Benoît Coeuré: Heterogeneity and the European Central Bank's
monetary policy
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the Bank of France Symposium & 34th SUERF Colloquium on the occasion of the 20th
anniversary of the euro on "The Euro Area: Staying the Course through Uncertainties", Paris, 29
March 2019.
* * *
From the beginning of the euro area's existence, it was well known that it did not meet all of the
classic requirements of an optimal currency area. Some critics have seen heterogeneity across
Member States as the factor that would ultimately cause the collapse of the single currency.
But the euro is still here, despite years of crisis. While managing heterogeneity between regions
and countries has been a challenge - at times tremendously so - this challenge is not
insurmountable. No single currency area in the world is free of heterogeneity, including the ones
widely regarded as most homogeneous.
In my remarks this morning, I will argue that the ECB has always found ways to accommodate
heterogeneity, particularly at times when it threatened to impair the uniform transmission of
monetary policy.
But I will also argue that if we want to minimise episodes of demoralising output and employment
losses, as we experienced after the financial and euro area crises, and if we want to avoid
overburdening monetary policy, then policymakers need to act more forcefully to reduce the
major sources of euro area heterogeneity - that is, we need a better economic policy framework.
Pre-crisis view on heterogeneity
To structure my remarks, I would like to briefly recall the pre-crisis view on heterogeneity in the
euro area.
Inflation differentials between regions and countries were not only thought to be unavoidable, they
1
were in fact thought to be a desirable feature of a currency union. The idea was that the
structural transformations sparked by monetary integration and the single market, together with
the free movement of goods, capital, services and labour, would create the conditions for all
countries to thrive and exploit their comparative advantages.
The prime concern at the time was that if these inflation differentials persisted, they could
undermine price competitiveness and thus hold back growth. This view was corroborated by the
fact that inflation dispersion among euro area countries was not very different from the level
observed between US metropolitan areas, but it was much more persistent. You can see both
aspects on my first slide.
The idea that heterogeneity could impair monetary policy transmission and jeopardise the
stability of the euro area was a distant thought, for three main reasons.
First, cross-border financial integration was on the rise and was increasingly seen as an effective
shield against idiosyncratic shocks. A broad operational framework for monetary policy that took
into account the heterogeneity of both the ECB's counterparties and available collateral would
2
complement growing market-based defences.
Second, the euro area was built on the idea - or, one might say the hope - of monetary
dominance, with policymakers in all other domains supporting the ECB's area-wide mandate by
addressing nominal and real rigidities and by running prudent fiscal policies which could be used
in rainy days. Such support was a necessary complement to a single monetary policy which
would be overburdened if it were held accountable for national developments.
And, third, the pre-crisis view was inspired by growing evidence that inflation expectations across
the euro area had largely decoupled from actual national inflation outcomes and had converged
3
towards the ECB's definition of price stability.
In other words, the combination of balanced fiscal policies over the cycle, the ECB's track record
and a clear primary mandate provided for a stable nominal anchor for the euro area as a whole.
This served to coordinate the largely decentralised decisions of price and wage-setters within
and between heterogeneous economies.
The need to enhance private risk-sharing in the euro area
This pre-crisis view was not wrong. But it underestimated the shortcomings in the euro area's
institutional framework and its potential to unleash diverging forces.
Let me take each aspect in turn, starting with financial integration.
European capital markets indeed appeared to be becoming more integrated, and hence provided
for increased cross-border risk-sharing, before 2008. You can see this clearly on my next slide,
which shows a composite indicator of euro area financial integration produced by the ECB. But
since the crisis broke, integration has reversed. It currently stands at 0.2 on a scale where zero
represents full fragmentation.
As a result, cross-border risk-sharing in the euro area is almost non-existent. On my next slide
you can see that, currently, around 80% of a country-specific output shock remains unsmoothed,
while in the United States it is at most 40% for a state-specific shock.4
More worryingly, the negative green bars point to a dangerous procyclical credit channel in the
euro area. That is, households and firms borrow abroad in good times and pay back in bad
5
times.
