Nout Wellink: Economic and Monetary Union at eight - achievements and
challenges
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee
on Banking Supervision, at the Nieuwegein Business Center, Studievereniging ECU '92, Nieuwegein,
31 May 2007.
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Introduction
Eight years after its establishment, it is sometimes forgotten what a monumental achievement Economic
and Monetary Union actually is. In the early nineties, many people believed it would never happen.
Others speculated that if it were to happen, it would soon fall apart. These doomsayers were wrong.
Monetary Union happened and it happened smoothly, bringing huge benefits to the people who share
the euro. With this in mind, I will today resist the temptation to predict the future of Monetary Union.
Instead, I will touch upon the benefits of having the Monetary Union and the key challenges it still faces.
By taking up these challenges, I am positive its future can be shaped into a more prosperous one.
The achievements of EMU
Let me first go into the economic benefits of the Monetary Union. The euro has brought about
substantial improvements in the macroeconomic policy framework. Most notable is that the ECB has
managed to deliver low and stable inflation. Although countries like Germany and the Netherlands also
enjoyed low inflation before the adoption of the euro, the ECB has been able to "export" that benefit to
other countries, such as Italy and Spain. This has been greatly facilitated by the ECB ́s independence
and its mandate to safeguard price stability. As a result, annual consumer price increases in the euro
area have been kept around 2 percent over the past 7 years. The ECB has also succeeded in anchoring
stable and low inflation expectations, as indicated by consumer surveys and inflation-indexed bonds.
This is a major achievement for a young central bank, in particular considering the shocks the euro area
faced such as sharp rises in oil prices. Along with lower inflation, interest rates have fallen dramatically.
Globalisation has definitely played a role, but the credibility of the ECB has also contributed to lower
interest rate levels.
It takes two to tango: macroeconomic stability in a monetary union cannot be guaranteed without sound
fiscal policies. The Stability and Growth Pact aims to ensure prudent fiscal policy over the economic
cycle. In the medium and long run, the Pact also promotes sustainability of public finances. If we look at
the cyclical-adjusted fiscal balance over time, we see an impressive improvement in the run up to the
euro. Between 1995 and 1999, the average public sector deficit fell from 4.5 to 1.5 percent of GDP. In
the following years this deficit worsened again, to a low-point of 2.8 percent of GDP in 2002. The good
news is that this bottom lies at a much better level than the troughs in the 1980s and 1990s. As a
consequence, the increasing trend in the debt-to-GDP ratio, which rose to almost 75 percent of GDP in
1997, has been reversed and declined to 69 percent of GDP in 2006. While this performance is not
impressive against the backdrop of lower interest rates, it does suggest that with the arrival of the euro
the worsening in public finances has come to a halt.
Besides supporting macroeconomic stability, Monetary Union has been a catalyst for integration. The
euro has eliminated exchange rate risks within the euro area and has increased price transparency
across borders. These factors have led to significant positive effects on trade within the euro area. A
popular empirical model to analyse trade flows is the so-called gravity model. It is a straightforward
application of the Newtonian model of gravity from physics. Translated to economics, bilateral trade
tends to increase with the size of the countries concerned and to decrease with their mutual distance.
Figuratively speaking, distances have become smaller between member states by the elimination of
exchange rate risk and the reduction of transactions costs. Studies using this method estimate a positive
growth effect on trade of 5 to 10 percent1. Another indication of increased trade within the Monetary
Union is the substantial decline in the differences of traded-good prices across member states. These
have dropped to a level akin to regional price differences in the US2.
