## Mr Duisenberg discusses the Eurosystem's strategy for the euro
Speech by Dr Willem F Duisenberg, President of the European Central Bank, at a confe organised by 'The Economist' in Rome on 12 March 1999.
I should like to start by thanking you for the invitation to speak here on the occ conference. It is only a little more than two months since the euro was launched. should like to discuss the main challenges for monetary policy at the start of Monet Clearly, keeping the internal value of the euro stable is the overriding task ahead this in mind I shall begin by broadly outlining the objectives and main element monetary policy strategy of the Eurosystem. I shall then turn my attention to the ro be played by fiscal policy and structural reforms in supporting the stability of t reducing unemployment. Finally, I should like to say a few words about the distrib responsibilities at different levels of economic policy-making with a view to ma stability and growth in the euro area.
## Monetary policy: objectives and strategy
Let me turn to the monetary policy strategy of the Eurosystem. The Treaty establis European Community assigns the European System of Central Banks (ESCB) the primar objective of maintaining price stability in the euro area. In order to guide exp future price developments and to facilitate the public's assessment of the success o monetary policy, the Governing Council of the European Central Bank (ECB) has announ a quantitative definition of its primary objective. This clarifies how the Treaty' interpreted by the Eurosystem, that is, by the ECB and the 11 participating nation banks (NCBs).
Price stability has been defined as a year-on-year increase in the Harmonised Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be ma over the medium term. According to the most recent available data, the annual rate of of 0.8%, measured on this harmonised basis, is consistent with this definition stability.
The Treaty states that the ESCB shall support the general economic policies in the Community only if it can do so without prejudice to the objective of price stability of the Treaty seems clear. It is acknowledged that the best contribution monetary p make to high employment and economic growth is to maintain price stability. In this it is difficult to see how certain proposals made in the ongoing public debate, w suggest that the focus of monetary policy should be shifted towards short-term g employment objectives, can be fulfilled without violating the primary objective of ma price stability, thus ultimately producing an overall deterioration in prospects f growth and employment.
Monetary policy needs a forward-looking, medium-term orientation. It would overambitious and therefore risky to steer the economy in the short term. Fine-tuni more likely lead to instability than stability. A medium-term orientation takes into fact that monetary policy affects the price level only with variable, usually unpredictable time lags. For example, a large proportion of the substantial red interest rates during the second half of last year will still have an impact on economy. To maintain price stability, we have chosen a distinct monetary policy stra
that reflects the special circumstances that exist at present as well as those likely to the foreseeable future. It ensures as much continuity as possible with the strategies pre pursued by the NCBs. At the same time, it gives due consideration to the unique situa which will prevail in the early years of Monetary Union. This strategy rests on two 'pill prominent role for money as expressed by the announcement of a reference value for t annual growth of M3 and a broadly based assessment of the outlook for price developments and the risks to price stability in the euro area as a whole.
Monetary developments can provide useful information about future price developments and thereby act as an important compass for the conduct of monetary policy. There is bro consensus that, in the medium to long term, the development of the price level is a mone phenomenon. Consequently, the Governing Council of the ECB has announced a quantitative reference value for M3 growth, which has been set at an annual rate of 4½%. Under norma circumstances, substantial deviations from the reference value would tend to indicate f risks to price stability. However, monetary policy does not react to deviations of mon growth from the reference value in a 'mechanistic' way. In the first instance, such devi will be thoroughly analysed to infer any signals which they may send about the prospects price developments. If this analysis points to a threat to price stability, monetary po react in a manner appropriate to counter this threat, rather than attempt to elimina deviation of monetary growth from the reference value in the short term.
Although monetary data contain information which is vital for monetary policy decisio making, monetary developments alone will clearly not constitute a complete summary of a the economic information necessary to enable appropriate policy decisions to be taken. Governing Council recognises that it is important, in parallel with the assessment of mon growth, to look at a wide range of financial and other economic indicators, inclu economic forecasts. This systematic analysis of all other relevant information about econ and financial conditions will ensure that the Governing Council is as well informed possible when taking monetary policy decisions.
