And finally, I will discuss the issue of the optimal economic management of the
euro area.
First reflection, why should the euro bring countries closer together? What is so special about a
monetary union among countries that are ready for this leap forward?
We know that by moving from several national currencies to a single currency, some pecuniary costs
disappear or at least decline. The introduction of the euro has therefore contributed to reducing trading
costs both directly and indirectly: e.g. by removing exchange rate risks and the cost of currency
hedging among the pre-euro legacy currencies. Information costs have been reduced as well. The
euro is also enhancing price transparency and discouraging price discrimination: this is helping to
reduce market segmentation and is fostering competition. Hence, the euro is acting as a catalyst for
the Single Market Programme.
But there is more to
it. The euro is rendering this single market irrevocable. A single currency among
partner countries, some of which already started integrating in the 1950s, is seen as "a much more
serious and durable commitment" than other monetary arrangements between countries.1 It precludes
future competitive devaluation, facilitates foreign direct investment and the building of long-term
relationships. Producers may be more willing to undertake large fixed costs associated with exporting
to other partner countries of the currency area. One single currency is more efficient than multiple
currencies in performing the roles of a medium of exchange and unit of account. As a result, a single
currency promotes convergence in social conventions with potentially far-reaching legal, contractual
and accounting implications.2
The euro is also rendering more obvious the need to intensify structural reforms, such as those
fostered and monitored in particular by the European Commission, the OECD and that we strongly
support ourselves. Reforms span product and labour markets, and as regards financial integration the
measures listed in the Financial Services Action Plan (FSAP), the launch of TARGET2, the
establishment of the Single Euro Payment Area (SEPA), the initiatives to further integration in the
Mortgage Credit Market in the EU, and others. This is in fact vital to enhance the success of EMU.
Hence, the euro is contributing to the removal of "borders". These are broadly intended to include the
former legacy currencies, but also national procedures, rules and conventions, plus many other
obstacles and hindrances to economic and financial integration. To what extent are we starting to see
these effects?
Let me now illustrate, and it is my second point, how the economic and financial environment
of the euro area has changed, and will continue to change. More and more research studies and
analyses on the effects of the euro are being conducted. The effects observed are generally beneficial
and euro area economies are becoming more interdependent.3
We have clear evidence of a significant increase in both intra and extra-euro area trade in goods
since the launch of the euro.4 Exports and imports of goods within the euro area increased from
about 26.5% of GDP in 1998 to around 31% in 2005. This may be partly related to the introduction of
the single currency and the increased price and cost transparency, which have promoted cross-border
trade. Over the same period, exports and imports of goods with trading partners outside the
euro area rose from about 24% of GDP to almost 30%. This is mainly due to more sustained growth in
world GDP, an increase in global trade integration, and a very sizeable increase in trade with the ten
new Member States of the European Union. All in all, these developments are particularly noteworthy
given the already high degree of openness of the euro area countries, suggesting that we are not
witnessing the creation of a "fortress Europe" but that the European integration is perfectly
complementary with the global integration.
1
See, among others, Engel and Rogers (2004) "European Product Market Integration After the Euro," Economic Policy, July
pp. 347-384, and McCallum (1995) "National Borders Matter: Canada-US Regional Trade Patterns", American Economic
Review 85 (3): 615-623. For a description of the European process of integration see Mongelli, F.P., E. Dorrucci, and I. Agur
(2005) "What does European institutional integration tell us about trade integration?", ECB Occasional Paper Series no 40.
2
Garcia-Herrero, Gaspar, Hoogduin, Morgan and Winkler (2001) Introduction of volume with Conference Proceedings, in
Why Price Stability, First ECB Central Banking Conference, European Central Bank.
3
In June 2005, the ECB held a workshop on "What effects is EMU having on the euro area and its member countries?" The
workshop was organised in five areas: 1) trade integration; 2) business cycle synchronisation, economic specialisation and
risk sharing; 3) financial integration; 4) structural reforms in product and labour markets; and 5) inflation persistence. All
proceedings are now available in the ECB Working Paper Series: see nos 594 to 599.
4
See Baldwin (2006) "The euro's trade effects," ECB Working Paper Series no 554, and Anderton, di Mauro, and Moneta.
(2004) "Understanding the impact of the external dimension of the euro area: trade, capital flows and other macroeconomic
linkages," ECB Occasional paper no 12.
