Mr Heikensten speaks on the euro and European economic policy
Speech by Mr Lars Heikensten, First Deputy Governor of the Sveriges Riksbank, the Swedish central
bank, at Merita-Nordbanken in Malmö, Sweden on 16 June 1999.
The single European currency, introduced at the beginning of this year, marks a major change for the
economic policies of countries in the euro area. The clearest example is, of course, the transition to a
single monetary policy. The proper functioning of the monetary union in the long term presupposes
that the new European Central Bank succeeds in making its policy and the euro understood and
credible. Important factors in this context are how the new central bank chooses to work, how
monetary policy is continuously formed and how it is communicated to the general public and to
markets.
However, a well-constructed monetary policy and a central bank that acts wisely are not sufficient to
ensure that the union functions in the longer run. If growth and employment in the euro area are to be
as high as possible without jeopardising price stability, all the components of national economic
policies will have to pull together. The fiscal, structural and labour market policies of the individual
countries influence both the conditions under which the new central bank is operating and, to the
highest degree, Europe's future prosperity.
A framework exists for this joint effort. Some common rules, for example the Stability and Growth
Pact, have been constructed to ensure that national fiscal policies do not pose problems for the union
as a whole. There is also a continuous discussion of economic policy in various fora, of which the
foremost are the Ecofin Council, made up of the ministers of finance and economy, and its
subordinate committee, the Economic and Financial Committee, which also includes representatives
of the national central banks. The euro countries' ministers of finance and economy also meet in what
is know as the Euro 11 Council.
This framework has been finalised in principle but is being reassessed continuously in the light of
new challenges. Economic activity in the euro area this spring has been weaker than anticipated and
this has been accompanied by growing disparities between national growth rates, budget balances and
inflation. As a result, a number of central questions about how the monetary union functions have
quickly come to the fore in the member states' discussions.
Although Sweden is not participating in the euro area, developments there will affect us. This is a
large currency area in our immediate vicinity with which we have widespread trading relationships.
As a member of the European Union, moreover, we have to observe many of the established rules and
guidelines; we also participate in the European discussion on the formation of economic policy.
Against this background, my talk today concerns economic policy in Europe and the new conditions
that accompany the euro.
The single monetary policy
Basic features
The European Central Bank (ECB) has been responsible since the beginning of this year for the single
monetary policy in the euro area, with the primary objective of maintaining price stability. The
general formulation of this objective has been defined more precisely by the ECB as being a
year-onyear increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per
cent. In that this definition refers to the rate of increase, it means that deflation is excluded in practice
and the annual rate of change in the HICP should accordingly be between 0 and 2 per cent.
The single monetary policy is based on assessments of a wide range of economic and financial
indicators of inflationary pressure. A prominent position is likely to be accorded to the money supply.
As a reference value for annual monetary growth, the ECB has initially set a rate of 41⁄2 per cent. The
combined strategy - focusing on inflation but with a reference value for monetary growth - is
motivated by the great uncertainty as to how the aggregate euro economy will function initially. The
ECB therefore wants to avoid having to stand on only one leg in its assessments. The ECB also states
that the objective is to be fulfilled over the medium term and thereby underscores that the single
monetary policy is not to parry every short-term shock. Deviations from the target may be acceptable
during a relatively short period.
An analysis of the economic situation is published by the ECB in a monthly bulletin, which aims to
'explain to the public the monetary policy decisions taken by the Governing Council of the ECB'. The
bulletin will also consider fiscal policies, economic structures and labour market tendencies in the
euro area. But the ECB does not publish either forward-looking assessments and forecasts of inflation
or the minutes of decision-making meetings and the positions of individual members. Press
conferences with the ECB Executive will be held, however, in connection with meetings of the
Governing Council. In addition, policy will be explained continuously by Executive Board members
in speeches and appearances before the European Parliament.
Inflation assessment
The ECB and the Riksbank both have price stability as the monetary policy objective but they have
given this objective different operational definitions. The ECB's formulation mirrors a different view
of monetary policy's ability to fulfil an explicit target. Presumably it also reflects a different view of
the margin a central bank shall have for tolerable deviations from the desired price stability. The
Riksbank has specifically targeted inflation, measured by the CPI, at a rate of 2 per cent, with a
declared tolerance interval of ±1 percentage point, thereby clearly identifying the preferred level of
inflation.
