European Commissioner for Economic and Monetary Affairs

SPEECH/06/529

Joaquín Almunia

European Commissioner for Economic and Monetary Affairs

Monetary and Economic Integration – the EU Experience

SingaporeManagementUniversity

Singapore, 18 September 2006

Good afternoon

It is a great pleasure to have the opportunity to address such a young and diverse audience here at the SingaporeManagementUniversity. What I would like to do today with you is to talk about monetary and economic integration in the European Union.

The East Asia region is currently undergoing rapid change with the fast emergence of China as a manufacturing hub and the increasing trade integration among countries in the region. History has shown that increasing trade integration leads sooner or later to calls for exchange rate coordination to avoid competitive depreciations, and the resulting distortions in competitiveness, disruption of trade and disruption of production. This is why monetary cooperation has been so intensively debated during the Annual Meetings of the IMF and of the World Bank, and why it is likely to be on the agenda of future policy-makers. So I am pleased to share Europe's experience with the East Asia's current and future intellectual elite.

My speech consists of four parts:

-First, I will give a brief history of economic and monetary unification in Europe.

-Second, I will present an overview of economic policy coordination and policy making in EMU, Europe's Economic and Monetary Union.

-Third, I will discuss the objectives and achievements of the common monetary policy implemented by the European Central Bank (ECB).

-Fourth, I will address the importance of sound budgetary polices and the need for structural reform for a smooth functioning of EMU.

I will then conclude with few words on the lessons from our experience and on monetary cooperation within East Asia.

1. A Brief History of Economic and Monetary Integration

The Treaty of Rome, which was signed in March 1957, established a customs union and, later, a common market but made no reference to EMU. Yet, just twelve years later, European leaders declared their commitment to monetary unification. The reason for this change was practical rather than ideological. The Bretton Woods agreement, which had underpinned the post-war international financial system, was struggling to maintain currency stability by the late 1960s. This instability threatened to stand in the way of European integration by deterring trade integration and hindering common policies, such as the Common Agricultural Policy.

Plans to establish EMU by 1980 were soon derailed. The USA's suspension of the dollar's convertibility into gold in 1971 and the 1973 oil shock frustrated efforts at exchange rate coordination. Undeterred, European leaders established the European Monetary System (EMS) in 1979. The EMS was based on a fixed-but-adjustable-exchange-rate mechanism. There were central parities defined against the European Currency Unit – a common basket of all the Community’s currencies - and mutual credit facilities.

The European Monetary System was largely successful, contributing to a significant reduction in exchange-rate volatility, particularly during the second half of the 1980s. It also exerted external discipline on economic-policy makers, helping to reduce high inflation rates in several MemberStates and promoting economic convergence within the EEC.

Supported by this success, European leaders revived the goal of EMU at a historic meeting in Hanover in 1988. The impetus was provided, in part, by the drive to complete the Single European Market by 1992. It had become apparent by then that the full benefits of free movement of goods, services, people and capital, would not be realised without eliminating the uncertainty and transaction costs associated with national currencies.

The goal of EMU was formally enshrined in the Maastricht Treaty, which entered into force in 1993. Given that a high degree of sustainable convergence would be important for the success of EMU, the Treaty sets out a number of economic convergence criteria for Member States that want to participate. These concerned the inflation rate, public finances (relating to deficits and debt), exchange-rate stability, and long-term interest rates. A high degree of political commitment by MemberStates and fortuitous economic conditions led to a remarkable degree of convergence in the European Union during the 1990s.

In May 1998, European leaders decided that eleven Member States, namely, Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, The Netherlands, Austria, Portugal and Finland, fulfilled the necessary conditions for the adoption of the single currency. These Member States adopted the euro on 1 January 1999, and the European Central Bank assumed control of euro-area monetary policy. Greece joined the euro area in January 2001 and participated with the eleven other Member States in the historic changeover to euro notes and coins on the 1st of January 2002.

The history of EMU continues to unfold. Of the 10 Member States that joined the EU in May 2004, seven – Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia, and Slovenia – are in the Exchange Rate Mechanism II, which fosters exchange-rate stability vis-à-vis the euro.

Earlier this year, the Commission concluded that Slovenia, one of the 10 new Member States that joined the EU just over two years ago, had achieved a high degree of sustainable convergence with respect to all Maastricht criteria and will become the thirteenth Member State to join the euro area on 1 January 2007. In the coming years, more countries are expected to join, once the necessary economic conditions are met.

