Yves Mersch: Optimal currency area revisited
Text of the Pierre Werner Lecture by Mr Yves Mersch, Governor of the Central Bank of
Luxembourg, at the European Institute, Florence, 26 October 2011.
* * *
"It is necessary that even those born well after the 1950s and 1960s realize that
the European Union has not come about by chance, but that it is based on the
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fundamental necessities of life amongst the peoples of Europe."
Pierre Werner
Ladies and Gentlemen,
It is my pleasure and privilege to talk here at the European Institute. I thank in particular
Professor Marcellino for this opportunity to share my thoughts on Optimal Currency Areas
(OCA) in general and the challenges of European Monetary Union (EMU) in particular.
Some countries in the euro area face a combination of high levels of indebtedness, budget
deficits and weak or absent growth. Amid market attacks and the risk of contagion an
increasing number of economists have already announced the unavoidable break-up of the
euro area. These predictions often share an anti-Euro sentiment and seem to be in
accordance with the naysayers who were taking potshots at the Euro even before its
inception in 1999. But they are wrong - as I intend to prove in the rest of my talk.
Comparison of two currency areas of similar size
Since the introduction of the Euro in 1999 the currency area has been regularly compared to
the US. Although, there are many arguments why such comparisons are difficult, they can
indeed yield useful insights. I will therefore start by looking at the facts, comparing basic
features, price stability, output growth, employment, heterogeneity within the respective
currency areas, public finance, private savings and trade in the US and the euro area.
Basic features
The US is a fully fledged political federation with 52 states. Over 312 million people live in the
US. The US economy is the world's largest national economy, with an estimated GDP of
12 trillion Euros in 2010 at purchasing-power parity, i.e. roughly 20 percent of global Gross
Domestic Product (GDP).
The euro area, by comparison, is a community of seventeen sovereign member states which
have introduced the euro as their common currency and sole legal tender. They are
embedded in the 27 nation European Union (EU).
332 million live in the countries of EMU. In 2010, the euro area generated a GDP of
9.2 trillion Euros. The economy of the euro area accounts for roughly 15 percent of world
GDP.
Price stability
The primary mandate of the ECB as the central bank of the euro area is to safeguard the
purchasing power of the citizens. Price stability in the understanding of the ECB is an
inflation rate below but close to 2 percent in the medium term.
Since its inception almost 13 years ago, the euro area has experienced an unprecedented
level of price stability: 2.0 percent average annual inflation.
In the US, during the same period of time, the annual inflation averaged at around
2.5 percent.
Output growth
The euro area has logged real per-capita income growth of around 1 percent a year since
1999, just below the US's 1.1 percent. International comparisons often look only at headline
growth figures; overlooking demographic developments.
Looking closer at the contributing elements in both currency areas some interesting aspects
are revealed. The standard growth accounting distinguishes mainly between employment
and labour productivity. Labour productivity itself can be further decomposed into changes in
labour composition, Information and Communication technologies (ICT) and non-ICT usage
per hour and (residual) Total Factor Productivity (TFP) growth. TFP accounts for effects in
total output not caused by inputs. If all inputs are accounted for, TFP measures an
economy's long-term technological progress. The distinction between ICT and non-ICT
reflects that the ICT sector is presumably one of the major drivers in growth across the world.
Comparing the contributions of labour productivity to growth between 1995 and 2007, a
significant difference becomes apparent: 1.7 for the euro area vs. 2.9 for the US. By adding
the contribution of hours worked (0.5 vs. 0.6) one gets the growth rate of output (2.2 vs. 3.5).
The main explanations for this difference are ICT capital services per hour (0.4 in the euro
area vs. 1.0 in the US) and economy-wide TFP (0.5 vs. 1.1).
Analyzing the sectoral decomposition of TFP growth, it can be stated that TFP in the
production of goods is slightly larger in the euro area than in the US. Rather, the higher
overall TFP growth in the US is driven by stronger TFP growth in services, in particular in
distributive trade (0.2 vs. 0.5).
For good order, one should not forget that productivity and technical progress in general and
in Services in particular are subject to measurement difficulties. TFP figures - being a
residual - can only represent a rough metric. Thus, the TFP contribution can be plagued by
measurement errors, erroneous assumptions about market structure, or the nature and
existence of the aggregative production function. The residual will also be a catch-all of
neglected factor utilization, factor quality improvements over time, statistical complications
associated in calculating factor rewards (appropriate tax and depreciation allowance for
capital income etc).2
In a nut shell: the main difference between the measured growth differences in the euro area
and the US are attributed to the difficulties to assess differences in the technological
progress of ICT services.