These aspects were often overlooked before the crisis. Financial frictions, for example, were
6
largely absent from mainstream central bank models. Generally speaking, there was a lack of
attention to "financial plumbing" - to the fact that differences in liquidity, capital and supervisory
7
standards meant that banks' reaction to shocks could magnify heterogeneity.
The creation of the banking union has fixed many of these shortcomings, but not all of them. In
particular, without further private risk-sharing, idiosyncratic shocks will continue to cause
persistent dispersion in economic outcomes. You can see this clearly on my next slide.
Dispersion in real per capita private consumption across euro area countries was twice its
historical levels for a period of more than three years after the outbreak of the global financial
crisis. By the same standard, the effects of recession and financial crisis are hardly visible for
the United States.
Monetary policy cannot eliminate such persistent differences, but it can accommodate them. We
have proven that a carefully calibrated package of non-standard policy measures, including our
targeted long-term refinancing operations, asset purchases, forward guidance and negative
rates, can successfully overcome even significant causes of heterogeneity, such as the
impairment of the bank lending channel across large parts of the single currency area in the
wake of the euro area's sovereign debt crisis. You can see this on my next slide.
Today, the bank lending channel in the euro area is fully operational after years of fragmentation.
To protect this achievement, we decided at our last monetary policy meeting in March to launch a
new series of targeted long-term refinancing operations, "TLTRO-III", starting in September 2019.
But to address the underlying vulnerabilities, and to bolster the credit and capital channels of
risksharing, we urgently need to make progress in completing the banking union and kick-starting the
capital markets union. Financial markets that can absorb shocks efficiently reduce the need for
macroeconomic stabilisation and thereby free up costly political capital.
Structural policies to enhance resilience and feed convergence
The second aspect of pre-crisis thinking concerned the role other policy domains should play in
supporting the single monetary policy. I will focus here on the structural side and turn to fiscal
policy in a minute.
Although pre-crisis policy advice strongly focused on reducing nominal and real rigidities in
product and labour markets, today there are still significant differences across countries in the
response to common euro area-wide shocks.
My next slide shows two ways of looking at this.
On the left-hand side you can see ECB research on the extent to which output in each country
responds to a common area-wide shock. Clearly, there are significant differences, even among
countries of broadly comparable size.
8
On the right-hand side you can see Eurosystem estimates of the slope of the Phillips curve. It
shows a high degree of heterogeneity across euro area countries for the sensitivity of core
inflation to economic slack. In other words, country-specific factors of inflation remain
considerable, for example the degree of wage negotiation centralisation. These factors are also
related to national institutions.
The upshot is that, in this environment, monetary policy is more difficult to calibrate. Different
transmission mechanisms propagate the same shock to different degrees and with lags that
may vary across countries.
Minimising these differences in transmission does not require all countries to adopt the same
9
economic structures. What matters is for countries to have institutions that deliver the right
outcomes, both individually and jointly. Our system of economic coordination, the European
10
Semester, still falls short of achieving this objective. And as a consequence, it still falls short of
supporting adequately the single monetary policy.
Strengthening domestic institutions is not only about improving shock absorption capabilities. It is
also about cohesion and sowing the seeds for renewed convergence. You can see this on my
next slide.
The more benign pre-crisis view of heterogeneity reflected the fact that the direction of travel was
at least similar among euro area countries, and not too different from, say, the United States. As
you can see from the chart, the longer we wait to improve the quality of the institutions that
underpin domestic growth and living standards, the larger the gap will be that separates the best
from the rest.
My next slide emphasises the close empirical relationship between the quality of national
institutions and living standards. This is primarily a national responsibility, meaning that in order
to recreate convergence the heavy lifting has to be done by reforms in individual Member States.
That said, the recently proposed budgetary instrument for competitiveness and convergence in
the euro area is a useful and necessary complement.