2. Economic policy coordination and policy making in EMU

Now let me turn to the second part of my speech: economic policy coordination and policy making in EMU. A high degree of policy coordination is an important condition for the success of an economic and monetary union.

So within EMU there is a lot of interaction between the different policy actors in the EU, including fiscal authorities, monetary authorities and the Commission. In these interactions there is a wide spectrum of coordination methods ranging from information exchange, discussion of best practices, policy dialogue, commonly agreed policy rules and objectives, and peer review, up to, in some cases, jointly determined actions.

Considerations of spillovers, common goods provision and subsidiarity are reflected in the current practice of economic policy coordination in EMU. Policy areas that have strong spillovers or common good characteristics are subject to stronger forms of coordination.

In the macroeconomic sphere the euro-area has a single monetary policy and a single exchange rate policy. Fiscal policies are in principle determined by the Member States. However, as sound fiscal policies are essential for the success of a single monetary policy, there are restrictions on the size of public deficits and debt and there is close surveillance of Member States' budgetary positions.

In the microeconomicsphere, there is a single EU competition policy. Internal market policies as well as the main aspects of financial market integration are subject to hard coordination. In contrast, labour market policies and social policies are a national responsibility but some so-called “soft” coordination of employment policies takes place. An important coordination instrument for the EU is the Integrated Guidelines package which gives the Member States policy advice on a range of macroeconomic and microeconomic policy issues.

3. Monetary policy

Now I come to the third part of my speech where I want to examine the objectives and the achievements of monetary policy been under EMU.

It is widely accepted that preserving price stability is the best way for a Central Bank to contribute to higher growth over the longer run. There are several strong arguments why low inflation is beneficial for long-term growth.

Firstly, price stability allows households and firms to make better informed consumption and investment decisions. Secondly, it lowers the risk premium on assets, thus improving the efficiency of capital markets. Thirdly, it reduces the need for households and firms to hedge against inflation. Empirical evidence from European countries confirms that price stability is conducive to growth.

Hence, the designers of EMU built upon the prevailing consensus that the best way to get low inflation is by creating an independent central bank and assigning it the primary objective of price stability. The EU Treaty created an independent European Central Bank (the ECB), thereby following a practice that is widespread in the industrialised world.

The ECB's objective has been to preserve price stability which is defined as keeping inflation "below but close to 2 per cent over the medium term". This definition is important for a number of reasons and I will highlight two. The first is that, it helps to anchor the expectations of economic agents. Thanks to its high degree of policy credibility, the ECB has been able to keep inflation expectations low and stable since the start of EMU, while interest rates have been low and supportive of growth. The second reason is that there is a need to maintain a sufficient safety margin against deflation as consumer price indices tend to overestimate inflation.

One of the main achievements of EMU, and of the convergence process that preceded it, has been to provide macroeconomic stability. An impressive degree of budgetary consolidation was achieved in the run-up to the launch of the euro. On average, public finance deficits fell by more than 5% of GDP during the 1993-1998 period. The run-up to the launch of the Euro also saw a significant reduction in inflation rates, from an average of over 4% in 1991 (and with some countries having inflation rates of more than 10%) to 1.5% in 1998.

During the first seven years of the Euro’s existence, inflation expectations have been remarkably stable and within the ECB’s price-stability definition. Long-term rates have also fallen dramatically and some countries experienced a very significant compression of the interest rate spread with the creation of the euro. As a consequence, the servicing of the public debt has become a lot lighter. These achievements reflect the high credibility of the ECB’s monetary strategy. This is a major success given that the ECB started out as a new central bank without any track record.

A second key achievement of EMU is, of course, the elimination of the exchange rate risk within the euro area. This was indeed the main reason for creating the euro. The elimination of intra-EMU exchange-rate changes has significantly reduced transaction costs for cross-border activities in the euro area, paving the way for an increase in trade and investment. Between 1998 and now, trade among EMU members has increased at significantly higher annual rates than the trade between EMU members and the other members of the EU.

There is also empirical evidence that the euro has boosted the attractiveness of the euro area as a destination for foreign direct investment.

