Nicholas C Garganas: Does one size fit all? Monetary policy and
integration in the euro area
Address by Mr Nicholas C Garganas, Governor of the Bank of Greece, at a visit to the
Central Bank of Chile, Santiago, 12 October 2007.
* * *
The euro has created a new reality for 318 million Europeans and has probably become the
most visible symbol of European integration. Its introduction was in itself a remarkable
achievement, representing the culmination of a process of convergence and integration that
began many years ago. However, the introduction of the euro did not mark the end of
European economic integration. Instead, the euro created new challenges for monetary
policy. I want to focus on two of those challenges in my presentation:
•
First, how would the newly-created European Central bank build credibility? Here, I
will argue that the adoption of a credible monetary policy strategy and its systematic
implementation would be crucial.
•
Second, does the single monetary policy fit the particular circumstances in each of
the countries of the euro area? In addressing this question, I will argue that the
traditional way of thinking about what constitutes an optimum currency area
overlooks the fact that the criteria used to judge optimality are, to some extent,
endogenous. In particular, I will argue that the creation of a monetary union can
itself create conditions that are favourable to the well-functioning of the union.
I. The ECB's monetary policy strategy and its implementation
The monetary policy strategy - which was initially adopted in 1998 and confirmed with a few
clarifications in 2003 - drew on decades of central bank policy experience and the strategies
of the most successful (in terms of inflation performance) central banks in the euro area. The
strategy includes three key elements.
First, there is the objective of price stability. The view that monetary policy can contribute
most to economic welfare by maintaining price stability is supported by a large body of
empirical evidence. Ultimately, monetary policy can influence only the price level and can
have no lasting influence on real variables. Price stability is defined as a year-on-year
increase in consumer prices for the euro area of "below, but close to, 2 per cent". The "close
to" was added in 2003 to establish a safety margin above zero inflation to guard against
deflationary risks. In the light of the long lags involved in the transmission of monetary policy,
price stability is to be maintained in the medium term.
Second, there are the "two pillars" of economic and monetary analyses.
•
The economic analysis focuses mainly on the assessment of current economic and
financial developments from the perspective of the interplay between supply and
demand in the product and factor markets, and provides short- to medium-term
indications of inflation.
•
The monetary analysis, which acts as a cross-check to the economic analysis,
focuses on money and credit developments in recognition of empirical evidence
suggesting that monetary growth and inflation tend to be closely related in the
medium to long run.
The third element in the strategy is central bank independence, counterbalanced by
accountability and transparency. The Maastricht Treaty granted full political independence to
the ECB in its pursuit of price stability. When exercising their duties, neither the ECB nor the
National Central Banks, nor any member of their decision-making bodies, is allowed to seek
or receive instructions from EU or member-state institutions. Long terms of office for
members of the Governing Council, who serve on the Council in a personal capacity, and a
rule that members of the Executive Board cannot be reappointed, also contribute to
minimizing potential political influences on members of the ECB's decision-making bodies.
In a democratic society, however, central bank independence needs to be counterbalanced
by accountability, that is, an obligation on the part of the central bank to explain its decisions
to the public and its elected representatives. In turn, accountability requires transparency
with respect both to objectives and decision-making. To this end, monetary policy decisions
taken by the ECB are explained "in real time" at a press conference immediately after each
rate-setting Governing Council meeting.
The ECB's record over the past nine years has been a positive one. It has delivered low
levels of inflation, inflation expectations and long-term interest rates. Average inflation in the
euro area since its inception has been 2.03 percent, a shade higher than the ECB's definition
of price stability, notwithstanding significant price shocks stemming mainly from oil price
increases. Inflation expectations have also been remarkably close to the ECB's definition of
price stability and long-term interest rates have been at historically low levels for a significant
period since the formation of the monetary union. The anchoring of expectations clearly
attests to the ECB's credibility.
Figure 1: Annual inflation (HICP) and Main Refinancing Operations (MRO) rate
(January 1998 - August 2007) (in percent)
5.0 5.0
HICP
4.5 4.5
HICP excluding unprocessed food and energy
MRO rate
4.0 4.0
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
1998 1998 1999 1999 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
Source: ECB
By maintaining low inflation and securing long-term inflation expectations at levels consistent
with price stability, the ECB makes its best possible contribution to supporting sustained
economic growth and employment creation. The stability-oriented policies have supported
both households, by maintaining the purchasing power of their income and savings, and the
business sector, by creating an environment of low and stable interest rates, conducive to
investment.