This broadly based assessment takes into account, inter alia, the information content of developments, exchange rates, fiscal indicators, real activity, assets and commodity p Internal forecasts of economic activity and prices in the euro area can also contribute success of an appropriately forward-looking monetary policy. Monitoring monetary, financi and economic developments also helps to identify the nature of shocks hitting the economy thereby contributes to the assessment of overall economic developments. On the basis of thorough analysis, the interest rate will be set in a way that best serves the mainten price stability.
## The contribution of fiscal policy to a stable euro
With regard to fiscal policies, I should like to stress the following main points of inte regard to a stable euro:
- A sound conduct of fiscal policies is important for the stability of the euro.
- In particular, strict implementation of the Stability and Growth Pact by each Memb State is vital.
- The targets envisaged in the current stability programmes to bring down gover deficits and debt levels represent a minimum requirement for most Member States than a final aim.
Budgetary positions in the euro area as a whole have not yet been consolidated suf Government debt as a percentage of GDP remains far too high on average and has only s declining hesitantly in the recent past. Deficit-to-GDP ratios in a number of countr closer to the 3% value set in the Treaty as a reference for excessive deficits medium-term balanced or surplus position envisaged in the Stability and Growth Pact. of a prolonged growth slowdown we might therefore easily see deficits reaching ex levels. In addition, deficits fell very slowly in 1998, this reduction in fiscal im the result of strong economic growth and falling interest payments rather than of fiscal consolidation measures. Structural and primary balances have even deterior addition, the progress in structural fiscal consolidation envisaged for the medium te to be only moderate.
Why should monetary policy-makers be bothered by such unbalanced budgetary positio Institutional arrangements for Monetary Union and the Eurosystem have been full specifically developed so as to prevent any direct link between an increase in pub deficits and a monetary expansion, and thereby inflation. This is ensured by (a) as the Eurosystem the primary objective of price stability, (b) banning the direct f government deficits by central banks, and (c) precluding any influence by governm other institutions on monetary policy decisions. However, even in this setting, the fiscal policies has a clear bearing on the objective of price stability. In particul the soundness of fiscal policy can influence the effectiveness of monetary policy i and can undermine the credibility of monetary policy.
For decades - and until very recently - fiscal policies have followed a trend of ev public sector and government debt levels. In Monetary Union, without binding fisca countries might have even less incentive to pursue prudent fiscal policies. The mai are, first, that risk premia offsetting inflation and exchange rate expectations d country-specific basis and may not be fully outweighed by default risk premia, and, that in Monetary Union fiscal consolidation and its effects on financial stability p the role of a public good, the benefits of which in terms of lower interest rates ca by individual countries even if they have not contributed to its supply. Hence, establishing the European Community contains, for good reasons, a number of provisi the conduct of fiscal policies, which have been further clarified by the Stability Pact. However, I must admit that the current position with regard to the implement these provisions in the stability programmes submitted to the European Commission number of Member States is less than fully satisfactory.
The centrepiece of the budgetary provisions to be respected by Member States is the term objective of a budgetary position close to balance or in surplus. Safeguard government finances is a means of reinforcing the conditions for price stabilit promoting strong sustainable growth which is conducive to employment creation. In ad by achieving at least balanced budgets in normal periods of the cycle, government create a sufficient safety margin to allow full operation of automatic stabilisers i a slowdown in growth without inflating deficits to excessive levels. In the euro whole we are still far from reaching this target. Substantial structural imbalances
restrict the flexibility of public sector budgets. Any significant increase in overall for instance, as a response to a decline in real GDP growth rates - could reverse the l progress we have seen in recent years in reducing debt ratios across the euro area. This imply the risk of initiating detrimental debt dynamics. Hence, governments could contri most effectively to supporting stability and growth in the euro area by regaining suff flexibility in their budgets as soon as possible. However, despite the desirability of a this room for manoeuvre swiftly, a number of stability programmes only aim to attain t flexibility at a relatively late date and on the assumption that economic growth wi sustained and interest rates low.