The last success of the euro - I would like to highlight - is its increased international role. After its launch on the 1st of January 1999, the euro area rapidly established itself as the world’s second leading currency after the US dollar. This is, in part, a reflection of the relative weight of the euro area in the world economy, but it is also due to the fact that the euro is underpinned by a sound macroeconomic policy framework. This framework helps economic agents to have confidence in the euro, and, consequently, encourages its use as a means of payment, store of value and unit of account – the three traditional functions of money.

4. Fiscal policy and structural reform

In addition to its supranational monetary policy, EMU entails a close coordination of Member States' budgetary policies and a concerted effort to promote structural reforms.

The Stability and Growth Pact ensures that Member States' budgetary policies are consistent with the smooth functioning of EMU. It does this by prohibiting budget deficits in excess of 3% of GDP and by encouraging Member States to pursue sound budgetary policies over the medium-term. By following this formula, Member States can ensure that automatic stabilisers can operate relatively freely in response to economic downturns.

In the medium and long run, the Pact promotes sustainable public finances which are particularly important in light of our demographic trends. It also favours a reallocation of public resources towards a more growth-friendly revenue system and expenditure structure.

The implementation of the Stability and Growth Pact revealed a number of shortcomings during the first six years of EMU. In particular, we saw quite often that countries failed to consolidate sufficiently in the upswing, thus not creating enough room for the automatic stabilisers to work in the downturn. To correct this situation, EU leaders agreed to revise the Pact in March 2005. This reform struck the right balance between economic rationale and simplicity, between allowing more room for economic judgement and maintaining the rigour of the rules-based system.

Our initial experiences with the revised Pact have been encouraging. Six cases where countries have breached the rules have been dealt with under the revised Pact during the last twelve months. In all cases, the response has been to apply the rules according to the letter and spirit of the Stability and Growth Pact.

Additionally, the Lisbon Strategy promotes structural reforms in European product, labour and capital markets. As the EU's competence in this field is limited, it ultimately falls to Member States to implement the reforms. Nevertheless, the EU has a key role to play by issuing advice to Member States on reform priorities, by stimulating debate on best practices on reform issues, and by continuously monitoring their reform efforts.

Let me stress that Structural reforms are essential for the smooth functioning of EMU and I would like to list three key reasons why.

-Firstly, structural reforms are necessary for achieving higher rates of potential growth in the euro area. This is paramount given the euro-area's sluggish recovery from the 2001-2002 slowdown. Structural reforms are also important in view of Europe's ageing population, which is likely to reduce potential growth to 1.3% between 2031 and 2050 – roughly half its current rate – unless policies change.

-Secondly, structural reforms can help to promote greater flexibility in product, capital and labour markets in the face of economic shocks. The first seven years of EMU suggest that some Member States have been slow to adjust in this regard, leading to persistent cross-country growth and inflation differences in the euro area.

-Thirdly, structural reforms are essential for safeguarding Europe's highly valued social models. Europeans are rightly proud of their social models which have achieved notable successes in reducing income inequality and poverty and securing universal access to primary and lower secondary education, basic health-care systems, and adequate incomes in retirement. To secure these benefits for current and future generations, structural reforms are essential. There is, for example, an urgent need to raise the participation rate so that all people that are able to work would have jobs. Moreover, we have to prepare for the increased budgetary costs associated with Europe's ageing populations.

There is a growing consensus among economists that EU Member States have actually implemented a number of structural reforms in recent years which are beginning to bear fruit. For example, the partial progress achieved in liberalising gas, electricity and water utilities has contributed to downward pressure on prices. In addition, these reforms have contributed to an impressive increase in labour productivity in these sectors. In the labour market, the benefits of reforms to tighten the eligibility criteria for early retirement are also beginning to materialize. The participation rate of older workers has increased considerably in recent years in a number of Member States.

In spite of this progress, the pace of structural reforms needs to be stepped up to further improve the functioning of European markets. Recognition of this fact was central to the re-launch of the Lisbon Strategy by EU leaders in March 2005. The EU's new-look reform agenda identifies a range of priorities for achieving higher growth and jobs in Europe. It has also invited the individual Member States to draw up National Reform Programmes for growth and jobs with a view to promoting greater ownership over reform efforts at the MemberState level.

5.Lessons from EMU

I now come to the final part of my speech, in which I will draw some lessons from the experience with EMU:

-Monetary integration and economic integration should be seen in relation to each other.Europe adopted a monetary union when it was recognised that the full benefits of free movement of goods, services, people and capital would not be realised without eliminating the exchange-rate uncertainty and transaction costs of different currencies.