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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

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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

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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
f 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

n 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

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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

verall 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

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For illustrative purposes I compare actual interest rates with those resulting from a standard Taylor rule. From Figure 3 it can be inferred that countries like Ireland, Greece, the Netherlands, Portugal and Spain in principle had needed, for domestic purposes, higher interest rates than Germany, France, Italy, Austria, Belgium and Finland. Equilibrating forces coming through external competitiveness have been offsetting to some extent. The majority of smaller countries have been prone to cost increases, although this was not true for Ireland and Finland, because of sizeable productivity gains. Among the larger countries, Germany and France posted gains in competitiveness, but in the case of Germany this has not sufficed to boost the economy out

f stagnation while Italy actually lost competitiveness.

Lasting gains could emerge from greater stability and more flexible markets The efficiency gains stemming from the single currency in terms of lower transaction costs and enhancing the internal market are considerable. But for individual countries membership in the euro area also implies the loss of sovereign interest rate and exchange rate instruments in the pursuit of stabilisation

goals. How big this potential cost is depends inter alia on:
The nature and frequency of shocks that hit individual countries (countries that are frequently

hit by asymmetric shocks will have to rely on real exchange rate adjustment via wages and prices, real interest rates may behave pro-cyclically)

Asymmetries in the transmission of common shocks including differences in monetary

transmission mechanism (Similar problems as those related to asymmetric shocks)

The effectiveness of market mechanisms (flexibility of prices and wages) and automatic fiscal

stabilisers (this determines how long it takes to absorb an asymmetric shock and the size of the sacrifice ratio) “Endogenous optimal currency area” theory predicts that monetary union will prompt integration progressively reduce long lasting cyclical divergence. Three mechanisms are prominent:

As product markets integrate and economies become more exposed to intra-area trade,

asymmetric shocks will be shared to a greater extent with the other countries in the monetary union via net imports

The integration of financial markets will allow greater diversification in country exposure in

portfolios, with a similar effect as greater trade exposure.

The risk of asymmetric policy shocks becomes smaller; the risk of asymmetric monetary

policy shocks disappears. This is less obvious for fiscal policy shocks, which is one reason why a common fiscal policy framework was seen as essential. Fiscal prudence also looks essential From the outset co-ordination of fiscal policy was seen as vital to underpin a strong and stable single currency. There are three main concerns, whose relative weights have evolved over time:

Once exchange rates within the area ceased to exist, financial markets would no longer act as a

discipline on fiscal policy. Growing deficits in one country would spill over into area-wide interest rates. 4

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(The situation is different from that in the United States where financial markets do act as a disciplining factor for states’ public finances, probably because states in the United States are faced with greater mobility (hence less ownership) of their tax bases than the countries that constitute the euro area.)

In a monetary union with downwardly rigid wages and prices and virtual absence of cross-border

labour mobility the adjustment to adverse shocks may be protracted and fiscal policy is an indispensable channel for adjustment. (Again the situation is different from that in the United States where labour is highly mobile and wages and prices respond more promptly to local slack)

Several countries participating in the euro area suffer from “deficit bias” in public finances and

require a “stick” to encourage fiscal consolidation. Over time, this consideration has gained prominence over the concerns regarding spill-over effects and fiscal stabilisation policy, and is now seen as the primary motivation for fiscal co-ordination in the euro area. However, contrary to earlier expectations, the smaller countries generally showed better fiscal discipline than the larger ones. Perhaps the smalls took the threat of sanctions under the Stability and Growth Pact more seriously. As well, their stronger growth performance made it easier to comply with the fiscal commitments in monetary union. Longer-term cost and benefits Possible scenarios In the long run, economies in monetary union would be inclined to integrate with the rest of the area. Standard neoclassical growth theory predicts that deep integration will reduce disparities in living standards across regions or countries. More trade, knowledge spillovers and capital and labour mobility lead to factor price equalisation and a convergence in the endowment with physical and human capital. But there are some counter arguments emerging from the “new economic geography theory”. The neoclassical growth model assumes constant returns to scale and diminishing returns to capital inputs. However some industries have increasing returns to scale and integration may result in geographic specialisation and concentration. In this case, some regions win and others loose. The ultimate outcome in terms of the geographic distribution of economic activity and living standards will then depend on the mobility of factors, transport costs and trade barriers and the costs and benefits of agglomeration. Three scenarios van be envisaged:

Concentration will take place if there are strong gains from agglomeration and labour is

highly mobile. Agglomeration gains stem from technological spillovers and the proximity of suppliers or consumers. Mobility of labour implies that workers follow firms to attractive regions, while competition ensures factor price equalisation. The process of concentration lasts as long as the benefits from agglomeration outweigh transportation and rising congestion and labour costs. As benefits from integration and specialisation are reaped, the area’s growth rate is enhanced. But economic activity could become geographically concentrated. The US situation fits this model pretty well.

Dispersion will prevail if agglomeration forces are weak, market segmentation prevails and

labour mobility is low. Integration leads to geographic specialisation based on comparative advantage and all regions retain a diversified industrial base. The low mobility of labour 5

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dilutes agglomeration forces and weakens demand links, while wage determination is dominated by local conditions. In equilibrium, activity will be more dispersed, overall efficiency suffers and differences in living standards will perpetuate.

Polarisation occurs when low skilled labour is immobile and agglomeration forces are strong.

Agglomeration forces push firms to relocate, to benefit from demand linkages, cost advantages and economies of scale. Highly qualified labour is mobile and moves where it is

required. Less skilled labour stays in less developed regions. As real wages are rigid, pockets
f unemployment persist in some regions. Polarisation may accelerate when trade barriers and

transportation costs decline, as it makes it easy for firms to relocate. In this case, the long term outcome could be divergence rather than convergence. A young monetary union may be gradually moving from dispersion to polarisation. If so, economic policies that focus on reducing gaps in endowments (such as education levels) will help to mitigate polarisation forces. Labour mobility and wage flexibility are also essential, as well as policies that reduce transport costs and trade barriers, as these will speed up convergence. Trapping idle (labour) resources in lagging regions via ill devised labour market policies and market protection will hamper convergence. Living conditions indeed still differ considerably across the euro area (Figure 4). Real GDP per capita at the country level varies from around two thirds of the euro area average to about 25 per cent above and is still considerably wider at the regional level. Unemployment also varies a lot, the unemployment rate ranging from 2 to 11 per cent in 2002. By comparison, the variation in the United States is considerably smaller, unemployment rates across the 51 states lying between 3 and 8 per cent, whilst GDP per capita ranges from a quarter below the national average to a quarter above the national average. Only two states in the United States, accounting for 2 per cent of the population, would be eligible for structural funds, while in the euro area regions encompassing 25 per cent of the population are eligible. The Irish experience Why has it been the star performer of the euro area, not only in comparison with the other “cohesion countries” (Greece, Portugal and Spain), but indeed in comparison with any euro area country? The Irish experience seems to confirm that in a polarisation model the country with the best “initial conditions”

wins. Figure 5 shows that Ireland, which in the 1980s was still one of the least prosperous countries in the

European Union, has virtually caught up with US per capita GDP. Also on other indicators (employment and unemployment rates for example) Ireland scores very high. So, what is the story? Ireland experienced an impressive acceleration in employment growth and combined this with a sustained high growth in labour productivity (Table 1). The exceptional labour productivity growth in Ireland stems in part from the large multinational presence. Labour productivity growth gauged by growth in GDP per worker is biased upwards by the growing share of output in foreign-owned multinationals, whose profits are possibly over-reported for tax planning purposes. Computing labour productivity growth

n the basis of GNP (excluding net factor income transfers to abroad) rather than GDP would perhaps

knock off another 1 percentage point from productivity growth. But the numbers remain striking. There has been a confluent of factors that together may explain the productivity and employment "miracle" in Ireland. First of all, GDP has been boosted by the massive inflows of foreign direct investment (FDI) that sharply accelerated in the wake of the creation of the internal market in 1992. Ireland has benefited tremendously from its EU membership and the internal market, which allowed foreign companies to get easy access to European markets via Ireland. Ireland is a more attractive place to settle for multinationals in search of EU market access than some other "peripheral" EU economies (Spain, Greece, Portugal), it being English speaking, having a competitive corporate tax system, disposing of a 6