Employment
Having identified the limited explanatory power of growth statistics to compare mature
economies with rather similar per capita growth rates, one might preferably rather look at the
development in labor markets to gain some information about the economic dynamism.
Between 1999 and 2011, the euro area has created 14 million jobs. During the same period
of time, 8 million jobs have been created in the US.
Heterogeneity within the currency area
Contrary to common belief, the heterogeneity within the euro area is not significantly bigger
than between US states. Although it is very common to distinguish between the countries of
the euro area and focus on the diversity among individual member states, this exercise is
rarely done for the US. In fact, however, the dispersion of many key economic indicators is
very similar. Let me provide some detail on the heterogeneity within the respective currency
areas.
Before the crisis, the dispersion of inflation in euro area countries had remained broadly
stable since the late 1990s. The level was similar to the 14 US Metropolitan Statistical Areas.
During the crisis a temporary increase in inflation dispersion in the euro area was observed.
This development has been reversed over the past 12 months, however.
In the same vein, the dispersion of GDP growth is quite similar on either side of the Atlantic.
Before the crisis the dispersion of growth rates was around 2 percent, in both the euro area
and the US. Dispersion increased somewhat during the crisis in both currency areas but
remained broadly in line with pre-crisis patterns.
Moreover, in both currency areas there are comparable patterns in the dispersion and
developments of competitiveness. In the US as well as in the euro area, regions can be
found with persistently above or below average unit labour cost growth - a good measure of
competitiveness. In the euro area, Greece, Portugal and Ireland, in particular, had
progressively lost competitiveness. They are now trying to catch-up by implementing
adjustment strategies. Germany, by contrast, had lost competitiveness in the reunification
process but has managed to regain competitiveness over the same period of time.
Looking at the most and least competitive states in the US states over the same period of
time, we see that some states have suffered from large or persistent increases in unit labour
costs. Some still exceed the national average by 20 percent. Other US states have been
improving their competitiveness compared to the national average over the past decade.
Public finance, household savings and trade
On a consolidated base public finances in the Euro are in a much better shape than in the
US. The euro area as a whole will run a budget deficit of about 4.5 percent of gross domestic
product this year. The International Monetary Fund (IMF) expects a US budget shortfall of
about 10 percent of GDP this year.
The UK government expects for this fiscal year to meet its deficit target of 7.9 percent of
GDP, down from 9.3 percent of GDP in the previous one ending in April 2011. The budget
forecasts however are based on the assumption that the economy will grow 1.7 percent in
2011 - in spite of economists' recent forecasts of around 1.0 percent.
According to the IMF the aggregate debt-to-GDP for the euro area stands at 87 percent.
Figures for the UK are similar. For the US the debt-to-GDP ratio in 2011 is expected to be
100 percent. In Japan debt-to-GDP exceeds 200 percent.
As far as private households' financial positions are concerned the euro area is in the best
position of all major currency areas. In 2010 gross savings as a fraction of households'
disposable income stood at roughly 14 percent in the euro area, 8.6 percent in the US, and
5.4 percent in the UK.
Trade within the euro area and the EU is flourishing as well as the exchange of goods and
services with the rest of the world. The euro area is the most open major economy in the
world. In 2011, exports of goods and services from the euro area stood at 22.7 percent of
GDP compared to 12.6 percent of GDP in the US.
The current account in the euro area is broadly in balance (-0.4 percent of GDP in 2010). For
this year the IMF forecasts a current account deficit of 3 percent for the US.
Optimum currency areas: basic considerations
The above mentioned figures are publicly available. They are well known to scholars and
market participants. Why then, one may ask, are markets still so suspicious against the euro
area? Why is there a talk of a sovereign debt crisis in the euro area rather than in the US or
the UK? And why has the epicenter of financial markets turmoil moved from the US to the
euro area.
Before I try to answer these questions in greater detail, let us recall some of the basic
considerations of optimal currency areas.
When countries or states participate in a currency union they abolish their nominal exchange
rate. By doing so they sacrifice a hitherto important means of adjustment vis-à-vis the other
countries or states participating in the currency area. 50 years ago Nobel Prize laureate
Robert Mundell argued that adjustment to economic shocks has to occur via other channels.
Mundell and other protagonists of the Optimum Currency Area theory highlighted three major
channels for adjustment in a monetary union in the absence of internal nominal exchange
rate flexibility:
- First, price flexibility can help countries or states to overcome economic shocks by
adjusting wages and reducing relative prices in order to rebuild competitiveness.
