Luncheon Address by the Governor of the Bank of Greece Mr Nicholas C. Garganas ''Adjusting to the Single Monetary Policy of the ECB'' before the Euro 50 Group
24/06/2005 - Speeches
Ladies and Gentlemen,
I would like to thank Professor Richard Portes for his kind
introduction. It is indeed an honour and a pleasure to address such a
distinguished audience of academics and practitioners specialized in the field
of European economic policies and broader issues linked to the Euro.
This meeting is an important event. It takes place at a time
of tensions about the impact of the single monetary policy on the euro area and
when several commentators have raised doubts about the sustainability of
monetary union. Europe's single-currency undertaking is perhaps the boldest
attempt ever in which a large and diverse group of sovereign states has
attempted to reap the efficiency gains of using a common currency. The euro has
created a new monetary reality for 307 million Europeans that few would have
thought possible a generation ago. Like most bold undertakings, however, the
euro has had its share of ups and downs. When the euro was launched in 1999,
skeptics were doubtful whether it would be possible to make the euro a stable
currency. Yet, the euro, which is probably the most visible and tangible symbol
of this integration process, is now in its seventh year and has been firmly and
credibly established as a stable currency.
Today, I want to address a widely-debated issue - - namely,
whether a single monetary policy can fit all parties in a supposedly
heterogeneous currency area. This issue has been debated extensively since the
start of EMU. The debate has recently intensified, reflecting concerns about the
increased divergence of growth rates over the past few quarters and
uncertainties deriving from French and Dutch rejections of the Constitutional
Treaty. Before I discuss this issue, allow me to offer the following
qualification. My perspective is that of someone from Greece, a small, open
economy with a history of very high inflation and enormous fiscal deficits in
the 1980s and the first half of the 1990s. Other countries' perspectives might
well highlight features other than those that I will discuss.
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.
This skepticism was supported by the arguments of the traditional theory of
optimum currency areas, which recommended monetary unification only among
economies with flexible markets, free mobility of labour, a centralised fiscal
policy, and a limited incidence of asymmetric shocks. Clearly, these conditions
did not - - and do not - - hold for the euro area. After all, the euro zone is
characterised by significant rigidities in labour and product markets, the
absence of a significant centralised fiscal transfer mechanism, and national
economies with unique institutional and economic features - - a set of
circumstances that results in a high incidence and impact of asymmetric shocks.
In these circumstances, so the argument goes, such shocks are
likely to lead to widening price differentials so that a common nominal interest
rate in the monetary union results in different 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 match the needs of all
members.
The foregoing, traditional view of optimum currency areas
neglects several important factors. It seeks to identify the characteristics
that a country should satisfy prior to joining a monetary union - - that is, ex
ante. We now know, however, that participation in a monetary union may itself
induce changes in economic structure and performance ex post through at least
two channels. These channels operate through enhanced credibility and trade and
financial integration.
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 inflation bias of
discretionary monetary policy. With low and stable inflation and inflation
expectations, nominal interest-rate differentials between these countries and
countries with histories of relatively-low inflation rates, such as Germany,
have almost been eliminated. With lower nominal interest rates in traditionally
high-inflation countries, the cost of servicing public-sector debt is reduced,
facilitating fiscal adjustment, and freeing resources for other uses. Moreover,
with low and stable inflation, economic horizons lengthen, encouraging a
transformation of the financial sector. The lengthening of horizons and the
reduction of interest rates stimulate private investment and risk taking,
fostering faster growth.
For Greece, entering the euro zone has meant not only the
loss of an independent monetary policy - - the fruits of which were amply
demonstrated in the 1980s and the early 1990s - - but also the credibility gains
associated with a stable, low-inflation monetary regime. In the 15 years until
1994 - - the year in which Greece's efforts to qualify for euro-area entry began
in earnest - - inflation averaged almost 20 per cent while real growth averaged
less than 1 per cent. In contrast, during the past 6 years real growth has
averaged more than 4 per cent while inflation has been slightly above 3 per
cent. Another way to infer the credibility gains is by looking at interest-rate
spreads. In 1997, the year in which a 10-year government bond was first issued
in the Greek financial market, the yield differential between that bond and the
comparable German bond was 412 basis points. Today, it stands at only 24 basis
points. I suggest, therefore, that giving up a nationally-tailored monetary
policy has not, in fact, been a cost, but a benefit.
Now let me turn to the trade channel. Recent empirical work
has shown that a common currency can promote trade and growth over and above any
effect produced by separate currencies tied together with fixed exchange rates.
For the euro area, the evidence suggests that the adoption of the euro has
already increased trade among EMU members by between 4 and 16 per cent compared
with trade among European countries that have not adopted the euro. Increased
trade integration leads to more-highly-correlated business cycles because of
common demand shocks and greater intra-industry trade, reducing the need for
country-specific monetary policies.
