Does One Size Fit All? Monetary Policy and Integration in the
Euro Area
Address by Governor Nicholas C. Garganas
Santiago, Chile, 12 October 2007
[SLIDE 1]
1.
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.
[SLIDE 2] 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.
Page 1 of 24
I.
The
ECB’s
Monetary
Policy
Strategy
and
its
implementation [SLIDE 3]
2.
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.
3.
[SLIDE 4] 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.
4.
[SLIDE 5] 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,
developments
in
focuses
recognition
on
of
money
and
empirical
credit
evidence
suggesting that monetary growth and inflation tend to be
closely related in the medium to long run.
Page 2 of 24
5.
[SLIDE 6] 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.
6.
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 ratesetting Governing Council meeting.
7.
[SLIDE 7] 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 [SLIDE 8]
[Figure
1:
inflation
and
interest
rates].
[SLIDE
9]
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. [SLIDES 10 (11)] [Figure 2: inflation expectations] The
anchoring of expectations clearly attests to the ECB’s credibility.
Page 3 of 24
8.
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.
II.
Does One Size Fit All? [SLIDE 12]
9.
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 [SLIDE 13]
10.
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 pre-requisites 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.
11.
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. [SLIDE 14] In these circumstances, so the argument
goes, shocks are likely to lead to widening inflation differentials so
Page 4 of 24
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.
12.
[SLIDE 15] 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
13.
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.
14.
[SLIDE 16] 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
1
For a survey of this literature, see DeGrauwe and Mongelli (2005).
Page 5 of 24
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.
15.
[SLIDE 17] 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.
16.
[SLIDE 18] 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.
17.
The euro has also had a positive effect on intra-euro area FDI.
Between 1999 and 2005 (the latest data available) the stock of intraeuro area FDI more than doubled, from around 14 per cent of euro
area GDP to over 30 per cent.
See Rose and Stanley (2005) for a survey of the literature on the trade-creation
effects of a common currency.
3
See Baldwin (2006).
2
Page 6 of 24
18.
Increased trade integration, along with growing intra-euro area
FDI flows, lead to more highly-correlated business cycles [SLIDES
19 (20)] because they increase the incidence of common demand
shocks and result in more intra-industry trade. [Figure 3 – rolling
business cycle correlations] As a consequence, the need for countryspecific monetary policies is reduced.
19.
[SLIDE 21] 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.
20.
[SLIDE 22] 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. [SLIDE 23] [Figure 4: corporate bond issues] 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. [SLIDE 24] [Figures 5: government bond market
spreads; [SLIDE 25] Figure 6: rolling correlations of equity market
returns] 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.
21.
[SLIDE 26] 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
Page 7 of 24
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.
22.
[SLIDE 27] 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 [SLIDE 28]
23.
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?
24.
[SLIDE 29] 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. [SLIDE 30] Since that time, inflation
dispersion has changed very little − and for some time now it has
been less than a percentage point. [Figure 7: inflation dispersion in
euro area cf US]
25.
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. [SLIDE 31] Where
Page 8 of 24
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.
26.
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 BalassaSamuelson 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. [SLIDE 32] 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. [SLIDE
33] [Figure 8: inflation and unit labour costs] 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.
Page 9 of 24
27.
[SLIDE 34] 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. [SLIDE 35] [Figure 9: growth dispersion euro area
– US] Moreover, inflation and growth across the euro area appear to
move together. [SLIDE 36] [Figure 10: inflation and growth scatter
plot]. [SLIDE 37] 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.
III. Conclusions
28.
[SLIDE
38]
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.
Page 10 of 24
29.
[SLIDE 39] 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.
30.
[SLIDE 40] 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.
31.
[SLIDE 41] 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.
Page 11 of 24
32.
[SLIDE 42] 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.
Page 12 of 24
Figure 1: Annual inflation (HICP) and Main Refinancing Operations (MRO) rate
(January 1998 - August 2007) (in percent)
5.0
5.0
HICP
4.5
HICP excluding unprocessed food and energy
4.5
4.0
MRO rate
4.0
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
Ju
Ja
n
19
9
8
l1
9
Ja 98
n
19
Ju 99
l1
9
Ja 99
n
20
Ju 00
l2
0
Ja 00
n
20
Ju 01
l2
0
Ja 01
n
20
Ju 02
l2
0
Ja 02
n
20
Ju 03
l2
0
Ja 03
n
20
Ju 04
l2
0
Ja 04
n
20
Ju 05
l2
0
Ja 05
n
20
Ju 06
l2
0
Ja 06
n
20
Ju 07
l2
00
7
3.5
Source: ECB
Page 13 of 24
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
SPF (4)
Consensus Economics (5)
0.0
0.5
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
Page 14 of 24
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
Page 15 of 24
0.9
Figure 3: Euro Area Rolling Business Cycle Correlations and
Logarithmic Trend Line (1997-2008)
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
business cycle correlations
Log. (business cycle
correlations)
0
1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 20052000 2001 2002 2003 2004 2005 2006 2007 2008
Page 16 of 24
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
Page 17 of 24
Figure 4: International Corporate Bonds by Country of Nationality:
Amounts outstanding (millions USD)
350000
300000
250000
200000
150000
100000
50000
Euro Area
Germany
Spain
France
Greece
03-07
03-06
03-05
03-04
03-03
03-02
03-01
03-00
03-99
03-98
03-97
03-96
03-95
03-94
03-93
03-92
0
Italy
Source: BIS database
Page 18 of 24
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
Figure 5: Spreads between 10-year benchmark european sovereign
bond yields and the German benchmark (per cent)
8
6
4
2
0
-2
France
Italy
Spain
Greece
Source: BIS database
Page 19 of 24
Figure 6: Correlations between German and other European
returns -on composite stock indices - Rolling 24-month window
1
0.75
0.5
0.25
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
0
France
Italy
Spain
Greece
Source: BIS database
Page 20 of 24
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
2007M01
2006M01
2005M01
2004M01
2003M01
2002M01
2001M01
2000M01
1999M01
1998M01
1997M01
1996M01
1995M01
1994M01
0.00
Source: US Bureau of Labor Statistics and ECB
Page 21 of 24
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
inflation
FR
IT
LU
NL
AT
PT
FI
ULCs
Source: ECB
Page 22 of 24
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
4.50
US50
US8
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
Page 23 of 24
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
Page 24 of 24