You can't always get what you want, but after
25 years of EMU, we just might find we get
what we need

Date: 9 November 2023
Speaker: Klaas Knot
Location:Bruegel and DNB conference on the future of the EMU

Good morning everyone, welcome to the joint Bruegel and DNB conference on the future of the
EMU. It is not often that I get to discuss these important matters with such a broad range of experts.
In my speech today, we will dive into the functioning of the EMU, now almost 25 years old. I will
discuss three conditions for its well-being as well as three suggestions for the way forward. My
contribution today also contains some sweet sounds of heaven, hence I would like you to listen
carefully.

But first, let's recall why we have the Economic and Monetary Union. After all, having a common
currency is not an end in itself. I like to think that an important reason to share a common currency
is to achieve a strengthening and convergence of our economies. This should lead to deeper
economic ties, contributing to greater prosperity and stability for all in Europe. Economic and
political stability, but I will focus on the former.

The question then is, did the EMU deliver on bringing greater economic prosperity and stability in
Europe? When looking at the union as a whole, my answer would be: yes. The EMU anchored its
members more firmly in the European project, and facilitated the deepening of the internal market.
One supporting piece of evidence comes from the estimated impact of the EMU on trade. [Figure
1] Arecent DNB study suggests significant trade benefits from EMU-membership. These positive
effects appear not only for trade between EMU countries but also for exports to other EU countries
and perhaps surprisingly - even for exports to the rest of the world.

1. EMU membership has a positive estimated impact
on EMU export

NO
a
7

15,7
15 I °

12,0
10 +

Percentage point change compared to
counterfactual of not joining EMU
e

To other EMU To non-euro EU To rest of the world

Notes: Figure shows point estimates and 95% confidence intervals based on robust standard erros (clustered by country-pair). The rest of
the world includes BRICS countries and the OECD countries that are not part of the EU. Source: Soons and van Overbeek (2023).

But we cannot reflect on 25 years of the EMU without acknowledging that there have been times
when the EMU, as initially designed, could give us no satisfaction. While the EMU appeared to be
a success in its first decade, major challenges emerged during and after the Global Financial Crisis.
Fixing these design flaws ex-post has proven to be difficult and costly, both in economic and
political terms. Many of you here in the room today have experienced this firsthand.

In the aftermath of the Global Financial Crisis and the sovereign debt crisis, remarkable measures
were taken that once had seemed out of the question. We now have common banking supervision
and a single resolution fund. We have the ESM as an emergency fund. And we even agreed on
common borrowing to fund the Next Generation EU recovery program.

The euro area has weathered the storms of two more recent crises, COVID and the increase in
energy prices following Russia's invasion of Ukraine. This leads me to believe there is room for
cautious optimism, but not for complacency. Because if we zoom in on the goal of "contributing to
greater prosperity and stability for all", the picture is, I'm afraid, mixed.

I will delve deeper into how the EMU can contribute to prosperity and stability for all by focusing
on three conditions that, in my view, are crucial for a well-functioning economic and monetary
union. Conditions that are intimately linked. First, and particularly relevant for me as a central
banker, price stability. Second, economic convergence. And finally, sound public finances.

Price stability

The costs of runaway inflation are well known. It goes without saying that, for the past two years,
inflation shocks have been hitting us like a bunch of wild horses, pushing up price growth to levels
that we haven't seen since the '70s. These developments stand in sharp contrast to the pre-COVID
period, during which the euro area struggled with stubbornly /ow inflation for years. Confronted
with the effective lower bound on nominal interest rates, the ECB went to unprecedented lengths to
maintain price stability.

Looking back and looking ahead, I believe there is room for improvement. Both in the low inflation
environment and in the recent high inflation years, the balance between monetary and fiscal policy
has been far from ideal. [Figure 2] Let me illustrate this using this figure, that displays aggregate
monetary and fiscal policy in the euro area. A balanced policy mix implies that monetary and fiscal
policy move in tandem, meaning they are both more restrictive during a boom and both more
accommodative during a crisis. But during the sovereign debt crisis, when inflation was stubbornly
low, this was clearly not the case. We saw substantial fiscal consolidation at the aggregate level,
while monetary policy had become more accommodative to ensure price stability. Fiscal and
monetary policy were only aligned during the COVID pandemic.