Strengthening policy complementarities
The third and last pre-crisis aspect concerned the role of monetary policy in coordinating price
adjustments in a heterogeneous currency union. The ECB's definition of price stability had
become a strong area-wide nominal anchor that largely marginalised the effects of actual
inflation outcomes on expected future inflation, thereby cushioning cross-country heterogeneity.
You can see this on my next slide. Before the crisis, survey-based long-term inflation
expectations revealed no statistically significant response to changes in actual HICP inflation.
They were well anchored at levels below but close to 2%. You can see this on the right-hand
side.
But the persistence of the effects of the crisis has, at times, challenged the coordinating role of
monetary policy. We have faced instances where protracted softness in actual inflation has
contributed to a reappraisal of medium to long-term inflation expectations. You can see this in the
grey range moving away from the zero line on the left-hand chart between 2010 and 2015.
Forceful monetary policy action has succeeded in restoring the important role that stable inflation
expectations play for the inflation process in a heterogeneous currency union. The chart clearly
demonstrates that the announcement of the asset purchase programme in January 2015 helped
to avert the danger of current inflation dragging down expected inflation.
But vulnerabilities remain. Nowhere is this more visible than in market-based inflation
expectations. You can see this on the left-hand side of my next slide. According to option prices,
the probability that inflation would be between 1.5% and 2% over the next five years fell
measurably as the euro area economy weakened over the course of 2018. On the right-hand
side you can see that medium-term inflation expectations are currently close to 1.3%, down from
2.5% ten years ago.
This no doubt partly reflects global factors. Inflation expectations in the United States have fallen
too. But apart from a short, temporary blip at the end of 2016, the gap between market-based
medium-term inflation expectations in the United States and the euro area is the widest it has
been for more than four and a half years.
This suggests that idiosyncratic factors are at work too. I would argue, though, that this is unlikely
to be related to concerns about the ECB's credibility.
A breakdown of inflation-linked swap rates into expected inflation and an inflation risk premium
suggests that medium-term inflation expectations have remained close to levels consistent with
price stability. You can see this on the left-hand side of my last slide. This is in line with our
reading of survey-based inflation expectations.
Rather, the marked fall in the inflation risk premium suggests that investors assign only a small
probability to inflation turning out to be higher than expected. Again, this is a global phenomenon
but in my view it is also linked to the unique institutional architecture that sets the euro area apart
11
from other constituencies. It relates to the question of how monetary and fiscal policies can
optimally interact and reinforce each other in an environment in which policy space is significantly
smaller today than it was before the crisis.
Our response to such concerns should not be to challenge our institutional arrangements. It
should not be about blurring the lines between monetary and fiscal policies. Central bank
independence, which has clear and indisputable benefits, is a public good that needs protection.
Instead, our response should be about strengthening complementarities.
ECB research shows that, during the early stages of the latest recovery, monetary policy was
the dominant driver of growth. You can see this on the right-hand side. Other policies subtracted
from growth.
This has changed more recently. The euro area aggregate fiscal stance will be slightly
expansionary in 2019, and will thereby support monetary policy. But to do it in a sustainable way,
it needs to be adequately distributed: while countries that have fiscal space should use it, in
countries where government debt is high, rebuilding fiscal buffers is the best contribution to
support the single monetary policy.
And while not all countries have the space to spend more, all have the opportunity to spend
12
better.
If fiscal policy preferences contribute to disinflationary concerns - for example, by holding back
public investments in education, future technologies and research and development - then they
directly counteract the efforts of monetary policy to bring inflation back to levels closer to 2%.
Conclusion
Heterogeneity is part of the euro area's DNA. It is a source of strength, provided our institutions
and markets have the instruments and ability to effectively absorb idiosyncratic shocks.