But Monetary Union has left it greatest mark on European financial markets. Traditionally, the efficiency
of these markets has been hampered by costs associated with the use of multiple currencies. Given the
large volumes traded in financial markets, even small transaction costs can produce substantial
distortions. The euro has reduced those transaction costs and has improved the efficiency of European
financial markets. For example, euro area cross-border holdings of bonds have increased strongly -
from about 10 percent at the end of the 1990s to 60 percent in 20063. This suggests that investors are
increasingly diversifying their portfolios across the euro area. Together with financial innovation, the euro
has increased market liquidity and the opportunity for risk sharing. The bond market's depth has recently
increased to 11 trillion dollar, outnumbering the size of euro area's GDP. Admittedly, the corporate bond
market in the euro area is still substantially smaller than in the US, as European firms traditionally rely
more on bank financing. However, firms on this side of the Atlantic increasingly make use of debt
securities. Between 1998 and 2006, the value of outstanding bonds in terms of GDP has doubled, while
it increased "merely" 60 percent in the US4. More efficient and deeper financial markets benefit
companies through lower borrowing costs.
The challenges for EMU
As we speak, the euro area is undergoing an upturn. Economic figures have been better than expected.
In 2006, GDP grew by 2.9 percent, outstripping the United States for the first time in 5 years.
Unemployment has fallen to 7.5 percent in 2006, the lowest level in 15 years. While the recovery reflects
a cyclical upswing, these figures also suggest that structural reforms in the past are starting to pay off.
However, as Henry Kissinger once said: "each success only buys an admission ticket to a more difficult
problem". Monetary Union's problem is twofold: weak public finances and subdued per-capita-income
growth. Things have improved, but I am convinced we can do much better. Without aiming to be
exhaustive, I will mention a few steps that enable countries to tackle these issues and to further
capitalise on the advantages of the single currency.
Creating sustainable fiscal positions
A first challenge will be to bring public finances on a sustainable footing. In periods of buoyant revenue
growth, there is often a tendency to overestimate the strength of the underlying budgetary position. That
is partially because economists can only tell you tomorrow why things predicted yesterday didn't happen
today. If spending is allowed to increase on a structural basis, but higher revenues turn out to be
transitory, the budgetary position starts to deteriorate as soon as economic conditions turn nasty. This
was exactly the mistake made by some countries in the beginning of this decade. Let's not repeat that
mistake. Countries with sizeable deficits and public debts should use the current windfall in tax revenues
to consolidate. Sound public finances are also crucial for dealing with the costs due to population
ageing. While living longer is good news, public expenditures in the euro area are projected to increase
by up to 10 percent of GDP by 2050 if the implications of ageing are not addressed5. Action is therefore
needed. By lowering public debt more financial room is created for less favourable democratic times. But
governments should also reduce the burden of ageing itself by, for example, reforming public
pay-asyou-go pension schemes. Germany and the UK have recently announced a gradual rise in the statutory
retirement age to 67 and 68. As this measure appears quite effective to absorb an increasing life
expectancy6, other European countries should follow this example.
Improving labour markets
Fiscal consolidation is more likely to succeed if it is accompanied by structural reforms that lift the
potential growth path. One obvious candidate is the labour market. The average participation rate in the
euro area still relatively low. This is most striking for workers aged between 55 and 64, where the rate is
just two-third of the figure in the US. It is often argued that this is because Europeans are keen on
leisure. But financial incentives play a large role in people's decision to either work or not. For example,
empirical studies show that labour supply is responsive to the tax rate on labour. This suggests that if we
want to increase economic wellbeing, improving financial incentives could be of help. Labour force
participation could be stimulated by further lowering marginal taxes on labour. According to the OECD,
the average marginal tax rate on labour in the euro area is high and it hovers around 15 percent points
above the rate in the US7. Female participation could be supported by providing adequate childcare
facilities. Euro area's labour markets could also use some extra flexibility. The OECD indicated that rigid
employment protection and generous unemployment benefits have barely changed over the last years.
In 2005, the average replacement rate of unemployment benefits8 in the euro area was more than 20
percent higher than the OECD average9. Improving labour market dynamics involves making
employment protection less stringent and reducing the length of unemployment benefits. Through this,
employees will get a stronger incentive to seek a job, while firms will find it more attractive to hire
people.
Fostering service market competition and a friendly business environment
Increasing competition in service markets is another condition for higher economic growth. A lack of
competition harms productivity growth by limiting efficient production and reducing the incentive to
innovate. "Necessity is the mother of innovation", Veblen once said. I think he is right. When there is
pressure from contenders, one tends to perform better than without competition. Much headway has
been made in raising competition in product markets. Also in some service sectors there has been
progress. Noteworthy in this regard is the opening up of the telecommunication sector in the late 1990s.