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flexible labour force (with many emigrated Irish returning) and being strategically located in a geographic sense (in Ireland you are probably the closest you can get to North America while still being in the EU, perhaps aside from Portugal). Moreover, the importance of investment in physical capital as a way of lifting labour productivity is well established. But because technological innovations are often embodied in new equipment, investment has the potentially more significant benefit of improving global connections, innovation and knowledge

diffusion. These factors may explain why countries with higher investment rates (relative to GDP) also

tend to have higher rates of multifactor productivity growth (albeit with causality flowing in both directions). The Irish performance is telling, it ranking very high in the OECD league of ICT investors (Figure 6). A series of other beneficial shocks, policy – and otherwise induced, contributed to the virtuous circle

f economic progress. A change in the fiscal strategy in 1987 allowed room for tax reductions, bolstering

competitiveness together with wage moderation. The doubling of EU aid in 1989 allowed to restart badly needed infrastructure projects that had been on hold because of the fiscal consolidation. Airline deregulation in 1986 prompted growth in tourism. Wage moderation has been argued to have promoted a shared understanding of the key economic mechanisms. It not helped to promote industrial peace but it also shifted wage leadership shifted from the high productivity growth FDI sector to the low productivity growth domestic sector. Unit wage costs increases dropped substantially as a result. Conclusions All considered, there appear to be both cost and benefits associated with the adoption of the euro, and these are not evenly distributed across countries:

The “ start-up shocks” associated with the convergence of interest rates and possible

misalignments of exchange rates when the conversion rates were fixed generally worked out favourably for the smaller countries and unfavourably for the bigger ones.

The loss of macroeconomic policy sovereignty is materially more important for small

countries who have little weight in the setting of area wide policy stances. Dealing with “asymmetric shocks” becomes a major challenge for them, although real exchange rate adjustment tends to be faster in the small economies than in the big economies participating in the monetary union.

Integration may prompt specialisation and this may carry significant social cost of adjustment.

On the benefit side, the following issues emerge:

The disappearance of exchange risk and the admission to a credible low-inflation

environment contributes to better capital allocation, lower real interest rates and higher profitability.

Economies will open up further and therefore asymmetric shocks will dilute via product (net

exports) and financial markets.

Integration into the euro area raises new opportunities for investment and growth, akin to the

Irish experience, provided that the policy settings – raising the quality of factor endowments, striving for efficient markets, keeping the fiscal house in order – are right. 7

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Figure 1. Inflation and output dispersion

1996 1997 1998 1999 2000 2001 2002 2003 0.0 0.5 1.0 1.5 2.0 0.0 0.5 1.0 1.5 2.0

A. Standard deviation of inflation

Euro area (1) United states (2)

0.0 0.5 1.0

B. Inflation differential against the aggregate rate (3)

United States

West urban Northeast urban Midwest urban South urban

0.0 0.5 1.0

Smalls Italy France Germany

Euro area

2 4 6 1 2 3 4

Inflation (1)

C. Correlation between inflation and activity (3)

Output gap (4)

R2 = 0.26 DEU FRA ITA AUT BEL FIN GRC IRL NLD PRT ESP LUX

2 4 6 8 1 2 3 4

Inflation (1) Real GDP growth

R2 = 0.42 DEU FRA ITA AUT BEL FIN GRC IRL NLD PRT ESP LUX

1. Harmonised index of consumer prices.
2. Consumer Price Index - All Urban Consumers for 27 areas.
3. Average for 1999 - 2003.
4. Per cent of potential GDP.