- Second, cross-border factor mobility - in particular on labour markets - can foster
adjustments to shocks as employees from anemic economies move to the healthier
ones until the former regain competitiveness and growth.
- Third, funds may flow from the more prosperous countries or states to the weaker
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ones via fiscal transfers.
While the first two adjustments channels clearly help to approach a new equilibrium in the
aftermath of an asymmetric shock, the third one could only temporarily dampen the burden of
adjustment and play a stabilizing role. In the long run, however, fiscal transfers would set the
wrong incentives insofar as internal pressure for adjustment would be weakened and free
rider behavior encouraged. By consequence, in a currency area it is essential that the
participating members have sound public finances beforehand to reduce the vulnerability
against asymmetric shocks and the need for temporary financial aid.
From theory to practice: a currency without a state
Let me move from the conceptual considerations of the theory of Optimum Currency Area
back to reality. The key challenge for a currency area is how to organize the incentive
structure and the adjustment channels of a currency union which lacks the flexibility of
nominal exchange rates.
Comparing the two major currency areas - the euro area and the US - the major difference
is clear: The US, being a fully fledged sovereign state has a central government. The
organizations of relevant policies and decisions are to a large extent federal and, therefore,
uniform at the central level of the federation.
The euro area by contrast is an alliance of sovereign countries with most of the relevant
political decisions - including public finance - being taken by national governments.
There is a risk embedded in the constellation of the euro area: moral hazard can arise when
fiscal profligacy of one single member state is averaged out by the virtuous behavior of the
majority of the other countries. Such an incentive structure would be flawed because it could
lead to unsustainable fiscal policies of individual member states which in turn would generate
negative spill over effects to the monetary union as a whole.
The run-up to the single currency
The intellectual architects of the single currency were aware that the management of a single
currency in a union of sovereign states would be challenging. Instead of a single government
effective rules were required to safeguard the credibility of the currency.
Although the vision of a single European currency is an ancient idea going back as far as to
the Roman Empire, the idea of a common European currency in recent history gained
momentum in the late 1960s. Luxembourg's Prime Minister Pierre Werner, also Minister of
Finance, was asked to steer a Committee mandated to design the path to an increased
economic and monetary integration of the six then members of the European Economic
Community. That report, finished on the 8 October 1970, was sent to the Ministers of
Finance in the first instance, laid down the achievement of Economic and Monetary Union by
1980.
The Werner report proposed the inception of an independent institution for fiscal monitoring
and coordination. This idea clearly reflected that a single monetary policy would need
support from sound public finances. More concretely, the Werner report called for closer
economic policy coordination with an agreed framework for national budgetary policies.
At the institutional level, it suggested a "centre of decision for economic policy". This
coordination body for economic policies should have been established alongside the
European system of central banks, i.e. the monetary authority. Both institutions were to be
independent from the national governments, being politically accountable only to a European
Parliament. This independent economic authority should have influenced the national
budgets with a focus on the level and the direction of the balances as well as the financing of
deficits and the use of surpluses, respectively.
In the next major attempt to design a single European currency, the Delors report in 1989,
the insight that sound fiscal policies would be necessary to safeguard the credibility of the
common money was still vivid. That blueprint named after the President of the European
Economic and Monetary Union
Commission at that time, Jacques Delors, stated that "an
could only operate on the basis of mutually consistent and sound behaviour by governments
and other economic agents in all member countries. (...) Uncoordinated and divergent
national budgetary policies would undermine monetary stability and generate imbalances in
the real and financial sectors of the community."
Almost exactly 20 years ago, the Maastricht Treaty was drafted by the European Council on
9/10 December 1991 in the Dutch city of Maastricht. It founded the European Union and led
to the creation of the single European currency and to provide a framework of lose policy
coordination.
At the very core of that framework the no-bail-out clause and the Stability and Growth Pact
(SGP) were installed. The first should have excluded free rider incentives and the second
should have aligned national fiscal policies to prevent negative spill over effects to the
currency union as a whole.
The SGP was a compromise of quantifying fiscal soundness without interfering with the
budgetary and fiscal policies of sovereign states. It aimed to maintain fiscal discipline within
EMU. Member states adopting the euro had to meet the Maastricht convergence criteria, and
the SGP should make sure that they continue to observe them. The compromise was also
characterized by the strong belief that governments would be reactive to market discipline.
However there was a lack of political will to commit to sustained stability-oriented fiscal
policy. The weak commitment was evident when the Stability and Growth Pact was watered
down under the pressure of France and Germany in 2003. Moreover, the rule book failed to
consider the possibility of a financial crisis in the euro area leaving an institutional vacuum for
crisis resolution.