However, differences in permits, regulations and national monopolies continue to hinder cross-border
competition in a number of service sectors, such as mail and electricity. This is particularly regrettable,
given that services represent 70 percent of GDP and employment in the euro area. That also illustrates
the importance of the European Service Directive. While this Directive has been watered-down
compared to the Commission's original proposal, it still has benefits. It has been calculated that
consumption in the EU can rise by 0.3-0.7 percent permanently due to the Directive10. I agree, this does
not sound spectacular, but it only entails the static effect of increasing trade opportunities. If the dynamic
effects from increased competition are taken into account, the number is expected to be higher. Air
travel offers an example of what can happen. Due to liberalisation and competition, air travel within the
EU has come within reach of tens of millions of people, often at lower fares than 20 years ago. In view of
these benefits, it is important that countries bring their legislation in line with the Directive over the next
years.
Enhancing cross-border competition one thing, creating an entrepreneur-friendly environment is another.
This includes lowering the costs and constraints imposed by the public sector on existing and start-up
firms. According to the World Bank, in 2005 the average cost of starting a business with up to 50
employees in the euro area is estimated to be 10 times higher than in the US. That is, if entrepreneurs
have not given up starting a business in the meantime, as it takes on average 27 days to set up a new
business in the euro area, compared to just 5 in the US11. I always had respect for entrepreneurs, but
it's getting larger in view of the red tape they have to cut through. In this respect, I fully underscore the
current EU Commission initiative for measuring the cost of existing legislation and reducing the
administrative burden on companies with 25 percent by 2012.
Stimulating further financial market integration
Economic growth can get an additional boost by more financial market integration. Clearly more needs
to be done in the equity market. While slowly increasing, only a quarter of the equity portfolio of euro
area residents consists of equity issued in another euro area country. Home-bias might be one reason
for lagging integration; high costs for cross-border transactions are another. This partly reflects the lack
of integration in market infrastructure for equities. Settlement of equities in Europe is divided over 19
different systems compared to only two in the US12.Since the introduction of the euro, consolidation in
this sector has failed to take place and barriers continue to hold back cross-border trade. This hampers
competition, keeps transaction costs high and weakens the opportunity for risk sharing. If the market
fails to produce satisfying results, than it is up to the public sector to act. Against this background, the
ECB has recently launched its proposal for a single securities settlement platform. The huge economies
of scale it aims to produce should create scope for lower transaction costs and a more efficient
allocation of savings and investment.
Another area where further integration is warranted is the retail banking sector. The cost of opening a
bank account and the cost of transferring money from it widely differs between euro area countries.
National discrepancies in legislation, technical standards and procedures are obviously major
impediments to further integration. Fortunately, the right initiatives are underway. It already started in
2001, with the Regulation on cross border payments in euro. Better known as the Bolkestein Regulation.
This Regulation paved the way for the Single Euro Payments Area. An ambitious initiative, where
European citizens should by 2010 be able to make payments throughout the euro area from their bank
account as easily and safely as in their own country today. By creating a pan-European infrastructure
and identical payment tools, all payments in the euro area essentially become domestic payments. 15
years ago this goal was beyond imagination. Now it appears within reach.
Concluding remarks
To conclude, the euro has seen a number of successes: the introduction of a new currency for more
than 310 million people, price stability, low interest rates and progress in the integration of the goods
and financial markets. These achievements are remarkable, as they have been realised in a short period
of time and in a unique political context. Indeed, Europe is the world's laboratory: we created the first
supranational entity based on a sense of solidarity rather than coercion. Of course it is not all plain
sailing. In the fields of public finances and the internal market work remains to be done to reap the full
benefits of the euro. It is therefore important to remain ambitious in the near future. Not ambitious to be,
but ambitious to do. How Monetary Union will evolve in the future is hard to predict. But if the past 8
years offer a compass for the future, I am optimistic we find the right answers to our current challenges.