Source: OECD, US Bureau of Labour Statistics.

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Figure 2. Crowding out and crowding in

1990 1992 1994 1996 1998 2000 2002

1 2 3

Per cent

5 10 15 20 25 1990=0

Germany

Output gap (1) Real effective exchange rate (2) Real interest rate (1)

1990 1992 1994 1996 1998 2000 2002

1 2 3

Per cent

5 10 15 20 25 1990=0

France 1990 1992 1994 1996 1998 2000 2002

1 2 3

Per cent

5 10 15 20 25 1990=0

Italy 1990 1992 1994 1996 1998 2000 2002

1 2 3

Per cent

5 10 15 20 25 1990=0

Other euro area countries

1. Differential against the euro area average (left scale).
2. Per cent difference from the euro area average, measured with relative consumer prices (right scale).

Note: The real interest rates shown in the figure refer to ex post real interest rates. In a currency union, ex ante real interest rates should be much more closely aligned across countries than ex post real rates since longer-term inflation expectations should not differ significantly across countries. As a consequence, national measures of ex post real interest rates contain only limited information about the true financing conditions in a country in a monetary union.

Source: OECD.

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Figure 3. Monetary conditions in the downturn Averages for the period 2001 - 2003

1 2 3 4 5

1 2 3 4 5 Real interest rate (1)

Short-term interest rate Long-term interest rate

DEU FIN BEL AUT FRA ITA GRC IRL PRT NLD ESP

2 4 6 8 10 2 4 6 8 10 Equilibrium real interest rate according to the Taylor rule (2)

Euro area average Taylor rule Euro area short-term interest rate

DEU AUT FIN BEL FRA ITA ESP PRT GRC NLD IRL

5 10 15

5 10 15 Real effective exchange rate (3)

Relative unit labour costs in manufacturing Relative consumer prices

AUT DEU FRA FIN BEL ITA PRT GRC ESP NLD IRL

1. Deflated by the GDP deflator.
2. The Taylor rule computes the amount whereby interest rates should be raised above (reduced below) their

equilibrium level if either inflation rises above (falls below) its target or the output gap turns positive (negative) in

rder to maintain a neutral policy stance. The weights attached to inflation and the gap are 1.5 and 0.5, respectively.

The price stability target is inflation of 1.5 per cent and the assumed equilibrium interest rate is 3.5 per cent.

3. Cumulated deviation of real effective exchange rate minus euro area average.

Source: OECD.

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Figure 4. Regional dispersion in the euro area

1. NUTS 1 as a ratio of the euro area average, except for Italy, NUTS 2.

Source: European Commission/Eurostat.

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Figure 5. Explaining the income gap 2002, 1995 PPPs

IRL BEL NLD FIN DEU FRA ITA EURO (4) ESP PRT GRC

Percentage gap with respect to USA GDP per capita =

Effect of labour resource utilisation (1,2)

10 + Effect of labour productivity (1,3)

CAN DNK AUS JPN SWE EURO (4) GBR NZL

1. Percentage gap with respect to the United States level.
2. Labour resource utilisation is measured as trend total number of hours worked divided by population.
3. Labour productivity is measured as trend GDP per hour worked.
4. Except Austria and Luxembourg.

Source: OECD.

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Figure 6. ICT investment rate Per cent of GDP, 2000

1 2 3 4 5

United States Finland Australia Japan Ireland Netherlands Sweden Portugal Canada Denmark Germany United Kingdom Greece New Zealand Italy Austria Belgium France Spain Software Communication equipment IT equipment

Source: Statistics New Zealand and OECD.

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Table 1. Decomposing potential output growth in Ireland Annual average, percentage points

1983- 1993 1993- 2003 Potential GDP growth 5.4 7.2 Potential labour productivity growth 4.8 4.5 Potential labour input growth 0.5 2.6 Contributions from Working age population 1.1 1.8 Trend participation rate 0.1 1.0 Change in structural unemployment

0.9 Hours worked per person