BIS Review 64/2006
A lesser-known feature is that trade in services with partners inside and outside the euro area has
also increased as a percentage of GDP in recent years. Intra-euro area exports and imports of
services increased from about 5% of GDP in 1998 to around 6.5% in 2005. Proportionately, this
represents a slightly higher increase than extra-euro area exports and imports of services, which
increased from about 7.5% of GDP in 1998 to around 9.5% in 2005. Trade in services can rise much
further when the single market for services is completed. We are perhaps already seeing the first signs
of this process: over the last three years the growth of the euro area's international trade in financial
services has surpassed the growth in all other sectors of services. Moreover, intra-euro area trade in
financial services grew almost as rapidly as extra-euro area trade. Other dynamic sectors on the
intratrade side were computer and information services as well as communication services.
Intra-euro area Foreign Direct Investments (FDIs) have grown considerably as well. They are now
catching up with extra-euro area FDIs. Between 1998 and 2004, total FDIs grew by about 180% in
nominal terms while cumulated total FDIs now account for around 24% of euro area GDP. Intra-euro
area FDIs grew instead by over 240% and now account for a little less than half total FDIs. Such FDIs
- which also include mergers and acquisitions (M&A) activity - accumulate over time and contribute to
reshaping Europe.
The faster movement towards a single market in financial services is another example of the euro
acting as a catalyst. Here I will give just a few examples. Last year, for the first time, the ECB
published a set of indicators on the state of integration of euro area financial and banking markets.
These indicators clearly show that the euro has been a remarkable catalyst, particularly in market
segments closer to the single monetary policy.
For example, the cross-country standard deviation of EONIA - i.e. overnight - and EURIBOR - i.e.
one-month and 12-month - lending rates among euro area countries plummeted to close to zero
following the introduction of the euro, and since early 1999 this standard deviation has remained low
at only 1-2 basis points. Just to give for comparison some figures from the time before Monetary
Union, let me mention that in January 1998, i.e. one year before the start of Monetary Union, the
indicator for the EONIA lending rates stood higher than 130 basis points and the indicators for the
EURIBOR lending rates stood at more than 100 basis points for the one-month maturity, and at
around 50 basis points for the 12-month rates.
The euro corporate bond market has grown very significantly since 1999, and has the potential to grow
even further. The outstanding volume of bonds issued by non-financial corporations of around €2.5
trillion in the United States is still three times larger than in the euro area (while the respective GDPs
are comparable). A rapid integration is also taking place in euro area equity markets. Stock prices
across the euro area increasingly react to euro area-wide factors and news. Furthermore, the
elimination of intra-euro area currency risk and, most importantly, the reduction of direct and indirect
costs for cross-border portfolio transactions has reduced the "home bias" in the equity holdings of
institutional investors. A simple inspection of the data reveals that European countries increased their
holdings of euro area international assets (as a share of their total international portfolio). Over the
1997-2003 period, the share of intra-euro area allocation increased markedly by 10 percentage points
for equity portfolios and by almost 25 percentage points for fixed income portfolios. There is
nevertheless potential for greater integration particularly in the equity market.5
Cross-border interbank loans and holdings of securities are another area in which we have seen
significant progress. At the end of 1997, securities issued by non-monetary financial institutions of
another euro area country accounted for only 16% of the securities held by euro area monetary
financial institutions (MFIs). This share has now reached almost 40%.
But integration in retail banking has been slow so far. Consolidation in the banking sector has taken
place mostly as a result of domestic mergers whereas cross-border banking mergers have started to
happen only over the recent years. In this respect, whereas a number of euro area banks have
considerably expanded their interests outside the euro area, cross-border activity within the euro area
has remained relatively limited, though it is gaining importance. The continuation of this trend is
expected to result in an increase in the level of competition and efficiency in the euro area financial
system.
Let me briefly mention that the ECB and the Eurosystem are actively involved in several initiatives that
help fostering financial integration. First, the launch of TARGET2 - the new payment platform for the
financial system - is planned for the end of 2007. Furthermore, we are participating in the Short-Term
European Paper (STEP) initiative to promote the convergence of better market standards and
practices prevailing in the European short-term securities markets, whereby Euribor ACI and Euribor
FBE formally adopted the STEP Market Convention just recently at the beginning of June. End of last
year, we also provided a contribution to the European Commission on the Green Paper on Mortgage
Credit in the EU, an important segment of the banking and retail markets that has an outstanding
volume of more than €4 trillion in residential mortgage debt in the EU, corresponding to around 40% of
EU GDP. Euro area mortgage markets are not yet fully integrated, and I see here great potential for
further integration. Last but not least, there is also the Single Euro Payments Area (SEPA) project that
aims at integrating the market for retail payment services.
