The single monetary policy and the analytics of OCAs: what has the euro area experience taught us?
30/04/2008 - Speeches
1. It gives me great pleasure to be here today to give this
public lecture on the European experience with monetary union. The fact that the
lecture is taking place at my Αlma Μater makes this occasion a particularly
special one for me, and I am grateful to Howard Davis and Kevin Featherstone for
extending me the invitation. I hope that what I have to say will provide some
food for thought. Indeed, I am hopeful that I may be able to convince some
sceptics in the audience – and I know that they are out there – that monetary
union among European countries can and does work!
2. The adoption of the euro by 11 EU countries in 1999 was a
remarkable achievement. It represented the culmination of a process of
integration and convergence that had begun some 50 years earlier. The creation
of the euro could be viewed as the end of a process, with Europe having finally
reached full economic and monetary integration. Such a view, however, would, at
best, be incomplete. Although the introduction of the euro marked the
culmination of a long process, it also marked the beginning of another one. In
particular, it created new challenges for economic policy. I will focus on these
challenges in what follows.
3. A natural starting point for analysis of the benefits and
costs of a monetary union is the theory of optimum currency areas, originated by
Robert Mundell in the early 1960s, and an important reason for his Nobel Prize
in Economics. This literature on optimum currency areas identifies two main
costs of a country’s participation in a monetary union. These costs are the loss
of an independent monetary policy and the ability to alter the nominal exchange
rate in order to mitigate the effects of asymmetric shocks. The theory also
identifies the desirable characteristics that potential members of a single
currency area should have in order to minimise these costs. The characteristics
are sometimes viewed as preconditions for judging whether a nation should join a
currency union.
4. I will argue that this traditional way of thinking about
judging optimality is incomplete. Underlying my argument are the following two
factors.
• First, the traditional approach has to be modified to take
modern developments in monetary theory and policy into account. In a world in
which monetary policy is best suited to achieve price stability, the loss of
monetary policy independence may not be very costly. In fact, for a small open
economy, such as Greece, it may actually provide net benefits.
• Second, it can be misleading to view the optimum-currency-area
characteristics as preconditions for ensuring the success of a country’s
participation in a monetary union. In particular, to view the characteristics as
preconditions overlooks the fact that the characteristics, or criteria, can
themselves be endogenous. 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 Loss of Monetary Policy Independence to the ECB
5. Let me first turn to the matter of the loss of monetary
independence. Modern monetary theory emphasises the role of monetary policy in
providing price stability. By so doing, monetary policy can best provide a
stable environment, which is a prerequisite for growth. This view contrasts
strongly with the view that monetary policy can be used for fine-tuning the
economy.
6. The intellectual underpinnings of the emphasis on price
stability can be traced to Milton Friedman’s and Ed Phelps’ critique of the
Phillips curve in the late 1960s. …. On a brief personal note, I was privileged
to have been taught macroeconomics at LSE by A W Phillips. Professor Phillips
was an excellent teacher who made contributions in many areas of macroeconomics.
In fact, it is well known that Milton Friedman tried to recruit him to the
University of Chicago, but, fortunately for LSE, he declined. …. The Phillips
curve expressed the idea of a trade-off between inflation and unemployment. The
Friedman-Phelps insight, which helped earn those economists their respective
Nobel prizes, was that the trade-off was, at best, temporary. Repeated attempts
to reduce unemployment by allowing inflation to rise would result in ever-increasing
inflation with unemployment returning to its natural rate. Although the Friedman-Phelps
hypothesis swept through academia in the 1970s, policy makers were slower to
catch on. As a result, the 1970s, and in some cases the 1980s, provided a real-world
laboratory for testing the Friedman-Phelps hypothesis. As we now know, central
banks that kept trying to pin down the rate of unemployment wound up with both
high inflation rates and high unemployment rates. This was a lesson that would
not be lost on subsequent generations of central bankers.
7. Building on the Friedman-Phelps insight, Finn Kydland and
Ed Prescott showed that a central bank engaged in discretionary policies has an
incentive to promise low inflation, but then to run an expansionary monetary
policy that produces higher inflation without lowering unemployment. In a
contribution that helped earn these authors the Nobel Prize in 2004, Kydland and
Prescott showed that, to be credible, central bankers must demonstrate that they
are fully committed to a low-inflation objective. Full commitment in the Kydland-Prescott
framework, necessitates independence from political pressures to follow
inflationary monetary policies. Otherwise, once inflation expectations become
entrenched, it can be very difficult to reduce them. The costs of doing so, in
terms of higher unemployment, can be substantial. Again, the experiences of
country after country which pursued expansionary monetary policies in the 1970s
and 1980s provided the laboratory.
8. These insights, and the subsequent literature built around
them, contributed to the now widely-held view that central banks should have
independence from the political process with a mandate to achieve price
stability. In this way the monetary authorities can make the best possible
contribution to supporting sustained economic growth and employment creation.