Figure 2: Indicators of long-term inflation expectations in the euro area
(January 1999 - September 2007) (monthly averages)
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
France (2013 maturity) (1, 2)
Euro area (2012 maturity) (1, 3)
Euro area (2015 maturity) (1, 3)
0.5 0.5
SPF (4)
Consensus Economics (5)
0.0 0.0
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
1999 1999 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007
Notes to Figure 2:
(1) The ten-year break-even inflation rate reflects the average value of inflation expectations over the maturity of
the index-linked bond. It is calculated as the difference between the nominal yield on a standard bond and the real
yield on an inflation index-linked bond, issued by the same issuer and with similar maturity.
(2) Issued by the French Government linked to the French CPI excluding tobacco.
(3) Issued by the French Government linked to the euro area HICP excluding tobacco.
(4) Survey of Professional Forecasters conducted by the ECB on different variables at different horizons.
Participants are experts affiliated with institutions based with the European Union. This measure of long-term
inflation expectations refers to an annual rate of HICP expected to prevail five years ahead.
(5) Survey of prominent financial and economic forecasters as published by Consensus Economics Inc. This
measure of long-term inflation expectations refers to an annual rate of inflation expected to prevail between six
and ten years ahead.
Source: ECB
II. Does one size fit all?
While the success of the monetary union in delivering low inflation and a credible currency is
beyond dispute, the issue of whether a single monetary policy can "fit" all member states of
the euro area, continues to be hotly debated.
i) EMU: an optimum - currency - area perspective
EMU brought unique challenges for monetary policy. Critical observers took the view that a
single monetary policy was doomed to failure because the euro area does not fulfill the
prerequisites of an Optimum Currency Area (OCA). This implies that if national economies are
affected by asymmetric exogenous shocks or if shocks are transmitted to different degrees in
different economies, because of unique economic and institutional characteristics in national
economies, the mechanisms which could temper their impact either do not exist or are not
strong.
It is certainly true that the euro area is characterized by a lack of labour mobility, because of
linguistic and cultural differences. There is also an absence of a significant centralized fiscal
transfer mechanism. In these circumstances, so the argument goes, shocks are likely to lead
to widening inflation differentials so that a common nominal interest rate in the monetary
union results in diverging real interest rates among countries. For member countries with
relatively-strong domestic demand and a higher-than-average inflation rate, the lower real
interest rate fuels domestic demand and national inflation. Conversely, for countries with
relatively-weak domestic demand and a lower-than-average inflation rate, the high real
interest rates put further downward pressures on domestic demand and inflation. A one-size
monetary policy, in other words, does not fit all.
The foregoing, traditional view of optimum currency area is static in nature. It assumes that a
country's characteristics, such as its degree of trade integration, are immutable. The
experience of the euro area, however, suggests that participation in a monetary union may
itself induce changes in economic structure and performance. Indeed, a good deal of
academic research, much of it reflecting the experience of the European monetary union,
also indicates that the creation of a monetary union can itself create conditions that are
favorable to the well-functioning of the union.1
The experience of the euro area has demonstrated that a common currency can affect an
economy's characteristics through at least two channels. These channels operate through
enhanced credibility, and trade and financial integration. In what follows, I will discuss each
of these channels in turn.
How does the credibility channel work? A major benefit of participating in EMU, especially for
countries such as Greece, Italy, Portugal, and Spain that have had recent histories of
relatively-high inflation rates, has been the credibility gain derived from eliminating the
inflationary bias of discretionary monetary policy. Since there is no devaluation risk, and no
need of an interest rate premium to cover the risk of devaluation, nominal and real interest
rates are lower than otherwise. Low and stable inflation and inflationary expectations
lengthen economic horizons, encouraging a transformation of both the financial and real
sectors.