It is still too early to say what the differences between the formulations will signify in reality, just
because we do not yet know how the ECB will act in practice. The conduct of monetary policy in
Sweden is also being developed and specified in the light of new experiences. Moreover, the ECB's
target is formulated in such a way that the level of ambition can be varied. It is perfectly possible, for
example, to strive for inflation around 1 per cent when inflation in the rest of the world is low and to
accept a higher rate when the external situation is less favourable. Historically, inflation in Germany
over the past two decades has averaged 2 to 2.5 per cent and the rate in the European Union in the
1990s has averaged 3.4 per cent, as against an average of 3.7 per cent in Sweden.
A common feature of the two monetary policy strategies is their focus on the medium term. The
Riksbank has expressed this in such statements as that policy is to be assessed in an annual
perspective and that its full impact occurs after twelve to twenty-four months. Moreover, the
Riksbank has clarified how transitory effects on inflation are to be treated. A deviation from the
inflation target on a single occasion will not lead either the Riksbank or the ECB to adjust interest
rates abruptly in order to achieve a rapid return to the target. Adjustments are to be gradual, which
implies smaller fluctuations in the interest rate and thereby also in production and employment.
Communication and evaluation
So far the ECB has chosen not to publish the assessment of inflation on which the single monetary
policy is founded. This has been justified by saying that it might cause more confusion than clarity
about the grounds for the policy. That has not been the Riksbank's experience. Our view of
inflationary pressure in the Swedish economy is published on a quarterly basis. The clear presentation
gives observers a chance of understanding and questioning our assessments. As new information
becomes available, moreover, they are in a position to relate it to our earlier assessment and
continuously form a fairly good picture of how interest rates are likely to move in the future.
The publication of our inflation assessments has also facilitated decisions in recent years to raise or
lower interest rates. In that the grounds for our actions are clearer, there is less risk of our being
accused of heeding extraneous considerations, a worry that featured in the European discussion last
autumn. It is my belief, however, that the ECB will become more open about its economic
assessments as it settles more comfortably into its forecasting process and inflation assessment.
Another difference in transparency concerns access to discussions at the decision-making meetings.
The ECB has chosen not to publish any minutes. An important argument for this policy - and one that
I find understandable but debatable - is that minutes disclosing how individual members voted might
occasion a greater element of national considerations. The Riksbank has chosen to publish minutes of
Executive Board meetings after an interval of 6-8 weeks; the minutes are to reflect the discussion and
indicate how the members voted.
The clearly independent status that has now been assigned to the Riksbank has much to do with this
choice. The minutes make it easier for policy evaluators to follow the formation of monetary policy
and assess the actions of Board members. This is a democratic interest. Moreover, the fact that the
voting will be published probably increases the members' motivation to form a personal opinion
about the difficult matters that have to be considered. I also believe that access to the minutes can help
people to understand the choices that have to be made in the formulation of monetary policy and
demystify what the Riksbank is doing. It is arguments of this type that made my British colleague
Mervyn King declare, with reference to the work of the Bank of England's Monetary Policy
Committee, that 'Divided we stand, united we fall'.
I want to emphasise that these matters are by no means simple. It seems to me that a clear analytical
framework, combined with a high degree of transparency, has provided a good foundation for
Swedish monetary policy in recent years. But with an Executive Board consisting of six members,
each of whom is in a position to voice an opinion on monetary policy, it is probable that from time to
time the Riksbank will be criticised for being indistinct. There were signs of that last week when the
minutes from April showed that I had not voted with the Board's majority. But as observers and
market players become more accustomed to how we operate, such differences of opinion are likely to
attract less attention.
Still, monetary policy signalling clearly cannot be arranged in quite the same way as before and in this
respect we will presumably become more like the ECB and the Bundesbank, where individual
statements do not automatically constitute a collective signal from the central bank. For those who are
interested in following us and our assessments, however, we strive to provide a good foundation by
publishing - at intervals of approximately six weeks - either an Inflation Report or a lengthy press
notice on the majority view of inflation prospects.
Fiscal policies in the euro area
Let me now turn to the conduct of fiscal policy in the euro area. A judicious monetary policy is not
sufficient to ensure that the monetary union functions properly. The single currency will make the
national economies more interconnected than before. The formation of fiscal policy in one country
will affect the overall picture of economic prospects and thereby monetary policy. In the Maastricht
Treaty the countries accordingly agreed on certain common rules for economic policy and these have
been fleshed out with additional legislation and political agreements.
Besides fixed and binding undertakings for each country, there are regular common processes for
producing more general guidelines and standards for economic policy. The national convergence or
stability programmes each member state presents to show how it intends to follow the guidelines
supplement the latter, which can be likened to a common budget statement for the euro area. It is
envisaged that the countries will exert peer pressure to bring about a good economic development in
each country and thereby fulfil the common objectives of sustainable growth with high employment
and stable prices.