Let me finally stress how important it would be to speed up progress in creating more flexible labour
and product markets. Advances in this area have been uneven across countries and as a whole too
slow.6 I will come back to this issue later on.
All in all, however, euro area countries are becoming more interdependent than they were at the start
What are some of the direct and indirect
of EMU. Simply put, we all have a bigger stake in each other.
implications from sharing the euro?
My third reflection is that the single currency has been largely beneficial. There are benefits of
intense trade in goods and services. By increasing intra-euro area FDIs and M&As, companies in
Europe are able to re-allocate their capital in a more efficient manner.
The Eurosystem - with the ECB at its heart - has built a successful monetary framework. This
includes a clear monetary policy strategy to deliver our primary objective, price stability, an effective
framework for the operational conduct of monetary policy, and an efficient payment system. As a
result, expected inflation levels have remained in line with our definition of price stability. This has
allowed nominal and real medium and long term market interest rates to contribute to favourable
conditions for sustained economic growth and job creation.
The euro area has become more resilient. As a whole, we find less dispersion because the cyclical
component of output growth is more synchronised. Since the start of EMU dispersion in annual
average real GDP growth rates across the twelve euro area countries, measured by the unweighted
standard deviation, has declined from a level of 2 percentage points, around which it has fluctuated
since the 1970s, to 1.5 percentage points in 2005.7 National economic policies have become better
coordinated, and in the case of monetary policy it has even been completely merged. A relevant factor
for some euro area member countries is that the risk of possible speculative attacks on national
currencies has been removed. Not so long ago, in the pre-EMU past, the impact of movements by the
Deutsch Mark against the US dollar was often aggravated by similar movements against euro legacy
currencies: this can no longer happen.
Clearly, there are also general economic benefits arising from more financial integration in the euro
area. I will mention a few here.8 Financial integration fosters financial development, the modernisation
of the financial system and, ultimately, economic growth. Some of our studies and a number of
analyses by the European Commission claim that the potential gains from the financial integration of
European bond and equity markets in terms of additional real GDP growth amount to around 1% over
a ten-year period.
Thanks to greater financial integration, economic agents can invest more easily in any part of the euro
area and thereby spread the risk of potential local shocks having an impact on income and
consumption. The potential benefits of this are very significant. As euro area investors assign more
weight to portfolio investment in euro area countries - and banking integration grows as well -
risksharing in the euro area increases. This is a very important shock absorber.
capital markets
I will give you a comparison. A few years ago some researchers showed that the US
smoothes 39% of the shocks to gross state product (that is equivalent to our GDP), 23% to credit
institutions and 13% to the federal government.9 25% of the shock is not smoothed. Hence, in the
United States, financial markets and financial institutions contribute 62% to the absorption of state
idiosyncratic shocks. The effect is substantially higher than the effect of the federal budget. While in
Europe the supranational budget plays a different role, we expect European financial markets to move
in this direction.
Furthermore, by making markets deeper and more liquid, financial integration creates economies of
scale and increases the supply of funds for investment opportunities. The integration process fosters
competition, the expansion of markets and intermediation, thereby complementing and leading to
further financial development. Financial development, in turn, leads to lower intermediation costs and
a more efficient allocation of capital. Allocating resources to the most productive investment
opportunities ultimately increases the potential for greater and more sustainable non-inflationary
economic growth.
All in all, there is no doubt that sharing the euro has been beneficial for all euro area countries. The
313 million people in the euro area and, more generally, the 460 million European Union citizens
expect such economic benefits. At the same time the euro area is now a very large economic area
which requires a new type of economic management than we were used to prior to 1999. We need to
think in terms of economic developments in the area area as a whole, in our home country and in euro
area-partner countries. This requires an enormous change in mentality, but it is indispensible for the
success of EMU.
My fourth reflection concerns the level of diversity within the euro area. Let me provide you only
a few snapshots of the evolution and dispersion of inflation, as well as indicators of growth
differentials, competitiveness and unit labour costs. Whenever possible, I like to compare and contrast
the euro area with the other major industrialised continental economy, the United States.
I would like to stress that monitoring economic developments and understanding what lies behind
diversities is an important aspect of the new economic management that I referred to above.
a. Inflation dispersion in the euro area declined considerably in the 1980s and 1990s, and is on a par
with the level found in the United States. Inflation dispersion among euro area countries has broadly
stabilised at a low level since the beginning of the euro. The progress made has been very impressive.
