lorenzo bini smaghi : real and nominal convergence – policy challenges speech by mr lorenzo bini smaghi, member of the executive board of the european central bank, at the conference on european economic integration 2007, currency and competitiveness, austrian national bank, vienna, 20 november 2007. * 1. * * introduction 1 ladies and gentlemen, it is a real pleasure for me to speak to you today at this conference. as you know, the maastricht treaty – and in this respect the reform treaty has not changed anything – says very little on the real economy, aside from the fact that growth and employment are an objective of the union. the articles contained in the monetary chapters of the treaty all refer to nominal variables, be they monetary policy or inflation, and so does the section that describes the criteria and procedure for the adoption of the euro. this does not mean, though, that the underlying developments in the real economy are unimportant. in fact, there is a burgeoning literature on the impact that the euro has had on the convergence of the member economies. among such a wide range of academic contributions, let me refer in particular to papers presented at a conference organised by the ecb in june 2005, which provide evidence of the changes brought about by the euro with respect to trade integration, structural reforms, financial integration, business cycle synchronisation and inflation differentials. 2 i will not dwell on those topics today, but will certainly refer to the literature in addressing the specific issue of convergence towards the euro area. as i just mentioned, the criteria for adopting the euro refer to nominal variables – the inflation rate, the long - term interest rate and the exchange rate – and to the budget deficit and debt ratios. is this a problem? should the treaty have been drafted differently? i will argue to the contrary. however, while it is wrong to suggest that the adoption of the euro solves all problems, it is equally wrong to suggest that real convergence does not pose considerable challenges in the path towards the adoption of the euro. the key policy message is that these challenges can be addressed as long as one is aware of them and explicitly takes them into consideration. hiding the issues does not help. it might actually backfire if and when difficulties arise as people might be inclined to think that the root of all problems lies with the euro and its early adoption, rather than inappropriate policy actions in other fields. this is not just a hypothesis. it ’ s what

to the fact that capital is scarcer and due to decreasing returns on capital accumulation. in a closed economy, this translates into a higher real equilibrium interest rate in east compared with west. in a world with full financial integration, we would observe large capital flows from west to east. since people in east expect to be richer tomorrow and want to smooth consumption over time, they will borrow, the more so the higher the expected economic growth rate. this phenomenon will not happen if there are financial frictions and borrowing constraints in east which prevent the real interest rate from rising or the borrowing demand from being satisfied. in that case we might even observe that the flow of capital is reversed, from east to west. this is the so - called lucas paradox ; it ’ s what we are currently observing, for example, in some eastern asian economies, notably in china, and what we saw in western europe in the 1950s and 1960s. in central and eastern european countries, there does not seem to be such a paradox. there are, by and large, no borrowing constraints as countries are bound by what is called the acquis communautaire, in other words, all the laws and agreements, including the treaties that apply in the eu. perhaps what is more important, they have implemented banking sector reforms that have led to an increase in banking competition. 4 so in the case of the european union the theory works. another element of the theory which seems to be working to some extent is the balassasamuelson effect, which contributes to a real exchange rate appreciation in east. 5 the real exchange rate appreciation associated with real convergence can obviously happen in two ways ( or a combination of them ) : first, with a stable nominal exchange rate and high inflation, as in japan in the postwar period up to the early 1970s ; second, with an appreciating nominal exchange rate and stable low inflation, as in japan in the subsequent period up to the early 1990s. i will not dwell on the choice of the exchange rate regime in my speech today, apart from noting that the second channel of real appreciation is obviously precluded after a country joins the monetary union. see arratibel et al. ( 2007 ) for a survey of these developments. egert, halpern and mcdonald ( 2006 ) calculate that the balassa - samuelson effect could contribute to real exchange rate appreciation in some new member states by around 1 to 2 percentage points annually, but not in all countries.