Let me now turn to the trade-creation effects of a common currency. Recent empirical
evidence has shown that a common currency (as opposed to separate currencies tied
together with fixed exchange rates) can also promote trade2. The basic intuition underlying
this view is that a set of national currencies is a significant barrier to trade. In addition to
removing the costs of currency conversion, a single currency and a common monetary policy
preclude future competitive devaluations, and facilitate foreign direct investment and the
building of long-term relationships. These outcomes, in turn, can promote (over-and-above
what may have been attained on the basis of the elimination of exchange-rate uncertainty
among separate currencies) reciprocal trade, economic and financial integration, and the
accumulation of knowledge. Greater trade integration can increase growth by increasing
allocative efficiency and accelerating the transfer of knowledge.
The euro-area's experience indicates that the euro has indeed acted as a catalyst for trade
integration. Intra-euro area trade in goods increased from 26% of euro area GDP in 1998 to
33% in 2006. Intra-area trade in services has also risen. Recent empirical work has shown
that similar increases in trade have not taken place among European countries which did not
adopt the euro3.
The euro has also had a positive effect on intra-euro area FDI. Between 1999 and 2005 (the
latest data available) the stock of intra-euro area FDI more than doubled, from around 14 per
cent of euro area GDP to over 30 per cent.
Increased trade integration, along with growing intra-euro area FDI flows, lead to more
highly-correlated business cycles because they increase the incidence of common demand
shocks and result in more intra-industry trade. As a consequence, the need for
countryspecific monetary policies is reduced.
Figure 3: Euro Area Rolling Business Cycle Correlations and
Logarithmic Trend Line (1997-2008)
0.9
0.8
0.7
0.6
0.5
0.4
0.3 business cycle correlations
0.2
Log. (business cycle
correlations)
0.1
0
19972000 19982001 19992002 20002003 20012004 20022005 20032006 20042007 20052008
Notes to Figure 3:
• The rolling business cycle correlations are constructed by calculating the pairwise correlation coefficients
between all euro area countries for the various 4-year periods (1997-2000, 1998-2001, etc). The average
of these coefficients is calculated for each time period.
• Data source: EU AMECO database
There are additional reasons that a monetary union reduces the incidence of country-specific
- -
shocks. One of the principal causes of asymmetric shocks divergent monetary policies
no longer exists. Furthermore, it is to be expected that deeper financial market integration will
also entail a convergence in the transmission mechanism of monetary impulses.
The introduction of the euro has helped make the euro area financial markets more
integrated. The money market has been almost perfectly integrated since the formation of
monetary union. The significant growth of the euro corporate bond market, while still smaller
than its US counterpart, also provides evidence of integration and widens the range of
potential investors to which firms have access. National bonds and equity market returns
exhibit closer co-movements than they did prior to the introduction of the euro, offering
investors the opportunity to diversify their holdings and reduce the risks for a given level of
return. The main area where financial integration has lagged is that of retail banking where,
in spite of an increase in cross-border M&As in recent year, cross-border activity remains
relatively limited.
Figure 4: International Corporate Bonds by Country of Nationality:
Amounts outstanding (millions USD)
350000
300000
250000
200000
150000
100000
50000
0
03-92 03-93 03-94 03-95 03-96 03-97 03-98 03-99 03-00 03-01 03-02 03-03 03-04 03-05 03-06 03-07
Euro Area Germany Spain France Greece Italy
Source: BIS database
Figure 5: Spreads between 10-year benchmark european sovereign
bond yields and the German benchmark (per cent)
8
6
4
2
0
-2
01-90 07-90 01-91 07-91 01-92 07-92 01-93 07-93 01-94 07-94 01-95 07-95 01-96 07-96 01-97 07-97 01-98 07-98 01-99 07-99 01-00 07-00 01-01 07-01 01-02 07-02 01-03 07-03 01-04 07-04 01-05 07-05 01-06 07-06 01-07 07-07
France Italy Spain Greece
Source: BIS database
Figure 6: Correlations between German and other European
returns -on composite stock indices - Rolling 24-month window
1
0.75
0.5
0.25
0
02-92 08-92 02-93 08-93 02-94 08-94 02-95 08-95 02-96 08-96 02-97 08-97 02-98 08-98 02-99 08-99 02-00 08-00 02-01 08-01 02-02 08-02 02-03 08-03 02-04 08-04 02-05 08-05 02-06 08-06
France Italy Spain Greece
Source: BIS database
Forces for further integration will continue, as market participants increasingly exploit the new
environment of monetary union. In addition, a number of initiatives, supported by the
Eurosystem and/or the Commission, will help increase integration. An example is TARGET2,
the new payment platform for the financial system, which is expected to begin operating in
November 2007. As integration proceeds, we can expect that the monetary transmission
mechanisms across the euro area will continue to converge, helping the implementation of
the single monetary policy.