A central issue here is the formation of fiscal policy, for which there are binding rules. In the
Maastricht Treaty the EU countries agreed that budget deficits and government debt relative to GDP
are to be limited to 3 and 60 per cent, respectively. In summer 1997 the EU finance ministers agreed
to clarify and tighten the existing fiscal policy goals so as to guarantee a sound development of
government finances in the Union. The background to this was that the rules of the game once the
monetary union had been established were less clear than the criteria for participation in the euro area.
More specifically, there were worries that once they had joined the euro area, countries with a high
debt ratio would implement a less vigorous policy because their incentives for exercising restraint
would not be as clear. The pressure on these countries to consolidate their budgets might also ease if
their interest rates fell on account of 'borrowed' credibility from the German economy.
The Stability and Growth Pact was initiated by Germany. It means that all EU countries - and thus
non-euro countries such as Sweden - are bound by the rules for fiscal policy and its surveillance
after the move to Stage Three. Each country is to strive for budgetary positions close to balance or in
surplus in the medium term. This is intended to allow the automatic stabilisers free play while keeping
the government deficit inside the 3 per cent limit. In this way the Pact provides for some flexibility in
fiscal policy, which may be particularly important when there is no recourse to exchange rate
adjustments.
If the budget deficit exceeds the 3 per cent limit, sanctions can ultimately be imposed on the country
in question if the problems are not tackled. It is only in exceptional circumstances that this may not
apply. A surveillance procedure has been established for monitoring developments; national stability
programmes are to be presented at regular intervals, showing how the goals are to be fulfilled. This
process is perhaps as important in practice as the threat of sanctions. The establishment of clear rules
and sanctions is intended to support the forces in each country that favour a disciplined fiscal policy.
The sanctions do not apply to non-euro countries and they submit convergence programmes instead of
stability programmes.
So what has happened so far? The assessment of convergence or stability programmes from all the EU
countries this spring shows a mixed picture. It is clear, however, that the ambitions of most countries
still fall short of the requirements in the Stability and Growth Pact. This is certainly attributable in
part to the economic slowdown, with Italy as the clearest example. But it is also notable that the
ambitions for budget consolidation are now lower than before the move to Stage Three. The relatively
good growth during 1998 ought to have left room for budget consolidation in many countries but it
was not used and in certain countries the structural deficit has actually increased. The Ecofin Council
has in fact criticised a number of countries, including Germany, France, Austria and the Netherlands,
for the low level of ambitions in their stability programmes.
In Sweden, the budget position looks comparatively healthy. Our fiscal policy is likewise less
restrictive than before but the structural deficit has been turned into a surplus that is now growing and
the ambition is still to achieve a budget surplus of 2 per cent of GDP on average over the business
cycle.
At the same time it should be underscored that some variation in the objective across countries seems
reasonable. The degree of fiscal readiness - and thus the requisite size of the surplus - depends on
a number of factors. One is the cyclical sensitivity of government finances and another is the level of
government debt. It is then reasonable that a country like Sweden has a larger public sector financial
surplus than a country where the automatic stabilisers and government debt are smaller. But it is also
important to maintain the peer pressure that has been used to ensure that the member states observe
the common rules. Arguing the case for adhering to these rules in a country's internal debate is
difficult if other member states lower their ambitions.
Policy interaction
Economic policy in the euro area is accordingly formed in the interaction of the single monetary
policy and what are primarily national fiscal and structural policies. If this interaction is to function
properly, much is required of the parties involved in the way of clarity and a dialogue.
The available structure for coordinating economic policies in the European Union consists of a
network of different bodies and reports, with the ultimate purpose of arriving at a shared picture of the
framework for economic policy. The forms for cooperation are being developed all the time and a
number of new instruments have been introduced in recent years.
A schedule has been established for the continuous exchange of information and views during the
year between the member states, the Commission and other Community bodies, including the ECB.
Reports on compliance with the guidelines for fiscal policy, employment and structural policy are
submitted by each country for discussion and examination by the other member states, the
Commission and the ECB. The ministers in the individual countries finally adopt the programmes,
which then form the basis for the next discussion of the general economic policy guidelines, which
are adopted each summer by the heads of state or of government. In between, each country is analysed
by the Commission, which is required to give early warning if countries do not fulfil undertakings
they have made in their national programmes.
The idea behind this structure is the principle of subsidiarity, that is, matters to be decided jointly by
the member states are to be limited to those for which a decision at this level is absolutely necessary;
everything else is a national concern.