Apart from showing slow progress in restoring budgetary flexibility for the purposes automatic stabilisation, governments have paid insufficient attention to other consider that are also of major importance in setting the appropriate medium-term objectives wh respect the requirements of the Stability and Growth Pact. This is the case with regard need to ensure a rapid decline in high debt ratios and the need to cater for the costs a with the ageing of the population. In particular, additional budgetary room for manoeuvre soon be required in order to address the substantial financial consequences of ag populations. According to long-term projections and estimates, current trends in birth and life expectancy, together with unfunded public pension and health care schemes, resul very high implicit government liabilities in most euro area countries. In many cases implicit liabilities appear to be far in excess of official government debt levels. Pr these financial burdens from being shifted onto future generations of taxpayers and the safeguarding sound government finances would require substantial surpluses to be built over the medium term.
## The contribution to lower unemployment made by structural reforms of the labour markets
I now turn my attention to the contribution that structural reforms, particularly of eu labour markets, can play in reducing unemployment and in supporting the stability of the The high level of European unemployment is quite rightly a source of deep concern. It i the utmost importance to implement policies than can bring about a lasting reduction unemployment. Clearly, the approaches that are most likely to have a lasting effect are that address the root cause of the problem, not just the symptoms. The root causes of unemployment in the European Union are structural rigidities in the labour market as wel tax and public transfer policies. This view is supported by a wide body of academic lite and was also a key finding of the OECD Jobs Study. It is obvious that structural probl require structural solutions. Implementing an inflationary monetary policy will not m lasting reductions in unemployment, but will actually serve to exacerbate the problem ove medium term. As we know, inflation distorts saving and investment decisions, raises the premium in long-term interest rates and undermines the allocative efficiency of the p mechanism. In addition, it is particularly detrimental from the perspective of social jus
The underlying structural nature of the European unemployment problem can be seen most strikingly if one compares developments in Europe with those in the United States over last three decades. In 1970 the unemployment rate in the United States, at around 4%, wa least twice as large as that prevailing in most European economies. Since 1970 there has significant cyclical variation in the unemployment rate in the United States but no up trend. At 4.4% in January 1999, the unemployment rate in the United States is almost same as it was in 1970. In contrast, average European unemployment appears to have ris
with each passing economic cycle. By the early 1980s the unemployment rates in the States and Europe had broadly converged. Since then the unemployment rate in the States has been below the average for the European Union. Despite recording a meas decline last year, the euro area unemployment rate remained at 10.8% in December, mor double the corresponding rate in the United States. However, some European coun particularly those with more flexible labour markets, have managed to avoid the tren rising unemployment. For example, the Netherlands, Ireland, Portugal, Austri Luxembourg at present have unemployment rates well below the euro area average.
If one examines the duration of unemployment, it is immediately apparent that Eu problem is principally one of long-term unemployment. According to OECD figures, ar half of the unemployed of the European Union have been out of work for at least a ye in the United States under 10% of the unemployed have been without work for this lon suggests that in Europe there is an urgent need to improve incentives aimed at ge long-term unemployed back to work. It also suggests that there is little scope for a increase demand, but rather that structural measures should be implemented.
It has been suggested that the Eurosystem focuses too exclusively on supply, almost demand. This is a misunderstanding. The truth is this, and I repeat: we are convin lasting cure for European unemployment can only be found by applying measures affe supply. It is not true, however, that our monetary policy strategy neglects the dem the economy. On the contrary, our monetary policy takes into account all moneta economic developments, including demand shocks, when decisions are taken on the mone stance which best serves the maintenance of price stability. One might rightly arg this way we do not actively respond to short-term changes in GDP. There is a good re this: it would be overambitious. We cannot steer demand precisely, especially in term. Therefore, we focus on creating the appropriate conditions for non-inflationa of demand in the medium term. With money supply growing at almost 5% and with r interest rates well below historical averages, monetary policy is delivering in pra have just explained in theory. It goes without saying that we will continue to m developments to determine the appropriate policy stance in the meetings of the Go Council.