The unweighted standard deviation of annual HICP inflation rates was still around 6 percentage points
in late 1990. It has dropped to 1 percentage point since the launch of the euro, a level at which it
broadly stabilised. This dispersion level is similar to that of the 14 US Metropolitan Statistical Areas
(MSAs) but somewhat higher than for the four US census regions. Although such comparisons are
subject to some well-known caveats, it can be argued that inflation dispersion in the euro area has not
been high by international standards.10
inflation differentials
A feature of euro area is their persistence. Inflation in most member countries
displays significant inertia. Many countries below, or above, the euro area average inflation rates in
recent years have remained in this position for at least a decade on average. Such widespread
persistence of inflation differentials over long periods does not occur in the United States. And we are
now seeing signs of limited reversals: some euro area countries with relatively high inflation rates have
moved down to, or even below, the euro area average. Overall, these corrections are welcome, but
the point is that they have been quite slow in coming. Whereas some wage or inflation differentials are
justified - and prove that monetary union promotes adjustments - there is a need to better understand
the reasons for this apparent sluggish adjustment process.
If we look at the cost side, in most countries domestic factors dominate external factors in generating
inflation differentials. In particular, we have witnessed a sustained divergence of wage developments
across the euro area, and narrower differences in labour productivity growth. These differentials in the
growth of unit labour costs have been the main sources of persistence. This suggests a link with
differing levels of wage rigidities across the euro area. However, changes in profit margins have also
contributed to inflation differentials. Furthermore, imperfect competition and associated price rigidities
across countries may also have been a factor.
If we look at product groups, there has been a relatively higher price dispersion in the area of services.
This is probably associated with the dispersion in wage developments in the services sector. By
contrast, inflation dispersion has been relatively low for tradable non-energy industrial goods. Then, of
course, products with relatively volatile price developments (such as energy, unprocessed food and
processed food) has also shown a high dispersion of price changes across countries.
Hence, there is a certain degree of structural diversity in inflation and cost developments among euro
area national economies. This is undesirable if it reflects misaligned policies and structural rigidities or
a lack of competition. If uncorrected, over time, it may engender negative effects and externalities for
the euro area as a whole.
The second snapshot of diversity in the euro area concerns growth dispersion.
b. Growth dispersion in
the euro area has been broadly stable since the early 1970s. Between 1999 and 2005 there were no
signs of increased divergence. The average dispersion of annual real GDP growth (measured as the
unweighted standard deviation) was around 2 percentage points. This is very close to the average
dispersion of real growth rates since the 1980s. By comparison, the dispersion of real growth across
the 50 US States has fluctuated around an average of 21⁄2 percentage points over the last 15 years,
while the average dispersion of the real growth rates was around 11⁄2 percentage points across the
eight US statistical regions.
There is also a relatively high degree of persistence of output growth differentials within the euro area.
A certain degree of persistence of growth differentials is also found in the United States. However, to
take the United States as a benchmark is useful only up to a certain point. On the one hand, the US
economy is known to be more flexible than the euro area (and thus effects of asymmetric shocks
should be absorbed more easily and faster). On the other hand, the United States exhibits stronger
regional specialisation than the euro area, making its regions more subject to specific asymmetric
shocks.
It is useful to distinguish between the main drivers of dispersion. Dispersion in real GDP growth rates
across the euro area countries reflects two main factors: dispersion of cycles and dispersion of trends.
The dispersion of cycles has steadily declined since the early 1990s from about 2 percentage points to
degree of synchronisation
1 percentage point. In this regard, the of business cycles across euro area
countries seems to have increased since the early 1990s. This holds true for various measures of
synchronisation applied to overall activity and to the cyclical component, for annual and quarterly data
as well as for various country groupings. In particular, the degree of correlation appears currently to be
at a historical high. These two features are unique to the euro area.11
This may indicate that EU integration and, more recently, EMU - as opposed to global forces - have
led to smaller differences in output gaps and an increase in the synchronisation of business cycles
across the euro area countries.
Instead, since the beginning of the 1990s we witness more lasting differences in trend growth, which
rose from about 1.2 percentage points to about 1.7 percentage points in the late 1990s before starting
to decline. Some euro area countries persistently exhibit trend output growth either above or below the
euro area average.12
Differences in trend growth among euro area countries can be explained by various structural factors,
including to some extent demographic trends and catching up in terms of the standard of living.