2. Monetary and fiscal policy in the euro area did not always move
in tandem

ex Cyclically adjusted balance eee Policy rate (left axis)

4 GFC Debt Crisis coviD 4
&
2 I 78
°
& °
$0 0
g 8
5 g
2+ -2 =
§ -2 a
a ®
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eS S158 SSesetesr Skee Seas g
oOo © Oo Oso 2 8G 20 C2 O28 f& & O&O 82: 2 Oo ©&
NNN NN NN NNN N NN NNN NN NN

Source: AMECO database and ECB data portal.

One could say: so what? Monetary and fiscal policy pursue different goals, and at least in the euro
area, are determined by different actors on different decision-making levels. But that would ignore
the fact that a balanced policy mix matters for macroeconomic outcomes. It has been well-
documented that expansionary fiscal policy in particular has stronger positive effects on output in
times when the effective lower bound is binding (Note 1). Therefore, if the policy mix had been
more balanced in the aftermath of the sovereign debt crisis, the euro area might have experienced
better economic outcomes. Not only in terms of price stability, but also in terms of employment.
You could say that in those years, monetary policy was waiting on a friend to help improve
economic conditions. Today, we see risks of the opposite, with a still accommodative fiscal policy
counteracting the efforts of a more restrictive monetary policy.

Economic convergence

So first of all, delivering price stability, but also promoting growth and employment, would benefit
from a more balanced policy mix in the EMU. I will now move to the second condition: economic
convergence. Or better perhaps, at a minimum: the absence of divergence. Divergent economic
developments between member states make it more difficult to set an appropriate single monetary
policy. Divergence can also become a political problem, if the idea takes root that not all countries
benefit from the common currency to the same degree, or even at all. [Figure 3] Unfortunately,
when we look at the data we observe episodes of significant divergence in terms of growth between
member states, particularly in the aftermath of the Global Financial Crisis.

3. Economic paths diverged across member states

ee Higher initial GDP per capita (DE, AT, Fl, NL)
==-=(ower initial GDP per capita (IT, ES, EL, PT)
140

135
130
125
120
115
110
105
100
FSP OFF FFP Foe og Grp og i pr ge ge pop high og
Source: AMECO database.

During the first decade of the EMU, we witnessed substantial capital flows from countries that had
a relatively high level of income at its inception, to some other member states that were catching
up. At the time this did not raise major concerns. After all, basic economic theory tells us that
capital tends to flow towards regions where expected growth is highest. And, as shown in the
figure, countries with a relatively low GDP per capita at the EMU's inception grew relatively fast.

But there was more going on. [Figure 4.] These capital flows also coincided with a spectacular
suppression of bond yield spreads. In some member states, this reduction in borrowing costs helped
finance a real estate investment boom, rather than productive capital formation. This led to an
increase in current account deficits and external debt. And in some cases, this boom translated into
higher wages in the non-tradable sector, stagnating productivity and a persistent real exchange rate
appreciation with respect to the rest of the EMU (Note 2). In other words, the apparent convergence
observed during the early stages of the EMU was partially fueled by external debt and led to the
build-up of macroeconomic imbalances.

4. Widening current account balances coincided
with divergent real interest rates

m= Long-term real interest rate (%) Current account balance (% of GDP)

Estonia
Portugal
Ireland
Spain
Luxembourg
Cyprus

Italy
Belgium
France
Finland
Netherlands
Austria
Germany I

4 4 J

-15 -10 -5 0 5 10
Percentage point change between 1995 and 2006

Source: AMECO database and IMF World Economic Outlook Database.

If you start it up, you will never stop, according to Mick Jagger. It turns out this is not always the
case. When the Global Financial Crisis and subsequently the sovereign debt crisis hit, it became
clear that these macroeconomic imbalances were not sustainable and that cross-border capital flows
could easily reverse. Such sudden stops resulted in a disorderly unwinding of imbalances, revealing
the fragility of the EMU. This adjustment turned out to be a slow and painful process that caused
the growth paths of member states to persistently diverge.

But what hindered the economic adjustment process after the Global Financial Crisis? Before
adopting the euro, countries with lower productivity growth and higher inflation were able to
remain competitive through a depreciation of their nominal exchange rate. Take Italy for example.
Between 1973 and 1999, the Italian lira depreciated by almost 80% vis-a-vis the Deutsche mark. In
the EMU, nominal exchange rate adjustment at the country level is of course no longer possible.
This implies that changes in wages, productivity, prices and thus the rea/ exchange rate become the
sole means of improving international competitiveness. But it can take a long time for such real
exchange rate adjustments to take place. This is because of nominal rigidities or frictions in labor
and capital markets that impede price adjustments.

