xperience to date Paul van den Noord OECD Invited lecture at the - PDF document

xperience to date Paul van den Noord OECD Invited lecture at the University of Iceland, 21 September 2004 Views expressed do not necessarily reflect those of the Organisation or its member countries Introduction The adoption of the euro by 12 of the then 15 members of the European Union represented a major step forward in the pursuit of economic integration, building upon and enhancing the achievements of the single market strategy. With the exchange risk disappearing, financial markets have deepened. Funding costs for European corporations have declined and corporate bond issues have soared. Mergers and acquisitions surged, strengthening the corporate sector. Price comparisons have become easier, which stimulates competition. Monetary union is now a tangible everyday reality for over 300 million citizens in Europe. The Eurosystem led by the European Central Bank, which is running the single currency, weathered a major stress test in the immediate aftermath of the 11 September 2001 terrorist attacks, with co-ordinated action to inject liquidity into the financial system organised effectively and timely. As well, supported by extensive and careful preparation, the introduction of cash euros on 1 January 2002, and the subsequent withdrawal of legacy currencies, turned out to be very smooth. Still, developments during the first five years of the single currency have been more challenging than expected. The global slowdown has affected the euro area more strongly than had been expected, with below potential growth continuing for four years. The closer integration that monetary union was seen as bringing has not yet translated into any visible strengthening of trend growth. While monetary policy has done relatively well and established its credibility, fiscal policies have fared less well. Several countries failed to move toward the medium-run fiscal goals set by the Stability and Growth Pact (SGP) at the cyclical peak in 1999-2000 and as a result went beyond the Treaty limits in the downturn, resulting in unpleasant tradeoffs between long- and short-run goals. How have individual countries – notably the smaller ones – fared against this backdrop? What lessons can be drawn? I will start my presentation with issues concerning macroeconomic management. Next I will look at longer-term growth implications. Hopefully this prepares the ground for an interesting Q&A session at the end. 1

Macroeconomic management Nominal convergence was a precondition for adoption of the euro After they had ratified the Maastricht Treaty in 1992, EU countries had to prepare for the adoption of the euro. The would-be euro members were committed to striving towards the eventual adoption of the euro upon fulfilment of the convergence criteria laid down in the Treaty, namely, a high degree of price stability, a sound fiscal situation, a stable exchange rate and low long-term interest rates: • Inflation should not exceed by more than 1½ percentage points that of, at most, the three best performing member states in terms of price stability. • The budget must not be in an excessive deficit position, i.e. the deficit must be below 3 per cent of GDP and gross debt below 60 per cent of GDP or converging towards this threshold at a satisfactory rate. • Long-term interest rates must not exceed that of, at most, the three best performing EU countries in terms of price stability by more than 2 percentage points. • Before adopting the euro, member states are required to have participated for at least two years in the Exchange Rate Mechanism II (ERM II) pegging their currencies onto the euro before the convergence assessment without severe tensions in the foreign exchange market. Denmark and the United Kingdom negotiated an opt-out clause, a. Sweden stayed out of ERMII and on that basis it has been granted a “derogation” and is not yet obliged to adopt the euro. As a rule EU countries without an opt-out are legally committed to adopt the euro eventually. Conversely, EU membership is a binding precondition for adoption of the euro. Convergence stalled somewhat after the introduction of the euro Inflation dispersion diminished considerably in the run up to the launch of the euro – moving towards the dispersion recorded in the United States (Figure 1). Inflation dispersion picked up after 1999, reflecting high inflation in some of the smaller economies (notably Ireland and the Netherlands), but it diminished again in 2003 as inflation in these countries moderated. Inflation dispersion has been somewhat larger than in the United States, but the difference is small considering that the US economy is more integrated and of course has a much longer history as a monetary union than the euro area. Since the launch of the single currency the dispersion of economic growth has been somewhat larger than the dispersion of inflation, although the two are correlated. Between 1999 and 2003, the smaller economies expanded at an annual rate of 3 per cent as compared with 1½ per cent for the three major economies, although more recently the growth difference between the smaller and larger countries has narrowed considerably, with growth coming down quickly in Finland, Ireland, the Netherlands and Portugal. Growth differences across countries may stem from different cyclical positions, but may also reflect differences in trend output growth. In either case this may contribute to inflation dispersion; and countries that are growing fast as they catch up with the rest of the area may post higher inflation on account of the “Balassa Samuelson” effect. Smaller countries benefited most as “start-up shocks” worked out favourable for them The admission to the euro had many advantages for smaller EU member countries. The most tangible advantage was that they benefited from the credibility of a low inflation target, especially those countries 2

that had a history of high inflation. Adoption of the single currency also eliminated the exchange rate risk and led to lower interest rates. It also allowed smaller countries to participate fully in a deep, liquid and integrated capital market. Trade with other EU member countries increased since transaction costs were reduced. Larger, more closed member countries had less of these benefits or were still digesting earlier problems. The adoption of the single currency thus resulted in major shocks to which individual countries are still adjusting. This may mask any underlying tendency towards a convergence of business cycles. A number of these “start-up” shocks can be identified, including: interest rate shocks (monetary union has meant sharply lower real interest rates in some countries) and rising capital mobility (with foreign direct investment benefiting also the “periphery” of the area which became less prone to exchange rate shocks). These shocks have worked out differently for the small and large countries. Housing markets may have acted as an important vehicle of transmission of these shocks onto economic activity and inflation. The main mechanisms involved are as follows: • Falls in the nominal interest rate or in the nominal exchange rate – via imported inflation – both lead to an initial decline in the real interest rate. • This, in turn, boosts activity and the demand for housing. House prices increase and the associated wealth effects reinforce activity and produce subsequent rounds of housing and overall inflation. • The impact on inflation and activity eventually peters out as the real effective exchange rate appreciates. Moreover, the rate of increase in house prices is choked off as real interest rates rebound and the level of house prices approaches equilibrium. The competitiveness effect affects the smaller euro area countries most because of their greater exposure to foreign trade. At the same time, the impact of the wealth effect on some of the smaller economies may also be larger as their financial and housing market institutions are more conducive to the withdrawal of housing equity while their typically more generous tax incentives for owner occupied housing render housing demand less sensitive to price fluctuations. Another “start-up shock” that may have contributed to diverging inflation and growth developments in the euro area stems from a possible misalignment of real exchange rates when the conversion rates between the euro and the old currencies were fixed. In the early-1990s the euro area was hit by a series of exchange rate shocks and the subsequent correction may have been incomplete when the euro was launched. Countries whose exchange rate was overvalued when the conversion rates were fixed would see their pricing power in world markets adversely affected, putting downward pressure on inflation and economic activity. Importantly, this may have been the case in Germany, which had experienced an appreciation in its real effective exchange rate in the aftermath of reunification (Figure 2). Its comparatively low inflation may thus be of an equilibrating character as the initial imbalances called for a decline in German relative prices against the rest of the euro area. However, the adjustment of relative prices may be costly in terms of lost growth due to rigidities and inflation inertia. This points to a need for structural reforms to heighten wage and price flexibility. The single currency has shielded countries from a repeat of such asymmetric exchange rate and interest rate shocks. This is a valuable asset. Nevertheless, with the single currency in place, monetary conditions in the individual countries during the recent downturn could not be attuned to domestic needs. 3