There are additional reasons that a monetary union reduces
the incidence of country-specific shocks. One of the principal causes of
asymmetric shocks - - the effects of divergent monetary policies - - no longer
exists. Furthermore, it is to be expected that the deepening of financial-market
integration will also entail a convergence in the transmission mechanism of
monetary impulses. Finally, the common currency helps to increase price
transparency and, therefore, competition in goods, services and factor markets,
leading to a further alignment of economic cycles.
Inflation Differentials
The fact remains, however, that there are inflation
differentials among the members of the euro zone. How significant are these
differentials and how concerned should we be? Recent evidence provided by the
ECB shows that, over the period 1990-99, the 12 countries now comprising 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 - - that is, it remains less than a percentage point. To provide a
basis of comparison, since 1999 inflation dispersion across the euro area has
fluctuated close to the level observed across the 14 metropolitan statistical
areas of the United States. Remarkably, the process of nominal convergence in
the euro area was not accompanied by greater dispersion of real GDP growth
rates, which has remained close to its historical average of around 2 percentage
points following the adoption of the euro.
There is one notable difference, however, between inflation
differentials in the euro area and those in the United States. Although
inflation differentials in the euro area have not widened, they have exhibited a
relatively-high degree of persistence, higher than that experienced across the
14 metropolitan statistical areas of the United States. Seven of the 12
euro-area economies have recorded annual inflation rates that have remained
either persistently above or persistently below the euro-area average since
1999. One of those countries is Greece, where inflation has persistently
exceeded the euro-area average by about one-and-a-half percentage points since
Greece became a member of the euro area in 2001.
Several factors have contributed to the persistence of
inflation differentials across euro-area economies. One factor in relatively-low
income countries, such as Greece, is 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. Although it is
difficult to quantify this effect with precision, it provides only a partial
explanation for the persistent inflation differentials that exist in the euro
area. In any case, this effect is a transitory one. It is part of what I have
called the adjustment mechanism - - in this case, the adjustment to a higher
standard of living.
Other factors contributing to the inflation differentials
within the euro area, including misaligned fiscal policies, wage dynamics not
linked to productivity developments and structural inefficiencies such as
rigidities in product and factors markets, are not so benign. Redressing these
problems, as you know, is not within the domain of monetary policy. National
economic policies are the relevant instruments to enhance the ability of
individual countries to respond to economic shocks and to national divergences.
I believe that EMU has helped stimulate reforms in the euro area. Major reforms
are undoing the rigidities accumulated over decades, preparing social
institutions for the looming demographic changes and making the euro area
increasingly competitive internationally. It is crucial to continue
strengthening competition in labour and product markets, for example, through
liberalisation and deregulation, to improve the efficiency of price signals.
National fiscal policies also provide important instruments. They can react to
shocks in such a way as to counteract the emergence of differentials. However,
sound public finances are an essential element of price stability and are
necessary if automatic stabilizers are to work fully without the risk of
excessively high deficits. In this respect it is important that Governments
strive to achieve balanced budgets or surpluses in periods of favourable
economic activity.
What difference would such changes make? I previously
referred to the relatively-low dispersion of real growth rates in the euro area,
which is, in fact, of an order of magnitude near that existing among regions of
the United States. The dispersion among US regions, however, is centered around
a higher average growth rate. Since 1999, the US economy, which is more flexible
than that of the euro zone, has grown at an average rate of about 3.1 per cent,
compared with about 1.9 per cent average in the euro area.
Although some reforms have been implemented since the start
of EMU, the euro area is still not an optimum currency area in the traditional
sense. This is the reason that it is important that national labour market
policies enhance flexibility at the national and regional levels. Structural
policies should also aim at improving the efficiency of the wage and price
setting mechanism to reduce the persistence of inflation divergence. In this
connection, I should note that in some countries, such as Greece, wage behaviour
has not fully adapted to the new regime.
Conclusions
Let me conclude with the following thoughts. Recent events
have given rise to some populist rhetoric about the wisdom of a single currency
within Europe. A few commentators have posed the question: Why have a monetary
union in Europe? My perspective is very different. I share the sentiment of my
colleagues on the Governing Council who have dismissed as "absurd"
speculation that the euro area's future has been thrown into doubt. A
single-size monetary policy has worked extremely well, delivering price
stability so that changes in prices convey more effective information about
demand and supply conditions.
The credibility of the ECB's monetary policy has delivered
interest rates that are at historically low levels to all member countries of
the euro-area. Yet, price stability and low interest rates are not enough to
raise growth and improve living standards. They provide the fabric upon which a
more dynamic Europe can be woven. Recent events, in my view, only confirm that a
currency union requires more flexibility and a higher level of competition than
do independent monetary areas. Flexible markets and strict fiscal rules are not
just superfluous conditions for members of a monetary union, but necessities
that will make monetary union work. In response to those who are asking,
"Why have a single currency? let me cite some wise words penned by the late
Irish playwright, George Bernard Shaw. "Some people," he wrote,
"look at things as they are and ask, 'Why?' I look at things as they might
be, and ask 'Why not?'" This, Ladies and Gentlemen, is the way I look at
the future of Europe. Why not, indeed?
Ladies and Gentlemen, thank you for your attention.