## Mr Duisenberg considers the euro, the dollar and national economic policies: what room f manoeuvre?
Speech by Dr Willem F Duisenberg, the President of the European Central Bank, at the J+80 Conference in Paris on 25 March 1999.
The euro made its debut on the international financial markets at the start of th successful launch in the 11 countries which form the so-called euro area constitutes a m the process of European integration. The introduction of the euro has created a singl area which approximately matches the United States in terms of economic size, is the largest with respect to its share in total world exports and ranks second in terms of t capital markets. Thus, the euro has had and will continue to have in the years to come impact upon both the euro area and the world economy.
The launch of the euro has raised questions concerning the relationship between the rate, the monetary policy of the ECB and the room for manoeuvre of national policy. purpose of today's discussion I would propose to break down this rather complex issue i aspects: namely, the role of the exchange rate of the euro in the Eurosystem's moneta strategy, the ECB's view of recent developments of the euro exchange rate vis-à-vis dollar, and the relationship between the single currency in the euro area and the fl macroeconomic and structural policies in euro area countries.
## The role of the exchange rate in the monetary policy of the Eurosystem
The introduction of the euro implies a change in the role and the importance of the exc in Europe. Considered individually, most euro area countries are exceptionally open ec In 1997 the sum of their exports plus imports as a share of their combined GDP was 5 contrast, for the euro area as a whole, trade in goods, measured as exports and imports is around 26% of GDP and thus only somewhat higher than that of the United States and Hence the importance of a certain movement in the euro exchange rate for domestic eco developments has become less compared with the same movement of the exchange rate o national currency in the past. Nevertheless, through its effect on economic activity an exchange rate affects the outlook for price stability and thus still undoubtedly plays role in the monetary policy of the Eurosystem. Let me therefore elaborate on this rol more detail.
The primary objective of the single monetary policy is the maintenance of price s Monetary policy will always be geared to this objective. Consequently, the monetary strategy of the Eurosystem does not embody an implicit or explicit exchange rate t objective, since gearing monetary policy decisions to maintaining such an exchange ra may, at times, conflict with the goal of price stability.
Consequently, the ECB subscribes to the view that the exchange rates are primarily the of current and expected monetary, fiscal and structural policies as well as cyclica economic developments, rather than an objective or target of monetary policy. Exchan misalignments and excessive volatility often reflect macroeconomic imbalances and/or uncertainties. Accordingly, stability-oriented macroeconomic policies pursued in a tr manner are the best contribution that can be made by policymakers to fostering excha stability. In other words, misalignments and excessive volatility should be cont addressing their underlying causes. The Eurosystem's stability-oriented monetary policy ensures that the single monetary policy makes the best possible contribution in this contrast, attempts to suppress exchange rate movements through direct targeting do not
by themselves, the underlying causes of misalignment. Monetary policy in particular cann correct misalignments caused by structural or fiscal policies. They need to be addressed via policy actions.
Moreover, in a world characterised by integrated and highly liquid international finan markets, there is serious doubt as to whether pegging or targeting exchange rates is feasibl sophistication, depth and liquidity of today's financial markets make it increasingly diffic central bank to defend an exchange rate for a prolonged period. In addition, the experience exchange rate coordination among the G7 countries shows that it has always been very difficul agree on a common objective. Obstacles to exchange rate coordination were also experienced some ERM member states. When during the late 1980s and early 1990s economic developments in some member states of the ERM diverged, their bilateral exchange rates came under pressur and eventually the exchange rate bands had to be widened to ensure two-way risk for speculat Some currencies were even forced to abandon the ERM. These experiences are now reflected in ERM II. ERM II has relatively wide standard fluctuation bands and the ECB has the possibility suspending intervention and financing if these could impinge on its primary objective maintaining price stability. ERM II is explicitly designed to foster convergence to the euro countries that have not yet adopted the euro.
For all these reasons, stable exchange rates of the euro are best served by stability-o policies that are consistent with economic fundamentals. In particular, exchange rate targ objectives would be neither a substitute for a credible and stability-oriented macroecon policy stance nor a surrogate for a flexible response on the part of domestic markets.
Nevertheless, exchange rates affect the maintenance of price stability as they influence i prices and activity, and thereby consumer prices, in the euro area. Moreover, they reflect expectations about future economic developments and policies. Furthermore, due consideratio has to be given to the exchange rate of the euro against the background of the importance o euro area in the international monetary and financial system.
Therefore, the ECB monitors exchange rate movements on an ongoing basis within its broadly based assessment of the outlook for price developments. The euro exchange rate is an inte part of the broad range of variables used by the Eurosystem to take its monetary policy deci The exchange rate is also monitored as it may be a channel for monetary policy transmission.
Clear exchange rate misalignments, although difficult to identify, would be a cause of concer the Eurosystem. If prolonged, they might affect inflation expectations and distort econ activity as well as hamper the efficient allocation of financial resources. Although in the e these negative effects will be mitigated, as a result of the low degree of openness of the e they cannot be ignored altogether.