9. The monetary policy strategy of the ECB can be seen in
this light. It involves three key elements. First, there is the objective of
price stability which the ECB defines 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. Price stability is a medium-term goal reflecting the
long lags involved in the transmission of monetary policy.
10. Second, the “two pillars” of economic and monetary
analyses have been formulated so as to enable the ECB to attain its objective.
• In the economic analysis, an assessment of current economic
and financial developments from the perspective of the interplay between supply
and demand in the product and factor markets is made. This provides short- to
medium-term indications of inflation.
• As a cross-check to the economic analysis, the monetary
analysis focuses on money and credit developments in recognition of empirical
evidence suggesting that monetary growth and inflation tend to be related in the
medium to long run.
11. The final element is central bank independence. The
Maastricht Treaty grants full political independence to the ECB in its pursuit
of price stability. 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, including, in the case of the ECB, those in the European
Parliament. 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.
12. The success of the ECB’s monetary strategy is borne out
by its record. Since the inception of the euro area, average inflation in the
euro area has been 2.08%, a shade higher than the ECB’s definition of price
stability. Inflation expectations have also remained firmly anchored around the
ECB’s definition of price stability, attesting to the ECB’s credibility. Long-term
interest rates have been at historically low levels.
13. For countries such as Greece, with histories of high
inflation, the gains from joining the euro area have been very substantial. For
years, Greece suffered from double-digit inflation. Growth was anaemic and
unemployment rose in spite of periods of fairly loose monetary policy. Nominal
interest rates were high, reaching close to 30 per cent at times during the
1980s. In contrast, the low levels of nominal interest rates experienced in the
euro area, reflecting the low levels of inflation expectations, have created
conditions for an improved business climate, higher investment and, ultimately,
higher growth.
14. In sum, the loss of monetary policy independence,
identified in the earlier optimum-currency-area literature as one of the two
main costs of joining a monetary union, is not necessarily a cost after all.
That earlier literature was formulated in the context of Keynesian demand-management
policies that were popular in the 1960s. Since that time, however, both economic
theory and the experience of high unemployment coupled with high inflation have
taught us the importance of a credible monetary policy aimed at providing price
stability.
15. Moreover, I have argued that for countries with histories
of high inflation and political interference in policy formation, a credible
monetary policy can be attained by joining a monetary union with an independent
central bank. I also mentioned, however, that the earlier literature on optimum
currency areas identified a second cost of joining a monetary union – the loss
of the exchange-rate instrument. After all, monetary policy can be focused on
price stability, but, in the face of an asymmetric shock, the nominal exchange
rate may change so that adjustment is facilitated. How important, then, is the
exchange-rate instrument in dealing with asymmetries among the countries
participating in the euro area?
II. Asymmetric shocks and the loss of the exchange rate as
a policy instrument: the preconditions for monetary union reassessed
16. The early literature on optimum currency areas included a
search for mechanisms that could replace the exchange rate or compensate for its
absence. This search led to the identification of a number of criteria on which
the optimality of a potential currency area could be assessed. These criteria
effectively became preconditions for forming a single currency area.
17. I will argue that this traditional view is static in
nature. It assumes that a country’s characteristics are immutable. In fact, the
experience of the euro area suggests that participation in a monetary union can,
in itself, induce changes in economic structure and performance that make the
currency area optimum. Much academic research, based on the experience of
European monetary union, indicates that the creation of a monetary union can
itself create conditions favourable to the well-functioning of the union, either
through endogenous changes in the way the economies of the union operate or
through policy changes induced by the existence of the union. Let me illustrate
by discussing some of the so-called preconditions enumerated in the early
literature and looking at their evolution within the euro area.
18. Mundell, in 1961, identified high mobility of the factors
of production (both capital and labour) as a precondition for giving up the use
of the national exchange-rate. While labour mobility is still low within the
euro area, reflecting, in part, linguistic and cultural differences, the
mobility of capital has been increasing as evidenced by the positive effect that
the euro has had on intra-euro area FDI. Between 1999 and 2006 (the latest data
available), the stock of euro area FDI more than doubled, from around 14 per
cent of euro area GDP to over 30 percent.
19. The importance of the mobility of financial capital was
highlighted not only by Mundell (1961), but also by James Ingram who, in 1962,
emphasised the role that financial market integration could play in reducing the
costs of monetary union. Deeper financial market integration can help in a
number of ways. First, it can cause the transmission mechanism of monetary
impulses to become more similar throughout the countries of the union. Second,
it can help reduce the impact of asymmetric shocks by causing equilibrating
movements in capital flows. Finally, it can allow members of the union to insure
against the impact of asymmetric shocks since it provides opportunities for
diversification of income sources. If members of the monetary union hold claims
on other countries within the union, then the income effect of any asymmetric
shocks would be mitigated.