To the extent that countries nevertheless continue to experience asymmetric shocks or
asymmetric responses to common shocks, financial integration can help members of a union
insure against the effects of such shocks by providing opportunities for diversification of
income sources and adjustments of wealth portfolios. In effect, the members can mitigate the
effects of shocks by insuring one another through their holdings of financial claims on each
other's output in financial markets.
ii) Inflation and growth differentials
Despite the increased trade and financial integration in the euro area, the fact remains that
divergences in economic performance continue to exist. How significant are these, and how
concerned should we be?
Recent evidence, provided by the ECB, shows that, over the period 1990-99, the euro area
-
experienced a downward trend in the degree of inflation dispersion measured as the
-
standard deviation of that dispersion from about 6 percentage points in the early 1990s to a
low of less than one percentage point in the second half of 1999. Since that time, inflation
-
dispersion has changed very little and for some time now it has been less than a
percentage point.
Figure 7: Dispersion of annual inflation rates
within Euro Area (13 countries), US (14 Metropolitan Statistical Areas) and US (4 regions)
(unweighted standard deviation in percentages)
7.00
6.00 EA13 US4 US14
5.00
4.00
3.00
2.00
1.00
0.00
1994M01 1995M01 1996M01 1997M01 1998M01 1999M01 2000M01 2001M01 2002M01 2003M01 2004M01 2005M01 2006M01 2007M01
Source: US Bureau of Labor Statistics and ECB
Another fact worth emphasizing is that inflation dispersion in the euro area does not differ
that much from dispersion across a similarly-sized monetary union, that of the US. Where the
euro area does differ from the US, however, is that the observed differentials seem to be
more persistent in the euro area. In part, persistence can be explained by the so-called
Balassa-Samuelson effect, according to which long-term differentials in regional inflation are
attributable to differences in the rate at which productivity increases in the various regions'
tradable and non-tradable goods sectors. This situation represents an equilibrium adjustment
process that does not, in principle, require economic policy correction. Indeed, differentials
arising from this source importantly do not lead to a permanent worsening of the competitive
position of the country experiencing the higher inflation.
However, given the degree of convergence in living standards experienced by euro area
countries over the last decade or so, it is difficult not to conclude that the contribution of the
Balassa-Samuelson effect to inflation differentials now is likely to be relatively small. This
may well give cause for concern since it suggests that the differentials originate from the fact
that adjustment mechanisms in the euro area are not functioning as smoothly as they might
and that policies other than monetary policy are not consistent with inflation rates close to the
euro area average. Thus, other factors are contributing to the inflation differentials within the
euro area, including misaligned fiscal policies, wage dynamics not linked to productivity
developments (something reflected in the significantly different rates of growth in unit labour
costs across the union), and structural inefficiencies such as rigidities in product and factor
markets. Persistent differentials that result from these factors lead to a loss in
competitiveness and cannot be considered benign.
Figure 8 indicates a strong positive relationship between average inflation rates in different
euro area economies and the average growth of unit labour costs over the period since
monetary union began.