According to the Maastricht Treaty, the ECOFIN Council may formulate so-called general orientations for exchange rate policy. These orientations - and this is consistent with the shall be without prejudice to the primary objective of the Eurosystem of maintaining p stability. Therefore, the EU finance ministers, who are ultimately responsible for the exc rate policy of the euro, agreed in December 1997 that they would only issue these gene orientations for the euro exchange rate in exceptional circumstances, such as in the case o and persistent misalignments of the euro. Successful and credible stability-oriented po should help prevent the emergence of misalignments in the future.
## The ECB's view on the dollar exchange rate
Let me now share with you our views on the exchange rate of the euro against the dol weakening of the euro vis-à-vis the dollar during January and February was mainly attrib a series of economic data releases over this period, which were mostly relatively favour as the US economy was concerned. The US economy surprised commentators with very positi data on employment and output. Over the same period data releases for the euro area we muted.
It appears, therefore, that the recent developments of the euro exchange rate primarily previously unexpected strength of the US economy.
Therefore, the recent fluctuations of the euro exchange rate should not be consider dramatic. The exchange rate of the euro against the dollar is now comparable with the which the so-called synthetic euro was quoted against the dollar prior to Septembe Moreover, long-term government bond yields of euro area member states continue to be than in the United States, also suggesting that investors believe in the stability of th
The current euro exchange rate, therefore, does not hint at a misalignment or at a weakness of the euro. Moreover, there is no indication that financial markets doubt the of the monetary policy of the Eurosystem. Nevertheless, we should keep in mind th credibility of a currency is a precious but likewise fragile asset. The possibilit excluded that increased uncertainty about the political support for a stability-orient and fiscal policy has contributed to the weakening of the euro. Through pursuing a oriented monetary policy, the Eurosystem underscores the confidence that the world has young currency, the euro.
## What flexibility is left to national governments?
I now turn to the final part of my talk. It is clear that euro area governments will co flexibility in national policies to address country-specific developments. For example need to be able to respond to asymmetric shocks, that by their nature do not affect al countries equally, and to more deep-seated economic problems related to the structure economies. Clearly, following the introduction of the euro, the instruments of moneta and the exchange rate are no longer available to national governments for addressing specific developments. Therefore the need for flexibility in other policies at the nat even more apparent than before. Such national flexibility will be necessary both to add term imbalances in demand and to deepen structural reform efforts with a view to improv supply-side conditions of the individual euro area economies. National governments re principal ability to address both objectives as they retain control of fiscal policy an to undertake structural reform.
## Responding to short-term imbalances in demand
Let us first consider the role that national governments continue to play in respondin term imbalances in patterns of demand. It is sometimes argued that the requirements Stability and Growth Pact will prevent national governments from using fiscal policy t these imbalances. However, if implemented correctly and without undue delay, the cont true, as compliance with the Stability and Growth Pact provisions will allow sufficien manoeuvre. The centrepiece of the budgetary provisions to be respected by member state medium-term objective of a budgetary position close to balance or in surplus. Sound gov finances are important to strengthen the conditions for price stability and for the sustainable growth necessary to support employment growth. Moreover, if governments ac
balanced budgets in normal periods of the cycle, they create a safety margin, sufficient to the operation of automatic stabilisers in the event of a slowdown, or in the face of unex shocks, without risking excessive deficits.
The problem at the moment is that in the euro area as a whole we are still far from reachi target of balanced budgets in normal cyclical conditions. Substantial structural imbala continue to restrict the flexibility of public sector budgets. In a number of countries, d GDP ratios remain close to the 3% value set in the Treaty as a reference for excessive def rather than the medium-term balanced or surplus position envisaged in the Stability and Gro Pact. Recent fiscal consolidation has been rather disappointing. A significant increase in deficits, for instance as a response to a decline in real GDP growth rates, could rever progress we have seen in recent years in reducing deficit-to-GDP ratios across the euro Moreover, in the case of a prolonged growth slowdown, it is quite possible that deficits quickly reach excessive levels.
So it is clear that it is of the utmost importance that governments make structural improve to their fiscal positions, as this would allow them to regain sufficient flexibility in the and, most importantly, could effectively contribute to supporting stability and growth in th area. However, despite the desirability of achieving this room for manoeuvre swiftly, moderate fiscal consolidation is currently envisaged for the medium term. A number of stabi programmes are aimed at attaining the necessary flexibility only at a relatively late date, is on the assumption of sustained economic growth and low interest rates. It is important th see a commitment from policymakers to ensuring the swift achievement of this aim or to goi beyond the aims envisaged in these programmes once economic growth has picked up.
## The role of longer-term structural reforms
The most important area where there is national flexibility is in relation to structural Indeed it is arguable that many of the important challenges which face euro area countries only be addressed through national policies in this area. As the March 1998 Convergence Repo of the European Monetary Institute already identified, there is an urgent need for lasting adjustments arising from:
- high and persistent unemployment which is largely of a structural nature;
- demographic trends which are expected to place a heavy burden on future public expenditure; and
- the high levels of public debt, which will weigh on the current budgets of many membe states until debt levels are reduced.