Conversely, and for the same reasons, the slow adjustment of the real exchange rate helps to
prolong the competitive edge of countries with relatively high productivity growth. [Figure 5] The
DNB study that I mentioned earlier indeed finds that the exports of those countries with a relatively
high level of income at the start of the EMU benefitted significantly more from EMU membership
than countries with a lower level of income (Note 3). To me, it seems no coincidence that those
countries that benefitted less are also those countries that, before the EMU, relied more on nominal
exchange rate adjustments to remain competitive.

5. Country-specific estimated impact of EMU membership
on export values

= 90

= Countries with higher initial Countries with lower initial
F om GDP per capita GDP per capita
=

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om

ze I

8 50

$2

gry

g2 ° we

a 7 eee

i=

oO

S

= 10

DoD

&

3

S -30

& NL AT DE FI IT ES EL PT

Note: Figure shows point estimates and 95% confidence intervals based on robust standard erros (clustered by country-pair). It is sorted by
GDP per capita at the start of the euro. Source: Soons and van Overbeek (2023).

So, all in all, the EMU has not always delivered on the prospect of economic convergence. In fact,
the EMU may at times have seemed a beast of burden to some member states whose growth rates
remained persistently below those of others and who were burdened by rigid real exchange rates.

Sound public finances

Economic divergence also has important consequences for public finances. This naturally brings
me to the final necessary condition for a prosperous EMU: sound public finances.

Sound public finances are another prerequisite for the stability of a monetary union. Threats to
fiscal sustainability could weaken the central bank's ability to maintain price stability, could spill
over from one member state to others, and could trigger financial stability risks. Today, in some
member states, we observe very high government debt-to-GDP ratios, which naturally fuel
concerns about fiscal sustainability.

6. Economic growth matters for public debt dynamics
errs Higher initial GDP per capita (DE, AT, Fl, NL)
== I ower initial GDP per capita (IT, ES, EL, PT)
» « » «Higher initial GDP per capita, denominator adjusted for growth differential
«lower intial GDP per capita, denominator adjusted for growth differential

Source: AMECO database.

It is often said, also in my own country, that countries with high debt ratios should simply pursue a
more stringent fiscal policy to ensure their debt is sustainable. And I certainly agree that sufficiently
prudent fiscal policy is needed to address debt sustainability risks. This is why it is so important to
reach agreement on the reform of the Stability and Growth Pact. But economists know that this is
not the whole story. In fact, since the start of the EMU, a high-debt country like Italy has on
average achieved higher primary surpluses, as a share of GDP, than a low-debt country like the
Netherlands. Some high-debt countries have also experienced low growth. And low growth and
higher interest spending make it challenging to grow out of legacy debts, as it requires even higher
primary surpluses than realized in the past.

[Figure 6] We can illustrate an important part of the effect of growth on public debt dynamics by
looking at how the debt ratio of countries with a lower GDP per capita at the start of the EMU
would have evolved if these countries had enjoyed the same growth rate as that of high-GDP
countries, and vice versa. As a simplification, we only adjust for the effect of growth on the
denominator of the debt ratio, and do not take into account the effect of growth on the budget
balance. We see that if only the growth rates of these two groups were reversed, the difference in
the debt ratio between them would not disappear, but it would be substantially smaller.

So while we need sound fiscal policy to get out of the red numbers and paint it black, a bit more
growth would be very welcome as well. At the same time, national fiscal space is required to
respond to shocks in order to minimize hysteresis effects. Capital markets and fiscal spending at the
European level, play only a small role as shock absorbers in the euro area. Consequently, adverse
shocks could have a much stronger effect on growth at times when national fiscal space is more
limited. Thus, sound public finances and sufficient fiscal space are important to prevent persistent
divergent economic trajectories, but are not always easily achieved, especially in those countries
that are stuck in a low-growth trajectory.

A way forward

So in sum: while the EMU has delivered benefits to its citizens, there is room for improvement.
Underlying vulnerabilities remain that render the EMU fragile to a wide spectrum of economic

shocks. I highlighted three such vulnerabilities, namely an unbalanced policy mix, sluggish
economic growth and stubbornly high public debt levels. If these vulnerabilities are left
unaddressed, we are likely to resort to the same type of costly and complex ex-post solutions of the
past two decades.

