A H E M Wellink: Heterogeneity in Europe and the role of monetary policy
Opening address by Dr A H E M Wellink, President of the Nederlandsche Bank, at the
CEPR/European Summer Institute conference, held in Amsterdam, on 15 September 2000.
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Introduction
It is a pleasure to be here to give the opening address to this conference and to welcome you to
Amsterdam. After only a couple of years, this annual conference has established a reputation for
stimulating discussion on economic policy issues in Europe. This year's programme looks set to
further enhance your reputation.
Issues of heterogeneity were the subject of much debate and analysis in the run-up to the introduction
of the euro. The debate has continued since then, too, and this conference will no doubt provide fresh
insights into the issue. Enlargement is also on the conference agenda. Obviously enlargement will
have implications for current EU members, as well as for accession countries. Further, there are links
between enlargement and heterogeneity.
This afternoon I would like to talk a little about heterogeneity in the euro area, and its implications for
policymakers. I would also like to look forward and discuss these issues in the context of EU and
EMU enlargement.
Heterogeneity
First, some thoughts about heterogeneity. We are used to thinking about heterogeneity mainly in terms
of nation states. We focus on differences between countries. Of course, it is not only when discussing
economic policies that we think about national differences. We also highlight differences in other
areas - the Netherlands was a mass of colour from supporters of different countries earlier this
summer during the European soccer championships. And, the Sydney Olympics provide an
opportunity to celebrate national achievement, as well as individual sporting excellence.
Traditionally, monetary policy has also been conducted on a national basis, although European
monetary policy did become more coordinated in the run-up to the introduction of the euro. Other
economic policies have generally continued to be set on a national basis, although EU membership
does impose some degree of consistency. Heterogeneity also occurs on other dimensions, such as
between sectors of the economy. I will return to that point in a minute, but first want to make a couple
of comments about country differences.
There have been many studies in recent years focussing on differences between euro area countries.
And, while a few studies find evidence to the contrary, there appears to be a general consensus that
business cycles have converged to some extent over the past decade or two. As a central banker, I am
naturally interested in inflation differentials, and these are certainly lower now than they were
10 or 20 years ago. For example, inflation rates among current euro area members ranged from 21% in
Italy to 5% in Germany in the last quarter of 1980. By the second quarter of this year the range was
only 31⁄2 percentage points.
Naturally, divergences do remain, and these reflect a number of factors. Some divergence is due to a
process of convergence as countries catch up to euro area averages, the well-known
Balassa-Samuelson effect. This effect explains how productivity growth during a catch-up process can
result in higher inflation without undermining competitiveness. Country-specific policies, including
fiscal policy and regulation, also result in divergences. Finally, countries have different industrial or
sectoral concentrations. Differences in the economic performance of various sectors will therefore be
reflected in cross-country divergences.
These factors are not going to disappear immediately, but may diminish as price and income levels
converge and through continued deepening of the internal market. However, we cannot be sure how
rapidly they will diminish, nor can we be certain what level of divergence will be normal in the long
run. In addition, the process of convergence will not necessarily be continuous. For example, inflation
differentials have widened a little over the last year or two, although they remain much smaller than
they were a decade ago.
For small areas within a monetary union, a common monetary policy does have some specific
implications. Small countries have little influence on the euro area inflation rate, which is a weighted
average of national inflation rates. If inflation rates in those small countries diverge from the euro area
average, that has relatively little impact on the overall monetary policy stance for the euro area.
Consequently, it is possible for smaller countries to temporarily have growth rates and inflation rates
that differ from those that would result from a national monetary policy aimed at maintaining price
stability at the country level. Large countries could also be in this position. If inflation is well above
the euro area average in one country, but below it in another, monetary policy may not contribute to
narrowing the divergences. Where such divergences are not the result of catching-up processes,
national economic cycles could potentially become more pronounced. Some euro area countries are
arguably in this position now, or heading towards it. The Netherlands is one of those countries. Of
course, such a deviation can also occur in the other direction, with inflation and output growth rates
remaining lower for longer than would occur with a national monetary policy. This can lead to
long-lasting social and economic costs if there are factors inhibiting a smooth adjustment process. I
will return to this issue shortly.
As I mentioned earlier, heterogeneity occurs across several dimensions. In addition to country
differences, there are also differences in economic performance between sectors in the economy. As
the internal market continues to deepen, there may be fewer regulatory differences between countries
and the Stability and Growth Pact constrains national fiscal policy. It seems likely that cross-country
divergences will increasingly reflect exposures that countries have to various sectors. Thinking about
heterogeneity at a sectoral level might therefore be more insightful for the euro area than focussing
solely on cross-country comparisons.
Consider trends in inflation. The Eurosystem has defined price stability as a positive inflation rate
below 2% over the medium term. The definition recognises the fact that at times inflation may
temporarily move outside that target range. That is currently occurring as a result of higher oil prices
which are a kind of sectoral shock. The weak exchange rate is also contributing to higher prices. The
most recent HICP inflation rate shows that euro area consumer prices increased by 2.4% in the year to
July. Almost half of that increase is due to higher energy prices. Naturally, cross-country inflation
differences remain, and are relevant. However, these cross-country differences are themselves affected
by higher oil prices, reflecting the fact that energy intensity and energy taxation vary between
countries. In the current circumstances, analysing relative price trends can help in assessing whether
inflation is confined to specific sectors, or whether it is leading to more generalised inflation.