There are many good examples of what can be done - and is currently being done in euro area countries - in terms of structural reforms. First, there are 'active l measures' which provide programmes of education, training and work experience target the long-term unemployed; second, reforms to the tax and benefit systems which ensu people are significantly better off in work than out of it; and third, there are ensure that low-productivity workers are not forced out of the labour market. To thi burden of taxes and non-wage labour costs could be reduced for low-paid worker addition, minimum wage schemes and wage agreements reached by collective bargaining n to take account of the need to preserve jobs for low-productivity workers by reduci costs.
The need for structural reform of the European labour markets is widely recognised a progress is already being made. At the meeting of the European Council held in Luxem in November 1997 it was decided to adopt 'guidelines for employment' at the EU level year. Each Member State has undertaken to draw up a national action plan for emplo based on these EU guidelines. Although of themselves guidelines will not r unemployment, if one looks at the national action plans for 1998 one can find man
examples of policy measures that are aimed at increasing labour market flexibility. Howe progress appears rather slow and uneven across Europe and it is important that we redou our efforts in this area.
I recognise that structural reforms are not always easy to implement. The benefits are enjoyed in the medium term, while short-term costs for some groups may mean that reforms are vigorously opposed by interest groups. Although there is a common objective of reduc unemployment, there is no common programme of reforms that will work in all countries. While it is possible to learn from the experience of others, each Member State will wi develop workable policies that reflect its own particular circumstances. Although the pa structural reform is not always an easy one, it is the only way in which we can achiev lasting reductions in unemployment that are so urgently required. I should wish to add contrary to competitive devaluations, such reforms, as well as wage moderation, are no z sum game. They contribute to net increases in average employment in an internationa perspective. They should thus not be criticised as 'wage or social dumping'.
## Monetary policy and other policy areas
In line with its clear mandate enshrined in the Treaty establishing the European Communi and for sound economic reasons, the ECB has to decide which monetary stance best serves t maintenance of price stability over the medium term and then act accordingly. At the s time, the Treaty also emphasises the need for sound fiscal policies. This clear separat responsibilities is both efficient and transparent. It takes account of the substantial evidence and practical experience, according to which monetary policy makes its best poss contribution to the achievement of other goals by focusing on the primary objective maintaining price stability over the medium term. This clear division of responsibiliti sound basis for the exchange of views and information about monetary, financial an economic matters between various political authorities in the euro area and the Eurosyste
The Eurosystem's monetary policy strategy does not foresee any mechanistic reaction specific variables, indices or forecasts. This also applies to fiscal developments, rega whether they are actual, planned or promised. Clearly, we will always have to anal thoroughly whether fiscal developments have any impact on the outlook for price stabil However, as already emphasised, we will also assess the information provided by the bro monetary aggregate and all other indicators relevant for price stability.
The clear distribution of responsibilities between monetary and government authorit enhances the credibility of monetary and economic policies in Europe. The 'policy mix resulting from monetary and fiscal policies will be an outcome of these policies rather our initial objective. This assignment of responsibilities increases transparency and fa accountability. Under normal circumstances the joint interaction of all policies woul optimal provided that the basic allocation of instruments and objectives is respected an policy-makers focus on their main objective. The Eurosystem is always ready to engage in open exchange of views and information with policy-makers. Moreover, the public and governments are kept well informed about the ECB's objective and strategy.
Monetary policy alone - however well designed and implemented - cannot solve Europe's economic problems. National fiscal authorities can make a significant contribution to establishment of favourable conditions for sustained economic growth and high employment in the medium to long term by conducting sound budgetary policies. Appropriate structur
reforms implemented by national governments that improve the flexibility and effici labour and goods markets are of utmost importance. An increase in the flexibility and goods markets would certainly also help to lessen the impact of shocks, regardles nature. Moreover, continued wage moderation in both the public and private sectors contribute to the reduction of the unacceptably high level of unemployment in many the euro area.
If policy-makers take their responsibilities seriously and respect the assignment of and objectives as laid down in the Treaty establishing the European Community, this the best contribution that they can make to establishing a solid foundation for stability and growth in the euro area.