20. The introduction of the euro has helped make 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 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. The main area where financial integration has lagged
is that of retail banking where, in spite of an increase in cross-border mergers
and acquisitions in recent years, cross-border activity remains relatively
limited.
21. 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, are further encouraging integration. An example is TARGET2, the new
payment platform for the financial system, which began operating in November
2007. As integration proceeds, we can expect that monetary transmission
mechanisms across the euro area will continue to converge, helping the
implementation of the single monetary policy and bringing the euro area closer
to an optimum currency area.
22. Ronald McKinnon, in 1963, added the criterion of openness.
The more open the economies of a monetary union, the less effective nominal
exchange rate changes will be in facilitating adjustment because the changes are
more likely to feed onto domestic prices and wages, offsetting the
competitiveness gains.
23. Recent empirical evidence, however, has shown that a
common currency (as opposed to separate currencies tied together with fixed
exchange rates) can promote openness, or trade integration. 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.
24. 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
euro.
25. Kenen (1969) emphasised product diversification, the idea
being that countries which were more diversified or less specialised in
production would be less likely to face asymmetric shocks. Indeed, before the
formation of European monetary union, there was considerable worry that monetary
union would cause national economies to become more specialised as production
became concentrated to reap the benefits of scale and agglomeration economies.
Whilst there is perhaps little evidence that the advent of monetary union has
caused economies to become even more diversified, there is no evidence that they
have become more specialised, thus allaying these early fears.
26. Another contribution to optimum-currency area literature,
again made by Peter Kenen in 1969, brought out the importance of establishing a
fiscal transfer mechanism at the supranational level in order to help stabilise
economies hit by asymmetric shocks. While such a centralised fiscal mechanism is
extremely limited in Europe, the Stability and Growth Pact with its emphasis on
budgets being either in balance or surplus over the economic cycle is designed
to ensure that national budget have the flexibility to react to adverse
asymmetric shocks.
27. In sum, the creation of the euro may itself be
contributing to the very conditions that make the use of nominal exchange-rate
adjustments among the members of the euro area less necessary than was the case
before they joined the euro area. Nevertheless, it can be argued that a country
surely must give up something if it no longer has the exchange-rate tool. My
reaction to this argument is that adjustment of the nominal exchange-rate is not
a magic bullet. One should not expect an economy with competitiveness problems,
running, say, current account deficits equal to 6 per cent of GDP, to depreciate
the nominal exchange rate and become competitive for-ever-after. We tried this
policy in Greece in the 1980s; and wound up with higher inflation, undiminished
current-account deficits, and a currency that became prone to speculative
attacks.
28. By its very nature, the current account is the result of
intertemporal decisions with respect to savings and investment by the private
sector and government. It should not be surprising, then, that the nominal
exchange rate cannot be relied upon to bring about lasting adjustment. Such
adjustment requires changes in an economy’s structure, and, as I have argued,
membership in a monetary union can encourage those changes.
III. Conclusions
29. I have argued that ways of thinking about monetary union
have evolved considerably from the early days of the literature on optimum
currency areas. Developments in modern macroeconomics recast the goals of
monetary policy. The focus nowadays on price stability and the creation of the
conditions necessary to support growth and employment changes the balance of the
arguments about the cost of giving up an independent monetary policy. Provided
that the monetary policy framework at the union level delivers price stability,
there is little to be lost from transferring monetary policy to the union level.
30. The success of the euro area has demonstrated that one
size can fit all. Let me briefly mention three pieces of evidence which support
this. First, inflation dispersion has declined and has been around 1 percentage
point since the second half of 1999. This compares favourable with inflation
dispersion across a monetary union of similar size, the US. Second, the decline
in inflation dispersion has not been at the expense of higher growth dispersion.
Growth dispersion has remained close to its historical average of around 2
percentage points and, if any trend is discernable, it is a downward one.
Finally, business cycles appear to have become more correlated.
31. The evidence from almost 10 years of monetary union in
Europe points to a euro area which is endogenously adapting itself to become an
optimum currency area. The euro area provides clear evidence that the criteria
identified in the earlier literature do not need to be exogenously in place
prior to monetary union. I do not want to leave you with the impression, however,
that euro-area policy-makers can sit back and relax because all the necessary
work has been done. After all, I began this lecture by remarking that the
adoption of the euro created new challenges for economic policy. The adoption of
the euro was neither the beginning nor the end of an optimum currency area among
European countries. The process is ongoing, and much more needs to be done,
especially in regard to structural policies, to ensure that the euro area
becomes a more dynamic force for growth in the global economy. It is my view
that the experience of the euro area to date only serves to highlight the fact
that a currency union requires flexibility and competition in factor and product
markets. These are the characteristics that will make monetary union work more
effectively.
Thank you for your attention.
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