Implications for policy
So we have heterogeneity across several dimensions. What does that mean for policy, and why should
policy makers be concerned about divergences? Let me focus on price divergences. In a market
economy, relative prices play an important role. And, relative prices include not only the prices of
different goods and services within a country, but also the prices of the same goods and services in
different countries. These relative price changes provide the signals to ensure that changes in
preferences or technology flow through to changes in resource allocation. In theory, therefore, relative
price movements are welfare enhancing and not something that we should be concerned about. In
practice, the world is not so simple and markets are not perfectly competitive. Relative price
movements do not always occur freely, and adjustments to changes in preferences or technology can
be costly.
Monetary policy cannot and should not influence relative prices within the euro area to offset
divergences between sectors or countries. Those relative prices are determined by real factors. Instead,
the best contribution that monetary policy can make to society's welfare is to stabilise the general euro
area price level. That reduces the noise in relative price changes, and therefore improves the workings
of the price mechanism.
Nonetheless, central bankers do monitor divergences. Why do we monitor divergences if there is
nothing we can do about them? First, our knowledge of the monetary transmission mechanism is
incomplete. Information about the various parts of the economy, including divergences, adds to our
knowledge of the economy as a whole. We are particularly conscious of this in the euro area where we
are still in the process of developing and enhancing indicators for the euro area as a whole. The second
reason for our interest is that regional or sectoral differences in economic performance can provide
early signals of area-wide developments, as US experience has shown.
If monetary policy cannot and should not react to divergences, what about other policy areas? As I
mentioned earlier, allowing relative price changes to occur is often the best approach, so that resources
are allocated to their most effective uses. Accordingly, structural reforms that allow the relative price
mechanism to operate are generally sensible. And, hearing central bankers call for structural reforms is
nothing new! My colleagues and I on the ECB Governing Council have been regularly calling for
further structural reform. For example, labour market reform that stimulates the movement of labour
around the euro area is likely to reduce euro area unemployment overall, as well as reducing disparity
in prices, wages and unemployment rates between regions. Central bankers in other countries make
similar points.
Another approach would be to use fiscal policy to try and dampen national divergences. However,
given the planning and implementation lags, it is not easy to use fiscal policy in a counter-cyclical
manner. In addition, the main objective of fiscal policy is not normally to reduce cross-country or
cross-sector divergences. Even though fiscal policy is normally formulated within a multi-year
framework, elements of discretion remain. Any discretion should be used to reduce, rather than
increase, cross-country divergences in inflation. Fiscal policy should also be in a sustainable position
so that automatic stabilisers can operate fully. At times it may even be appropriate for fiscal policy to
seek to offset divergences. It is certainly the case that there is little to be gained from discretionary
pro-cyclical policies. Rather, economic cycles could become more pronounced, resulting in costly
adjustment taking place in downturns.
The point I made earlier about small countries is relevant here. Euro area monetary policy is not
significantly influenced by the inflation rate of a small country. It is therefore important for small
countries to have the flexibility in other policy areas to offset inflation. Of course, large countries
would also gain if they undertook structural reform and avoided pro-cyclical fiscal policy. And there
could be times when it is appropriate for large countries to use national policies to offset divergences. I
would merely make the point that the costs of not being flexible might be greater for small countries in
the event of a downturn.
Monetary policy after enlargement
I would also like to briefly discuss how these issues apply to enlargement. First, the points made
regarding small countries currently in the euro area apply with even greater force to accession
countries. Given the relative size of accession countries, monetary policy for the enlarged euro area
will be little influenced by their inflation rates. Accession countries are in general less converged in
real terms than the initial EMU members were when monetary union began. This is true when
measured on the basis of GDP per capita, and when adjustments are made for differences in
purchasing power. Real convergence may therefore take a considerable period of time. Ongoing
convergence, EU membership, and eventually adoption of the euro, could all result in economic
shocks that mean monetary policy requirements in an accession country differ from those in the euro
area as a whole. Given these factors, the extent of the difference in monetary policy requirements
could be greater or more protracted than is the case for small countries currently in EMU. To minimise
the economic and social impact of divergences, it is important that accession countries have flexible
economies, sound financial systems, a solid fiscal position, and a well-developed institutional
framework. Arguably, accession will therefore have greater consequences for countries now than was
the case previously, in the sense that they are less converged in real and institutional terms than initial
EMU members. A cautious approach to the adoption of the euro therefore appears appropriate, as
premature adoption could prove costly.
Second, monetary policy within the EMU will continue to focus on area-wide conditions. Obviously,
that area will be larger following enlargement. One of the important issues for us will be to ensure that
the indicators we use in our monetary policy deliberations are based on developments across the
enlarged area. Our data requirements will expand accordingly. We will also need to learn how the
monetary policy transmission mechanism works across the new area. I expect that the national central
banks from the accession countries will have an important role to play here in helping us understand
the workings of the enlarged euro area.
Conclusion
Despite having given some warnings about the consequences of divergences, I would like to conclude
on an optimistic note. Yes there are differences within the euro area. But the differences do not create
problems for euro area monetary policy. The overall gains from membership certainly outweigh the
costs. I am confident the same will apply for accession countries. What the divergences do teach us is
that other policies must play their part if we are to maximise the gains from a common monetary
policy. That is particularly important for small countries.
Thank you for your attention. I would like to repeat my welcome to you, and wish you well for the
remainder of the conference. I am sure that it will be both stimulating and fruitful.