The ECB is to guarantee price stability. Monetary policy has to be formed in the light of fiscal
policy's expected development. Similarly, inflation has to be assessed in the light of the existing trade
policies and the prevailing structures in labour markets, agriculture and so on. There is no question of
coordinating policy in the sense of the ECB undertaking to act in a certain way if policy in other fields
is adjusted or realigned - what euro jargon refers to as ex ante coordination. This naturally
accentuates the need for clarity in monetary policy. It is reasonable that politicians in Europe are
enabled to assess what an adjustment of fiscal policy, for example, would have for consequences for
the interest rate.
Against this background I now want to consider three issues to do with European economic policy
that in my opinion have been illustrated by developments in the past six months and should be
discussed in the European economic policy debate. All these issues concern the need to develop the
institutional framework so that it covers coordination problems that may arise even though the rules
are being followed.
Firstly, monetary policy is naturally not fully attuned to every euro country at present. Cyclical
activity as well as other factors that affect inflation vary over the euro area and as I mentioned earlier,
these differences have become somewhat larger. By itself, this need not be a major problem for the
monetary union as a whole. The differences may reflect entirely natural deviations in productivity
growth, for instance. In these cases the differences in inflation need not be all that important in the
longer run.
The differences in inflation are more of a problem if they derive from differences in the development
of demand. But even in this case it can be argued that they will mainly lead to problems for the
particular country where inflation is higher; rising costs ultimately result in downward adjustments of
production, employment and inflation. There may be uncertainty, however, about the smoothness of
such an adjustment and its consequences for the union as a whole. Even if the development of
inflation in one country may conceivably disturb the path for the union, that country cannot be
required to tighten its fiscal policy as long as it complies with the Stability and Growth Pact.
Secondly, at present there is thus no mechanism whereby a fiscal adjustment could be spread over the
participating countries. This is also a problem because the implementation of the Pact indicates that
there is a risk of this contributing to a procyclical budget policy. To date, the Pact's surveillance
process has focused on countries with a budget deficit close to the limit. There is nothing remarkable
about that: this is where the problems are most apparent and the risk of failure - with problems for
the credibility of the Pact as a whole - is most acute. But there is also the risk of the Pact having a
procyclical effect. Countries that are close to the maximum deficit on account of weak activity are
obliged to follow a restrictive line, while those with good activity and a surplus do not need to tighten
their policies in this way.
This problem has arisen because the Pact was actually constructed so that it only functions properly
when all the member states have established the necessary margins. That is still not the case. For the
euro area as a whole it would presumably be best in the present situation if the countries with high
activity were to tighten their policies even more. That might create room for a somewhat lower
interest rate in this area in the coming years and thereby ease the situation for the consolidation of
government finances in the countries with the greatest problems. At present, however, there are no
mechanisms for bringing such a policy about.
Thirdly, even if the fiscal position in all the countries in question were now in good order, the
tradeoff between fiscal and monetary policy raises issues for which there are still no ready-made solutions.
Let us take the hypothetical case of a falling stock market in the United States that pulls the dollar
down. The recent trend would then be reversed into an appreciation of the euro. That would be liable
to check the recovery of manufacturing in the euro area. What should the EU finance ministers do?
One possibility would be to go for an overall tightening of fiscal policy in order to pave the way for
lower interest rates and a weaker euro. As things stand, however, it is not clear how this could be
done in practice. Once again we face the question of the restriction's distribution among the
participating countries.
These three interrelated issues are all important. The solutions are hardly self-evident, partly because
they involve the difficult balance between national concerns and matters that should be decided at
union level.
Conclusion
The euro's introduction in eleven countries in our part of the world is the biggest economic policy
change in Europe for decades. New conditions have been created not only for households and firms in
the euro area and adjacent countries but also for economic policy.
Sweden is by no means unaffected by this change, even though we are outside the euro area at the
start. Economic development in the euro area is crucial for Sweden's economy. As a member of the
European Union, moreover, we are involved in many of the contexts where policy is formed. We have
also undertaken to conduct our policy in accordance with the rules that have been established for the
Union.
Against this background it is important that we are engaged in the discussion of economic policy in
Europe. My purpose today has been to highlight a number of issues of importance for the European
debate. I have tried to describe how the ECB works, the rules that have been built up for fiscal policy
and so on. I have also said something about events in the past six months and discussed some of the
problems as I see them.
One thing is certain: the euro's introduction does not constitute the final step in the integration of
Europe. The single currency will raise new questions that will be answered by degrees through the
cooperation between the countries of Europe. It is important that Sweden takes an active part in that
debate.