Painful lessons from the Great Financial Crisis
The global financial crisis with its consecutive phases has disclosed the weaknesses of that
institutional set up and the overestimated belief in market discipline. Originally, the financial
crisis erupted in August 2007with the epicenter at the US subprime mortgages markets. It
deteriorated dramatically in September 2008 when the US investment bank Lehman Brothers
collapsed. And it triggered the sovereign debt crisis in the euro area in spring 2010.
The pre-crisis situation of public finances differed in the various countries of the euro zone,
sometimes significantly. Regardless of whether private debt has been socialized or the
problem was from the beginning in public finances itself, the outcome was a drastic increase
in the public debt burden. The financial aid packages for stressed banks and fiscal and social
stimulus programs to combat the recession disclosed painfully the limits of the financial
capacity in some countries.
With hindsight we have to acknowledge that in some countries fiscal profligacy, weaknesses
in the banking sector and deteriorating competitiveness have been observed. The
institutional setup could neither prevent nor resolve a severe crisis of the magnitude that we
are currently experiencing. Where the instruments and procedures were available, they were
not implemented, ignored, or watered down.
Flaws in the Maastricht Treaty
With today's knowledge and experience let me highlight just two major weaknesses in the
Maastricht Treaty: It was based on a flawed economic paradigm and it did not foresee
geopolitical developments before and after the introduction of the single currency.
1. Overestimation of free markets
The spirit of the Stability and Growth Pact was also characterized by a strong belief in the
power of free markets to discipline governments. This belief reflected the prevailing paradigm
in economics at that time. But the global financial crisis has undoubtedly marked a turning
point also in that context.
The financial crisis has put the legitimacy of absolutely free financial markets into question.
At the same time, the concept of market economies is challenged in many places, and the
voices calling for the state are getting louder. The pendulum strikes back.
There is a clear risk that the well founded desire for improved regulation leads to a too tight
corset that ultimately might strangulate market dynamics. It would be misleading to assume
that partial market or regulatory failure in the past means that the government would always
provide superior solutions by governments.
Excessive faith in the state as well as a sprawling public sector lead in the long run into
servitude, as argued by the Austrian economist Friedrich August von Hayek and proved by
the communist movements of the previous century. Only in the market economy, freedom
and wealth come together. However, also those err who rely alone on the self-regulation of
markets.
The challenge is to find the right balance between market and state, to define reasonable
rules set by the state to generate the greatest possible freedom for sustained prosperity to
the benefit of the society.
In less general terms it is worth recalling how financial markets have been assessing the
creditworthiness of sovereigns within the euro area. Countries with weaker positions which
introduced the Euro could refinance themselves roughly at the same cost as the most solvent
states. Spreads, if existing, were very narrow, even between Greece and Germany. Financial
markets were irrationally optimistic.
Today, markets seem to be irrationally pessimistic. Even wealthy states with sound economic
fundamentals are in trouble to refinance themselves at reasonable conditions. Recently, for
instance, Italian sovereign funding costs were driven above 5 percent. The UK by contrast
funds itself at 1.6 per cent - although Italy and the UK are two countries of roughly the same
size, wealth and income. While the Italian public debt with some 119 percent of GDP is larger
than that of the UK (80 percent of GDP), the Italian private sector has much stronger balance
sheets than the UK private sector. This means that the Italian government has stronger
private wealth for potential future taxation than the UK. Moreover, the consolidation plans of
the Italian government are far more ambitious that the British ones.
Some argue that growth prospects for the UK are more promising as its central bank could
depreciate its own currency by a very lax monetary policy. By doing so, future growth and tax
revenues would be boosted. The problem is, however, that the UK economy heavily relies on
a huge non-exporting service sector (while in Italy manufacturing plays a bigger role), which
does not profit from a weaker currency. Indeed, exports in the UK have failed to recover in
spite of the great sterling depreciation. By contrast, since the end of 2007, the British GDP
has contracted cumulatively by 3.4 per cent. Moreover, depreciation comes at huge costs:
The weaker sterling has made the UK's people poorer in real terms through higher inflation.
In 2007, the average UK citizen was 30 percent richer than the average Italian; now they are
just 5 percent richer.4
2. Geopolitical changes
The Maastricht Treaty was signed on 7 February 1992 by the members of the European
Community by the six original members of the community - Belgium, France, Italy,
Luxembourg, the Netherlands, and West Germany - and those six countries who had joined
the EC later, namely Denmark, Ireland, the UK, Greece, Portugal and Spain.