Differences in the timing and extent of past structural reforms in euro area countries are likely to have
played a significant role. For example, the Netherlands have undertaken labour market reforms earlier
than the largest euro area countries. As a result, diverse long-term trends in labour productivity and
employment growth have been observed. More generally, the degree of economic flexibility could be a
factor explaining trend growth differences. In some countries, short-term shocks may have had more
persistent effects on growth differentials due to slow adjustment processes in the presence of
structural rigidities.
The increasing weight of differences in trend growth and the lower weight of dispersion in business
cycles has important implications. Macroeconomic policies can only partly address this dispersion,
whereas structural reforms can address it more fully.
c. My third snapshot of diversity concerns the rapidity with which relative changes in cost and price
competitiveness are occurring.
These movements mainly reflect changes in relative unit labour costs
and inflation differentials. They demonstrate that there is significant leeway for losing, or gaining,
competitiveness, even in the absence of exchange rate adjustment: more leeway than was foreseen
prior to the launch of the euro. Let me give you an order of magnitude. Between 1999 and 2005 the
difference in the cumulated growth of unit labour costs for the total economy between the "highest
increase" and "lowest increase" countries was about 20-25%.
This is an important phenomenon that requires an understanding of the factors driving it. I will touch
upon a few related developments:
•
Unit labour costs are increasing at a relatively fast pace in those euro area economies which
started at significantly lower price and cost levels. In most, but not all, cases this
phenomenon is driven by the Balassa-Samuelson effect, which occurs when there is a
catching-up to higher living standards, and is thus generally acceptable, as it reflects the
movement to a new equilibrium.
• Germany has seen very moderate growth in unit labour costs over an extended period,
leading to a correction of the losses in competitiveness which arose in the aftermath of
German reunification. This correction and the related sustained period of relatively low
inflation is, of course, fully justified and perfectly welcome. It also shows that adjustment
mechanisms in EMU do work. A high degree of wage flexibility would help to accelerate such
welcome adjustment processes.
•
However, the persistence of growth and inflation differentials also show that some other
sources of diversity are not economically justified. They might be partly attributable to
insufficient flexibility; in such economies corrections must be made. For example, in some
economies the combination of weak labour productivity growth and of strong nominal
increases of wages and salaries for a sustained period might lead to a progressive
deterioration of their competitiveness. Furthermore, in several euro area countries there
exists specificities in wage formation (for example due to indexation mechanisms or due to
the influence of the public sector) and in price formation in general. This limits the
responsiveness to shocks.
My final reflection concerns the optimal economic management of the euro area. The economic
management of the euro area needs to reflect the increasing interdependence of euro area economies
and ensure that the above-mentioned diversity can be addressed. I will now stress the importance of
three "guiding principles" for this.
The first principle is a rigorous implementation of the Stability and Growth Pact.
a. There are several
reasons for clear fiscal rules in a monetary union, such as those embodied in the Stability and Growth
Pact, including correcting the "deficit bias" of fiscal policy and preventing spillovers from fiscal policies
to monetary policy. I have made these reasons clear on numerous occasions. Euro area countries
need to maintain budgetary positions that are close to balance or in surplus over the medium term.
They also need to reduce public debt to a low and sustainable level.
I would like to
But the subject of my speech today is the economic integration of the euro area, so
mention a few other reasons for supporting sound fiscal policies. First, the need to reduce the risk of
fiscal policy externalities; additionally, the need to gain flexibility and adaptability; and finally, the
importance of ensuring proper incentives. Sound fiscal policies allow for flexibility, which cushions the
effects of the economic cycle through the working of automatic stabilisers. Additionally, sound fiscal
policies create room for domestic economic management, say, to pursue the desired tax and spending
policies. Furthermore, the tax and benefit system should avoid major distortions affecting incentives to
work, save, invest and innovate. This creates conditions conducive to stability and sustainable growth.
Ireland is one very clear example of such a virtuous process inside the euro area.
The public sector also has a "role model" function, for example, concerning public wages and/or
administrative prices. Its behaviour can make the social partners more aware of the trade-off between
higher salaries and job creation.
Although a sound fiscal policy is in a country's own interests, it is very much in the interests of the euro
area as well. An inappropriate fiscal policy in one country directly affects other countries, as the impact
on interest rates is no longer confined to one country but spreads across the euro area.
b. The second principle is a close monitoring of the implementation of structural reforms. Earlier, I
re