The euro has very rapidly created a zone of monetary stability in Europe. The average inflation rate in the euro area has been a little above 2%. This is somewhat above the level of what the ECB defines as price stability, but a good performance in view of the increases in oil prices that have occurred. Even more remarkable is that longer-term market inflation expectations have consistently been close to levels compatible with price stability. Somehow, the ECB has become credible without having a track record of low inflation. What has helped is the clear mandate of the ECB, its independence and the careful preparation of a monetary policy strategy. The ECB may also have inherited some of the credibility of the most successful national central banks, the Bundesbank in particular. The world wide emphasis on the importance of low inflation and intense global competition has contained actual inflation.
There were some problems though. President Duisenberg had to show the ECB’s independence in practice, when the German minister of Finance loudly asked for an interest rate cut.
There has also been much discussion initially about the ECB’s transparency and the clarity and even meaning of its strategy. The ECB made many efforts to explain its policy decisions, its economic outlook and its strategy. There has in the meantime been an evaluation of the strategy, which basically confirmed the strategy with some clarification and minor changes. Over time, the ECB’s communication policy has been refined, with a publication of its forecasts as one of the most visible changes.
In the first years, when the euro depreciated strongly against the dollar there was a lot of debate and criticism surrounding it. This was also caused by deficiencies in the ECB’s communication.
Looking back, two things stand out. First, how irrelevant all the turmoil apparently has been for the ECB’s credibility. It has not really affected inflation expectations. Second, it is surprising how much attention at the time was paid to the euro’s depreciation. In the past we had also seen major swings in exchange rates without so much debate as this time. The more recent major appreciation of the euro has drawn far less attention. Have we learned quickly that such swings do not say much about maintaining price stability in the euro area?
Differences in inflation in the euro area have slightly fallen since the introduction of the euro rather than increased as sometimes thought. At the same time, no further major convergence of price levels has taken place. There appears to remain some potential for further price level convergence in the years to come.
One hard to quantify benefit of the single currency is its contribution to maintaining stability in the euro area when external shocks occur. We have witnessed oil price increases, the aftermath of the Asian and Russian crises, September 11 2001, and the bursting of the internet bubble. Without the euro these shocks would certainly have been amplified by creating tensions among European currencies.
The euro has reduced transaction costs of trading in euro area markets. This has stimulated the integration of financial markets, most clearly of the interbank markets and derivate markets. The issued amount of corporate bonds has increased strongly, admittedly from very low levels. Bond markets in general have become more liquid.
Trade in goods and services among euro area countries, has increased since 1999. The average of imports and exports of euro area countries to other euro area countries amounted to 11.3% of GDP in the period 1993-1998. This number rose to 14.4% in the years 1999-2004.
It has been argued that the euro would lead to increased regional specialisation in the euro area, making it more sensitive to sector specific shocks, making the ECB’s life more difficult. The European Commission defended the opposite view. Although it is too early to draw definite conclusions, there are indications that specialisation has somewhat increased in the euro area. At the same time this has not led to an increase in GDP-growth differentials between euro area countries.
The ECB has established itself as a major central bank. it will continue to face challenges in monetary policy like other central banks do. In addition to that the institutional set up of monetary policy making in Europe will evolve. An important issue is the possible development of specialisation among the ECB and national central banks and a possible trend towards centralisation of monetary policy operations and possibly also of some aspects of policy preparation. This could imply smaller national central banks, both in terms of staff and balance sheets.
The euro could provide even more benefits if remaining impediments to market integration were to be removed. A follow-up to the financial services action plan and an opening up of the markets for services would be helpful. It also entails taking steps towards a more European organisation of supervision of the financial sector.
The above challenges are important, but not decisive for the longer term viability of the euro as a strong currency. Three other challenges are not only important for further increasing the benefits of the euro, but may be crucial for its viability in the longer run. A stable currency requires sustainable fiscal policies. The stability and growth pact was supposed to ensure this. The weakening of this pact following the non compliance with it has raised doubts whether it will. This will not immediately undermine the euro, but over time it may, step by step. The fiscal framework should be taken more seriously. In the end this may require more power for the European Commission.
The structural growth rate of the European economy is low. Whereas productivity growth in the US has accelerated over the past decade, in Europe it has fallen. This is mainly due to a more productive application in the US services sector of information and communication technology (ICT) than in Europe. Adapting to a new production structure proves to be a slow process in Europe. Structural reforms to make Europe better adaptable to change are urgently needed.
It was hoped that the introduction of the euro would stimulate structural reforms. The reasoning was that if European economies were not made more flexible, the loss of the interest rate as a policy instrument would be rather costly. The euro would force structural reforms on countries. It did not so far. Without more dynamism in euro area economies, economic growth will remain weak structurally and the euro will not function optimally in the long run.
Finally, it has been argued that the single currency can only survive in the long run if Europe develops more social cohesion, also reflected in steps towards more political union. If this is true, and the jury is still out on it, recent developments in Europe are in the wrong direction. Europe has become less popular. A vision of what Europe should be and where it should go from where it stands is missing. The good news, however, is that the process of European integration has always been plagued by setbacks, but then always made further progress. It may well be the same in the years to come. As in the past, favourable economic conditions, even if cyclical, may turn setback into progress. The current outlook is for a cyclical upswing in Europe next year.