Amid the various enlargement steps of the EU and the euro area several problems have
emerged, some of which are interrelated.
First, economically, the situation of those countries that joined the EU later differed
sometimes greatly from the original core. That holds particularly true for those countries that
entered the EU after the breakdown of the Berlin Wall and the communist bloc. Laggard
countries while catching up in their productivities in traded goods' sectors tend to suffer from
higher inflation rates because within the service sector productivity growth rates are
restricted but wages still catch up (Balassa-Samuelson hypothesis)5. This, of course, poses
a potential threat to a currency union with the aim of a stable price level.
Second, an institutional problem is the indirect result of these developments. The intellectual
architects of the euro area assumed the member states of the currency area were basically
the same who constituted the European Union. Only one institution on the union level - the
Commission - would then have been necessary to represent the EU and to be in charge of
the currency area's rule book. Today, the EU comprises 27 countries, the euro area only 17.
However, with the exception of the field of monetary policy the euro area still lacks a true
institution on its own with competencies on the community level.
A lot has been achieved - responses within the existing Treaty
The sovereign debt crisis has revealed that the euro area suffered from serious weaknesses
in the fields of financial, fiscal and economic governance on the preventive side and had
lacked a crisis resolution mechanism.
But the current crisis has also been recognized as an opportunity to repair the institutional
shortcomings of the "currency without a state". Europe has always made its greatest steps
forward in times of crisis mirroring the words of Jean Monnet: "People may accept change
when they are faced with necessity, and only recognize necessity when a crisis is upon
them."
And indeed, Europe has already undertaken major steps to tackle the identified weaknesses
within the existing Treaty.
1. In the absence of a nominal exchange rate the alignment of national fiscal policies
and the prevention of imbalances via rules is a necessary condition to support the
credibility of the single currency. The recent agreement reached by the European
Parliament and the Council on the "Six Pack" is a step in the right direction. The
Stability and Growth Pact has been strengthened; imbalances and competitiveness
will be monitored at an earlier stage.
2. Since the beginning of this year, the European Systemic Risk Board and the
European Supervisory Authorities are operationally. These truly European bodies
are responsible for providing the incentives to avoid excessive risk taking in the
financial industry and to promote a level playing field in support of beneficial
financial integration within the euro area.
3. A crisis mechanism has been set up and is still being improved. Countries with
stressed liquidity positions which are subject to market attacks receive financial aid
from the Luxembourg based European Financial Stability Facility (EFSF). This
support should allow them to return to a sustainable level of debt and regain
competiveness as soon as possible.
4. In order to eliminate any doubts on the sufficient fire power of the EFSF,
governments of the euro area Member States plan to provide appropriate leveraging
of the fund. The EFSF will operationally be allowed to intervene in the primary and
secondary markets as soon as possible to tackle fundamentally unfounded
distortions in the sovereign bonds markets. These distortions hamper the smooth
functioning of the single monetary policy stance.
Within the given framework, the implementation gap must be closed to resolve the
confidence crisis that the euro area currently faces. Most of the above mentioned proposals
have been decided already. As soon as possible the new governance rules must be applied
completely and rigorously.
Moreover, as stated earlier, factor mobility in particular on labour markets is an important
adjustment mechanism. Labour mobility within the euro area works rather smoothly at the
lower and higher skill ends. But the high share of closed public service in Europe,
nonportability of pension rights, rigid labour laws and cultural differences make labour mobility a
slow process. Additionally a further improvement of the Single Market - including markets for
products and services - is important for fast and market-based adjustment in case of shocks.
... but challenges remain beyond today's Treaty
Challenges remain, however. They refer to the institutional framework of the euro area to
safeguard the own life of a currency union within a common market to further proceed in the
direction of an Optimum Currency Area.
In the medium to long run, we will need an institution that is solely responsible for the euro
zone.
Remembering core elements of the Werner Plan, a single monetary policy needs support
from sound public finances and closer economic policy coordination with an agreed
framework for national budgetary policies. This could be realized by either be a European
Commissioner with special authority or a finance minister (not necessarily with a huge
budget), as it has been suggested by outgoing ECB President Jean-Claude Trichet, or
another, ideally independent body that makes sure that national policies do not generate
negative spill over effects which jeopardize the currency union as a whole. But in any case,
the institutional vacuum that currently exists must be filled.
I am confident that Europe can also overcome these challenges. There can be no doubt,
however, that current and future steps for further European integration will be accompanied
by a credible and stable Euro that deserves the faith of financial markets, international
investors and - last but not least - the more than 320 million citizens of the euro area.
Ladies and gentlemen, thank you for your attention.