Heterogeneous currency unions need a sufficient degree of private and public risk-sharing, and
they need economic policymakers doing their part to preserve and nurture cohesion and
convergence. Not doing so means that too much of the burden of macroeconomic stabilisation
falls on the ECB, thereby challenging the achievement of its medium-term price stability
objective.
Thank you.
1
See, for example, ECB (2005), "Monetary policy and inflation differentials in a heterogeneous currency area",
Monthly Bulletin, May.
2
See Coeuré, B. (2016), "The ECB's operational framework in post-crisis times", speech at the Federal Reserve
Bank of Kansas City's 40th Economic Policy Symposium, Jackson Hole, 27 August.
3
See, for example, Trichet, J.-C. (2007), "The euro area and its Monetary Policy", President's address at the
conference "The ECB and its Watchers IX", Frankfurt am Main, 7 September; and Trichet, J.-C. (2011), "Two
continents compared", keynote address at the "ECB and its Watchers XIII" conference, Frankfurt am Main, 10
June.
4
See Cimadomo, J. et al. (2018), "Risk sharing in the euro area", Economic Bulletin, Issue 3, ECB.
5
Also note that the credit channel includes both private and public borrowing, meaning the contribution of private
risk-sharing is likely to have been even more negative if one accounts for the establishment of the European
Financial Stability Facility/European Stability Mechanism in 2010. Research shows that these institutions made
a substantial contribution to the absorption of country-specific shocks. See, for example: Cimadomo, J., Furtuna,
O. and Giuliodori, M. (2018), "Private and public risk sharing in the euro area", Working Paper Series, No 2148,
ECB, May; and Milano, V. (2017), "Risk sharing in the euro zone: the role of European institutions", CeLEG
Working Paper Series, No 1701, LUISS University, March.
6
See Beyer, A., Coeuré, B. and Mendicino, C. (2017), "The Crisis, Ten Years After: Lessons Learnt for Monetary
and Financial Research", Economie et Statistique / Economics and Statistics, Institut National de la Statistique et
des Études Économiques (INSEE), Issue 494-495-4, pp. 45-64.
7
See, for example, de Santis, R. and Surico, P. (2013), "Bank lending and monetary transmission in the euro
area", Working Paper Series, No 1568, ECB, July; and Singh, M. (2014), "Financial Plumbing and Monetary
Policy", IMF Working Papers, No 14/111, International Monetary Fund, June.
8
See Ciccarelli, M. and Osbat, C. (eds.) (2017), "Low inflation in the euro area: Causes and consequences",
Occasional Paper Series, No 181, ECB, January.
9
See Coeuré, B. (2017), "Convergence matters for monetary policy", speech at the Competitiveness Research
Network (CompNet) conference on "Innovation, firm size, productivity and imbalances in the age of
deglobalization", Brussels, 30 June.
10
See, for example, ECB (2018), "Country-specific recommendations for economic policies under the 2018
European Semester", Economic Bulletin, Issue 5.
11
The importance of monetary and fiscal policy interactions has been well known ever since Sargent and
Wallace's seminal work. See Sargent, T. J. and Wallace, N. (1981), "Some Unpleasant Monetarist Arithmetic",
Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 5, No 3, pp. 1-17. See also Galí, J. and Monacelli, T.
(2008), "Optimal monetary and fiscal policy in a currency union", Journal of International Economics, Vol. 76, No
1, pp. 116-132; Beetsma, R.M.W.J. and Jensen, H. (2005), "Monetary and fiscal policy interactions in a
microfounded model of a monetary union", Journal of International Economics, Vol. 67, No 2, pp. 320-352; and
Bianchi, F. (2012), "Evolving Monetary/Fiscal Policy Mix in the United States", The American Economic Review,
Vol. 102, No 3, pp. 167-72.
12
See ECB (2017), "The composition of public finances in the euro area", Economic Bulletin, Issue 5; and Coenen
et al. (2012), "Effects of Fiscal Stimulus in Structural Models", American Economic Journal: Macroeconomics,
Vol. 4, No 1, pp. 22-68.