So allow me to share three avenues that I think are worth exploring:

First, acknowledging that some economies tend to benefit more from the common currency than
others provides a rationale for addressing some of the underlying vulnerabilities at the
supranational level. I've already said on earlier occasions that the Next Generation EU instrument
can help increase the growth potential in those economies that need it the most, by bolstering public
investment and structural reforms. From a political economy perspective it also makes sense to
ensure the provision of European common goods, such as climate, energy or defence, at the
European level. A supranational approach to these policies can be especially beneficial in the face
of large adverse shocks, and when national fiscal space is limited. This could serve as a true EU
version of gimme shelter. Hence, common fiscal spending has the potential not only to benefit
individual countries, but the monetary union and its citizens as a whole.

Obviously, you cannot talk about more spending at the European level without talking about
funding. It would be up to politicians to choose between higher national contributions to the EU-
budget, common debt issuance or a European tax. Common debt issuance could bring additional
benefits in terms of financing costs and capital market integration. After all, teaming up is not a
zero-sum game. However, more spending at the central level should not one-for-one lead to more
public debt or higher taxes in the euro area. After all, the national and European taxpayer are
ultimately one and the same. More fiscal space at the European level should therefore go hand in
hand with less fiscal space at the national level. This is what we see in the Unites States, for
instance, another currency area: states have stringent budget rules, and fiscal stabilization happens
mainly through the federal budget. This brings me to my second point. Deeper European
integration only reinforces the need for fiscal rules to ensure sound public finances at the national
level. Therefore, agreement on a credible reform of the Stability and Growth Pact is of the essence.
The role of budget constraints to discipline fiscal policy is particularly relevant today, as inflation is
still too high and government spending keeps adding to inflationary pressures. If we do not act, the
policy mix may become more unbalanced, making it more difficult to ensure price and
macroeconomic stability.

And finally, durable economic convergence would benefit from a well-developed and resilient
European capital markets union. I say resilient because it is crucial that trust remains in capital
markets also during times of crisis, to avoid sudden stops as those we saw during the sovereign
debt crisis. A sufficiently deep and integrated European capital market will help ensure that capital
is allocated more efficiently across borders. Indeed, integrated and mature capital markets are
indispensable to finance a successful green and digital transition in the EU. These transitions
require equity funding, while Europe is currently overly reliant on bank financing. In addition,
well-diversified cross-border capital holdings will improve the resilience of the European economy
by distributing shocks more evenly across the entire union. More ambitious steps should therefore
be taken to establish common European supervision of capital markets and to harmonize
insolvency, tax and corporate laws. And of course, even with a larger role for capital markets the
banking sector will remain important for financial intermediation. Therefore steps to complete the
banking union are equally desirable.

After more than 60 years, the Rolling Stones still rock on, as I personally witnessed when I
watched them play live last year here in Amsterdam. Sure, they've had their tough times, like the
EMU, but their joint love for playing good rock music has kept them together. And don't
underestimate the money. This also applies to the EMU. If we were all on our own, our economies
and currencies would be blown around like leaves in an autumn storm. And it would definitely
leave us much poorer. Not to speak of the geopolitical damage we would do to ourselves in a more
divided world. So let's see how we can strive towards a more perfect Union. I hope that more
supranational solutions, reform of our fiscal rules, and a resilient capital markets union can be seen

as constructive steps in that direction. You can't always get what you want... but after 25 years of
EMU, we just might find we get what we need. I look forward to your views.

Thank you.

Notes

1. See for example Amendola et al. (2020) and Bonam et al. (2022).

2. See for example Gopinath et al. (2017) and Gilbert and Pool (2020).
3. See Soons and van Overbeek (2023)

References

Amendola, A., Di Serio, M., Fragetta, M., & Melina, G. (2020). "The euro-area government
spending multiplier at the effective lower bound." European Economic Review, 127, 103480.

Bonam, D., De Haan, J., & Soederhuizen, B. (2022). "The effects of fiscal policy at the effective
lower bound." Macroeconomic Dynamics 26(1), 149-185.

Gilbert, N., & Pool, S. (2020). "Sectoral allocation and macroeconomic imbalances in EMU."
Review of World Economics, 156(4), 945-984.

Gopinath, G., Kalemli-Ozcan, $., Karabarbounis, L., & Villegas-Sanchez, C. (2017). "Capital
allocation and productivity in South Europe." The Quarterly Journal of Economics, 132(4), 1915-
1967.

Soons, O., van Overbeek, F. (2023). "The effects of the Economic and Monetary Union on export"
DNB Analyse

DNB Analysis on the EMU
The study Klaas Knot mentioned in his speech is the DNB Analysis 'The heterogenous effects of
the Economic and Monetary Union on trade'