To start with the first long-term economic issue, I now turn my attention to the contributi structural reforms to euro area labour markets can make to reducing the very high level European unemployment. As I have done in my comparison of the euro with the dollar, let u again contrast the developments in Europe with those of the United States. In 197 unemployment in the United States, at around 4%, was actually significantly higher than in m European economies. Since then, although there has been a marked variation in the US unemployment rate during the course of each economic cycle, there has been no apparent lon term trend, as the unemployment rate stood at 4.4% in January 1999. In contrast, avera European unemployment has been on a steadily rising path. The unemployment rates in the United States and Europe appeared to have broadly converged by the early 1980s, and since t time the unemployment rate in the United States has been below the EU average. Even though th euro area unemployment rate fell last year, the January 1999 figure of 10.6% was more th double the corresponding US rate.
Looking at the latest unemployment rates around the euro area - which range from 2. Luxembourg (January 1999) and 3.6% in the Netherlands (December 1998) to 17.8% in Spa (January 1999) - suggests that policies must be developed at the national level. What appears to be national structural reforms to make sustainable reductions in unemploymen than a boost to euro area aggregate demand. Moreover, making labour markets more flexib also make it easier to cope with short-term imbalances in demand.
However, the situation in euro area labour markets is not uniformly bad. Some cou particularly those with more flexible labour markets, more moderate wage increases a discouraging tax and social security policies, have managed to avoid the trend of e unemployment. For example, the Netherlands, Ireland, Portugal, Austria and Luxembour currently show unemployment rates well below the euro area average. There are also exam other countries with higher unemployment rates, such as Spain, that have begun to take reform their labour markets and are now beginning to see tangible results. We can als some of the non-participating member states, such as Denmark and the United Kingdom, t that high unemployment can be reduced through structural reforms.
The need for structural reform is widely recognised, for instance in the OECD Jobs Stud the November 1997 Luxembourg European Council meeting, and some progress with new polic measures is already being made. First, there are 'active labour market measures' to education, training and work experience - particularly targeted at the long-term une Second, there are reforms to ensure that tax and social security systems make people si better off in work than out of it. Third, there are measures to ensure that low-producti are not forced out of the labour market. These include reducing the burden of taxes and labour costs and making sure that minimum wage schemes and collectively bargained w agreements take account of the need to preserve such jobs. I would also wish to add that to some suggestions, such policies do not amount to 'competitive devaluations', and s reforms and wage moderation are no 'zero sum game'. They can help generate net increa average employment and should not be criticised as 'wage or social dumping'.
The second long-term economic issue I should like to address today is the need to prepa substantial financial consequences of the ageing of European populations. On the basis trends in birth rates and life expectancy, unfunded public pension and healthcare generate very high implicit government liabilities in most euro area countries. Indee cases these implicit liabilities appear to be of such magnitude that they dwarf even official government debt levels. Unless action is taken quickly, these financial burde on future generations of taxpayers and may also threaten the soundness of government f Therefore, to prepare for the ageing of the population, substantial savings need to be m
The third key issue is the need to make progress in reducing the high government debt ratios that have substantially increased over the past two decades. Whilst there improvement in the run-up to the start of EMU, the recent progress has been disappointi average debt-to-GDP ratio for the euro area fell only slightly to 73.8% in 1998, comp 74.6% in 1997. Such imbalances are undesirable and can also have wider implications conduct of monetary policy. If there are any doubts about the soundness of fiscal polici influence the effectiveness of monetary policy instruments, and undermine the credi monetary policy.
In addition to the long-term economic issues mentioned so far, I should also like to that the structural reform agenda available to national governments to promote e development extends well beyond the reform of labour markets and public finances. For ex national governments can take steps to promote entrepreneurship and make it easier for
start and run businesses and thus create new jobs. This could involve encouraging competit through measures to promote the entry of new firms, such as reducing the administrative burd they face, making markets more competitive and facilitating access to venture capit Governments can also liberalise previously highly regulated sectors, such as utilities, to efficiency and reduce prices to the benefit of industrial and household users of these se National governments may also wish to take steps to raise productive investment in research development to increase growth in expanding high-tech industries.
The introduction of the euro and a common monetary policy has certainly not rendere national governments impotent. With the ability to vary fiscal policy and undertake stru reforms, national governments retain the key powers to address the real needs of t economies. If the terms of the Stability and Growth Pact are adhered to, then there is su flexibility to allow automatic stabilisers to work in the event of a slowdown. Stru reforms provide the only means of achieving lasting reductions in unemployment, prepari for the ageing of the population and reducing the burden of government debt. Nation governments would be well advised to press ahead with such reforms. Apart from having the own merits, such policies would also support the ECB in maintaining price stability in euro area.