Figure 8: Cumulative Deviation of Inflation and ULCs Relative to
Euro Area Average
(1999-2006, in percentage points)
20
15
10
5
0
-5
-10
-15
BE DE IE GR ES FR IT LU NL AT PT FI
inflation ULCs
Source: BIS database
Figure 9: Dispersion of real GDP growth rates
within Euro area (13 countries), US (50 states and D. Columbia) and US (8 regions)
(unweighted standard deviation in percentages)
5.00
EA13 US50 US8
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: US Bureau of Economic Analysis and EU AMECO database
It is important to note that the process of nominal convergence from the early 1990s
onwards, which culminated in the adoption of the euro, was not accompanied by a greater
dispersion of real GDP growth rates. Nor has dispersion increased following the adoption of
the single currency. If any trend is discernable, it is a slight downward one, with dispersion
remaining close to its historical average of around 2 percentage points, which is no greater
than that found in the US. Moreover, inflation and growth across the euro area appear to
move together. Those countries with higher than average inflation rates (Ireland, Greece,
Spain, for example) appear to have higher growth rates. This suggests that, to the extent that
inflation differentials do not reflect differences in growth rates of productivity, the dampening
effect of loss in competitiveness has been offset by other factors, such as interest rate
decreases in the period up to the adoption of the euro, inflows of EU structural funds,
immigration and financial liberalization. These favourable factors are unlikely to persist
indefinitely and, once they diminish, the consequences of falling competitiveness are more
likely to become a dominant determinant of actual growth outcomes.
Figure 10: Scatter Plot of Inflation and Growth in Euro
Area Countires (1999-2006)
Growth
0.12
0.1
0.08
0.06
0.04
0.02
0
-0.02
Inflation
0 1 2 3 4 5 6
Source: ECB and EU AMECO database
III. Conclusions
A single-size monetary policy has worked extremely well in the euro area. I have argued that
this is partly the result of endogenous changes brought about by the very existence of the
monetary union. Increased trade and financial integration, spurred on by the common
currency, have contributed to making the euro area closer to an optimum currency area. In
addition, the credibility of the ECB's monetary policy has delivered low interest rates and
price stability.
Yet these are not sufficient alone to increase economic growth and raise living standards.
Low interest rates and a stable price level provide the fabric upon which a more dynamic
Europe can be woven. Whilst endogenous responses by the private sector to the creation of
monetary union can contribute to the necessary increases in flexibility in product and labour
markets, there is also a need for countries themselves to adopt measures in this direction.
Between 2001 and 2005, euro area growth was relatively weak. Moreover, in spite of
declines in the dispersion of inflation rates and growth rates, their persistence raised some
concerns in terms of the competitiveness of certain countries within the euro area.
In these circumstances, some countries (the most prominent example being Germany)
undertook structural reforms, the fruits of which began to be seen in the second half of 2004.
Thus euro area unemployment has fallen sharply, reaching its lowest level since the start of
monetary union. Although this outcome reflects, in part, a cyclical rebound, part of the
decline in the unemployment rate may well be due to the impact of structural reforms.
However, structural impediments continue to exist in the euro area; they help explain still
high levels of unemployment and low participation rates. Further reforms can only foster
economic growth and create additional employment opportunities.
Fiscal developments in the euro area have also been favorable in recent years. However,
budgetary improvement has largely been the result of strong output growth and revenue
windfalls. Only a small part has been due to policy measures. Against the background of the
current economic expansion, it is essential to sustain the momentum toward improving public
finances and to accelerate the pace of fiscal consolidation. This would strengthen the
capacity of the euro area to adjust to external shocks, increase consumer and investor
confidence, and hence support growth and employment.
To conclude, the euro area has indeed come a long way. The success of the single currency
has demonstrated that one size can fit all. Such has been the success of the euro area that it
has given rise to considerations, still at an early stage, of regional currency arrangements in
Africa, Asia and Latin America. Nevertheless, much more needs to be done to ensure that
the euro area becomes a more dynamic force for growth in the global economy on a
sustainable basis. It is my view that the experience of the euro area to date only serves to
highlight the fact that a currency union requires more flexibility in factor and product markets,
and greater competition than do independent monetary areas. Flexible markets and strict
fiscal rules are not just superfluous conditions for members of a monetary union. They are
necessities that make monetary union work by providing the adjustment mechanisms that the
one size fits all monetary policy cannot.
References:
Baldwin R E (2006) "The Euro's Trade Effect" ECB Working Paper, no. 594.
De Grauwe P and Mongelli F P (2005) "Endogeneities of Optimum Currency Areas: what
brings countries sharing a single currency closer together?" ECB Working Paper, no. 468.
Rose A and Stanley T D (2005) "A meta-analysis of the effect of a common currency on
international trade", Journal of Economic Surveys, vol. 19.